Econ 140 chapter 6

Specialized Investments involve higher transaction costs because of the following reasons:

1. Cost Bargaining 2. Underinvestment 3. Opportunism and Hold up problem

Vertical Integration Disadvantages

1. Managers must create an internal regulatory mechanism. 2. Bear the cost of setting up production facilities. 3. No longer specialized in producing its output.

Types of Specialized Investments

1. Site specificity 2. Physical-asset Specificity 3. Dedicated Assets 4. Human capital

Vertical Integration (Use when inputs require)

1. a substantial specialized investment. 2. generate significant transaction cost. 3. complex contracting or uncertain economic environments.

Costly Bargaining

: The two parties in the relationship-specific exchange bargain with each other over the price of the input. The bargaining process is generally costly, as each party tries to get a more favorable price.

Incentive Contract

A way to align owners' interests with that of the actions of its manager. Prevent Principal Agent Problem

Relationship-Specific Exchange

An exchange which involves a specialized investment because of which the parties are 'tied together' is called relationship-specific exchange.

Dedicated Assets

An investment in plant and equipment made to satisfy a particular buyer represents a dedicated asset. Without the promise of that particular buyer's business, the investment would not be profitable. Example - A port may have dedicated facilities to serve the specific needs of import and/or export customers. It may require long-term contracts from its customers before making such multimillion dollar investments.

The large-scale firm

Due to the economies of scale, average costs decline at higher levels of output. This explains (partially) the large firm size.

Contracts - Alternative

Given the problems mentioned about spot exchange, an alternative is to procure an input under a properly structured contract. Advantages: A contract specifies prices of the input before the parties get involved in specialized investments. *Avoids underinvestment* Requires decision on optimal contract length.

The division of a large office services company that makes high-end copiers recently signed a five-year, $25 million contract for IT services from CGI Group, a Canadian information technology company. If you were the manager of the division, how would you justify the long-term nature of your contract with CGI Group?

High-end copiers require large specialized investments, which increases the marginal benefit of contract length. correct

Site Specificity

The buyer and seller of an input must locate next to each other. This can reduce the transportation cost or inventory cost. Example - Traditional Steel Manufacturing - Side -by-side location of blast furnaces, steelmaking furnaces, casting units and mills saves fuel costs.

Opportunism and Hold Up Problem

When a specialized investment must be made to acquire an input, the buyer or seller may attempt to capitalize on the "sunk" nature of the investment by engaging in opportunism, and cause the hold-up problem. The car firm might think that it might become too dependent on that supplier for a vital input. Because specialized equipment is required to produce the fuel injection systems, the car firm cannot easily switch its orders to other suppliers who lack that equipment. Thus, the dependency may create opportunism problems (and hence high transaction costs) for the car firm.

Human Capital

When a worker has acquired skills, know-how, and information that are more valuable inside a particular relationship than outside it.

Optimal Input Procurement

When inputs require substantial specialized investments, spot exchange will generally result in high transactions costs due to opportunism, bargaining costs and underinvestment.

Physical-Asset Specificity

When the capital equipment needed to produce an input (or simply an asset) is tailored to meet the needs of a specific buyer, and cannot be easily used to produce inputs needed by other buyers.

If the car manufacturer asks an independent supplier to provide this specialized asset, then mutual dependency is created. They are in a ?

relationship-specific exchange, and are 'tied together'.

The owner-managed firm

run by a sole proprietor who was both owner and manager. As sole owner, the proprietor claimed all profits (and paid all losses) from the business He/she had a strong incentive to take optimal actions because ultimate profit depended on it.

Vertical Integration Advantages

1. "Skips the middleman." 2. Reduces opportunism. 3. Mitigates transaction costs.

Principal-Agent Problem

Problem arising when agents (example, a firm's managers) pursue their own goals rather than the goals of principals (example, the firm's owners).

Solutions to the Manager-Worker Problem

Profit sharing. Revenue sharing. Piece rates. Time clocks and spot checks.

A car manufacturer has developed a new high-performance and uniquely designed fuel injection system. This will increase fuel efficiency and help sell more cars. Manufacturing this uniquely designed system requires investments in a machine that can be used only for this purpose. The machine cannot be used to make fuel injection systems for any other automaker. Thus, investment in this machine constitutes a?

Relationship-Specific Exchange

Outside forces can provide managers with the incentive to maximize profits, and include:

Reputation. Takeover threat.

HomeGrown is a small restaurant that specializes in serving local fruits, vegetables and meats. The company has chosen to enter into a long-term relationship with Family Farms, a local farming operation. The two parties have decided to enter into a long-term contract where Family Farms will supply produce to HomeGrown at specified prices and volume each year. Before signing a contract, HomeGrown is trying to decide how long the contract should be. It estimates that each year the contract covers saves the restaurant $1,400 in bargaining and opportunism costs. However, each year the contract covers also requires more legal fees. HomeGrown estimates that the number of hours it will need from lawyers, L, has a quadratic relationship with the number of years on the contract so that L = Y2 where Y is the number of years for the contract. If HomeGrown's lawyers charge $180 per hour, how long should the contract be?

The marginal benefit for each year of the contract is $1,400 as stated in the problem. The total cost of Y years is $180×L = $180×Y2. This means the marginal cost of Y years is $360×Y. Setting marginal benefit equal to marginal cost gives us Y = 3.9.

Underinvestment

The specialized investment may be lower than optimal. For example, if a seller of a specialized machine is not able to sell to the buyer it was made for, then the seller cannot use it anywhere else. The seller has the incentive to produce a cheaper machine.

Transaction Costs

These include the cost of searching a seller of input, negotiating a price at which the input will be purchased, and other expenditures required to facilitate exchange.

Jiffyburger, a fast-food outlet, sells approximately 8000 quarter-pound hamburgers in a given week. To meet that demand, Jiffyburger needs 2000 pounds of ground beef delivered to its premises every Monday morning by 8 am sharp. As the manager of Jiffyburger, what problems would you anticipate if you acquired ground beef using spot exchange?

This is a dedicated asset (specialized investment) - delivering one ton of meat to a particular store. Jiffyburger can face 'hold-up' problem, as the meat supplier may try to ask for a higher price at 8 am. Jiffyburger will be stuck and will find it hard to find another meat supplier on such short notice. Or the meat supplier may supply low quality meat. Thus spot exchange can involve problems like opportunism, bargaining and underinvestment. Managers then must consider alternatives to spot exchange.

specialized investment

an investment in a particular exchange that cannot be recovered in another trading relationship