Managerial Economics & Business

Strategy

The Organization of the Firm

Overview
I. Methods of Procuring Inputs

Spot Exchange
Contracts
Vertical Integration

II. Transaction Costs

Specialized Investments

III. Optimal Procurement Input

Firms and Markets

Adam Smiths pin factory

Team production yields

more than the sum of
individual productions

Firms and Markets

Adam Smiths pin factory

factory firm
Factory:
- a physical thing
where people meet
for team production

Firm:
- a legal structure
that provides the
organizational basis
for team production

What determines the

boundaries of the firm?

Ronald Coase #1: The Nature of

the Firm (1937)
employing the price
mechanism to allocate
resources is costly
Market:
Firm:
- resource allocation
- resource allocation
through price
by authoritative
mechanism
direction

Why Do Firms Exist?

Some transactions are co-ordinated by
markets
Some transactions take place inside
firms
The firm is the supersession of the
market mechanism
The firm is that set of transactions which
is co-ordinated by managerial authority
instead of the market
Why does this happen?

Transactions inside a firm

Factor
Market
Factor of
Production

Product
Market
Product

FIRM
Entrepreneur

Consumers

(Goods &
Services)
e.g. a shirt

Cloth

Designer
Cutter
Sewer

Product

Firms Choice: Firms Costs and Production

Decision

A firm chooses:

What quantity of the good to produce,

The price of the good (sometimes...).

Firms decision depends on:

Costs of production.
The degree of competition in the market (if there
are more sellers, more competitive).

Firms Choice: Firms Costs and Production

Decision

Firms Objective

The goal of a firm is to maximize profits.

Total Revenue, Total Cost, and Profit

Profit is the firms total revenue minus its total

cost.

Profit = Total Revenue - Total Cost

Total Revenue, Total Cost, and Profit

Total Revenue

The amount a firm receives for the sale of its

output. For a competitive firm, TR = P x Q

Total Cost

The market value of the inputs a firm uses in

production.

PRODUCTION AND COSTS

The Production Function

The production function shows the relationship

between quantity of inputs (Ex: number of
workers) used to make a good and the quantity of
output of that good.

Excel illustration

comp_firm

firm

FIRM structure

Supply-Chain Management

Management of integrated activities that

Involves everyone in the supply-chain.

11-16

procure materials,
transform them into final products, and
deliver them to customers.

Example: Your suppliers supplier.

The Supply-Chain
VISA

Credit Flow

Material Flow

Supplier
Supplier

Manufacturing

Supplier

Retailer

Wholesaler
Schedules

11-17

Consumer

Order
Flow

Retailer
Cash
Flow

Walmart supply chain

https://www.youtube.com/watch?
v=cVOV7GV8wGY

Supply-Chain Strategies
How

best to work with upstream

suppliers and downstream distributors
and customers.

To manage procurement, transportation,

inventory, warehousing, distribution, etc.

Outsourcing:

Logistics activities (transportation, delivery,

inventory, etc.).
Information systems.
Accounting and payroll.

Vertical integration.

11-19

Make/Buy Considerations

Reasons for Making

Lower cost to produce.

Unsuitable suppliers.

Reasons for Buying

Poor quality.
Price too high.
Item not available.

Utilize surplus labor.

Protect proprietary
design.
Increase/maintain size
of company.
11-20

Lower cost to buy.

Preserve supplier
commitment.
Obtain technical or
management ability.
Inadequate capacity.
Item is protected by
patent or trade secret.
Frees management to
deal with its primary
business.

6-21

Methods of Procuring Inputs

Spot Exchange

Contracts

When the buyer and seller of an input meet,

exchange, and then go their separate ways.
A legal document that creates an extended
relationship between a buyer and a seller.

Vertical Integration

When a firm shuns other suppliers and chooses

to produce an input internally.

Key Features

Spot Exchange

Contracting

Specialization, avoids contracting costs, avoids

costs of vertical integration.
Possible hold-up problem.
Specialization, reduces opportunism, avoids
skimping on specialized investments.
Costly in complex environments.

Vertical Integration

Reduces opportunism, avoids contracting costs.

Lost specialization and may increase
organizational costs.

6-22

Transactions Costs

A transaction takes place when a good or a service is

transferred from one party to another
Direct costs arise in respect of:

locating buyers and sellers

acquiring information about their availability, quality,
reliability and prices
negotiating, re-negotiating and concluding contracts
co-ordinating the agreed actions of the parties
monitoring performance with respect to fulfilment of contracts
taking action to correct any failure to perform

Opportunity costs arise in respect of:

inefficiencies if inappropriate equipment used

failure to adapt to changing conditions
23

Transaction
Transaction costs
costs include:
include:
information
information and
and measurement
measurement costs
costs
negotiation
negotiation costs
costs
contracting
contracting costs
costs (ink
(ink costs,
costs, legal
legal costs)
costs)
monitoring
monitoring and
and enforcing
enforcing costs,
costs, etc.
etc.

24

The Characteristics of a contract

the extent to which complete contracts are

possible note that the term contract here
refers to any agreement between parties,
not just those which are formally written
down
the extent to which there is a threat of
opportunism on the part of transactors
the degree of asset-specificity or
idiosyncratic investment involved in a
transaction
the frequency with which the transaction is
repeated

25

Contracts are Never Complete

Uncertainty/complexity
Bounded rationality
Asymmetric information

hidden information
leads

to adverse selection

hidden action
leads

to moral hazard

26

Incomplete Contracts Are Not

a Problem in Themselves

Parties to the contract could agree to treat each

other fair and square if something unexpected
happens
The problem arises because human beings are
opportunistic
self-interested behaviour with guile
cheating
Before the contract is made
strategic misrepresentation - it will cost me
much more to do that !
After the contract is made
reneging - I wont do what I promised
hold up - Pay me more or I wont do27it

Incomplete Contracts And Opportunism

Are Still Not The Problem

If one party cheats, the other party can simply take their
business elsewhere
A third condition is required before arms length
transactions between independent parties become too
expensive
IDIOSYNCRATIC INVESTMENT
or
ASSET SPECIFICITY
Investment in assets which lose their value if the
transaction does not take place with a specific partner
When there is asset-specificity the parties cannot take
their business elsewhere - there is the small numbers
problem
28

2.2. Transaction costs

The Transaction costs theory is based on the idea that
contracts are incomplete so that coordination and
motivation costs arise that can be reduced by completing
transactions inside an organization.
- Coordination costs: before signing the contract
- Motivation costs: after signing the contract

2.1. Asset specificity

Definition: an asset is specific if it is much more valuable
in a given transaction than in the best alternative available.
In the presence of specific assets, the terms of a transaction
are determined by bilateral bargaining, (fundamental
transformation, Williamson 1985).
For example, the producer of aluminum realizes a
specific investment when designing its plant so as to use a
certain type of bauxite.

2.1. Asset specificity

Different types of specificity.

1. Site specificity. This refers to assets that are located side-by-side to

save on production, transportation or inventory costs. Examples:
steel production, oil.
2. Physical asset specificity. This refers to assets with physical
characteristics that are designed for a specific transaction.
Examples: mold, perfumes.
3. Dedicated asset. It corresponds to an investment in plants and
equipment that are completed in order to satisfy the demand of a
particular client. Example: car manufacturer.
4. Specific human capital.

2.2. Quasi-rents

Definition: the rent associated to an input is the difference between

the revenues obtained by the owner of the input and the minimum
revenue necessary to make sure that he will supply the input.
Definition: the quasi-rent is the difference between the rent
associated to a specific transaction and the rent obtained in the best
alternative available.

2.3. The holdup problem

The holdup problem appears when a party that does not invest in a
specific asset behaves opportunistically modifying the terms of the
transaction.
The holdup problem is based on the following two deviations of
the neoclassical model.
1. Asset specificity (imperfect competition).
2. Incomplete contracts (agents are boundedly rational).

2.4. Transaction costs and the holdup problem

There exist 4 cases in which the holdup problem

increases transaction costs:

1.

Negotiations and renegotiations of the contract

2.

Investments to improve the bargaining position

3.

Distrust

4.

Reduction in investment

Sap procurement

https://www.youtube.com/watch?
v=Dbqh2Y8bqkg

Negotiation Strategies
Cost-based

price model.

Supplier opens its books to purchaser.

Price based on fixed cost plus escalation clause
for materials and labor.

Market-based

Price based on published price or index.

Competitive

11-36

price model.

bidding.

Potential suppliers bid for contract.

2.4. Vertical integration as a solution to

the holdup problem

Definition: vertical integration consists in the control by

a single entity of successive steps of the production or
distribution process of a product or service.

1.

Differences in government.
The role of hierarchy and corporate culture to manage conflicts.

2.

Repeated relationship.

6-38

Specialized Investments
Investments made to allow two parties to
exchange but has little or no value outside
of the exchange relationship.
Types of specialized investments:

Site specificity.
Physical-asset specificity.
Dedicated assets.
Human capital.

Lead to higher transaction costs

Costly bargaining.
Underinvestment.
Opportunism and the hold-up problem.

Vertical
Integration

Produce a good or service previously

purchased.

Forward (towards customers) or backwards

(towards supplier.).
Develop the capability independently or buy a
firm.

Advantages:

May be less expensive than buying.

Provides more control.

Disadvantages:

11-39

Can be expensive.
Hard to do all things well.

6-40

The Principal-Agent Problem

Occurs when the principal cannot observe

the effort of the agent.

Example: Shareholders (principal) cannot observe the

effort of the manager (agent).
Example: Manager (principal) cannot observe the effort of
workers (agents).

The Problem: Principal cannot determine

whether a bad outcome was the result of
the agents low effort or due to bad luck.
Managers must recognize the existence of
the principal-agent problem and devise
plans to align the interests of workers with
that of the firm.
Shareholders must create plans to align the
interest of the manager with those of the
shareholders.

You tube video

https://www.youtube.com/watch?
v=ydh_TXrkj54

6-42

Solving the Problem Between Owners

and
Internal
incentives
Managers

Incentive contracts.
Stock options, year-end bonuses.

External incentives

Personal reputation.
Potential for takeover.

6-43

Solving the Problem Between

Managers
Profit sharing
and Workers

Revenue sharing
Piece rates
Time clocks and spot checks

Forms of Vertical Integration

Iron Ore

Silicon

Backward
Integration

Steel

11-44

Raw Materials

Automobiles

Integrated
Circuits

Distribution
System

Circuit Boards

Dealers

Computers
Watches
Calculators

Current
Transformation
Forward
Integration

Finished Goods

Arguments Against Vertical Integration

Cost disadvantages

Rapid technological change

Tying a company to an obsolescent technology

Demand unpredictability

Company-owned suppliers that have higher costs

than external suppliers

Difficulty of achieving close coordination among

vertically integrated activities

Bureaucratic costs

Copyright Houghton Mifflin Company. All

rights reserved.

9 - 45

Alternatives to Vertical Integration:

Cooperative Relationships
Short-term

contracts and competitive

bidding
Strategic alliances and long-term
contracting
Building long-term cooperative
relationships

Hostage taking
Credible commitments
Maintaining market discipline

Parallel sourcing policy

Copyright Houghton Mifflin Company. All
rights reserved.

9 - 46

Strategic Outsourcing of Primary Value

Creation Functions

Copyright Houghton Mifflin Company. All

rights reserved.

9 - 47

Benefits of Outsourcing

Reducing costs

Differentiation

The specialist company is less than what it

would cost to perform the activity internally
The quality of the activity performed by the
specialist is greater than if the activity were
performed by the company

Focus

Distractions are removed; the company can

focus attention and resources on activities
important for value creation and competitive
advantage
Copyright Houghton Mifflin Company. All
rights reserved.

9 - 48

Identifying and Managing the Risks of

Outsourcing

Holdup

Scheduling of activities

The company can become too dependent on the

provider of the outsourced activity so that the
provider can raise prices
Loss of control can result in distorted signals in the
supply chain

Loss of information

Contact with the customer may be lost

Copyright Houghton Mifflin Company. All

rights reserved.

9 - 49

Purchasing & Acquisition

Acquisition of goods & services.

Activities:

11-50

Decide whether to make or buy.

Identify sources of supply.

Select suppliers & negotiate contracts.

Control vendor performance.

Importance:

Major cost center.

Affects quality of final product.

Purchasing Costs as a Percent of Sales

Industry

11-51

All industry
Automobile
Food
Lumber
Paper
Petroleum
Transportation

Percent of Sales

52%

61%

60%

61%

55%

74%

63%

Vendor Selection Steps

Vendor evaluation.

Identifying & selecting potential vendors.

Vendor development.

Integrating buyer & supplier.

11-52

Example: Electronic data exchange.

Negotiations.

Results in contract.

Specifies period of agreement, price, delivery

terms, etc.

Vendor Selection Criteria

11-53

Company
criteria

Service criteria

Delivery on time.

Financial stability.

Condition on arrival.

Management.

Technical support.

Location.

Training.

Product criteria

Quality.

Price.

Vendor Selection Rating Form

11-54

Dell Strategy Study

Expanding the operations frontier:

Dells revolution in the PC market
Dells competitive advantage: Provide customized

PC configurations, with short delivery times and

affordable prices.
Dells success in PC market:

Supporting Dells competitive advantage

through a new operational model

Focused on strategic partnerships: suppliers down from 200

to 47
Suppliers maintain nearby ship points; delivery time 15
minutes to 1 hour
Suppliers own inventory until used in production
Demand pull throughout value chain information for
inventory substitution
Demand forecasting is critical changes are shared
immediately within Dell and with supply base
Customers frequently steered to recommended
configurations with high availability to balance supply and
demand
External logistics supplier used to manage inbound supply
chain

PC SUPPLY CHAINS
Customer

Customer

Distribution
Channels

PUSH
Manufacturer

Suppliers

Typical PC Supply
Chain
(Compaq, HP, IBM,

Virtual Integration

PULL

PULL
Dell

Suppliers

PUSH

Dell Supply Chain

The CSFs underlying Dells

competitive advantage

Very high product (configurable) variety mass

customization!
Direct fulfillment - no intermediaries
No production launch until customer order
booked (pure pull!)
Very low finished goods inventory (costs) high
inventory turns (raw material inventory
influenced by recommended configurations)
High velocity material flows & fulfillment

Dell performance

Emerging factors and trends

enabling Dells strategy
The commoditization of the PC industry

Standardized and interchangeable components

Emergence of reliable manufacturing service providers

Recent advances in Supply Chain Management

Information Technology (IT) platforms that allow the

effective and efficient information exchange and
coordination across the entire supply chain
3rd party logistics service providers
Emerging emphasis on virtual rather than vertical
company integration

Vertical Integration
Vertical integration strategy considers how much to
extent a firm integrate activities of the industry
whole value chain.
Two Types of Integration:
- Backward integration
- Forward Integration

Disintegration
Outsourcing

62

McKinseys Value-Chain Analysis

The

value chain refers to the idea that a firm is a

chain of activities (steps) for transforming inputs into
outputs that customers value.

Technology Design ProductionDistribution Sales & Service

Marketing
Development

Dell vs. HP in early 2000s

Technology Design ProductionDistribution Sales & Service

Marketing
Development

Reseller

Three Drivers for Vertical Integration

<1> Resource & Capability Driver
- Based on resource based theory
<2> Power Driver
- Based on five-forces
<3> Transaction Cost Driver
- Based on transaction cost theory
65

(1) Resource Driver

A firm

prefers to internalize activities in which it has

VRI resources and/or capabilities.

Technology Design ProductionDistribution Sales & Service

Marketing
Development

(1) Resource Driver: Dell

Dell did not have VRI resources in each of the value

chain activities.

However, through developing Dell Direct model, Dell

eventually developed a capability to manage the
entire-value chain efficiently.

67

(2) Power Driver

A firm prefers integration to overcome its

disadvantaged-power position against its suppliers
and buyers

Key Factors:
(1) Market concentration (CR3) of buyers or
suppliers industry
(2) Importance of suppliers inputs, or Importance of
a firms industry products to the buyers industry
68

(2) Power Driver: Dell in early 2000s

By

selling its products directly to customers, Dell

mitigate the threat from buyers.

Technology Design ProductionDistribution Sales & Service

Marketing
Development

(3) Transaction Cost Driver

Williamson 1975: A firm prefers vertical integration when the market

transaction cost (cost of contracting) exceeds the cost of integration.

Sources of Transaction Costs

Specificity: Can you specify all potential future contingencies of transactions?

Potential opportunistic behaviors of your counterpart:

Can you 100% believe your counterpart?

e.g. Customization

70

(3) Transaction Cost Driver:

Dell in early 2000s

Dells

unique strength was in its build-to-order

(BTO) system and customization.

Technology Design ProductionDistribution Sales & Service

Marketing
Development

Dells Value-chain flow

HPs Value-chain flow

(3) Transaction Cost Driver: Dell

Dells unique strength was in its build-to-order

(BTO) system and customization. Despite BTO,
Dells lead time to shipping was is short.

For producing customized products, the transaction

cost tends to become higher. Dell mitigate this cost
by vertically integrating many activities.

72

Whats going on with Dell?

India

Technology Design ProductionDistribution Sales & Service

Marketing
Development

The primary drivers for achieving strategic fit

in Supply Chain Strategy
(adapted from Chopra & Meindl)

Corporate Strategy

Supply Chain Strategy

Efficiency

Facilities

Inventory

Responsiveness

Transportation

Information

Market
Segmentation

The role of Facilities

Facilities: The locations where inventory is

processed and transformed into another state (manufacturing) or

staged before being shipped to the next stage (warehousing)

In general, centralization boosts efficiency, while decentralization boosts responsiveness (but

not always)
Primary decisions:

Location

Capacity

Capital cost vs. responsiveness

Operations Methodology for Manufacturing Facilities

Proximity to the customer

Proximity to resources
Access to markets (ability to circumvent quotas and tariffs)
Infrastructure
Operational costs and tax incentives

Product vs. functional focus

Flexible vs. dedicated capacity

Warehousing methodology

SKU-based storage
Job lot storage
Cross-docking

The role of Inventory

Primary inventory components:

It exists because of the finiteness of the production and

transportation rates (Littles Law: I=TH*T)
Types of Inventory

Raw Material
Work In Process (WIP)
Finished Goods

Cycle Inventory: It is incurred in an effort to control the impact of

fixed ordering and set-up costs.
Safety Inventory: It is used to deal with the randomness in the
experienced demand; it is set so that it meets the supply chain to
meet some service level (i.e., control the probability that no stockout will be experienced at any replenishment cycle).
Seasonal Inventory: It is used to help the supply chain deal with
predictable variability in demand.
Opportunistic Inventory: Takes advantage of bargains.

Sourcing: Determine the set of suppliers / subcontractors to be

used, and develop the contracts that will govern the relationship.

The role of Transportation

Transportation: The SC element that moves product between

its different stages.
Primary decisions:

Mode(s) of Transportation

Air: fastest but most expensive

Truck: Relatively quick, inexpensive and very flexible mode

Rail: Inexpensive mode to be used for large quantities

Ship: Slowest but often the most economical choice for large overseas
shipments

Pipeline: Used (primarily) for oil and gas

Electronic transportation: for goods as music and movies

Route and Network Selection

Inhouse or Oursource to some 3PL provider

The role of Information

Information exchange is necessary for the most extensive

modes of coordination sought in contemporary supply chains. It
allows the supply chain to improve simultaneously its efficiency
and responsiveness.
Information-related decisions

Push vs. pull

Extent and modes of information sharing and coordination
Forecasting and Aggregate Planning schemes
Pricing and revenue management policies
Enabling Technologies:

Electronic Data Interchange (EDI): Enables paperless transactions,

primarily for backend operations of the SC.

The Internet and the WWW.

Enterprise Resource Planning (ERP): enables transactional tracking and

global visibility of information in the SC.

Supply Chain Management (SCM) software: decision support tools.

Thank u

Supplier Strategies
Negotiate

with many suppliers; play

one supplier against another.

Negotiated, sporadic small purchase orders.

Adversarial relationship with little openness.

Work

with few suppliers and develop

long-term partnering arrangements.

11-80

Exclusive long-term contracts with large orders

(and lower prices).
Long-term, stable relationship.

Vendor Selection Steps

Vendor evaluation.

Identifying & selecting potential vendors.

Vendor development.

Integrating buyer & supplier.

11-81

Example: Electronic data exchange.

Negotiations.

Results in contract.

Specifies period of agreement, price, delivery

terms, etc.

Vendor Selection Criteria

11-82

Company
criteria

Service criteria

Delivery on time.

Financial stability.

Condition on arrival.

Management.

Technical support.

Location.

Training.

Product criteria

Quality.

Price.

Vendor Selection Rating Form

11-83

Negotiation Strategies
Cost-based

price model.

Supplier opens its books to purchaser.

Price based on fixed cost plus escalation clause
for materials and labor.

Market-based

Price based on published price or index.

Competitive

11-84

price model.

bidding.

Potential suppliers bid for contract.

Logistics & Materials Management

All transportation and storage activities for

origin or to consumption.
Integrates:

11-85

Purchasing.
Inventory management.
Production control.
Inbound and outbound transportation.
Warehousing and stores.
Incoming quality control.

Review

Strategy & Competitive Advantage

Strategy refers to the

ideas, plans, and support that

firms use to compete
successfully against rivals.

Competitive advantage
comes from a firms ability
to perform activities more
distinctively or more
effectively than its rivals.

Distinctive
competencies unique

strengths that allow a

company to achieve superior
efficiency, quality, innovation,
or customer responsiveness.
Copyright Houghton Mifflin Company. All rights reserved.
9 - 86