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ECONOMICS 3200BLecture 3

Ch. 2

September 24, 2013

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Existence of Firms

Options

• Markets and firms alternative means for completing related sets of transactions

• Short-term contracts – costs, uncertainty re. supply

• Long-term contracts – opportunistic behavior

• Ownership/control – internalization

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Existence of Firms

Transactions costs:

• Costs in using markets– Search costs – suppliers, prices

– Negotiating, writing, monitoring and enforcing contracts

• Classical firm as nexus of contracts – hub/spoke

• Duration of contracts and increasing complexity– Uncertainty re. future states

– Increasing number of contingencies – increasing complexity

– Incomplete contracts – trade-offs between more complex contracts/higher costs and simpler, incomplete contracts

– Opportunistic behavior – incentives to breach contracts

• Proprietary rights to information – investment ideas, market demands, product design, service innovations, etc.– Value depends on package of rights and other factors – cannot contract for

all factors

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Existence of Firms

• Internalization (insourcing)– avoid using marketplace by ownership of inputs, expansion of value-added activities conducted within firm– Bargaining power vis a vis market – credible threat to shift

production

– Inefficiencies as firm becomes larger• Control problems associated with bounded rationality (limits to

information any person can absorb and massage); weak incentives (difficulty in measuring direct contributions of individuals or divisions to overall financial performance of company); distortion as information (decisions) pass through more levels within organization

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Existence of Firms

Internalization• Vertical integration, horizontal diversification

• Reduce transactions costs

• Economies of scale, scope

• Transferability of source of competitive advantage (design, marketing, costs, superior management, reputation)

• Proprietary information

• Tax advantages – transfer pricing

• Quality control – minimize liability risks; Boeing and 787

• Entry deterrence – BCE, Rogers and MLSE; BCE and Astral; Airlines

and slots • Circumvent rate of return regulations

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Existence of Firms

Disadvantages of Internalization• Diseconomies of scale – outsourcing

• Internal transfer prices and corporate politics

• 3rd party opportunities for internal divisions – economies of scale, creating opportunity for competition

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Existence of Firms

• Advantages of engaging in market transactions – outsourcing (near-sourcing) a new term for an old idea, namely, using the market to acquire inputs or sell outputs– Specialization/focus for firm

– Market prices serve as reference points for internal transfer pricing

– Economies of scale – ability to serve 3rd party customers

– Link between performance/rewards

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Existence of Firms

Optimal size of firm• MC of internalizing vs. MC of external transactions

• Diseconomies of scale vs. economies of scale/scope

• Technological change (communications, transportation, organization)

• Optimal size differs across industries, time, location (country-specific characteristics)

• Costs – e.g. transportation costs; reputation

• Optimal size different question than why do firms grow

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Typology of Costs

Variable costs, fixed costs• Time dimension• Fixed costs

– Independent of output– May be fully or partially recoverable if firm exits

• Variable costs– Vary with rate of production

• Demand variability and ratio of fixed to variable costs– Cyclical industries

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Typology of Costs

Fixed costs, sunk costs• Distinction between sunk and fixed costs: no market

value; no retrieval/scrap value

• Sunk costs– Not recoverable if firm exits or fails– Specialized equipment with zero scrap value – no alternative

uses– Specialized investment: wastewater treatment plant; specialized

dies/molds; advertising campaign; advisory fees (investment banking services for raising capital or acquisition/divestiture)

– Ex post, sunk costs do not impact pricing or other strategic decisions

– By-gones are by-gones – historical costs not important for decision-making; what matters are actual current market values

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Typology of Costs

• Ex ante vs. ex post costs of investment – prior to making an investment, must consider the size of the investment (the actual current cost of physical capital to be acquired or the R&D or marketing budget); following approval of the investment, only the opportunity cost of the actual current market value of the investment matters in the decision-making process

• Pricing of hotel rooms, seats on planes, rental cars, cloud computing – inventory committed so fixed costs become sunk costs if inventory not used/sold (investment in an empty hotel room or an empty seat on a flight or server capacity is not recoverable)

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Typology of Costs

Opportunity costs– Consider in decision-making re. investment strategies– Investing in new equipment: cost of capital –

opportunity cost of capital, e.g. equity• Cost of equity: expected return on next best investment

opportunity with comparable risk profile, i.e. bankruptcy risk

• Equity a higher cost source of capital than debt even though there are no fixed interest payments

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Typology of Costs

Opportunity costs

– Fully depreciated real estate, capital equipment: opportunity cost is return on selling these assets and investing the market price proceeds; even if fully depreciated, market value of assets should be factored into investment/strategic decisions of company

– Non-performing loans – market for non-performing loans priced at discount to face value

• Non-performing loans should be written down to prevailing market price – loans generally marked to market

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Typology of Costs

Marginal, average variable, average fixed and average total costs

– Marginal costs: change in total costs (variable costs) resulting from increased production/distribution of one unit

– Average variable costs: total variable costs divided by total number of units produced

– Average fixed costs: total fixed costs divided by total number of units produced

– Average total costs: sum of average variable costs and average fixed costs

• Shut-down point – if negative cash flows with AVC < P < ATC, will creditors provide additional financing?

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Cost Minimization

• Value-added chain scope for company• What should a company do?

– Core competencies, basis for competitive advantage critical as is organization structure, diseconomies of scale and importance of control over proprietary information or distribution

• Boundaries for a firm: what should it buy in marketplace, where should it come in contact with marketplace, internalizing vs. outsourcing?

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Costs

• Determinants of total costs– Input prices; quantities of each input; value

chain activities; transportation costs; distribution costs

– Trade-offs between economies of scale and transportation costs

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Costs

• Input prices– Location of the company

– Location of the sources of inputs– Exchange rates

• Hedging

– Transportation costs

– Tax and tariff rates

– Bargaining power

– Quality of the inputs

– External (outsourcing) vs. internal (insourcing) transactions

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Costs

• Quantities of each input – Technology

– Organization structure – X inefficiency

– Economies of scale – external, internal

– Learning curves

– Quality of inputs

– Relative prices

– Production rates – peak load, smoothing and inventories, overtime

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Cost Minimization

• Minimize costs – unit costs (average total costs), marginal costs, fixed costs, total costs

– Minimizing unit costs may require operating at or near capacity – optimal capacity level

– Different technologies for different levels of capacity – flexibility, different cost structures

– Economies/diseconomies of scale – level of demand– Economies of scope– Rate of production

• Time frame for minimizing costs – adjustment opportunities, competitive disadvantages for slow adjustment, behavior of competitors, adjustment costs

• Can any company afford not to focus on minimizing costs?

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Cost Minimization

• Decisions facing companies:– Production technologies: flexibility for production,

substitutability among inputs, knowledge about alternative technologies, vintage of technologies, optimal level of capacity, skills to accommodate different technologies (training)

– Does company use different production technologies in different countries?

– Location: exchange rates and costs, tax rates, subsidies, input prices, transportation costs

– Organization structure – HR policies• Rate of expansion, pricing: first mover advantages

(economies of scale, learning curves); first mover disadvantages (selecting inferior technologies, wrong set of value chain activities)

– Investment in capacity in anticipation of increased sales volume, e.g. new production equipment imbedding latest technologies

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Cost Minimization

• Inputs: labor, capital, other inputs, components, services– Availability, prices, trade-offs – some inputs available at lower

prices in some locations, while others available at lower prices in other locations (location decisions)

– Optimal combination of inputs depend upon relative prices, technologies, activities of company (where is the company located in the value-added chain, degree of vertical integration)

– Organization structure – mechanism for controlling production and other value added chain activities

• Outsourcing vs. insourcing

– Incentives to maximize effort, minimize waste and defects – hierarchical and control structure, internal rewards/penalties, reputation (invisible handshake/implicit contract)

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Cost Minimization

• Human resources (cost cutting through layoffs and wage concessions)

– Labor costs and availability of skills – training costs, commitment to work, effort

– Productivity enhancing innovations recognized by employees• Loyalty and effort – work generates negative utility/welfare for

individuals (people work for the income that affords them the opportunities to buy desired goods/services)

– Incentives for encouraging loyalty and effort• Rewards (bonus, promotions, recognition)• Invisible handshake (commitment by employers to maintain

employment levels, offer training and upgrading of skills, and continually offer promotion opportunities)

• Golden handcuffs – job ladders and seniority, vesting in pensions, economic rents (above market compensation)

• Penalties (firing)• Job uncertainty, reneging on invisible handshake – impacts on

motivation, effort (longer-term cost implications)

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Cost Minimization

• Location decision– Transportation costs – inputs, outputs– Labor costs, availability of labor skills– Costs and availability of variety of qualities of other inputs – Property taxes, business taxes– Personal taxes impact location decisions because executives

concerned with after-tax income – agency problem– Exchange rates – currency risks– Access to specialized resources – capital equipment

manufacturers, research facilities, subcontractors (including advertising, finance)

– Regulations: environment, health and safety, product liability, employment standards, etc.

– Legal system: rent seeking, bribes

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Costs

• Minimum efficient scale – relation to size of market influences number of potential competitors

• Economies of scope

• C(Q10) + C(Q20) > C(Q10, Q20)– Cost advantages of producing more than one product (joint production)

rather than specialization in single product

– Complementarities in production, marketing, distribution, research

• Search and transactions costs – impact of Internet

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Efficiency

• Production efficiency– Minimize costs of production

– With given state of technology (origins?) and factor prices, optimal combination of factors of production and optimal organization structure to minimize shirking

– X-inefficiency

– Agency problem and alignment of of interests – corporate jets vs. flying on commercial airlines

• Allocative efficiency– Optimal allocation of scarce resources among products produced in

economy

– Prices reflect social value of inputs at margin

– Pareto efficient allocation – unable to reallocate factors so as to improve one person’s welfare without reducing another’s

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Efficiency

• Dynamic efficiency– Productivity growth and improvements in real standards of living

– Rate of innovation and rate of diffusion of innovation

– Lower production costs because of reduced resource use (higher productivity), higher quality products, new products more highly value by consumers

– Market structure required to maximize dynamic efficiency?