ECO 610-401Monday, December 1st

– Organizational Design: Centralized vs. Decentralized

– Readings, Brickley et al., 11-13

Monday, December 8th

– Performance Measures• Readings, Brickley et al., 16

– Extended Assignment 3 due

Exam Distribution

Organizational Architecture

Any complex firm or organization must address:• The assignment of decision rights within the firm• The method of rewarding individuals• The structure of systems to evaluate the

performance of both individuals and business units.

The Fundamental Problem

• Produce output customers want at the lowest cost• The answer to this challenge is complicated by:

– Information held by different parties– Information is expensive to transfer (specific

rather than general)– Asymmetric information (workers and

supervisors don’t have the same information – principal agent problem)

– Incentive Problems

The Market Solution

• With Markets individuals have property rights• Prices:

– Are a signal– Give incentives– Promote economic efficiency

• Decisions tend to be made by individuals with specific knowledge

Architecture within the Firm

• No Automatic Systems for:– Assigning decision rights to individuals with

information– Motivating individuals with information to use

them to promote a firm’s objectives• Decision Rights:

– Most firms by Administrative Decision rather than Prices

– Grant authority to have control of firm resources by employees not owners

• Since employees are not owners, have fewer incentives to use resources efficiently.

Architecture within the Firm (2)

• Controls– Necessary to control incentive problems– Consist of:

• Reward and performance evaluation

• Tradeoffs– In larger firms, CEO can’t know and do all

• IF CEO makes decisions will lack information• If CEO tries to get information, will be costly• If CEO delegates decisions to those with information,

incentive problems arise

The Determinants of Architecture

Vertical Integration and the Make or Buy Decision

• What determines when a firm should make (vertically integrate) or buy (outsource)?

• Examined in the simple transfer pricing framework, now add some other considerations

Make or Buy Continuum

Make or Buy Fallacies

1. Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for the firm

2. Firms should buy, rather than make, to avoid the costs of making the product.

3. Firms should make, rather than buy, to avoid paying a profit margin to independent firms.

4. Firms should make, rather buy, because a vertically integrated producer will be able to avoid paying higher market prices for the input during periods of peak demand or scarce supply.

5. Firms should make to tie up a distribution channel. They will gain at the expense of rivals.

Benefits and Costs of Using the Market

Benefits• Market firms can achieve economies of scale that in-house

departments cannot.• Market firms are subject to the discipline of the market and

must be efficient and innovate to survive. Overall corporate success may hide the inefficiencies and lack o innovation of in-house markets.

Costs• Coordination of production flows through the vertical chain

may be compromised when activity is purchased from outside vendor.

• Private information may be leaked.• There may be costs of transacting with independent market

firms that can be avoided by performing the activity in-house.

An Example: Rustic Homes

Rustic Log Cabin (2)

• Cabin cost $10,000 each• Costs include

– Labor ($4,000)– Lumber

• $7,000• $5,000• $3,000

– 100 confirmed orders

Rustic Log Cabin (3)

• Rustic Cabin is considering 2 options:– Buy lumber from mill– Purchase forest land and mill for annual bank

payment of $350,000 ($3,500 per cabin)• Cost of milling is $1,500• Effective cost of lumber is $5,000 per cabin

• Other Options?

Rustic Log Cabin (4)

Reasons to “Buy”

• Exploiting Scale and Learning Economies• Agency Costs

– “Cost” Centers • do not face market pressures• difficult to measure performance

• Influence Costs– Scarce capital and resources in a firm are bid

by competing divisions• Lobbying is a waste of resources• Inappropriate allocations as a result

Reasons to Make

• Reasons to make are associated with the costs associated with writing and enforcing contracts

• Complete versus Incomplete Contracts– Complete contract eliminates opportunistic

behavior– Requires knowledge and agreement on all

contingencies– Requires enforcement by outside party

• The problems arise with contracts because of– Bounded rationality– Difficulties specifying or measuring performance– Asymmetric Information

Reasons to Make (2)

• Leakage of Private Information• Transaction Costs• Relation-Specific Assets

– Value of assets depends on the relationship – value of assets diminishes if relationship is severed.

– Types of Asset Specificity:• Size Specificity• Physical Asset• Dedicated Assets• Human Asset Specificity

The Fundamental Transformation

• Need to create relation-specific assets transforms relationships as the transaction unfolds.– Before the transactions, firms can choose the

most profitable partnership– After the transaction they will have few

alternatives.

Rents and Quasi-Rents

• Example: Cup Holders for Ford Taurus• 1,000,000 holders with average variable cost of C

per unit• Factory is constructed with loan with interest of I

per year.• TC = I + 1,000,000C• Expect Ford to buy. If not sell to “jobbers” to

resell at price of Pm giving revenue of 1,000,000Pm

Rents and Quasi-Rents (2)

• Suppose Pm > C then ignoring I, profit is 1,000,000(Pm-C) but

• I > 1,000,000(Pm-C) then• I - 1,000,000(Pm-C) represents relation-specific

investment (RSI)– Amount of investment firm cannot recover if it

doesn’t do business with Ford• If I = $8,500,00, C = 3, and Pm = 4 then RSI =

8,500,000 – 1,000,000(4-3) = 7,500,000• Suppose Ford will pay P* > Pm

• Rent is 1,000,000(P*-C) – I, profit you expect

Rents and Quasi-Rents (3)

• Quasi-Rent– Suppose the deal with Ford falls through

– I is a sunk cost and sell to Jobbers if PM > C

– Quasi-Rent = [1,000,000(P*-C)-I] - [1,000,000(PM-C)-I] = 1,000,000(P*-PM)

• Extra profit if deal goes through

The Hold-Up Problem

• If Quasi-Rent is large, firm has a lot to lose in second-best alternative.

• This gives the possibility of hold-up through renegotiation when contractions are incomplete

• Example: P* = 12, PM = 4, C = 3, I = 8,500,000

• At P*=12, Rent is 500,000 per year• Quasi-Rent is (12-4)1,000,000 = 8,000,000• If Ford renegotiates down to $8, it increases its

profits by $4,000,000• You lose (8-3)1,000,000-8,500,000=-3,500,000