The Economics of Business

The Economics of Business Class 5 Notes Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

Recap of Previous Episodes • What is the fundamental source of increased human productivity? • Why is this more fundamental than technology? Than natural resource endowment? • What factor did Coase argue led to the emergence of firms? • In what way did Alchian and Demsetz extend the explanation of the nature of the firm?2 • How did Demsetz later characterize firms in terms of contracts? Outline provided as a courtesy, incomplete without oral presentation

Recap, continued • How did Stigler explain the disintegration of vertically integrated firms? • How useful is simple “profit maximization” as a guide to decision-making under uncertainty? • What are the economic analogues to genetic heredity, mutations, and natural selection? • What can a nearsighted grasshopper teach us about optimization by trial-and-error? • What is the competence paradox? • What is meant by “routines as genes” ? Outline provided as a courtesy, incomplete without oral presentation

Recap, continued • What two forms of research and development provide firms in the Klepper model with competitive advantage? • What factor conditions demand for new products? • In Klepper’s model, which form of R&D eventually comes to dominate? • What six regularities are frequently observed throughout the product life cycle? • How do successive cohorts of new entrants typically compare with respect to product innovation skill? Outline provided as a courtesy, incomplete without oral presentation

Recap, continued • How does the relative level of investment in process versus product innovation typically change over the PLC? • What factors tend to decrease the real cost and hence price of the standard or dominant product? Outline provided as a courtesy, incomplete without oral presentation

Hirshleifer, Transfer Pricing Internal pricing, two intermediate goods, one finished good, sold into competitive market: Outline provided as a courtesy, incomplete without oral presentation

One Final Product Sold in Competitive Market, Two Intermediate Goods, Autonomously Derived Joint Profit Managers of B derive a net marginal revenue curve, present it to A who then maximizes “profit” at MCA = (P-MCB) = MRA Result is identical to the centrally determined transfer prices in preceding example Outline provided as a courtesy, incomplete without oral presentation

Imperfectly competitive output market Case a: Perfectly competitive input (intermediate) goods markets Outline provided as a courtesy, incomplete without oral presentation

Case b: Imperfect competition in final output andboth intermediate goods markets. Assume Division B is selling the final good and its own intermediate good Step 1. Determine (estimate) the demand and marginal revenue curves for the intermediate good A in the market. Outline provided as a courtesy, incomplete without oral presentation

Case b, Step 2 Step 2. Identify the demand curve, DF, and the associated marginal revenue curve, MRF, for the final (combined) good. Determine net marginal revenue curve, netMRB, for Division B when it is selling the final good by subtracting the marginal cost of B, MCB, from the marginal revenue of final good F. This provides the amount Division B has available to buy inputs from Division A. Outline provided as a courtesy, incomplete without oral presentation

Step 3 Step 3. Plot marginal revenue of intermediate good A, mrA, (from Step 1) and netMRB (from Step 2) plus their horizontal sum or total marginal revenue, MRT. This represents the marginal revenue available to intermediate good A from both internal and external customers. Next introduce the marginal cost curve for good A, MCA. Now we can establish the optimum output level of intermediate good A - enough for it to sell directly in the intermediate market and also meet the needs of B in the final goods market. Using the general rule of producing at the point where MC=MR, Division A should produce quantity Q’. The appropriate internal transfer price for intermediate A is p =OAp as indicated on the vertical axis. Outline provided as a courtesy, incomplete without oral presentation

Step 4 Step 4. The graphic from Step 2 is reproduced below. Division B then sets its output level at the point where intermediate good A’s transfer price or marginal cost, AP, equals its net marginal revenue from sales of the final good, netMRB. This leads B to produce Q’B of final output. This is equivalent to the point on the final product marginal revenue curve, MRF, at the level indicated by C. Outline provided as a courtesy, incomplete without oral presentation

Step 5 Voila! Step 5. The market demand, dA, and marginal revenue, mrA, curves are reproduced below. Equating marginal cost and transfer price, AP, to marginal revenue, mrA, indicates that quantity QA be produced and sold to outsiders at P = AOP. (Recall that the quantity sold is determined by MC intersecting with MR but the price, P, is where the demand curve indicates the price for that quantity will satisfy demand.) Division A earns a “monopoly” profit in this case by selling at a price above its MC. Outline provided as a courtesy, incomplete without oral presentation

Hirshleifer, continued • Demand dependence and technological dependence among the divisions: • Demand dependence reflects the degree of connectedness between the two markets. Depending upon the relative market power enjoyed by the firm in each of the markets, it may, under some circumstances, pay to subsidize the final good selling division (distribution or B). • Technological dependence, when output by one is technologically dependent on the other or there are production complementarities across the outputs, is extremely difficult to work with on a generalized basis. Outline provided as a courtesy, incomplete without oral presentation

Hirshleifer, continued Relationship to vertical integration, outsourcing: Hirshleifer recognized that his analysis would be attractive to those considering divesting or acquiring elements of a vertical production process Warned that such decisions should be based on a more comprehensive firm-wide analysis. What additional costs might be included in the wider analysis? (Hint: What costs did Coase [1937]emphasize?) Outline provided as a courtesy, incomplete without oral presentation

Oliver Williamson’s Transactions Cost Approach to Economic Organization Three areas of interest: • Overall structure of enterprise, how operating parts relate to one another • Defining efficient boundaries of the firm • Organizing internal work groups (teams?) with respect to worker attributes and governance options Outline provided as a courtesy, incomplete without oral presentation

Dimensionalizing Transaction: a good or service is transferred across a technologically separable interface • Transaction cost is the opportunity cost of resources consumed by the transaction • Transaction cost economics looks at the comparative costs of transactions under alternative governance structures • Three dimensions: • Uncertainty (used here in the common sense rather than as defined by Knight) • Frequency • Asset specificity Outline provided as a courtesy, incomplete without oral presentation

Efficient Boundaries Company conducts those transactions where the net advantage in production cost and governance costs favors internal production Outline provided as a courtesy, incomplete without oral presentation

Degree of Asset Specificity and Consequences for Production Costs • Asset specificity is desired not for itself but because of increased performance or design respects • Asset specificity may not decrease and may increase costs because standard or general assets could achieve greater scale economies • The optimal level of asset specificity involves considering both demand and production cost consequences • Governance costs also vary with asset specificity and must be considered • In general, if assets or goods are non-specific, markets enjoy advantages Outline provided as a courtesy, incomplete without oral presentation

Finding the Internal-External Boundary The progression from market to internal provision can be described algebraically: • Let ∆C = f(A) the production cost difference between internal and market • Let ∆G = g(A) the governance cost difference between internal and market • If ∆C + ∆G > 0 market transactions are advantaged • If ∆C + ∆G = 0 the firm is indifferent between market and internal provision • If ∆C + ∆G < 0 internal production is advantaged over market Outline provided as a courtesy, incomplete without oral presentation

Internal - External Boundary (graphic) Graphical representation of preceding arithmetic: Outline provided as a courtesy, incomplete without oral presentation

Asset Specificity and Vertical Integration Williamson discusses two examples: • General Motors/Fisher Body • Initial contract was imperfect (all are, the specifics vary) • GM desired closer integration of effort by Fisher • Fisher was reluctant, feared hold-up • GM finally bought Fisher and achieved integration • 19th century forward integration by manufacturers into wholesale and retail operations Outline provided as a courtesy, incomplete without oral presentation

Human Asset Specificity and Governance Williamson extends the metering considerations introduced by Alchian and Demsetz with the notion of differential human asset specificity to create a rough taxonomy of governance forms Outline provided as a courtesy, incomplete without oral presentation

Application of Human Asset Specificity to Union Organization Incentive to organize production workers within collective governance structure increases with human asset specificity The degree to which an internal structure is elaborated (e.g. ladders, scales, procedures, etc) varies directly with human asset specificity TCE predicts production worker organization earlier in sectors with specific jobs skills (e.g. railroads) and that the degree of internal elaboration will be highest in those sorts of industries Williamson’s discussion of alternative approaches is interesting but dated. Outline provided as a courtesy, incomplete without oral presentation

Next Week An overview of basic incentive compensation issues Minor discussion of control *************** Outline provided as a courtesy, incomplete without oral presentation

The Economics of Business