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ECO 610-401. Monday, December 1 st Organizational Design: Centralized vs. Decentralized Readings, Brickley et al., 11-13 Monday, December 8 th Performance Measures Readings, Brickley et al., 16 Extended Assignment 3 due. Exam Distribution. Organizational Architecture.

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eco 610 401
ECO 610-401
  • Monday, 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
organizational architecture
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
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
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
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
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
vertical integration and the make or buy decision
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 fallacies
Make or Buy Fallacies
  • Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for the firm
  • Firms should buy, rather than make, to avoid the costs of making the product.
  • Firms should make, rather than buy, to avoid paying a profit margin to independent firms.
  • 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.
  • 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 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.
rustic log cabin 2
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 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?
reasons to buy
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
  • 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
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
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
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
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
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
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