# Transaction Scale Profit by wzw10454

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```									 The Organization of the Firm
 The Multi-Plant Problem
 Cost-Volume-Profit Analysis
 Managerial Decisions
– Securing Inputs and Transaction Costs
– Managerial Compensation
– Worker-Management Relations
Cost Elasticity

 Cost Elasticity = Percentage change in total
cost associated with a 1% change in output.
   % Change in TC / % Change in Q
   Note the dependent and independent variable.
 Interpretation
   Ec < 1         Increasing Returns to Scale
   Ec = 1         Constant Returns to Scale
   Ec > 1         Decreasing Returns to Scale
Long-Run Average Cost
 Capacity – Output level at which short-run
average costs are minimized.
   If a firm moves beyond ‘capacity’ the firm may
want to consider building a larger plant.
   BE ABLE TO ILLUSTRATE THIS STORY IN THE
SHORT-RUN
   Minimum Efficient Scale – Output level at which
long-run average costs are minimized.
   BE ABLE TO ILLUSTRATE LONG-RUN AVERAGE
COST AND IDENTIFY THE LEVEL OF OUTPUT
CORRESPONDING TO MES.
Firm Size and Plant Size

 Multi-plant Economies of Scale – Cost
advantages from operating multiple
facilities in the same line of business
or industry.
 Multi-plant Diseconomies of Scale –
Cost disadvantages from operating
multiple facilities in the same line of
The Economics of Multi-Plant Operations

 Elements needed for problem
 Equation for Demand Curve
 Short-run Total Cost Function

 Steps in Solving the Problem
 Solve for profit maximizing output, price, and profit.
 Solve for average cost minimizing output.
 Solve for MC when firm produces at capacity.
 Set MR equal to MC at capacity to determine optimal
multi-plant operation.
 Determine the optimal number of plants.
 Determine price and profit when firm employs the
optimal number of plants.
Cost-Volume-Profit
Analysis
• Cost-Volume-Profit Analysis – Analytical technique
used to study the relations among cost, revenues, and
profits.
• Breakeven Quantity – A zero profit activity level
• TR = TC
• P*Q = TFC + AVC*Q
• TFC = [P – AVC] *Q
• Q = TFC / [P-AVC]
• Profit Contribution = P – AVC
CVP Analysis Example
• Price = \$80         AVC = \$60
• TFC = \$20K
• Desired Profit = \$40K
• Q = [Fixed Cost + Profit
Requirement] / Profit
Contribution
• Q = [\$20,000 + \$40,000] / \$20
• Q = 3,000 units
• Given price, cost conditions,
and desired profit, firm will need
to produce 3,000 units.
Degree of Operating
Leverage
• Degree of Operating Leverage –
Percentage change in profit from a 1%
change in output.
• DOL = % change in profit / % change in Q
• DOL = Elasticity of Profit
• DOL at a given level of output =
[Q(profit contribution)] / {[Q(profit
contribution)] – Total Fixed Cost}
• OR        [P-AVC] / [P-ATC]
Limitations of CVP
Analysis
• Assumes selling price is
constant. Each time the selling
price changes the analysis must
be completed again.
• Assumes that average variable
cost is also constant. If this is
not true, then the analysis is not
particularly useful.
Methods of Acquiring Inputs:
Spot Exchange
 Spot Exchange – an informal
relationship between a buyer and seller
in which neither party is obligated to
adhere to specific terms for exchange.
 This is often used when inputs are
standardized so effort in finding the
‘best’ input is not needed.
Methods of Acquiring Inputs:
Acquiring Inputs Via Contract
 Contract – a formal relationship
between a buyer and seller that
obligates the buyer and seller to
exchange at terms specified in a legal
document.
 Contracts can reduce uncertainty, but
increase the transaction costs incurred
by the firm.
Methods of Acquiring Inputs:
Internal Production
 Vertical Integration – a situation where
a firm produces the inputs required to
make its final product.
 Vertical integration (alternative
definition)- various stages of
production of a single product are
conducted by a single firm.
 Motivation: Reduces Transaction
Costs
Transaction Costs
 Transaction costs - the expenses of
trading with others above and beyond
the price. i.e. the cost of writing and
enforcing contracts.
 Transaction costs determine whether
markets are internalized or allowed to
remain external to the firm.
More on Transaction Costs: The Work of
Oliver Williamson
    Four basic concepts that underlie
transaction costs analysis.
1.    Markets and firms are alternative means for completing related sets
of transactions.
2.    The relative cost of using markets or a firm’s own resources should
determine the choice.
3.    The transaction cost of writing and executing contracts across a
market is a function of
1.   the characteristics of the involved human actors
2.    the objective properties of the market
4.    In sum, both human and environmental factors impact the
transaction costs across firms and markets.
More from Williamson
 Purpose of this analysis is to identify
the set of environmental and human
factors that explain both internal firm
and industrial organization.
 Key environmental factors:
Uncertainty and number of firms
 Key human factors:
Bounded rationality and opportunism
Bounded Rationality and
Opportunism
   Bounded rationality - the limited human capacity to
anticipate and solve complex problems.
   Opportunistic behavior - Taking advantage of another
when allowed by circumstances.
   High transaction costs:
 Specialized products: The creation of specialized
products, where only a single buyer and/or seller
exists, can lead to opportunistic behavior. This provides
an incentive for vertical integration.
 Changing market conditions: Bounded rationality and
uncertain market conditions make the writing and
enforcement of contracts involving future conditions
undesirable for both parties. Such high transaction costs
increases the likelihood of vertical integration.
Market vs. Internal Production
   Labor theory: Wages = Marginal Revenue
Product
   Marginal Revenue Product = Marginal
Revenue of Output (MR) * Marginal Product of
Labor (MP)
   However, for this to be true for each worker a
firm would need to measure MP.
   What if a firm cannot measure MP? Then a
worker can reduce effort an still maintain the
same wage.
   When monitoring costs are high, a firm has an
incentive to sub-contract work.
   Why? For independent workers the wage
(profit) is closer linked to productivity.
More Benefits from Vertical Integration

 In addition to transaction costs, vertical
integration is also motivated by two
 Vertical integration provides assurance
of supplying inputs/outputs in a market
that may be unstable.
 Threatens potential entrants by raising
entry barriers (aluminum example)
The Principal-Agent Problem
   A principal is the person who wants an action taken.
In the work environment, this is the owner of the firm.
   The agent is the person who takes the action. In the
work environment, this is the worker.
   If motivations differ between the principal and
agent, and information is not perfect, a principal-agent
problem exists.
   A specific example is the issue of moral hazard. Moral
hazard occurs when the agent can take actions that the
principal cannot directly observe that will reduce the
welfare of the principal. For example, consider
shirking.
   How can the firm limit shirking?
Difficulty of Vertical Integration
Shirking of Workers
   Shirking - the behavior of a worker who is putting
forth less than the agreed to effort.
   Efficiency Wages – Paying the worker a wage above the
market wage.
   Why is this necessary? Because workers can vary
productivity, a firm may need to pay higher wages to
ensure higher levels of output.
   Why would firms pay efficiency wages? In other words,
why do higher wages elicit higher productivity.
a.      The Gift exchange hypothesis
b.      Worker turnover
c.      Worker quality
Shirking Defense
   How do firms prevent the manager from shirking?
Make the manager a residual claimant.
• Residual claimant - persons who share in the profits of the
firm.
   How do firms prevent workers from shirking?
• Profit sharing – mechanism used to enhance workers’ efforts
that involve tying compensation to the underlying profitability
of the firm
   STOCK OPTIONS, etc..
• Revenue sharing – mechanism used to enhance workers’
efforts that involve tying compensation to the underlying
revenues of the firm
   SALES COMMISSIONS, TIPS, etc...
   NO INCENTIVE TO LOWER COSTS
Teams and Productivity
   Teamwork is employed when a team of
individuals can produce more than the
sum of individuals working alone.
   Observing individual productivity is
difficult, so shirking can occur: The Free
Rider Problem
   Profit Sharing: If team members share in
the profits of the firm, then they have an
incentive to monitor other team
members. If the incentive to monitor
exceeds the free-rider effect, profit
More Defense: Piece Rates
   Piece-Rate Compensation –
Employee is paid according to
productivity.
   Such a compensation plan will
increase productivity.
   Will only work if productivity can
be measured.
   Problems
• Teamwork will diminish.
• Quantity is easy to measure, quality is
not. Thus quality can suffer with this
compensation plan.
Subjective Evaluations
   Why are subjective evaluations
employed? To encourage
innovation, dependability,
cooperation, etc...
   Subjective evaluations can lead
to rent-seeking by workers, or
actions taken to re-distribute
resources from others.
   Subjective evaluations can also
be quite inaccurate.
Inaccurate evaluations can
The Role of Management
   What is the primary role of the manager?
   To prevent shirking, which limits the
production of the firm.
   In essence, employees employ the manager
to raise the return to the firm.
   Implications: If the manager is poor,
employees will leave. If the returns of the
firm do not accrue to the employees, the
employees will leave.
   Remember, the labor market is like any
other market. Exchange takes place by both
parties because benefits exceed the costs.
The Objectives of Management

   Managers seek to maximize utility (A.A. Berle and Gardner
Means)
   Focus of these authors is on the separation of ownership
and management, which arose due to the rise of the
corporation.
   How would this impact market behavior? Studies have
shown that managerial control is less profitable than owner
control. Manager’s are more risk adverse, due to an
inability to diversify.
   A related view.... Managers seek to satisfice (Richard Cyret,
James March and Herbert Simon)
   In this class we assume that firms seek to maximize profits.
This is a simplification.
   WHY DO WE NEED TO ANSWER THIS QUESTION? We need
to know the motivation of the people we study.

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