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.
   Minimum Efficient Scale – Output level at which
    long-run average costs are minimized.
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
  business or industry.
    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 – Analytical technique
  used to study the relations among cost, revenues, and
• 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
• 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
• 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
• 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
 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
         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
   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
   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
  additional considerations.
 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
   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
   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...
       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
   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
   Focus of these authors is on the separation of ownership
    and management, which arose due to the rise of the
   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.
    to know the motivation of the people we study.

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