ECO 370 – Economics of Organization
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ECO 370 – Economics of Organization
(10 marks) QUESTION 1
Fully explain why the make-or-buy decision is irrelevant when contracts are complete.
The following reasons explain why a complete contract is equivalent to a fully
integrated vertical organization so that make or buy decisions become irrelevant:
A complete contract eliminates opportunities for shirking by stipulating each party’s
responsibilities and rights for each contingency that could conceivably arise during the
transaction.
By using a complete contract, a firm can get its trading partner to mimic any of the
steps that would have been taken by a vertically integrated firm, as well as replicate the
profits accruing to each participant in the vertical chain.
A complete contract with respect to a critical asset (that makes an essential input) is
equivalent to an incomplete contract that operates under the property rights theory
where the owner of that critical asset has a right to decide or delegate the decision-
making with respect to an issue not covered in the incomplete contract.
(10 marks) QUESTION 2
In many modern industries, the following patterns seem to hold:
a. Small firms are more likely to outsource production of inputs than are large firms.
b. Standard inputs (such as a simple transistor that can be used by several electronics manufacturers) are more likely to be outsourced than “tailor-made” inputs (such as a circuit board designed for a single manufacturer’s specific needs). Fully explain what factors might explain these patterns?
a. Small firms are more likely to outsource the production of inputs because they
are unable to reach the necessary economies of scale efficiencies in-house.
So vertical integration so that they make inputs leaving the firms uncompetitive
or inefficient.
b. Complex inputs are more likely to be made in-house than standard inputs
because the specificity of these products and the assets needed to produce them
could lead to a holdup problem.
The downstream firm is at risk from the expropriation of the profits as quasi-rents
the input provider makes from the production of the inputs, which are worth less
in alternative uses.
The upstream firm will under invest and fail to produce the inputs at the optimal
level of quality and efficiency for the downstream firm, which may also be
exposed to high costs if there is any supply disruption.
It is more efficient for the downstream firm to take control of the production of
complex inputs themselves.
(10 marks) QUESTION 3
What are quasi-rents? If an agent provides a critical input from machinery it owns, how do quasi-rents effect the compensation a firm buying the input pays this agent? What happens to the agent’s compensation if the buyer owns the asset but the agent continues to provide its input using this machine?
A firm’s quasi-rent is the difference between the profits earned between two (2) alternative activities.
For example, an agent can extract an additional amount of profit called a quasi-rent from a Principal
separate and apart from its operating profit when this Principal knows the Agent can obtain this
amount as additional profit if the Agent were to switch to a competing activity or rival.
When a buyer (Principal) obtains ownership of the asset, the Agent’s quasi-rent would likely
disappear. Operating compensation has to offset the liability created by the Agent as the Agent
continues to engage with the asset.
In many cases, compensation to the Agent increases to motivate greater care and efficiency from the
Agent to avoid this liability.
(10 marks) QUESTION 4
If organizations cannot protect specific assets, then firms may as well transact at arms-length.” Fully explain.
This answer is related to the answer given in Question 2. Arms-length means firms
remain separate organizations.
When a firm does not own the assets of another firm it also loses the right to deploy
the assets as the firm sees fit.
A firm cannot adjust, for example, the level of investment in relationship-specific
investments to maximize the value of the integrated firm.
If internal governance cannot facilitate the desired outcome because the parties
involved with the transaction believe internal governance is not strong enough to
ensure that all parties will recover at least the opportunity cost of their own efforts
(that is, parties still fear hold up situations), then the firm may not see an increase in
its value after integration and instead deal at arms-length.
(10 marks) QUESTION 5
Using the model concerning firm A and firm B with
Demand for product A: Demand for product B:
xA = 1 – pA + pB
xB = 1 – pB + pA
Fully explain what happens if Firms A and B prohibit their agents from selling the goods of the rival?
This is essentially the exclusive agency result detailed in Lecture 4 involving
decentralized firms with agents that compete on price in retail markets – each agent
only sells the good made by its principal.
Students do not have to present mathematical derivations to their answers as long as
they mention the following key points in their answer:
Prices in the downstream market will fall in relationship to , the degree of
substitutability between products A and B.
The ө measures competitiveness – the degree to which a consumer will choose the
rivals product – so if this is low, firms can more afford to make centralized decisions
concerning their product
As this parameter decreases, each producer becomes more of a monopoly and the
exclusive dealership status keeps prices higher. Double markup becomes more
significant in keeping retail prices higher.
Where the principal strategizes its input price on the conditions faced by its exclusive
agent – this input price would be higher because of the output price being higher.
Output levels for A and B will be smaller.
Students can briefly discuss the conditions under which the exclusive dealership
organization would be terminated – for example, when < 0.71. For < 0.71, both
firms will choose integration as this organizational strategy maximizes the
organization profits.
(10 marks) QUESTION 6
“Firms that seek a cost advantage should adopt a learning curve strategy; firms that seek to differentiate their products should not.” Fully explain these statements.
A learning curve reflects a reduction in the marginal cost of output as a function
of time as the firm builds on the experience gained from its production history. Pursuing
a learning curve strategy could be advantageous to firms that seek a cost advantage and
firms that seek to differentiate their products based on experience.
A learning curve strategy is one in which a firm seeks to reduce costs by learning.
This is but one of many ways in which a firm can achieve a cost advantage.
Other cost drivers include economies of scale, economies of scope, capacity utilization,
economies of density, process efficiency, government policy, and a firm’s location.
Learning curves can also confer quality advantages. If there is a first mover
advantage in establishing a particular quality position (say the goods are experience
goods), then it may pay to push aggressively down the learning curve to gain that quality
advantage.
(10 marks) QUESTION 7
Does the presence of quasi-rents always reflect a holdup problem? Explain. Fully explain two (2) strategies a firm facing hold-up can follow to extract quasi-rents?
The holdup problem arises in incomplete contracts when one (or even
both) parties (firms) to the contract worry about being forced to accept
disadvantageous terms after an investment is made. Usually the party (Agent)
that can impose hold-up, will refrain from hold-up in exchange for quasi-rent. The
GM takeover of Fisher Body is perhaps the most famous of many examples of
holdup problems.
On the other hand, parties may act upon worries about hold-up by adopting
defensive strategies that impede total value maximization. In anticipating holdup
problems, parties might wish include more contractual terms which would lead to
higher transaction costs.
One strategy is to buy or get control of the asset by a take – over of the
agent, through co-operation or a hostile take-over.
A second strategy is to extract the quasi-rent through vertical contracts –
such as Franchisors charging fees to the Franchisee or charging higher markup
prices.
(10 marks) QUESTION 8
A principal owns a critical asset and makes inputs with the specific asset that will be used in making an output. The principal hires an agent to do the actual work and pays the agent a payment in the form of W = MAKE P where W represents total compensation to this agent, P is some form of performance evaluation. What three (3) incentive issues are in the MAKE parameter?
The three (3) incentive issues are related to the following three (3) parameters:
1, 2 = scale parameters rated to scale of long-run production
1, 2 = performance parameters rating subjectivity or objectivity of the chosen
performance measure
1, 2 = parameters rated to the long run value of the specific asset (investment,
human or social capital) brought by the agent
MAKE = ( + ) + ( + )( + )
(10 marks) QUESTION 9
Using the model concerning the differentiated price duopoly firms A and B in Question 5, what would happen if A and B merged into one firm?
Students do not have to present mathematical derivations to their answers as long as
they mention the following key points in their answer:
The merged firm will maximize joint profits, creating two “internal” response functions –
the merged firm and market with two (2) rival firms are both types of organizations.
A + B = (pA)(1 – pA + pB) + (pB)(1 – pB + pA)
Profit maximization – Response Functions
pA = (1/2)(1 + 2pB)
pB = (1/2)(1 + 2pA) Symmetry
The merged firm will create higher prices, due to this collusion. Merger is a form of
collusion.
pA = 1/2(1 - )
pB = 1/2(1 - ) Symmetry
The merged firm will create lower levels of outputs prices, due to this collusion.
xA = ½
xB = ½ Symmetry
Profit maximization - Profit
A + B = 1/2(1 - )
From Lecture 2
A + B = 2/(2 - )2
By total value maximization, then
A + B > A + B which is true, since 0 < < 1
The merger of Firms A and B would increase social surplus (ignoring consumers) and total value. This
is a form of Total Value Maximization.
(10 marks) QUESTION 10
A franchisor owns a franchise. The franchisor licences a franchisee to operate the franchise in a local market. The franchisee pays the franchisor a fee for licence. What are three (3) incentive issues here and how are they reflected in the franchise contract?
For full marks, students identify and comment on three (3) of the five (5) issues:
1 Franchises are a form of integration
2 Franchisors expropriate long term profits of franchisee – a quasi-rent.
3 Franchisees keep short-run profits, location specific profits, etc.
4 Franchisors engage in Total Value Maximization – PRT involved
5 Input prices in Franchises are generally lower
2022-03-22