Procurement and incentives within the firm Flashcards
(10 cards)
Methods of Procuring Inputs
Consider the manager of a car rental company.
The manager has three options:
Consider the manager of a car rental company.
- One input needed to produce output (rental cars) is automobile servicing (tune-ups, oil changes, lube jobs, and the like).
The manager has three options:
- Simply take the cars to a firm that services automobiles and pay the market price for the services.
- Sign a contract with a firm that services automobiles and, when service is needed, pay the price negotiated in the contract for that particular service.
- Create within the firm a division that services automobiles.
Methods of Procuring Inputs 2
What is a spot market?
What is a contract?
What does it mean to produce inputs internally (vertical integration)?
What is a spot market?
- An informal relationship between a buyer and seller in which neither party is obligated to the other beyond the current exchange.
What is a contract?
- A formal relationship between a buyer and seller that obligates the buyer and seller to exchange at terms specified in a legal document.
What does it mean to produce inputs internally (vertical integration)?
- A situation where a firm produces the inputs required to make its final product.
Methods of Procuring Inputs - Option 1: Spot market for goods or services
What is a spot exchange?
What is the advantage of using a spot exchange?
What are the disadvantages of using a spot exchange?
When is spot exchange often used?
What is a spot exchange?
- Buyers and sellers remain “anonymous” and can make exchanges without knowing each other’s names or having a formal legal relationship.
What is the advantage of using a spot exchange?
- Firms can specialize in their core tasks: converting inputs into outputs, while input manufacturers focus on producing inputs.
What are the disadvantages of using a spot exchange?
- Risk of the good or service not being available when needed.
When is spot exchange often used?
- Spot exchange is commonly used when inputs are standardized.
Methods of Procuring Inputs - Option 2: use of Contract for supply of goods/services
What does a contract specify?
What can parties address in the written contract?
What happens if the contract is incomplete?
What are the advantages of using a contract? (2)
What are the disadvantages of using a contract? (3)
What does a contract specify?
- Specifies the range of services covered, the price of each service, and the hours during which the cars will be serviced.
What can parties address in the written contract?
- If the service requirements for the automobiles are understood beforehand, parties can address all important issues in the written contract.
What happens if the contract is incomplete?
- Sometimes a contract is incomplete, for example, if a car needs a new transmission and the contract does not specify the price.
What are the advantages of using a contract?
- Allows the purchasing firm to specialize in what it does best.
- Provides greater ability to purchase “nonstandard” services.
What are the disadvantages of using a contract?
- Costly to write and time-consuming to draft.
- Often requires legal fees.
- Difficult to cover all future contingencies in a contract.
Determine whether the following transactions involve spot exchange, a contract, or vertical integration:
- Clone 1 PC is legally obligated to purchase 300 computer chips each year for the next 3 years from AML. The price paid in the first year is £200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years.
- Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in the back of a computer magazine.
- Clone 3 PC manufactures its own motherboards and computer chips for its personal computers.
Determine whether the following transactions involve spot exchange, a contract, or vertical integration:
-
Clone 1 PC is legally obligated to purchase 300 computer chips each year for the next 3 years from AML. The price paid in the first year is £200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years.
- Clone 1 PC is using a contract.
-
Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in the back of a computer magazine.
- Clone 2 PC used the spot exchange.
-
Clone 3 PC manufactures its own motherboards and computer chips for its personal computers.
- Clone 3 PC uses vertical integration.
Compensation and the Principal-Agent Problem
How best for owners to compensate managers in order to encourage maximum effort?
What is the primary obstacle in compensating managers?
What is the principal-agent (P-A) problem?
How best for owners to compensate managers in order to encourage maximum effort?
- Owners need to find effective ways to compensate managers to ensure they put in maximum effort.
What is the primary obstacle in compensating managers?
- The separation of ownership and control creates challenges in ensuring managers are motivated to perform well.
What is the principal-agent (P-A) problem?
- Owners must provide incentives to managers because they cannot directly monitor their actions.
Managers’ Compensation Mechanisms
What is the manager’s economic trade-off? (2)
What does the job description indicate about the manager’s work hours?
What is the important question from the owner’s point of view?
What forms can shirking take?
What does the owner want from the manager?
What is the manager’s economic trade-off?
- Leisure.
- Labor.
What does the job description indicate about the manager’s work hours?
- The job description indicates that the manager is supposed to spend 8 hours per day on the job.
What is the important question from the owner’s point of view?
- The important question, from the owner’s point of view, is how much leisure (shirking) the manager will consume while on the job.
What forms can shirking take?
- Shirking may take the form of excessive coffee breaks, long lunch hours, leaving work early, or, in the extreme case, not showing up on the job at all.
What does the owner want from the manager?
- Note that while the manager enjoys shirking, the owner wants the manager to work hard to enhance profits.
Managers’ Compensation Mechanisms (2)
What is the impact of receiving a fixed salary on managers’ behavior? (3)
How does the manager view income and shirking?
What can be drawn based on consumption theory?
What does a family of these curves represent?
What does the opportunity set of income/shirking combinations reveal?
What is the result of a fixed salary in this model?
What is suggested as an alternative to fixed salary?
What is the impact of receiving a fixed salary on managers’ behavior?
- Receives wage independent of labor hours and effort.
- No strong incentive to monitor other employees’ labor hours and effort.
- Adversely impacts firm performance.
How does the manager view income and shirking?
- The manager views both Income and Shirking as ‘goods’: he/she will derive utility (happiness) from both.
What can be drawn based on consumption theory?
- Draw a convex indifference curve for the manager, based on the combinations of income and shirking which generate identical levels of utility.
What does a family of these curves represent?
- Representing higher levels of utility as we move North East (i.e., towards the top right-hand corner of the diagram).
What does the opportunity set of income/shirking combinations reveal?
- Point A allows the manager to reach his/her highest indifference curve (max utility).
What is the result of a fixed salary in this model?
- Leads to maximum shirking (8 hrs) and therefore minimum work (0 hrs) and damaging the firm’s profit levels (zero profits).
What is suggested as an alternative to fixed salary?
- What if part of his or her salary was linked to the firm’s profits?
Forces that Discipline Managers (2/3,6)
What are Incentive Contracts?
A way to align owners’ interests with managers’ actions.
Examples include:
- Stock options
- Other bonuses directly related to profits (performance-based rewards)
What are External Incentives?
Outside forces that provide managers with motivation to maximize profits, including:
-
Reputation:
- Job mobility
- Even without explicit performance bonuses, managers may strive for high performance to secure future job opportunities.
-
Takeover/bankruptcy threat:
- If managers fail to maximize profits, the firm may collapse, or investors may attempt to take over and replace management.
Manager’s Compensation: fixed + bonus (pictures)
We now see that the manager no longer maximises their utility at point A (max shirking) but instead can reach a higher indifference curve at point B, which corresponds to working 6 hrs and shirking only 2 hrs.
This is better for the firm, which now obtains a profit of £2.25m rather than zero.
The next graph shows the relationship between the firm’s profit, the bonus payment (10% of profit) and the new optimal point for the manager.
