Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Theory of the Firm
- Economics of Strategy II
Prof. Dr. Christian Ernst
Winter Semester 2009 / 2010
Contents
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
III. Firm Boundaries
III.I The Horizontal Boundaries of the Firm
•
•
•
•
•
•
•
III.II
Economies of Scale
Economies of Scope
Where do Economies of Scale come from?
Special Sources of Economies of Scale and Scope
Diseconomies of Scale
The Learning Curve
The Learning Curve vs. Economies of Scale
The Vertical Boundaries of the Firm
•
•
•
•
•
•
•
Make vs. Buy
Upstream, Downstream
Defining Boundaries
Some Make-or-Buy Fallacies
Reasons to “Buy”
Reasons to “Make”
The Make or Buy Decision Tree
Theory of the Firm
2
Firm Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Firm Boundaries:
THE HORIZONTAL BOUNDARIES
OF THE FIRM
Theory of the Firm
3
Horizontal Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Horizontal Boundaries
•
identify the quantities and varieties of products and services that a firm produces
•
differ markedly across industries and across the firms within them
In some industries:
• a few large firms account for an extremely large share of industry sales, and there
are few viable small firms (e.g. airframe manufacturing  Airbus / Boing vs. Cessna
Aircraft Company (Textron Inc.))
• small firms predominate; even the largest firms in these industries are small by most
conventional measures of business size (e.g. management consulting  BCG / Mc
Kinsey/ Roland Berger etc.)
• small firms and corporate giants coexist successfully (e.g. computer software 
Microsoft vs. Adobe Systems, Inc.)
But why do giants dominate some industries and not others?
Theory of the Firm
4
Horizontal Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Horizontal Boundaries
The optimal horizontal boundaries of firms depend critically on “economies of scale and
scope”.
Economies of scale and scope are present whenever large-scale production, distribution
or retail processes have a cost advantage over smaller processes. Economies of scale
and scope are not always available.
Many activities, such as landscaping, tailoring, or the preparation of gourmet food, do not
appear to enjoy substantial scale economies.
 Therefore, these activities are typically performed by individuals or relatively
small firms.
Economies of scale and scope are also central to many issues in business strategies
(e.g. merger and diversification strategies, pricing, entry and exit, the ability to secure a
long-term sustainable advantage).
Theory of the Firm
5
Horizontal Boundaries: Economies of Scale
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Economies of Scale
The production process for a specific good or service exhibits “economies of scale” over a
range of output when average cost declines over that range. If average cost (AC) declines as
output increases, then the marginal cost of the last unit produced (MC) must be less than
average cost. If average cost is increasing, then marginal cost must exceed average cost, and
we say that production exhibits “diseconomies of scale”. Why is that true?
Average cost curves are often depicted as U-shaped. But, if capacity does not prove to
be constraining, average cost curves may also tend to be L-.shaped.
Theory of the Firm
6
Horizontal Boundaries: Economies of Scope
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Economies of Scope
Economies of scale are related to economies of scope, and the to terms are sometimes
used interchangeably.
Economies of scope exist if the firm achieves savings as it increases the variety of goods and
services it produces. Whereas economies of scale are usually defined in terms of declining
average cost functions, economies of scope are usually defined in terms of the relative total
cost of producing a variety of goods and services together in one firm versus separately in two
or more firms.
Mathematical abstraction:
TC (Qx , Qy) = total cost to a single firm producing Q x of good X and Qy of good Y
TC (Qx , 0) = total cost to a single firm producing Qx of good X and zero of good Y
TC (0, Qy) = total cost to a single firm producing zero of good X and Qy of good Y
Then a production process exhibits scope economies if:
TC (Qx , Qy) < TC (Qx , 0) + TC (0, Qy)
Theory of the Firm
7
Horizontal Boundaries: Economies of Scope
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Economies of Scope
Example:
Producing message notes:
TC (Qx , 0) = $50m + $0.05 Qx
Producing tape:
TC (0 , Qy) = $100m + $0.20 Qy
Producing both:
TC (Qx , Qy) = $120m+ $0.05 Qx + 0.20 Qy
Theory of the Firm
8
Horizontal Boundaries:
Where do Economies of Scale come from?
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Where do Economies of Scale come from?
•
Indivisibilities and the spreading of fixed costs
The most common source of economies of scale is the spreading of fixed costs over an evergreater volume of output. Fixed costs arise when there are indivisibilities in the production
process. Indivisibility simply means that an input cannot be scaled down below a certain
minimum size, even when the level of output is very small.
•
•
•
Economies of scale due to spreading of product-specific fixed costs
Economies of scale due to tradeoffs among alternative technologies (short run vs.
long-run)
Indivisibilities are more likely when Production is capital intensive
Theory of the Firm
9
Horizontal Boundaries:
Where do Economies of Scale come from?
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Where do Economies of Scale come from?
•
Increased productivity of variable inputs (specialization)
Economies of scale are closely related to the concept of specialization. To become specialists,
individuals or firms must often make substantial investments. They will not do so unless
demand justifies it; if demand is inadequate, they will not recover their costs and they will be
reluctant to specialize.
“The division of labor is limited by the extent of the market”
(Adam Smith)
•
•
Division of labor
Extent of the market


specialization of productive activities
magnitude of demand for these activities
Smith‟s theorem states that individuals or firms will not make specialized investments
unless the market is big enough to support them.
Theory of the Firm
10
Horizontal Boundaries:
Where do Economies of Scale come from?
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Where do Economies of Scale come from?
•
Inventories
Firms carry inventory to minimize the chances of running out of stock  costs to carrying
inventory (expenses borne in producing the inventory/ depreciate in value etc.)  Inventory
costs drive up the average costs of the goods that are actually sold.
Example:
A firm needs to hold inventories equal to 15 percent of its sales to maintain a tolerable level of
expected stock outs. This will increase its average cost of goods sold by as much as 15 percent.
In general, inventory costs are proportional to the ratio of inventory holdings to
sales.
But the need to carry inventories also creates economies of scale because firms doing a
high volume of business can usually maintain a lower ratio of inventory to sales while
achieving a similar level of stock outs  reduction of average costs
Theory of the Firm
11
Horizontal Boundaries:
Where do Economies of Scale come from?
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Where do Economies of Scale come from?
•
The Cube-Square Rule and the Physical Properties of Production
The Cube-Square Rule:
As we increase the volume of the vessel (e.g., a tank or a pipe) by a given proportion (e.g., we
double it), the surface area increases by less than this proportion (e.g., it less than doubles).
The physical properties of production often allow firms to expand without
comparable increase its costs.
• oil pipelines
• warehousing
• brewing beer
Theory of the Firm
12
Horizontal Boundaries:
Special Sources of Economies of Scale and Scope
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Special Sources of Economies of Scale and Scope
•
Economies of Scale and Scope in Purchasing
Big businesses that make large purchases from their suppliers may obtain discounts,
enabling them to enjoy a cost advantage over smaller rivals.
There is no requirement that big buyers obtain bulk discounts. A supplier would care, for
three possible reasons:
• it may be less costly to sell to a single buyer
• a bulk purchaser has more to gain from getting the best price and therefore will
be more price sensitive
• the supplier may fear to lose a large purchaser
If these conditions do not hold, then purchasing economies may be
nonexistent.
Theory of the Firm
13
Horizontal Boundaries:
Special Sources of Economies of Scale and Scope
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Special Sources of Economies of Scale and Scope
•
Economies of Scale and Scope in Advertising
Larger firms often enjoy lower advertising costs per consumer either because they have
lower costs of sending messages per potential consumer or because they have higher
advertising reach.
This is because important fixed costs are associated with placing an ad,
including preparation of the ad and negotiation with the broadcaster etc.
Theory of the Firm
14
Horizontal Boundaries:
Special Sources of Economies of Scale and Scope
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Special Sources of Economies of Scale and Scope
•
Economies of Scale in Research and Development
R&D expenditures exceed 5 percent of total sales revenues at many companies.
 Developing new pharmaceutical products for the U.S. market:
$500 million to successfully develop a new drug
This is a substantial indivisible investment, implying that average fixed costs will decline
rapidly as sales of a particular drug increase.
R&D may also entail economies of scope  ideas developed in one research project
create positive spillovers to another project
•
Complementarities and Strategic Fit
The concept of complementarities (better known as “Strategic Fit”) describes the synergies
among organizational practices. Practices display complementarities when the benefits of
introducing one practice are enhanced by the presence of others.
Theory of the Firm
15
Horizontal Boundaries: Diseconomies of Scale
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Diseconomies of Scale
•
Labor Costs and Firm Size
Larger firms generally pay higher wages and provide greater benefits  many studies
confirm that the wage and benefit premium persists  a wage gap of 10 percent or more
between large and small firms is not unusual.
•
Spreading Specialized Resources Too Thin
The attempt to duplicate success achieved in one venue to another often leads to disaster.
The same lesson also apply to specialized capital inputs, such as computers, tools or
assembly lines.
Theory of the Firm
16
Horizontal Boundaries: Diseconomies of Scale
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Diseconomies of Scale
•
“Conflicting Out”
With the continued growth and consolidation of professional services firms (marketing/
consulting, law etc.) it is important to consider another source of diseconomies of scale –
“conflicting out”:
 conflict of interest
 the firm might not take its client’s interests fully to heart
 sensitive competitor information might leak out
•
Incentive and Bureaucracy Effects
 In larger firms it, compensation is much less likely to be tied to the worker’s
contribution toward firm profit
 Larger firms may also have a more difficult time monitoring and communicating with
workers, further leading to difficulties in promoting effective worker performance
Theory of the Firm
17
Horizontal Boundaries: The Learning Curve
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Learning Curve
Experience is an important determinant of ability in many jobs, and in the past three
decades strategists have discovered the significance of experience for firms.
 The importance of experience is conveyed by the idea of the learning curve
The learning curve (or experience curve) refers to advantages that flow from accumulating
Experience and know-how.
Theory of the Firm
18
Horizontal Boundaries: The Learning Curve
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Learning Curve
Example:
Manufacturer of DRAM chips:
• cumulative production of 10,000 chips
• MC: $2.50
• the firm believes that once it has produced an additional 100,000 chips its unit
costs fall to $2.00, with no further learning benefits.
The firm has orders to produce an additional 200,000 chips when it unexpectedly
receives an offer to bid on an order for 10,000 chips to be filled immediately.
The firm must determine the lowest price it would be willing to accept for this order.
But which price should be accepted?
Theory of the Firm
19
Horizontal Boundaries: The Learning Curve
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Learning Curve
Example:
Unfortunately, true marginal cost is not $2.50
To determine the true marginal cost, the chip maker must consider how its
accumulated experience will affect future costs.
Before (planned):
200,000 chips
($2.50 x 100,000 + $2.00 x 100,000 = $450,000)
After (new order taken):
200,000 chips remaining
($2.50 x 90,000 + $2.00 x 110,000 = $445,000)
 Reduction of future production costs by $5,000
In effect, the incremental cost of filling the additional order is only $20,000, which is the
current cost of $25,000 less the $5,000 future cost savings .
 true marginal cost per chip: $2.00
Theory of the Firm
20
Horizontal Boundaries:
The Learning Curve vs. Economies of Scale
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Learning Curve vs. Economies of Scale
Economies of learning differ from economies of scale. Economies of scale refer to the ability
to perform an activity at a lower unit cost when it is performed on a larger scale at a particular
point in time. Learning economies refer to reductions in unit costs due to accumulating
experience over time.
Theory of the Firm
21
Firm Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Firm Boundaries:
THE VERTICAL BOUNDARIES
OF THE FIRM
Theory of the Firm
22
Vertical Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Vertical Boundaries
The vertical boundaries of a firm define the activities that the firm itself performs as opposed
to purchases from independent firms in the market.
Therefore, we will examine a firm‟s choice of its vertical boundaries and how
they affect the efficiency of production.
A firm‟s decision to perform an activity itself or to purchase it from an independent firm
is called a make-or-buy decision. “Make” means that the firm performs the activity itself;
“buy” means it relies on an independent firm to perform the activity, perhaps under
contract.
Theory of the Firm
23
Vertical Boundaries: Make vs. Buy
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Make vs. Buy
Make and buy are two extremes along a continuum of possibilities for vertical integration:
Theory of the Firm
24
Vertical Boundaries: Upstream, Downstream
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Upstream, Downstream
In general, goods in an economy “flow” along a vertical chain from raw materials and
component parts to manufacturing, through distribution and retailing.
•
•
early steps in the vertical chain are upstream (in the production process)
later steps are downstream
 E.g.: Lumber flows from upstream timber forests to downstream mills.
But the vertical chain also involves many specialized support activities, such as:
• accounting
• finance
• human resources management
• strategic planning
Theory of the Firm
25
Vertical Boundaries: Upstream, Downstream
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Upstream, Downstream
Theory of the Firm
26
Vertical Boundaries: Defining Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Defining Boundaries
Regardless of a firm‟s position along the vertical chain, it needs to define its boundaries.
To resolve the associated mare-or-buy decisions, the firm must compare the benefits and
costs of using the market as opposed to performing the activity in-house.
Theory of the Firm
27
Vertical Boundaries: Some Make-or-Buy Fallacies
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Some Make-or-Buy Fallacies
Five common, but incorrect, arguments:
(1) Firms should make an asset, rather than buy it, if that asset is a source of competitive
advantage for that firm
(2) Firms should buy, rather than make, to avoid the costs of making the product
(3) Firms should make, rather than buy, to avoid paying a profit margin to independent
firms
(4) Firms should make, rather than buy, because a vertically integrated producer will be
able to avoid paying high market prices for the input during periods of peak demand
or scarce supply
(5) Firms should make to tie up a distribution channel. They will gain market share at the
expense of rivals
Theory of the Firm
28
Vertical Boundaries: Some Make-or-Buy Fallacies
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Fallacy of Argument (4)
Integration appears to eliminate all risk  prevent bankruptcy when price is $ 7.000
BUT  Modern finance instruments (future contracts to hedge against price of lumber risk)
Integration requires a loan that must be serviced ($ 350.000 p.a.)  instead LoC for state 3
Theory of the Firm
29
Vertical Boundaries: Reasons to “Buy”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Reasons to “Buy”
Firms use the market (or “buy”) primarily because market firms are often more efficient:
•
exploiting scale and learning economies
Firms need to produce quantity A* to reach minimum
efficient scale and achieve average costs of C*. A firm
that requires only A’ units to meet its own needs will incur
average costs of C’, well above C*. A firm that requires
output in excess of A*, such as A’’, will have costs equal to
C* and will not be at a competitive disadvantage.
•
•
avoiding agency costs
influence costs
(internal allocation of resources  costs of influence/ bad decisions)
Theory of the Firm
30
An example you will never
forget!
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
You are the first female CEO of XYZ Inc. This afternoon, there will be a
meeting where two division heads will outline their investment requests
for the upcoming year
2 pm meeting with vice president BP 4 pm meeting with vice president GU
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Reason to “Make”
The three major costs associated with using the market include:
• costs of poor coordination between steps in the vertical chain
• reluctance of trading partners to develop and share valuable information
• transaction costs
Each of these problems can be traced to costs associated with writing and
enforcing contracts.
Thus, we motivate our discussion of reasons to “make” by exploring the limitation of
contracting.
Theory of the Firm
32
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Complete versus Incomplete Contracting
A “complete contract” eliminates opportunistic behavior. A complete contract stipulates each
party’s responsibilities and rights for each and every contingency that could conceivably arise
during the transaction. A complete contract binds the parties to particular courses of action as
the transaction unfolded. Neither party could exploit weakness in the other’s position while the
transaction was in progress.
The requirements for complete contracting are severe. As might be imagined,
virtually all real-world contracts are incomplete.
Three factors prevent complete contracting:
• Bounded rationality
• Difficulties specifying or measuring performance
• Asymmetric information
Theory of the Firm
33
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Role of Contract Low
A well-developed body of contract law makes it possible for transactions to occur
smoothly when contracts are incomplete.
In the United States, contract law is embodied in both:
• common law
• uniform commercial code (UCC)
The doctrines of contract law specify a set of “standard” provisions applicable to wide
classes of transactions.
These doctrines eliminate the need for parties to specify these provisions in
every single transaction.
Contract law is not a perfect substitute for complete contracting for two reasons:
• doctrines of contract law are phrased in broad language
• litigation can be a costly way “completing” contracts
Theory of the Firm
34
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Vertical Chain /Coordination
Contracts between independent firms are often essential for assuring coordination of
production. For coordination to succeed, players must make decisions that depend, in
part on, on the decisions of others.
Working together, firms can assure a good fit along all dimensions of production:
• timing fit
• size fit
• color fit
• sequence fit
Coordination is especially important in processes with design attributes (attributes that
need to relate to each other in a precise fashion).
Without good coordination, bottlenecks may arise.
Theory of the Firm
35
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Leakage of Private Information
A firm’s private information is information that no one else knows. Private information may
pertain to production know-how, product design, or consumer information. When firms use
the market to obtain supplies or distribute products, they risk losing control of valuable
private information.
Well-defined and well-protected patens afford research-driven organizations the
ability to outsource downstream activities from production through marketing without
compromising the principal source of their competitive advantage.
concern about sharing critical information that is seemingly protected by patent
plays a central role in dictating tne boundaries of firms in the pharmaceutical
industry.
Theory of the Firm
36
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Transactions Costs
The concept of transaction costs was first described by Ronald Coase *(1937),
and further developed by Oliver Williamson*.
Coase raised the following question: in light of the efficiencies of the competitive market
mechanism emphasized in economic theory, why does so much economic activity take place
within firms in which market transactions are replaced by centralized direction? Coase
concluded that there must be costs to using the market than can be eliminated by using the firm.
•
•
•
search and information costs
bargaining costs
policing and enforcement costs
References:
* Coase, R. (1937), The Nature of the Firm, Economica, November, p. 386 – 405.
* Williamson, O. (1983), Markets and Hierarchies: analysis and antitrust Implications, A Study in the Economics of Internal Organization, New York
Theory of the Firm
37
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Transactions Costs
Influencing Factors:
• Uncertainty
• Specificity
• Frequency
Theory of the Firm
38
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Relationship-Specific Assets
A relationship-specific asset is an investment made to support a given transaction. They are
often essential for the efficiency of a particular transaction. A relationship-specific asset cannot
be redeployed to another transaction without some sacrifice in the asset or some cost in
adapting the asset to the new transaction.
•
•
•
•
Site Specificity
Physical Asset Specificity
Dedicated Assets
Human Asset Specificity
•
The Fundamental Transformation
Firms that have invested in relationship-specific assets cannot switch trading
partners without seeing a decline in the value of these assets.
Theory of the Firm
39
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Rents and Quasi Rents
The fundamental transformation has significant consequences for the economics of
bargaining between buyer and seller, which in turn affects the costs of arm‟s-length
market exchange.
Rent:
Rent is simply the profit you expect to get when you build a plant, assuming all goes as
planned.
Quasi-Rent:
Quasi-rent is the extra profit that you get if the deal goes ahead as planned, versus the
profit you would get if you had to turn to your next-best alternative.
Theory of the Firm
40
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Rents and Quasi Rents
Example:
Suppose your company contemplates building a factory to produce cup holders for the Ford
Taurus automobile. The factory can make up to 1 million holders per year at an average cost
of C dollars per unit. You finance the construction of your factory with a mortgage from a
bank that requires an annual payment of I dollars (represents your annualized cost of
investment in this plant).
Total cost (1 million cup holders per year): I + 1,000,000 C
Factory designed and built specifically to produce cup holders for the Ford Taurus.
But if you do not end up selling cup holders to ford, you still have a “bail-out” option:
You can sell the holders to jobbers who will resell them (after modifying) to other
automobile manufacturers  Pm  total revenue: 1,000,000 Pm
Pm > C  market price covers variable costs
Theory of the Firm
41
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Rents and Quasi Rents
I > 1,000,000 (Pm - C)  If you sell only to jobbers, you will not recover your investment.
In this sense, a portion of your investment is specific to your relationship with Ford. In
particular, the difference I – 1,000,000 (Pm - C) represents your company’s relationshipspecific investments (RSI):
•
The RSI equals the amount of your investment that you cannot recover if your
company does not business with Ford.
•
I = $8,500,000,
C = $3,
and
Pm = $4
 RSI = $8,500,000 – 1,000,000 (4-3) = $7,5000,000.
Theory of the Firm
42
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Rents and Quasi Rents
Rent:
Ford agreed to buy 1 million sets of cup holders per year at a price of P* per unit, where
P* > Pm . Thus your company expects to receive total revenue of 1,000,000 P* from Ford.
Suppose that I < 1,000,000 (P* - C) , so that given your expectation of the price ford will
pay, you should build the plant.
Rent = 1,000,000 (P* - C) - I
Quasi-Rent:
You quasi -rent is the difference between the profit you get from selling to Ford and the
profit you get from your next-best option, selling to jobbers.
Quasi-Rent =[1,000,000 (P* -C)-I] – [1,000,000(Pm - C) – I] = 1,000,000 (P* - Pm )
Theory of the Firm
43
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Holdup Problem
If an asset was not relationship-specific, the profit the firm could get from using the asset
in its best alternative and its next-best alternative would be the same  the associated
quasi -rent would be zero.
But when a firm invests in a relationship-specific asset, the quasi-rent must be
positive - it will always get more from its best alternative, than from its secondbest alternative.
If the quasi-rent is large, a firm stands to lose a lot if it has to turn to its second-best
alternative. This opens the possibility that its trading partner could exploit this large
quasi-rent through holdup.
A firm holds up its trading partner by attempting to renegotiate the terms of the deal. A firm
can profit by holding up its trading partner when contracts are incomplete and when the deal
generates quasi-rents for its trading partner.
Theory of the Firm
44
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Holdup Problem
Example:
P*
Pm
C
I
= $12
= $4
= $3
= $8,500,000
•
A the original expected price of $12 per unit, your rent is
(12 - 3) 1,000,000 – 8,500,000 = $500,000 per year
Your quasi-rent is (12 – 4) 1,000,000 = $8,000,000 per year
If Ford renegotiates the contract down to $8 per unit, Ford will increase its profits by $4
million per year and it will have transferred half of your quasi-rents to itself.
•
•
Note:
After the holdup has occurred, you realize that you are getting a profit of
(8-3) 1,000,000 – 8,500,000 = - $3,500,000.
Theory of the Firm
45
Vertical Boundaries: Reasons to “Make”
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Holdup Problem and Transaction Costs
The holdup problem raises the cost of transaction arm‟s length market exchanges in four
ways. It can lead to:
•
More difficult contract negotiations and more frequent renegotiations
•
Investments to improve ex post bargaining positions
•
Distrust
•
Reduce Investments
Theory of the Firm
46
A (familiar example)
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Before entering a joint investment, 2 firms must invest 1.5 mio $ each.
The gross payoffs depend on firm strategy (behavior) where each firm
can play „holdup“ or „cooperate“. Gross (net) payoffs (like NPV) are:
Holdup Cooperate
Holdup
0.5;0.5 4.5;-0.5
Cooperate -0.5;4.5 3.5,3.5
Holdup Cooperate
Holdup
-1;-1
3;-2
Cooperate -2;3
2,2
Unlike classic prisoner„s dilemma, firms can here decide whether to play or
Not  Despite a mutually beneficial outcome (2,2) firms will not play (enter
A business relationship) since Holdup is a dominant and Nash equilibrium
Vertical Boundaries:
The Make or Buy Decision Tree
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Make or Buy Decision Tree
Theory of the Firm
48
Literature and further Reading
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Besanko, David et al. (2007): Economics of Strategy, 4th Ed., Evanston, Illinois.
• The Horizontal Boundaries of the Firm: Economies of Scale and Scope (p. 74 – 104)
• The Vertical Boundaries of the Firm (p. 105 – 135)
• Examples 2.1 – 3.6 (see HOMEPAGE → STUDENTEN/- INNEN LOGIN
→ Masterstudiengänge)
Theory of the Firm
49