Chapter 6: The Organization of the Firm
In this section the optimal way to acquire an efficient mix of inputs and the role of the
management in achieving maximum productivity is discussed.
Principal-agent problem – when employees and owners of a firm have conflicting interests.
3 methods managers can use to obtain inputs needed in product:
1. Spot exchange – An informal relationship between a buyer and seller in which neither
party is obligated to adhere to specific terms for exchange. Buyers and sellers essentially
are anonymous.
Key advantage: A firm specializes in doing what it does best: converting the inputs into output.
2. Contracts – A formal relationship between a buyer and seller that obligates the buyer
and seller to exchange at terms specified in a legal document. The firm enjoys the
benefits of specializing in what it does best, because the other firm actually produces the
inputs the purchasing firm needs.
Disadvantage: A contract is quite costly to write and it is difficult to cover all of the
contingencies that could occur in the future.
3. Vertical integration – A situation where a firm produces the inputs required to make its
final product.
The firm loses the gains in specialization it would realize were the outputs purchased from an
independent supplier. Vertical integration also increases bureaucratic costs.
Advantage: The firm does not need to rely on other firms to provide them with inputs
Transaction costs – Costs associated with acquiring input that are in excess of the amount paid
to the input supplier. They include:
1. The cost of searching for a supplier willing to sell a given input.
2. The costs of negotiating a price at which the input will be purchased (e.g. time, legal
fees).
3. Other investments and expenditures required to facilitate exchange.
In this section the optimal way to acquire an efficient mix of inputs and the role of the
management in achieving maximum productivity is discussed.
Principal-agent problem – when employees and owners of a firm have conflicting interests.
3 methods managers can use to obtain inputs needed in product:
1. Spot exchange – An informal relationship between a buyer and seller in which neither
party is obligated to adhere to specific terms for exchange. Buyers and sellers essentially
are anonymous.
Key advantage: A firm specializes in doing what it does best: converting the inputs into output.
2. Contracts – A formal relationship between a buyer and seller that obligates the buyer
and seller to exchange at terms specified in a legal document. The firm enjoys the
benefits of specializing in what it does best, because the other firm actually produces the
inputs the purchasing firm needs.
Disadvantage: A contract is quite costly to write and it is difficult to cover all of the
contingencies that could occur in the future.
3. Vertical integration – A situation where a firm produces the inputs required to make its
final product.
The firm loses the gains in specialization it would realize were the outputs purchased from an
independent supplier. Vertical integration also increases bureaucratic costs.
Advantage: The firm does not need to rely on other firms to provide them with inputs
Transaction costs – Costs associated with acquiring input that are in excess of the amount paid
to the input supplier. They include:
1. The cost of searching for a supplier willing to sell a given input.
2. The costs of negotiating a price at which the input will be purchased (e.g. time, legal
fees).
3. Other investments and expenditures required to facilitate exchange.
