Returns to Scale

CONSTANT RETURNS TO SCALE (CRS): f(2L, 2K) = 2f(L,K) = 2q

- A technology exhibits constant returns to scale if doubling inputs exactly doubles the
output. The firm builds an identical second plant and uses the same amount of labor and
equipment as in the first plant.

INCREASING RETURNS TO SCALE (IRS): f(2L, 2K) > 2f(L,K) = 2q

- A technology exhibits increasing returns to scale if doubling inputs more than doubles
the output. Instead of building two small plants, the firm decides to build a single larger
plant with greater specialization of labor and capital.

DECREASING RETURNS TO SCALE (DRS): f(2L, 2K) < 2f(L,K) = 2q

- A technology exhibits decreasing returns to scale if doubling inputs less than doubles
output. An owner may be able to manage one plant well but may have trouble
organizing, coordinating, and integrating activities in two plants.

VARYING RETURNS TO SCALE

- Many production functions have increasing returns to scale for small amounts of output,
constant returns for moderate amounts of output, and decreasing returns for large
amounts of output.

Varying Scale Economies

a to b: When a firm is small, increasing labor

and capital allows for gains from cooperation
between workers and greater specialization of
workers and equipment, so there are
increasing returns to scale

b to c: As the firm grows, returns to scale are

eventually exhausted. There are no more
returns to specialization, so the production
process has constant returns to scale.

c to d: If the firm continues to grow, the owner

starts having difficulty managing everyone, so
the firm suffers from decreasing returns to
scale.
 Productivity and Technology Change
RELATIVE PRODUCTIVITY

- Firms are not necessarily equally productive

- A firm may be more productive than others if: a manager knows a better way to organize
production; it’s the only firm with access to a new invention; union-mandated work rules,
government regulations, or other institutional restrictions affect only competitors.

- Firms are equally productive in competitive markets, not in oligopoly markets

INNOVATION

- An advance in knowledge that allows more output to be produced with the same level of inputs
is called technological progress.

- Technological progress is neutral if more output is produced using the same ratio of inputs. It
is nonneutral if it is capital saving or labor saving.

- Organizational changes may also alter the production function and increase the amount of
output produced by a given amount of inputs. In the early 1900s, Henry Ford revolutionized mass
production of automobiles through interchangeable parts and the assembly line.

Managerial Solution
MANAGERIAL PROBLEM

- Labor productivity during recessions

- How much will the output produced per worker rise or fall with each additional layoff?

SOLUTION

- Layoffs have the positive effect of freeing up machines to be used by remaining workers.
However, if layoffs force the remaining workers to perform a wide variety of tasks, the firm will
lose the benefits from specialization.

- Holding capital constant, a change in the number of workers affects a firm’s average product
of labor. Labor productivity could rise or fall.

- For some production functions layoffs always raise labor productivity because the APL curve is
everywhere downward sloping, for instance the Cobb-Douglass production function.
Total Product, Marginal Product, and Average Product of Labor
with Fixed Capital

Output Produced with Two Variable Inputs

Substitutability of Inputs
 Costs
INTRODUCTION
MANAGERIAL PROBLEM
- Technology choice at home versus abroad: In the United States, firms use relatively capital-
intensive technology
- Will that same technology be cost minimizing if they move their production abroad?
SOLUTION APPROACH
- First, a firm must determine which production processes are technically efficient so that it can
produce the desired level of output without waste. Second, a firm should pick from these
technically efficient processes the one that is also economically efficient (minimum cost). By
minimizing costs, a firm can increase its profit.
EMPIRICAL METHODS
- When considering costs, a good manager includes opportunity costs or foregone alternatives.
- To minimize costs, a manager should distinguish short-run costs from long-run costs.
- Firms may reduce costs overtime based on experience or its learning curve.
- If a firm produces several goods, individual cost may depend on the cost of producing multiple
goods.

THE NATURE OF COSTS

EXPLICIT AND IMPLICIT COSTS
- Explicit costs are direct, out-of-pocket payments for labor, capital, energy, and materials.
- Implicit costs reflect only a foregone opportunity rather than explicit, current expenditure.

OPPORTUNITY COSTS
- The opportunity cost of a resource is the value of the best alternative use of that resource.
- Value of Manager’s Time example: Maoyong owns and manages a firm. He pays himself only
$1k per month but could work for another firm and make $11k per month. Working for another
firm is the best alternative use of his time, so his opportunit y cost of time is $11k.

RELEVANCE OF CONSIDERING OPPORTUNITY COST

- Maoyong example: Assume monthly revenue is $49k and explicit costs are $40k, including
Maoyong’s monthly wage. The accounting profit is $9k and Maoyong collects $10k per month
(profit + wage). However, his opportunity cost is $11k. So, he incurs an economic loss of $1k.

COSTS OF DURABLE INPUTS

- Durable inputs are usable for a long period, perhaps for many years.
- Capital such as land, buildings, or equipment are durable inputs.
COSTS OF DURABLE INPUTS (TRUCK EXAMPLE)
- There are two problems. First, how to allocate the initial purchase cost over time. Second, what
to do if the value of the capital changes over time.
- Solution if there is a rental market: The accountant may expense the truck’s purchase price or
may amortize it over the life of the truck, following IRS rules. The firm’s opportunity cost of using
the truck is the amount that the firm would earn if it rented the truck to others.
- Solution if there is no rental market: The opportunity cost of capital of using the truck a year
would be the interest forgone in a year.

SUNK COST
Sunk cost is a past expenditure that cannot be recovered.
- If an expenditure is sunk, it is not an opportunity cost. So we should not consider it for
managerial decisions.
- However, sunk costs appear in financial accounts.

MANAGERS SHOULD IGNORE SUNK COSTS

- A firm paid $300k for a parcel of land but the market value is now $200k. If the firm builds a
plant on this land, the value for the firm becomes $240k.
- Is it worth carrying out production on this land or should the land be sold for its market value
of $200k?
- The land’s opportunity cost is $200k and the market value loss of $100k is a sunk cost. The sunk
cost cannot be recovered and should not be considered in the decision. The values to compare
are $240 versus $200. Certainly, the firm should carry out production on this land.

SHORT-RUN COSTS

Common Measures of Cost

Fixed Cost (F) + Variable Cost (VC) = Total Cost (C = F + VC)

- Fixed Cost (F) does not vary with the level of output; includes expenditures on land, office space,
production facilities, and other overhead expenses; are often sunk costs, but not always.
- Variable Cost (VC) changes as the quantity of output changes; refers to the costs of variable
inputs.
- Total Cost (C) is the sum of fixed and variable costs. • F and VC should be based on inputs’
opportunity costs.
 Average Fixed Cost (AFC = F/q) + Average Variable Cost (AVC= VC/q)
= Average Cost (AC = C/q = AFC + AVC)

- Average Fixed Cost (AFC) falls as output rises because the fixed cost is spread over more units.
- Average Variable Cost (AVC) or variable cost per unit of output may either increase or decrease
as output rises.
- Average Cost (AC) or average total cost may either increase or decrease as output rises.

Marginal Cost: MC = ΔC/Δq

- Marginal cost (MC) is the amount by which a firm’s cost changes if the firm produces one more
unit of output; ∆C is the change in cost when the change in output, ∆q, is 1 unit.

Marginal Cost: MC = ΔVC/Δq

- Marginal cost also equals the change in variable cost from a one-unit increase in output.

Marginal Cost using Calculus: MC = dC/dq = dVC/dq

- Marginal cost is the rate of change of cost as we make an infinitesimally small change in output.
MC=dVC/dq because dF/q=0.

How Cost Varies with Output

PRODUCTION FUNCTIONS AND THE SHAPES OF SHORT-RUN COSTS CURVES

- In the short run, the firm increases output by using more labor. However, each extra worker
increases output by a smaller amount. Diminishing marginal returns to labor determine the
shape of the production function.
- The production function determines the shape of the variable cost curve. As output increases,
variable cost increases more than proportionally because of diminishing marginal returns.
- The production function determines the shape of the marginal cost, average variable cost, and
average cost curves.
 THE MARGINAL COST CURVE

THE AVERAGE COST CURVE

Short-Run Cost Summary

- In the short run, the cost associated with fixed inputs is fixed, while the cost from inputs that
can be adjusted is variable.
- Given that input prices are constant, the shapes of the variable cost and the cost-per unit curves
are determined by the production function.
- Where there are diminishing marginal returns, the variable cost and cost curves become
relatively steep as output increases, so the average cost, average variable cost, and marginal cost
curves rise with output.
- The average cost and average variable cost curves fall when marginal cost is below them and
rise when marginal cost is above them, so the marginal cost cuts both these average cost curves
at their minimum points.
 Long Run Costs
INPUT CHOICE
- In the long run, the firm adjusts all its inputs so that its cost of production is as low as possible.
- The firm can change its plant size, design, build new machines, and otherwise adjust inputs that
were fixed in the short run.

TECHNICALLY AND ECONOMICALLY EFFICIENT

- From among the technically efficient combinations of inputs that can be used to produce a
given level of output, a firm wants to choose that bundle of inputs with the lowest cost of
production, which is the economically efficient combination of inputs.
- To do so, the firm combines information about technology from the isoquant with information
about the cost of production.

- An isocost represents all the combinations of inputs that have the same (iso-) total cost.
- In Figure 6.3, the $200 isocost line represents all the combinations of labor and capital that the
firm can buy for $200.

PROPERTIES OF ISOCOSTS
- The points at which the isocost lines hit the capital and labor axes depends on the firm’s cost,
and on the input prices.
- Isocost lines that are farther from the origin have higher costs than those closer to the origin.
- The slope of each isocost line is the same: ∆K/∆L = –w/r, the rate at which the firm can trade
capital for labor in input markets

A FAMILY OF ISOCOST LINES

ISOCOST AND ISOQUANT COMBINED
- The firm minimizes its cost by using the combination of inputs on the isoquant that is on the
lowest isocost line that touches the isoquant.

ISOCOST AND ISOQUANT COMBINED: GRAPH ANALYSIS

- In Figure 6.4, the lowest possible isoquant that will allow the beer manufacturer to produce
100 units of output is tangent to the $2,000 isocost line.
- At x, the bundle of inputs are L = 50 workers and K = 100 units of capital.
- At x, the isocost is tangent to the isoquant, so the slope of the isocost, –w/r = –3, equals the
slope of the isoquant, which is the negative of the marginal rate of technical substitution.
- Notice, y and z also produce 100 units of output but at a cost of $3,000. The x input combination
is economically efficient.

COST MINIMIZATION

Three Equivalent Rules to Minimize Costs in the Long-Run

The Lowest Isocost Rule

- The firm minimizes its cost by using the combination of inputs on the isoquant that is on the
lowest isocost line that touches the isoquant.
The Tangency Rule: MRTS = - w/r
- At the minimum-cost bundle, x, the isoquant is tangent to the isocost line. The slope of the
isoquant (MRTS) and the slope of the isocost are equal.

The Last-Dollar Rule: (MPL /w) = (MPK /r)

- Cost is minimized if inputs are chosen so that the last dollar spent on labor adds as much extra
output as the last dollar spent on capital. Thus, spending one more dollar on labor at x gets the
firm as much extra output as spending the same amount on capital.

PRODUCTION FUNCTIONS AND THE SHAPES OF LONG-RUN COSTS CURVES

- In the long run, returns to scale determine the shape of the production function, and the
production function, in turn, determines the shape of the AC curve and other cost curves.
- If a production function has increasing returns to scale at low levels of output, constant returns
to scale at intermediate levels of output, and decreasing returns to scale at high levels of output,
the LRAC curve must be U-shaped.
- LRAC curves can have many different shapes depending whether the production process has
economies or diseconomies of scale.
- Perfectly competitive firms typically have U-shaped AC curves. Noncompetitive markets may
be U-shaped, L-shaped, everywhere downward sloping, everywhere upward sloping or have
other shapes.

The Learning Curve

LEARNING BY DOING
- Learning by doing refers to the productive skills and knowledge that workers and managers
gain from experience.
- Workers add speed with practice. Managers learn how to organize production more efficiently,
assign tasks based on worker’s skills, and reduce inventory costs. Engineers optimize product
designs with experimentation.
- For these and other reasons, the average cost of production tends to fall over time, and the
effect is particularly strong with new products.

LEARNING CURVE AND COSTS

- The learning curve is the relationship between average costs and cumulative output.
- The cumulative output is the total number of units of output produced since the product was
introduced.
- If a firm is operating in the economies of scale section of its average cost curve, expanding
output lowers its cost for two reasons. Its average cost falls today because of economies of scale,
and also because of learning by doing.

COSTS OF PRODUCING MULTIPLE GOODS

JOINT PRODUCTION IS LESS COSTLY
• If a firm produces two or more goods that are linked by a single input, the cost of one good
may depend on the output level of another. For example, cattle provide beef and hides.
• A firm enjoys economies of scope if it is less expensive to produce goods jointly than separately.
• It is less expensive to produce beef and hides together than separately, so there are economies
of scope.

ECONOMIES OF SCOPE: SC = [C(q1 ,0) + C(0,q2 ) - C(q1 , q2 )]/C(q1 , q2 )

• C(q1 , 0) is the cost of producing q1 of the first good, C(0, q2 ) is the cost of producing q2 of the
second good, and C(q1 , q2 ) is the cost of producing both goods together.
• If SC is zero, the cost of producing the two goods separately, C(q1 ,0) + C(0,q2 ), is the same as
producing them together, C(q1 , q2 ). There are no economies of scope.
• If SC is positive, it is less expensive to produce goods jointly than separately. There are
economies of scope.
• If SC is negative, there are diseconomies of scope, and the two goods should be produced
separately

Managerial Solution
Managerial Problem
• Technology choice at home versus abroad: In the United States, firms use a relatively capital-
intensive technology
• Will that same technology be cost minimizing if they move their production abroad?

Solution
• The answer depends on relative factor prices and whether the firm’s isoquant is smooth.
• If the isoquant is smooth, even a slight difference in relative factor prices will induce the firm
to shift along the isoquant and use a different technology with a different capital-labor ratio.
• If the isoquant has kinks, the firm will use a different technology only if the relative factor prices
differ substantially.
BUNDLES OF LABOR AND CAPITAL THAT COST THE FIRM $200

RETURNS TO SCALE AND LONG-RUN COSTS

Firm Organization and Market Structure

Introduction
MANAGERIAL PROBLEM
• Many managers who receive an annual bonus based on the firm’s performance this year may
take actions that increase the firm’s profit this year but reduce profits in future years.
• Does evaluating a manager’s performance over a longer time period lead to better
management?

SOLUTION APPROACH
• Owners have to decide what objectives the firm should pursue, and they need to structure
incentives to induce managers to pursue these objectives. In addition, managers need to decide
which stages of production the firm should perform and which to leave to others.

EMPIRICAL METHODS
• Ownership and governance of firms affect the firm’s objectives.
• The owner-manager relationship is one of principal-agent relationship where the principal
delegates tasks to an agent. This delegation creates a transaction cost called an agency cost and
many features of the firm’s organization try to minimize it.
• In the pursuit of their main goal, such as maximizing profit, owners and managers must make
decisions about the nature of the firm, such as the make or buy decision. Market structures affect
such a decision.

Ownership & Governance of Firms

PRIVATE, PUBIC AND NON-PROFIT: THE PRIVATE SECTOR
• Consists of firms that are owned by individuals or other nongovernmental entities and whose
owners may earn a profit
• Examples are Apple, Heinz, and Toyota. In almost every country, this sector provides most of
that country’s gross domestic product (75% of GDPUSA).

PRIVATE, PUBIC AND NON-PROFIT: THE PUBLIC SECTOR

• Consists of firms and other organizations that are owned by governments or government
agencies, called state-owned enterprises
• Examples are the armed forces, the court system, most schools, colleges, universities, and
Amtrak. This sector may be small or large (12% of GDPUSA).

PRIVATE, PUBIC AND NON-PROFIT: THE NON-PROFIT SECTOR

• Consists of organizations that are neither government owned nor intended to earn a profit,
but typically pursue social or public interest objectives (non-government, not for-profit sector) •
Examples include Greenpeace, Alcoholics Anonymous, the Salvation Army, and other charitable,
educational, health, and religious organizations.

OWNERSHIP OF FOR-PROFIT FIRMS: SOLE PROPRIETORSHIPS

• Firms owned and controlled by a single individual

OWNERSHIP OF FOR-PROFIT FIRMS: PARTNERSHIPS

• Businesses jointly owned and controlled by two or more people operating under a partnership
agreement.

OWNERSHIP OF FOR-PROFIT FIRMS: CORPORATIONS

• Firms owned by shareholders, who own the firm’s shares or stocks.
• Each share is a unit of ownership in the firm. Therefore, shareholders own the firm in
proportion to the number of shares they hold.
• Shareholders elect a board of directors to represent them. In turn, the board of directors
usually hires managers who manage the firm’s operations.
• The legal name of a corporation often includes the term Incorporated (Inc.) or Limited (Ltd) to
indicate its corporate status. Ownership & Governance of Firms

A. Publicly Traded Corporation

• Corporations whose shares can be readily bought and sold by the general public
• Stocks may be available at the New York Stock Exchange, the NASDAQ, the Tokyo Stock
Exchange, the Toronto Stock Exchange, or the London Stock Exchange.

B. Closely Held Corporation

• Shares not available for purchase or sale on an organized exchange.
• Typically, its stock is owned by a small group of individuals (private equity).

C. From Publicly Traded to Closely Held Corporation

• To make the transition the closely held firm makes an initial public offering (IPO) of its shares
on an organized stock exchange.
• One major advantage of going public is to raise money. However, a major disadvantage is that
ownership of the firm becomes broadly distributed, possibly causing the original owners to lose
control of the firm.
• It is also possible for a publicly traded firm to go private and convert to closely held status.
Examples are Toys-R-Us and Burger King

D. Liability and Ownership

• Owners of a corporation are not personally liable for the firm’s debts; they have limited liability:
The personal assets of the corporate owners cannot be taken to pay a corporation’s debts even
if it goes into bankruptcy.
• Traditionally, the owners of sole proprietorships and partnerships were fully liable, individually
and collectively, for any debts of the firm. Now they can be a limited liability company (LLC). The
precise regulations that apply to LLCs vary from country to country and from state to state within
the United States.

E. Firm Size and Ownership

• Most large firms are corporations. According to the U.S. Statistical Abstract 2012, U.S.
corporations are only 18% of all nonfarm firms but make 81% of sales revenue and 58% of net
income. Nonfarm sole proprietorships are 72% of firms but make only 4% of the sales revenue
and earn 15% of net income.
• Corporations that earn over $50 million are less than 1% of all corporations, but they make
77% of revenue.

F. Firm Governance : Small Firms

• In a small private sector firm with a single owner -manager, the governance of the firm is
straightforward : the owner -manager makes the important decisions for the firm .
G. Firm Governance : Publicly Traded Corporation
• The shareholders own the corporation. However, most of them play no meaningful role in day
-to -day decision -making or even in long range planning .
• Shareholders elect a board of directors and delegate many of their ownership rights to them.
• The board of a large publicly traded corporation normally includes outside directors and inside
directors, such as the chief executive officer (CEO) of the corporation and other senior
executives.

Profit Maximization
Revenue – Cost = Profit π = R – C

• Revenue (R) is price times quantity.

• Cost(C), the correct measure is the opportunity cost: the value of the best alternative use of
any input the firm employs. The full opportunity cost of inputs used might exceed the explicit or
out-of-pocket costs recorded in financial accounting statements.
• Profit (π) is Revenue minus Cost. If π < 0, the firm makes a loss.
• To add profits over time calculate the present value, in which future profits are discounted
using the interest rate.

• Two Steps to Maximize Profit: π (q) = R (q) – C (q)

- Profit varies with the level of output because both revenue and cost vary with output.
- There are two key decisions to maximize profit.

• First Step: Output Decision

- What is the output level, q, that maximizes profit or minimizes loss?

• Second Step: Shutdown Decision

- Is it more profitable to produce q or to shut down and produce no output?

• Rule 1: Set output where profit is maximized

- If the firm knows its entire profit curve (Figure 7.1), it sets output at q*to get π*.

• Rule 2: Set output where Mπ = 0

- Marginal profit, p/∆q, where ∆q = 1, is the slope of the profit curve. The maximum
profit occurs where the slope is zero.
• Rule 3: Set output where MR(q)=MC(q)
- Marginal Profit = MR - MC. The extra income raises profit, but the extra cost reduces
profit. Maximum profit occurs at MR(q) = MC(q).
- Using calculus: dπ (q)/dq = dR (q)/dq – dC (q)/dq = 0; MR(q)=MC(q)

MAXIMIZATION
• SHUTDOWN RULES
- Should the firm shut down if its profit is negative? It depends

Shutdown Rule 1: Shut down only if loss is reduced

- This rule applies to the short run and long run alike.

Shutdown Rule 2: Shut down only if revenue < avoidable cost

- In the short run, variable costs are avoidable but fixed costs are unavoidable (sunk
costs).
- As long as revenue covers variable costs and some fixed costs, no shut down occurs.
- In the long run all costs are avoidable; shutting down eliminates all costs.

PROFIT MAXIMIZATION

PROFIT OVER TIME

• Firms maximize profit not only for the current period. They are normally interested in
maximizing profit over many periods.
• The difference between maximizing the current period’s profit and long-run profit is important
in some situations.

PRESENT VALUE: PV = FV / (1+i)t

• Compound Interest Rate: $100 today (PV) at a 10% interest rate has a future value (FV) of $110
in one year, and $121 in two years. In general FV = PV (1+i) t , where t is the number of years.
• Money in the future is worth less than money today: $100 in one year is less than $100 today.
In general, PV = FV / (1+i) t
• Shareholders of a firm may value a stream of profits over time by calculating the present value,
in which future profits are discounted using the interest rate (see Appendix 7 for more detail).
 Owners’ vs. Managers’ Objectives
CONSISTENT OBJECTIVES: PRINCIPAL-AGENT PROBLEM
• Owners (principal) delegate tasks to managers and other workers (agent) in most firms.
• If the principal wants to maximize profit and agents want to maximize their own incomes or
perks the resulting profit is not the maximum (agency cost).

CONSISTENT OBJECTIVES: CONTINGENT REWARDS

• To make the owner and manager objectives more closely aligned, many firms use contingent
rewards: higher pay if the firm does well.
• A year-end bonus based on the performance of the firm or a group of workers within the firm
• A stock option or the right to buy a certain number of the firm’s shares at a pre-specified
exercise price within a specified time

CONSISTENT OBJECTIVES : PROFIT SHARING

• If profit is easily observed and the owner and manager want to maximize their own earnings,
pay the manager a share of the firm’s profit .

GRAPH APPLICATION
• In the figure in the next slide, the manager (agent) earns 1 / 3 of the joint profit, shareholders
(principals) get 2 / 3 . The output level, q*, maximizes both shares . No conflict .
• By 2005 over 70 % of firms provided annual stock options to their top three executives,
compared to virtually none in 1950 and about 50 % in 1970 .
• 75 % of total compensation of a chief executive at S&P 500 firms came from incentives in 2009.

PROFIT SHARING
CONFLICTIVE OBJECTIVES: REVENUE OBJECTIVES
• Sometimes profit can be manipulated by owners or managers. So profit sharing is not possible.
• Revenue sharing: executive compensation is primarily determined by the firm’s revenue. But,
managers prefer to maximize revenue rather than profit.

GRAPH APPLICATION
• In the next slide, the manager is paid a share of revenue. It is best for the manager to set output
at q = 5, where revenue is 25 and profit just 5. The output that maximizes profit, q = 3, where
profit is 9 and revenue is 21, is not chosen.

REVENUE MAXIMIZATION

CONFLICTING OBJECTIVES: PERSONAL EFFORT AND EARNINGS

• A manager who receives a fixed salary or a compensation not tied to performance and who
values leisure may not work hard to maximize profit.
• If a board insists on a profit target, a manager may only satisfice it.

CONFLICTING OBJECTIVES: SOCIAL OBJECTIVES

• Corporations often make large contributions to hospitals, universities, environmental projects,
disadvantaged groups, or other causes. Are these managers pursuing social policy with
shareholders’ money?

CONFLICTING OBJECTIVES: PERKS

• Some perks save a manager’s time and increase productivity . However, some managers
unilaterally grant themselves perks with little or no tangible advantage to the firm . If the firm
reduces the manager’s salary by the cost of such benefits, then these benefits do not harm the
firm’s bottom line .
MONITORING & CONTROLLING MANAGER’S ACTIONS: DIRECT MONITORING
• If the owner and manager work side by side, monitoring the manager is easy.
• However, most of the time the owner cannot observe the actions of the manager; profit is
subject to uncertainty; and parties cannot write an enforceable contract.

MONITORING & CONTROLLING MANAGER’S ACTIONS: INDIRECT MONITORING

• Board and Managers: Senior executives are restricted in their ability to carry out activities
outside the firm (disclosure conflict of interest)
• Shareholders and Board: rules may require to have outside directors; nature and frequency of
elections. But, difficult to specify or legally enforce what constitutes appropriate effort for board
members.
• Say-on-Pay (SOP), the Dodd–Frank Wall Street Reform, and Consumer Protection Act of 2010:
shareholders vote periodically on compensation going to senior executives.

TAKEOVERS & THE MARKET FOR CORPORATE CONTROL

• Managers can be disciplined through the market for corporate control : outside investors buy
enough shares to take over control of an under - performing publicly traded firm .

POISON PILL DEFENSE

• Firms can defend with a shareholder rights plan (poison pill) in the United States .
• Poison pills may not prevent a takeover, but usually benefits the original managers or board of
directors to induce them not to further fight the takeover.

The Make or Buy Decision

Horizontal and Vertical Dimensions
• Managers make decisions that affect the structure of the firm in two dimensions
• Horizontal dimension: size of the firm in its primary market
• Vertical dimension: stages of the production process in which the firm participates

Supply Chain Management

• To produce and sell a good involves many sequential stages of production, marketing, and
distribution activities.
• A manager decides how many stages the firm will undertake itself
• Also, at each stage, whether to carry out the activity within the firm or to pay for it to be done
by others.
STAGES OF PRODUCTION
• The figure illustrates the sequential or vertical stages of a
relatively simple production process (such as bread).
• At the top of the figure, in the upstream, firms use raw inputs
(such as wheat) to produce semi-processed materials (such as
flour).
• Then, in the downstream, the same or other firms use the
semi-processed materials and labor to produce the final good
(such as bread), q = f(M, L). • In the last stage, the final
consumers buy the product

VERTICAL INTEGRATION
• A firm that participates in more than one successive stage of the production or distribution of
goods or services is vertically integrated .
• A firm may vertically integrate backward and produce its own inputs, or forward and buy its
former customer.
• A firm can be partially vertically integrated . It may produce a good but rely on others to market
it . Or it may produce some inputs itself and buy others from the market .
• Some firms buy from a small number of suppliers or sell through a small number of distributors
. These firms often control the actions of the firms with whom they deal by writing contractual
vertical restraints that create quasi -vertical integration (franchisor and franchisee) .

VERTICAL INTEGRATION IS RELATIVE

• All firms are vertically integrated to some degree.
• At one extreme, we have firms that perform only one major task and rely on markets and
outsourcing for all others. For example, a computer retailer.
• At the other extreme, we have firms that perform most stages of the production process. For
instance, Foster Farms.
• However, no firm is completely integrated: It would have to run the entire economy. As Carl
Sagan observed, “If you want to make an apple pie from scratch, you must first create the
universe.”

PROFITABILITY & SUPPLY CHAIN DECISIONS

• Firms decide whether to vertically integrate, quasi -vertically integrate, or buy goods and
services from markets or other firms depending on which approach is the most profitable .
KEY CONSIDERATIONS FOR PROFITABLE VERTICAL INTEGRATION
• First, the firm has to take into account all relevant costs including some that are not easy to
quantify such as transaction costs .
• Second, the firm must ensure a secure and flexible supply of needed inputs to its production
process .
• Third, the firm may vertically integrate even if doing so raises its cost of doing business so as
to avoid government regulations .

REDUCING TRANSACTION COSTS

• Probably the most important reason to integrate is to reduce transaction costs, especially the
costs of writing and enforcing contracts.
• A manufacturing firm may decide to vertically integrate forward (downstream) into distribution
if the expense from trying to prevent opportunistic behavior by these firms is high.
• Opportunistic behavior is particularly likely when a firm deals with only one other firm: a classic
principal-agent problem.
• Another potential source of transaction costs is a need for coordination. American Apparel felt
coordination costs were high enough to justify vertical integration. The Make or Buy Decision

SECURITY AND FLEXIBILITY OF INPUTS

• A common reason for vertical integration is to ensure supply of important inputs .
• Having inputs available on a timely basis is very important . Costs would skyrocket if a car
manufacturer had to stop assembling cars while waiting for a part . Backward (upstream)
integration to produce the part itself may help to ensure timely arrival of parts .
• Alternatively, this problem may be eliminated through quasi -vertical integration contracts
(reward prompt delivery, penalize delays), or just -in -time systems .
• It is also important to be able to vary production quickly . A firm may want to cut output during
a recession, and reduce its use of essential inputs . By vertically integrating, firms may gain
greater flexibility

AVOIDING GOVERNMENT REGULATION

• Firms may also vertically integrate to avoid government price controls, taxes, and regulations.
• A vertically integrated firm avoids price controls by selling to itself. For example, steel buyers
bought steel producers that did not want to sell as much as before the U.S. government price
controls.
• More commonly, firms integrate to lower their taxes. Tax rates vary by country, state, and type
of product. A vertically integrated firm can shift profit from a high-tax country/state to a low-tax
country/state by changing its transfer price between the firm’s divisions.
MARKET SIZE & LIFE CYCLE OF A FIRM
• If there is relatively little demand for a product at current prices, the entire industry is small,
each firm produces all successive steps of the production process. All firms are vertically
integrated .
• As the market and the industry grows, firms vertically disintegrate. Each firm buys services or
products from specialized firms.
• As an industry matures further, new products often develop and reduce much of the demand
for the original product. The industry shrinks in size. Firms vertically integrate again.

Market Structure
MORE TO CONSIDER FOR VERTICAL INTEGRATION
• When making horizontal and vertical decisions, managers need to consider the behavior of
actual and potential rival firms .
• Profit may be affected by the output and price levels of rivals, as well as the entrance of new
firms into the market .

THE FOUR MAIN MARKET STRUCTURES

• The behavior of firms depends on market structure : the number of firms in the market, the
ease with which firms can enter and leave the market, and the ability of firms to differentiate
their products from those of their rivals .
• The four main market structures are perfect competition, monopoly, oligopoly and
monopolistic competition . Their main characteristics are in the table .
MANAGERIAL SOLUTION

MANAGERIAL PROBLEM
• Does evaluating a manager’s performance over a longer time period lead to better
management?
SOLUTION
• The answer depends on whether the reward induces the manager to sacrifice long-run profit
for short-run gains.
• If the reward is based on a single year firm’s performance, most likely it is a bad incentive. It
may induce to increase profit that year in detriment of future profits.
• Paying over time gives a better incentive structure: bonuses based on more than one year or
bonuses clawed back to performance in subsequent years.

SOME TAKEOVER DEFENSE TERMS