Costs of Production and the Organization of the Firm
In the previous two chapters we examined the economics underlying decisions related to which goods and services a business concern will sell, where it will sell them, how it will sell them, and in what quantities. Another challenge for management is to determine how to acquire and organize its production resources to best support those commitments. In this chapter and in the following chapter we will be discussing key concepts and principles from microeconomics that guide its organization and production activities to improve profitability and be able to compete effectively.
A number of highly useful methodologies have been developed based on the concepts and principles discussed. This text will not address specific techniques for tracking costs and planning production activities. Readers seeking guidance on these tasks might consult a text on cost accounting or operations management.Two classic texts on cost accounting and operations management are by Horngren (1972) and Stevenson (1986), respectively.
4.1 Average Cost Curves
In Chapter 2 "Key Measures and Relationships", we cited average cost as a key performance measure in producing a good or service. Average cost reflects the cost on a per unit basis. A portion of the average cost is the amount of variable costs that can be assigned to the production unit. The other portion is the allocation of fixed costs (specifically those fixed costs that are not sunk), apportioned to each production unit.
The average cost generally varies as a function of the production volume per period. Since fixed costs do not increase with quantity produced, at least in the short run where production capabilities are relatively set, the portion of the average cost attributable to fixed cost is very high for small production volume but declines rapidly and then levels off as the volume increases.
The portion of average cost related to the variable cost usually changes less dramatically in response to production volume than the average fixed cost. In fact, in the example of the ice cream bar business in Chapter 2 "Key Measures and Relationships", we assumed the average variable cost of an ice cream bar would remain $0.30 per unit whether the operation sold a small volume or large volume of ice cream bars. However, in actual production environments, average variable cost may fluctuate with volume.
At very low production volumes, resources may not be used efficiently, so the variable cost per unit is higher. For example, suppose the ice cream bar venture operators purchase those bars wholesale from a vendor who delivers them in a truck with a freezer. Since the vendor’s charge for ice cream bars must cover the cost of the truck driver and truck operation, a large delivery that fills the truck is likely to cost less per ice cream bar than a very small delivery.
At the same time, pushing production levels to the upper limits of an operation’s capability can result in other inefficiencies and cause the average variable cost to increase. For example, in order to increase production volume in a factory, it may be necessary to pay workers to work overtime at a rate 1.5 times their normal pay rate. Another example is that machines may be overworked to drive higher volume but result in either less efficiency or higher maintenance cost, which translates into an increase in average variable cost.
Figure 4.1 "Breakdown of Average Cost Function Into Variable Cost and Fixed Cost Component" shows a general breakdown of average cost into average fixed cost and average variable cost. The figure reflects the earlier situations of variable cost inefficiencies at very low and very high production volumes. Note that even with the continued decline in the average fixed cost, there is a production level (marked Q*) where the average total cost is at its lowest value. Economists called the production volume where average cost is at the lowest value the capacity of the operation.
In conversational language, we often think of the capacity of a container as the maximum volume the container can hold. In that sense of the word, it seems awkward to call the production level Q* the capacity when the graph indicates that it is possible to produce at higher volume levels but just that the average cost per unit will be higher. However, even in physics, the volume in a container can be changed by the use of pressure or temperature, so volume is not limited by the capacity under normal pressures and temperatures.
Figure 4.1 Breakdown of Average Cost Function Into Variable Cost and Fixed Cost Component
The production level corresponding to the lowest point on the graph for average cost indicates the short-run capacity of the business operation.
In the economic sense of the word, we might think of capacity as the volume level where we have the most efficient operation in terms of average cost. Many businesses can operate over capacity, up to some effective physical limit, but in so doing will pay for that supplemental production volume in higher costs, due to needing to employ either more expensive resources or less productive resources, creating congestion that slows production, or overusing resources that results in higher maintenance costs per unit.
If the price earned by the business at these overcapacity volumes is sufficiently high, the firm may realize more profit by operating over capacity than at the capacity point where total average cost is at its lowest. Similarly, if demand is weak and customers will pay a price well in excess of average cost only at volumes lower than capacity, the firm will probably do better by operating below capacity. However, if a firm that is operating well above capacity or well below capacity does not see this as a temporary situation, the discrepancy suggests that the firm is either too small or too large. The firm may be able to improve profits in future production periods by resizing its operations, which will readjust the capacity point. If the firm operates in a very competitive market, there may even be little potential for profit for firms that are not operating near their capacity level.
4.2 Long-Run Average Cost and Scale
In the last chapter, we distinguished short-run demand from long-run demand to reflect the range of options for consumers. In the short run, consumers were limited in their choices by their current circumstances of lifestyles, consumption technologies, and understanding. A long-run time frame was of sufficient length that the consumer had the ability to alter her lifestyle and technology and to improve her understanding, so as to result in improved utility of consumption.
There is a similar dichotomy of short-run production decisions and long-run production decisions for businesses. In the short run, businesses are somewhat limited by their facilities, skill sets, and technology. In the long run, businesses have sufficient time to expand, contract, or modify facilities. Businesses can add employees, reduce employees, or retrain or redeploy employees. They can change technology and the equipment used to carry out their businesses.
The classification of short-run planning is more an indication of some temporary constraint on redefining the structure of a firm rather than a period of a specific length. In fact, there are varying degrees of short run. In a very brief period, say the coming week or month, there may be very little that most businesses can do. It will take at least that long to make changes in employees and they probably have contractual obligations to satisfy. Six months may be long enough to change employment structures and what supplies a firm uses, but the company is probably still limited to the facilities and technology they are using.
How long a period is needed until decisions are long term varies by the kind of organization or industry. A retail outlet might easily totally redefine itself in a matter of months, so for them any decisions going out a year or longer are effectively long-term decisions. For electricity power generators, it can take 20 years to plan, get approvals, and construct a new power generation facility, and their long-term period can be in terms of decades.
One important characteristic that distinguishes short-run production decisions and long-run production decisions is in the nature of costs. In the short run, there are fixed costs and variable costs. However, in the long run, since the firm has the flexibility to change anything about its operations (within the scope of what is technologically possible and they can afford), all costs in long-run production decisions can be regarded as variable costs.
Another important distinction between short-run production and long-run production is in the firm’s ability to alter its capacity. In a decidedly short-run time frame, the firm’s capacity or point of lowest average cost is effectively fixed. The firm may elect to operate either under or slightly over their capacity depending on the strength of market demand but cannot readily optimize production for that selected output level. In the long run, the firm is able to make decisions that alter its capacity point by resizing operations to where the firm expects to have the best stream of profits over time.
Because a business has the ability to redesign all of its operations to suit a targeted level of production, average cost curves for long-run planning are flatter than short-run average cost curves. If it appears that a low-volume operation would yield the best returns, the firm can be downsized to remove the cost of excess capacity and arrive at a lower average cost than would be achievable in the short run. By expanding its capacity, a firm would be able to perhaps even lower average cost, but certainly avoid the inefficiencies of being overcapacity, should higher production levels appear to be better.
One way to think of a long-run average cost curve is that each point on the curve reflects the lowest possible average cost of an operation resized to be optimal for that level of production. For example, in Figure 4.2 "Graph of Long-Run Average Cost (LRAC) Function Shown as the Short-Run Average Cost (SRAC) at Capacity for Different Scales of Operation'', the long-run average cost on curve LRAC at a production rate of 1000 units per period is the lowest cost, or cost at the capacity point, for a cost structure reflected by short-run average cost curve SRAC1. The long-run average cost at a production rate of 2000 units per production period is the lowest cost for average cost curve SRAC2 (which has a capacity of 2000). The long-run average cost at a production rate of 3000 units per production would be the average cost at capacity for SRAC3.
Like short-run average cost curves, long-run average cost curves trend downward at low target production rates, although the rate of decline in the long-run average cost curve is somewhat flatter due to the ability to readjust all factors of production. The typical reason for this declining long-run average cost curve at low production levels is because there are efficiencies in cost or production that can be exploited for modest increases in quantity. For example, for a business that is manufacturing major appliances or vehicles that require several assembly steps, in a larger operation it is possible to assign different assembly steps to different workers and, via this specialization, speed up the rate of production over what would be possible if the firm hired the same workers with each worker performing all assembly steps. As we pointed out in the previous chapter, customers who buy in large quantities can sometimes buy at a lower per unit price. Since most firms are buyers as well as sellers, and larger firms will buy in larger quantities, they can reduce the contribution of acquired parts and materials to the average cost.
Figure 4.2 Graph of Long-Run Average Cost (LRAC) Function Shown as the Short-Run Average Cost (SRAC) at Capacity for Different Scales of Operation
The ability to reduce long-run average cost due to increased efficiencies in production and cost will usually eventually subside. The production level at which the long-run average cost curve flattens out is called the minimum efficient scale. (Since the business is able to adjust all factors of production in the long run, it can effectively rescale the entire operation, so the target production level is sometimes called the scale of the business.) In competitive seller markets, the ability of a firm to achieve minimum efficient scale is crucial to its survival. If one firm is producing at minimum efficient scale and another firm is operating below minimum efficient scale, it is possible for the larger firm to push market prices below the cost of the smaller firm, while continuing to charge a price that exceeds its average cost. Facing the prospect of sustained losses, the smaller firm usually faces a choice between getting larger or dropping out of the market.
The increase in capacity needed to achieve minimum efficient scale varies by the type of business. A bicycle repair shop might achieve a minimum efficient scale with a staff of four or five employees and be able to operate at an average cost that is no different than a shop of 40 to 50 repair persons. At the other extreme, electricity distribution services and telephone services that have very large fixed asset costs and low variable costs may see the long-run average cost curve decline even for large production levels and therefore would have a very high minimum efficient scale.
Most firms have a long-run average cost curve that declines and then flattens out; however, in some markets the long-run average cost may actually rise after some point. This phenomenon often indicates a limitation in some factors of production or a decline in quality in factors of production if the scale increases enough. For example, in agriculture some land is clearly better suited to certain crops than other land. In order to match the yield of the best acreage on land of lower quality, it may be necessary to spend more on fertilizer, water, or pest control, thereby increasing the average cost of production for all acreage used.
Businesses that are able to lower their average costs by increasing the scale of their operation are said to have economies of scale. Firms that will see their average costs increase if they further increase their scale will experience diseconomies of scale. Businesses that have achieved at least their minimum efficient scale and would see the long-run average cost remain about the same with continued increases in scale may be described as having constant economies of scale.
The impact of an increase of scale on production is sometimes interpreted in terms of “returns to scale.” The assessment of returns to scale is based on the response to the following question: If all factors of production (raw materials, labor, energy, equipment time, etc.) where increased by a set percentage (say all increased by 10%), would the percent increase in potential quantity of output created be greater, the same, or less than the percent increase in all factors of production? If potential output increases by a higher percent, operations are said to have increasing returns to scale. If output increases by the same percent, the operations show constant returns to scale. If the percent growth in outputs is less than the percent increase in inputs used, there are decreasing returns to scale.
Returns to scale are related to the concept of economies of scale, yet there is a subtle difference. The earlier example of gained productivity of labor specialization when the labor force is increased would contribute to increasing returns to scale. Often when there are increasing returns to scale there are economies of scale because the higher rate of growth in output translates to decrease in average cost per unit. However, economies of scale may occur even if there were constant returns to scale, such as if there were volume discounts for buying supplies in larger quantities. Economies of scale mean average cost decreases as the scale increases, whereas increasing returns to scale are restricted to the physical ratio between the increase in units of output relative to proportional increase in the number of inputs used.
Likewise, decreasing returns to scale often translate to diseconomies of scale. If increasing the acreage used for a particular crop by using less productive acreage results in a smaller increase in yield than increase in acreage, there are decreasing returns to scale. Unless the acreage costs less to use, there will be an increase in average cost per unit of crop output, indicating diseconomies of scale.
4.3 Economies of Scope and Joint Products
Most businesses provide multiple goods and services; in some cases, the number of goods and services is quite large. Whereas the motivation for providing multiple products may be driven by consumer expectations, a common attraction is the opportunity to reduce per unit costs. When a venture can appreciate such cost savings, the opportunity is called an economy of scope.
Of course, not just any aggregation of goods and services will create economies of scope. For significant economies of scope, the goods and services need to be similar in nature or utilize similar raw materials, facilities, production processes, or knowledge.
One type of cost savings is the ability to share fixed costs across the product and service lines so that the total fixed costs are less than if the operations were organized separately. For example, suppose we have a company that expands from selling one product to two similar products. The administrative functions for procurement, receiving, accounts payable, inventory management, shipping, and accounts receivable in place for the first product can usually support the second product with just a modest increase in cost.
A second type of cost savings occurs from doing similar activities in larger volume and reducing per unit variable costs. If multiple goods and services require the same raw materials, the firm may be able to acquire the raw materials at a smaller per unit cost by purchasing in larger volume. Similarly, labor that is directly related to variable cost may not need to be increased proportionally for additional products due to the opportunity to exploit specialization or better use of idle time.
In some cases, two or more products may be natural by-products of a production process. For example, in refining crude oil to produce gasoline to fuel cars and trucks, the refining process will create lubricants, fertilizers, petrochemicals, and other kinds of fuels. Since the refining process requires heat, the excess heat can be used to create steam for electricity generation that more than meets the refinery’s needs and may be sold to an electric utility. When multiple products occur as the result of a combined process, they are called joint products and create a natural opportunity for an economy of scope.
As with economies of scale, the opportunities for economies of scope generally dissipate after exploiting the obvious combinations of goods and services. At some point, the complexity of trying to administer a firm with too many goods and services will offset any cost savings, particularly if the goods and services share little in terms of production resources or processes. However, sometimes firms discover scope economies that are not so obvious and can realize increased economic profits, at least for a time until the competition copies their discovery.
4.4 Cost Approach Versus Resource Approach to Production Planning
The conventional approach to planning production is to start with the goods and services that a firm intends to provide and then decide what production configuration will achieve the intended output at the lowest cost. This is the cost approach to production planning.Stevenson (1986) addresses this approach to production planning extensively. Once output goals are set, the expected revenue is essentially determined, so any remaining opportunity for profit requires reducing the cost as much as possible.
Although this principle of cost minimization is simple, actually achieving true minimization in practice is not feasible for most ventures of any complexity. Rather, minimization of costs is a target that is not fully realized because the range of production options is wide and the actual resulting costs may differ from what was expected in the planning phase.
Additionally, as we saw in Chapter 2 "Key Measures and Relationships", the decision about whether to provide a good or service and how much to provide requires an assessment of marginal cost. Due to scale effects, this marginal cost may vary with the output level, so firms may face a circular problem of needing to know the marginal cost to decide on the outputs, but the marginal cost may change depending on the output level selected. This dilemma may be addressed by iteration between output planning and production/procurement planning until there is consistency. Another option is to use sophisticated computer models that determine the optimal output levels and minimum cost production configurations simultaneously.
Among the range of procurement and production activities that a business conducts to create its goods and services, the firm may be more proficient or expert in some of the activities, at least relative to its competition. For example, a firm may be world class in factory production but only about average in the cost effectiveness of its marketing activities. In situations where a firm excels in some components of its operations, there may be an opportunity for improved profitability by recognizing these key areas, sometimes called core competencies in the business strategy literature, and then determining what kinds of goods or services would best exploit these capabilities. This is the resource approach to the planning of production.Wernerfelt (1984) wrote one of the key initial papers on the resource-based view of management.
Conceptually, either planning approach will lead to similar decisions about what goods and services to provide and how to arrange production to do that. However, given the wide ranges of possible outputs and organizations of production to provide them, firms are not likely to attain truly optimal organization, particularly after the fact. The cost approach is often easier to conduct, particularly for a firm that is already in a particular line of business and can make incremental improvements to reduce cost. However, in solving the problem of how to create the goods and services at minimal cost, there is some risk of myopic focus that dismisses opportunities to make the best use of core competencies. The resource approach encourages more out-of-the-box thinking that may lead a business toward a major restructuring.
4.5 Marginal Revenue Product and Derived Demand
In Chapter 2 "Key Measures and Relationships", we discussed the principle for profit maximization stating that, absent constraints on production, the optimal output levels for the goods and services occur when marginal revenue equals marginal cost. This principle can be applied in determining the optimal level of any production resource input using the concepts of marginal product and marginal revenue product.
The marginal product of a production input is the amount of additional output that would be created if one more unit of the input were obtained and processed. For example, if an accounting firm sells accountant time as a service and each hired accountant is typically billed to clients 1500 hours per year, this quantity would be the marginal product of hiring an additional accountant.
The marginal revenue product of a production input is the marginal revenue created from the marginal product resulting from one additional unit of the input. The marginal revenue product would be the result of multiplying the marginal product of the input times the marginal revenue of the output. For the example in the previous paragraph, suppose that at the current output levels, the marginal revenue from an additional billed hour of accountant service is $100. The marginal revenue product of an additional accountant would be 1500 times $100, or $150,000.
In determining if a firm is using the optimal level on an input, the marginal revenue product for an additional unit of input can be compared to the marginal cost of a unit of the input. If the marginal revenue product exceeds the marginal input cost, the firm can improve profitability by increasing the use of that input and the resulting increase in output. If the marginal cost of the input exceeds the marginal revenue product, profit will improve by decreasing the use of that input and the corresponding decrease in output. At the optimal level, the marginal revenue product and marginal cost of the input would be equal.
Suppose the marginal cost to hire an additional accountant in the previous example was $120,000. The firm would improve its profit by $30,000 by hiring one more accountant.
As noted earlier in the discussion of marginal revenue, the marginal revenue will change as output is increased, usually declining as output levels increase. Correspondingly, the marginal revenue product will generally decrease as the input and corresponding output continue to be increased. This phenomenon is called the law of diminishing marginal returns to an input. So, for the accounting firm, although they may realize an additional $30,000 in profit by hiring one more accountant, that does not imply they would realize $3,000,000 more in profits by hiring 100 more accountants.
If the marginal revenue product is measured at several possible input levels and graphed, the pattern suggests a relationship between quantity of input and marginal revenue product, as shown in Figure 4.3 "Typical Pattern of a Derived Demand Curve Relating the Marginal Revenue Product to Quantity of Input Employed in Production". Due to the law of diminishing marginal returns, this relationship will generally be negative. Thus the relationship looks much like the demand curve corresponding to output levels. In fact, this relationship is a transformation of the firm’s demand curve, expressed in terms of the equivalent marginal revenue product relative to the number of units of input used. Due to the connection to the demand curve for output, the relationship depicted in Figure 4.3 "Typical Pattern of a Derived Demand Curve Relating the Marginal Revenue Product to Quantity of Input Employed in Production" is called a derived demand curve.
Figure 4.3 Typical Pattern of a Derived Demand Curve Relating the Marginal Revenue Product to Quantity of Input Employed in Production
One difficulty in comparing marginal revenue product to the marginal cost of an input is that the mere increase in any single input is usually not enough in itself to create more units of output. For example, simply acquiring more bicycle frames will not result in the ability to make more bicycles, unless the manufacturer acquires more wheels, tires, brakes, seats, and such to turn those frames into bicycles. In cases like this, sometimes the principle needs to be applied to a fixed mix of inputs rather than a single input.
For the accounting firm in the earlier example, the cost to acquire an additional accountant is not merely the salary he is paid. The firm will pay for benefits like retirement contributions and health care for the new employee. Further, additional inputs in the form of an office, computer, secretarial support, and such will be incurred. So the fact that the marginal revenue product of an accountant is $150,000 does not mean that the firm would benefit if the accountant were hired at any salary less than $150,000. Rather, it would profit if the additional cost of salary, benefits, office expense, secretarial support, and so on is less than $150,000.
4.6 Marginal Cost of Inputs and Economic Rent
In cases where inputs are in high supply at the current market price and the market for inputs is competitive, the marginal cost of an input is roughly equal to the actual cost of acquiring it. So, in such a situation, the principle described earlier can be expressed in terms of comparing the marginal revenue product to price to acquire the input(s). If the number of accountants seeking a job were fairly substantial and competitive, the actual per unit costs involved in hiring one more accountant would be the marginal cost.
If the market of inputs is less competitive, a firm may have to pay a little higher than the prevailing market price to acquire more units because they will need to be hired away from another firm. In this situation, the marginal cost of inputs may be higher than the price to acquire an additional unit because the resulting price increase for the additional unit may carry over to a price increase of all units being purchased.
Suppose the salary required to hire a new accountant will be higher than what the firm is currently paying accountants with the same ability. Once the firm pays a higher salary to get a new accountant, they may need to raise the salaries of the other similar accountants they already hired just to retain them. In this instance, the marginal cost of hiring one more accountant could be substantially more than the cost directly associated with adding the new accountant. As a result of the impact on other salaries and associated costs of the hire, the firm may decide that the highest salary for a new accountant that the firm can justify may be on the order of $50,000, even though the resulting marginal revenue product is substantially greater.
If inputs are available in a ready supply, or there are close substitutes available that are in ready supply, the price of an additional unit of input typically reflects either the opportunity cost related to the value of the next best use of that input or the minimum amount needed to induce a new unit to become available. However, there are some production inputs that may be in such limited supply that even further price increases will not attract new units to become available, at least not quickly. In these cases, the marginal revenue product for an input may still considerably exceed its marginal cost, even after all available inputs are in use. The sellers of these goods and services may be aware of this imbalance and insist on a price increase for the input up to a level that brings marginal cost in balance with marginal revenue product. The difference between the amount the provider of the limited input supply is able to charge and the minimum amount that would have been necessary to induce the provider to sell the unit to the firm is called economic rent.
Suppose a contracting firm was hired to do emergency repairs to a major bridge. Due to the time deadline, the firm will need to hire additional construction workers who are already in the area. Normally, these workers may have been willing to work for $70 per hour. However, sensing the contracting firm is being paid a premium for the repairs, meaning the marginal revenue product of labor is high, and there are a limited number of qualified workers available, the workers can insist on being paid as much as $200 per hour for the work. The difference of $130 would be economic rent caused by the shortage of qualified workers available on short notice.
Economic rent can occur in agriculture when highly productive land is in limited supply or in some labor markets like professional sports or commercial entertainment where there is a limited supply of people who have the skills or name recognition needed to make the activity successful.
4.7 Productivity and the Learning Curve
The resource view of production management is to make sure that all resources employed in the creation of goods and services are used as effectively as possible. Smart businesses assess the productivity of key production resources as a means of tracking improvements and in comparing their operations to those of other firms.
Earlier in this chapter we introduced the concept of marginal product. This measure reflects how productive an additional unit of that input would be in creating additional output. However, for some inputs, there are differences in marginal productivity across units. For example, in agriculture an acre of land in one location may be capable of better yields than an acre in another location. At any given input price, firms will seek to employ those units with the highest marginal product first.
In looking at the collective performance of a production operation, we need a measure of productivity that applies to all inputs being used rather than the last unit acquired. One means of doing this is using the measure of average productivity, which is a ratio of the total number of units of output divided by the total units of an input. An alternative measure of average productivity would be the total dollars in revenue or profit divided by the total units of an input.
Computations of average productivity make sense for key inputs around which production processes are designed. In the example of the accounting firm used in this chapter, the number of accountants is probably a good choice. Average productivity could be in the form of labor hours billed divided by accountants hired. If a firm managed to sell 1600 billable hours in 1 year, but only 1500 billable hours in another year, the earlier year indicated higher productivity.
In retail stores, a key resource is the amount of floor space. The productivity of a store could be measured by the total revenue over a period divided by the available square footage. This measure could be compared to the same measure for other stores in the retail chain or with similar competitor stores. Even sections within the store can be compared for which types of goods and services sold are most effective in generating sales, although given that costs vary too, a better productivity measure here may be profit contribution (revenue minus variable cost) per square foot.
The productivity of firms may change over time. In the case of labor, the productivity of individual workers will rise as they gain experience and new workers can be trained more effectively. There is also an improvement in overall productivity from the increased knowledge of management in how to employ productive resources better. These productivity gains from experience and improved knowledge are sometimes called learning by doingThe economics of learning by doing was introduced by Arrow (1962).
In addition to the increased profit potential of improved productivity, new firms or firms starting new operations need to anticipate these gains in deciding whether to engage in a new venture. Often a venture will not look attractive if the assumed costs of production are based on the costs that apply in the initial periods of production. Learning improvements need to be considered as well. In some sense, decreased profits and even losses in the initial production periods are necessary investments for a successful long-term operation.
Improvements due to productivity gains will usually result in decreased average costs. The relationship between cumulative production experience and average cost is called the learning curve. An example appears in Figure 4.4 "Pattern of a Learning Curve Showing Average Cost Declining by a Fixed Percentage for Each Doubling of Cumulative Output". One point to be emphasized is that the quantity on the horizontal axis is cumulative production, or total production to date, rather than production rate per production period. This is not a scale effect per se. Even if the firm continues to produce at the same rate each period, it will see declines in the average cost per unit of output, especially in the initial stages of operation.
One numerical measure of the impact of learning on average cost is called the doubling rate of reduction. The doubling rate is the reduction in average cost that occurs each time cumulative production doubles. If the average cost declines by 15% each time cumulative production doubles, that would be its doubling rate. A learning curve with a doubling rate of 15% may be called an 85% learning curve to indicate the magnitude of the average cost compared to when cumulative production was only half as large.
Figure 4.4 Pattern of a Learning Curve Showing Average Cost Declining by a Fixed Percentage for Each Doubling of Cumulative Output
Note that the number of units required to double cumulative production will get progressively higher. For example, if cumulative production now is 1000 units, the next doubling will occur at 2000 cumulative units, with the next doubling at 4000 cumulative units, and the following at 8000 cumulative units. Thus the rate of decline in average cost for each successive unit of production will diminish as cumulative production increases.
Economics of Organization
For many years, the field of microeconomics focused primarily on the relationship between firms and the outside environment of consumers, suppliers, competitors, and regulators. Internally, it was assumed that a firm was able to measure the costs associated with any pattern of exchanges with the outside environment in order to determine the best production and marketing decisions. However, the conduct of the actual processes involved in production was not regarded as an issue of economics in itself. Rather, these matters were treated as issues of organizational behavior and organizational design to best assign, coordinate, and motivate employees, much like a military unit.
In recent decades, economists have applied and developed economic principles that inform a better understanding of activity inside the firm. One focus in this newer endeavor is the firm’s decisions on which goods and services they will provide. A related topic of interest to economists is how much of the production activity will be done by the firm and how much will be purchased from other firms or contracted out to other businesses.
When a business elects to provide a large number of goods and services or has complex, multistage production operations, operations must be assigned to departments or divisions and the firm faces challenges in coordinating these units. Although organizational psychologists have addressed these issues for many years, economics has been able to provide some new insights.
Another issue in the design of a firm is motivation of units and individuals. In analyses based on organizational behavior, individuals are regarded as having psychological needs and the challenge to the organization is how to design procedures to meet those needs so that employees better support the needs of the organization. The new perspective from economics views an employee as an independent agent whose primary objective is to maximize his own welfare and the challenge to the organization is to structure incentives in a manner that aligns the economic interests of the firm with economic interests of the employee.
5.1 Reasons to Expand an Enterprise
Businesses usually sell multiple products or services, and they alter the collection of goods and services provided over time. Several factors motivate changes in this composition and can result in decisions either to expand an enterprise by increasing the range of goods and services offered or to contract the enterprise by suspending production and sale of some goods and services. In this section, we will list some key motivations for expanding the range of an enterprise. Bear in mind that when these motivations are absent or reversed, the same considerations can lead to decisions to contract the range of the enterprise.
Earlier, in Chapter 4 "Cost and Production", we discussed the concepts of economies of scale (cost per unit decreases as volume increases) and economies of scope (costs per unit of different goods can be reduced by producing multiple products using the same production resources). Businesses often expand to exploit these economies.
As we will see in Chapter 7 "Firm Competition and Market Structure", in markets with few sellers that each provide a large fraction of the goods or services available, the sellers possess an advantage over buyers in commanding higher prices. Businesses will often either buy out competitors or increase production with the intent to drive competitors out of the seller market in order to gain market power.
Many businesses sell products that are intermediate, rather than final, goods. Their customers are other businesses that take the goods or services they purchase and combine or enhance them to provide other goods and services. As a result, the profit that is earned in the production of a final product will be distributed across several firms that contributed to the creation of that good. However, the profit may not be evenly distributed across the contributing firms or proportional to their costs. Sometimes a firm will recognize the higher profit potential of the firms that supply them or the firms to which they are suppliers and will decide to participate in those more lucrative production stages.
Due to the considerable uncertainties of future costs, revenues, and profits and the need for firms to commit resources before these uncertainties are resolved, business is a risky prospect. Just as investors can mitigate the inherent risk of owning stocks by purchasing shares in different firms across somewhat unrelated industries, large firms can reduce some of their risk by producing unrelated products or services. Additionally, there may be increased efficiencies in movement of resources between different production operations when done by the same company.
5.2 Classifying Business Expansion in Terms of Value Chains
We noted earlier that many businesses sell goods or services that are intended to help other businesses in the creation of their goods and services. Many of the goods we consume as individuals are the result of a sequence of production operations that may involve several firms. If the final goods are traced backward through the intermediate goods that were acquired and utilized, we can usually envision the participant firms in a creation process as a network of production activities or a sequence of production stages.
For example, consider a loaf of bread purchased at a grocery store. The grocery store may purchase the loaf from a distributor of bakery products. The distributor likely purchased the loaf from a baking company. In order to produce the loaf of bread, the bakery would need flour and yeast, along with packaging material. These may be purchased from other businesses. The flour came from a grain grinding process that may have been done by a different business. The business that ground the grain would need grain that may have come from an agricultural cooperative, which in turn was the recipient of the grain from a farmer. In order to grow and harvest the grain, the farmer needs seed, tractors, and fuel, which are usually obtained from other sources.
Each of the firms or production operations that contributes to the creation of the final product can be considered as adding value to the resources they acquire in their completion of a stage of the creation process. Since the network of operations that account for the creation of a product can often be represented by a sequence of stages, the network is commonly called the value chain for the product.
Figure 5.1 "Generic Value Chain for a Manufactured Good" shows a generic value chain for a manufactured good. This value chain begins with the raw materials that eventually go into the product that must be acquired, possibly by mining (e.g., metal) or harvesting (e.g., wood). Next, the raw material is processed into a material that can be used to create parts in the next stage. Using these parts, the next stage of the value chain is the assembly of the product. Once assembled, the product must be distributed to the point of sale. In the final stage, a retailer sells the finished product to the consumer.
Business expansions are classified based on the relationship of the newly integrated activity to prior activities engaged in by the firm. If the new activity is in the same stage of that value chain or a similar value chain, the expansion is called horizontal integration. If the new activity is in the same value chain but at a different stage, the expansion is called vertical integration. If the new activity is part of a quite different value chain, the new combined entity would be called a conglomerate merger.
Figure 5.1 Generic Value Chain for a Manufactured Good
5.3 Horizontal Integration
In horizontal integration, a firm either increases the volume of current production activities or expands to similar kinds of production activities. Consider a television manufacturer that operates at the assembly stage of its value chain. If that company bought out another manufacturer of television sets, this would be horizontal integration. If the company were to decide to assemble computer monitors, the product would be a form of horizontal integration due to the high similarity in the two products and type of activity within those value chains.
Cost efficiencies in the form of economies of scale from higher volumes or economies of scope from producing related products are primary driving factors in horizontal integration. When a firm expands to a new product that is similar to its current products, usually there is a transfer of knowledge and experience that allows the expanding firm to start with higher cost efficiency than a firm that is entering this market with no related experience. If an enterprise possesses core competencies in the form of production processes that it can perform as well or better than others in the market, and can identify other products that can employ those core competencies, the enterprise can enter new markets as a serious competitor.
Market power from holding a higher share of all sales in a market is the other major motivation for horizontal integration. As we will discuss in later chapters, the possible gains from increased market power are often so significant that the governments in charge of overseeing those markets may limit or forbid horizontal mergers where one company buys out or combines with a competitor.
Since most firms are buyers as well as sellers, horizontal integration can create an advantage for large firms in demanding lower prices for goods and services they purchase. For example, a national chain like Walmart may be the principal customer of one of its suppliers. If Walmart decides to use a different supplier, the former supplier may have difficulty remaining in business. Consequently, the supplier may have little choice about accepting reduced prices.
5.4 Vertical Integration
Vertical integration occurs when a firm expands into a different stage of a value chain in which it already operates. For example, suppose the television manufacturing firm had been purchasing the electronic circuit boards that it uses in its television set products but decides to either buy the supplier or start a new operation to make those parts for itself. This would be vertical integration.
Usually vertical integration will extend to a neighboring stage in the value chain. When a business expands into an earlier stage in the value chain, the business is said to be doing upstream integration. When the expansion is to a later stage of the value chain, the result is downstream integration.
A major motivation for vertical integration is the potential for improved profitability. As noted earlier, firms at some stages of the value chain may enjoy better market conditions in terms of profitability and stability. If two stages of the value chain are performed by two divisions of the same company rather than by two separate companies, there is less haggling over price and other conditions of sale. In some cases, through a process that economists call double marginalization,A nice discussion of double marginalization appears in Shugart, Chappell, and Cottle (1994). it is possible that a single vertically integrated firm can realize higher profit than the total of two independent firms operating at different stages and making exchanges. An independent partner may not conduct its business the way that the firm would prefer, and possibly the only means to make sure other stages of the value chain operate as a firm would like is for the firm to actually manage the operations in those stages.
Another possible motivation for vertical integration is risk reduction. If a firm is highly dependent on the goods and services of a particular supplier or purchases by a particular buyer, the firm may find itself in jeopardy if that supplier or buyer were to suddenly decide to switch to other clients or cease operations. For example, if the supplier of electronic circuit boards were to cancel future agreements to sell parts to the television manufacturer and instead sell to a competitor that assembles television sets, the television company may not be able to respond quickly to the loss of supply and may decide it needs to either buy out the supplier or start its own electronic parts division. From the circuit board supplier’s perspective, there is also risk to them if they invest in production capacity to meet the specific part designs for the television company and then the television company decides to get the circuit boards elsewhere. By having both operations within the boundaries of a single enterprise, there is little risk of unilateral action by one producer to the detriment of the other producer.
5.5 Alternatives to Vertical Integration
If the reduction of risk related to the actions of an independent supplier or buyer is a motivation for vertical integration, the firm may have alternatives to formally integrating into another stage of the value chain through use of a carefully constructed agreement with a supplier or buyer. Done correctly, these agreements can result in some of the gains a business might expect from formal integration of the other stage of value-adding activity.
If the concern is about the reliability of continued exchanges, the supplier firm can establish a long-term agreement to be the exclusive dealer to the buyer firm, or the buyer firm can contract to be the exclusive buyer from the seller firm. In the retail business, these sometimes take the form of franchise outlets, where the franchise enjoys the assurance that their product will not be sold by a competitor within a certain distance and the supplier is assured of having a retailer that features their goods exclusively.
In some cases, the concern may be about future prices. If the upstream firm is concerned that the downstream firm will charge too little and hurt their profitability, the upstream firm can insist on a resale price maintenance clause. If the downstream firm is concerned that the upstream firm will use their exchanges to build up a business and then seek additional business with other downstream clients at lower prices, the downstream firm can ask for a best price policy that guarantees them the lowest price charged to any of the upstream firm’s customers.
Some upstream suppliers may produce a variety of goods and rely on downstream distributors to sell these goods to consumers. However, the downstream firm may find that selling just a portion of the upstream firm’s product line is more lucrative and will not willingly distribute the upstream firm’s entire line of products. If this is a concern to the upstream firm, it can insist on the composition of products a distributor will offer as a condition of being a distributor of any of its products.
One way firms protect themselves from supply shortages is by maintaining sizeable inventories of parts. However, maintaining inventory costs money. Firms that exchange goods in a value chain can reduce the need for large inventories with coordinated schedules like just-in-time systems.The best-selling book by Womack, Jones, and Roos (1990) describes the just-in-time philosophy. In situations where quality of the good is of key concern, and not just the price, the downstream firm can require documentation of quality control processes in the upstream firm.
When upstream firms are concerned that they may not realize a sufficient volume of exchanges over time to justify the investment in fixed assets, the upstream firm can demand a take-or-pay contract that obligates the buyer to either fulfill its intended purchases or compensate the supplier to offset losses that will occur. This type of agreement is particularly important in the case of “specific assets” in economics, where the supplier would have no viable alternative for redeploying the fixed assets to another use.
Although some of these measures may obviate the need for a firm to expand vertically in a value chain, in some circumstances forming the necessary agreements is difficult to accomplish. This is especially the case when one party in a vertical arrangement maintains private information that can be used to its advantage to create a better deal for itself but potentially will be a bad arrangement for the party that does not have that information in advance. As a result, parties that are aware of their limited information about the other party will tend to be more conservative in their agreement terms by assuming pessimistic circumstances and will not be able to reach an agreement. This reaction is called adverse selection in economic literature.Nobel laureate George Akerlof (1970) wrote a seminal paper examining adverse selection in the context of used cars.
In some cases, one party in a vertical arrangement may have production or planning secrets that do not affect the agreement per se but risk being discovered by the other party as the result of any exchange transactions. These secrets may be the result of costly research and development but may pass to the other party at essentially no cost, and the other party may take advantage of that easily obtained information. This is a version of what economists call the free rider problem.See the text by Brickley, Smith, and Zimmerman (2001) for more about the free rider problem in economics of organizations. Due to the difficulty of protecting against problems of adverse selection and free riders, firms may conclude that vertical integration is the better option.
5.6 Conglomerates
As stated earlier, a conglomerate is a business enterprise that participates in multiple value chains that are different in nature. An example of a conglomerate is General Electric, which engages in the manufacture of appliances, construction of energy facilities, financing of projects, and media ventures, just to name a portion of its product portfolio.
One attraction of conglomerates is the ability to diversify so that the firm can withstand difficult times in one industry by having a presence in other kinds of markets. Beyond diversification, a conglomerate can move capital from one of its businesses to another business without the cost and difficulties of using outside capital markets. Often conglomerates will have some divisions that are cash cows in being profitable operations in mature markets, and other businesses that have great potential but require sizeable investment that can be funded by profits from the cash-cow businesses.The concept of cash-cow businesses is an aspect of the Boston Consulting Group matrix for corporate strategy (1970).
Another argument for conglomerates is that companies with very talented management staffs may be capable of excelling in more than one type of business. For instance, the former chairman of General Electric, Jack Welch, was widely praised as providing superior senior management for the wide range of businesses in which General Electric participated.
5.7 Transaction Costs and Boundaries of the Firm
We have discussed several reasons a firm may decide to expand. At first glance, it may seem that expanding a business is often a good idea and has little downside risk if the larger enterprise is managed properly. In fact, during the last century successful businesses often engaged in horizontal and vertical integration and even became conglomerates due to such reasoning.
However, as many of these large corporations learned, it is possible to become too large, too complex, or too diversified. One consequence of a corporation growing large and complex is that it needs a management structure that is large and complex. There needs to be some specialization among managers, much as there is specialization in its labor force. Each manager only understands a small piece of the corporation’s operations, so there needs to be efficient communication between managers to be able to take advantage of the opportunities of integration and conglomeration. This requires additional management to manage the managers.
Large firms usually have some form of layered or pyramid management both to allow specialization of management and to facilitate communication. Still, as the number of layers increases, the complexity of communication grows faster than the size of the management staff. Information overload results in the failure of key information to arrive to the right person at the right time. In effect, at some point the firm can experience diseconomies of scale and diseconomies of scope as the result of management complexity increasing faster than the rate of growth in the overall enterprise.
Another problem with expansion, especially in the cases of vertical integration and conglomerates, is that different kinds of businesses may do better with different styles of management. The culture of a successful manufacturer of consumer goods is not necessarily the culture of a startup software company. When many kinds of businesses are part of the same corporation, it may be difficult to synchronize different business cultures.
Economists have developed a theory called transaction cost economics to try to explain when a firm should expand and when it should not, or even when the firm would do better to either break apart or sell off some of its business units. A transaction cost is the cost involved in making an exchange. An exchange can be external or internal. An external exchange occurs when two separate businesses are involved, like the television manufacturer and its parts supplier in the earlier example. Prior to the actual exchange of parts for cash, there is a period in which the companies need to come to agreement on price and other terms. The external transaction costs are the costs to create and monitor this agreement.
If a firm decides to expand its boundaries to handle the exchange internally, there are new internal transaction costs. These would be the costs to plan and coordinate these internal exchanges. If exchanges of this nature have not been done before, these internal transaction costs can be significant.
Nobel Prize laureate Ronald Coase introduced the concept of transaction costs and also proposed a principle for determining when to expand known as the Coase hypothesis.The initial article that stimulated later development of the transaction cost concept was by Ronald Coase (1937). Essentially, the principle states that firms should continue to expand as long as internal transaction costs are less than external transaction costs for the same kind of exchange.
5.8 Cost Centers Versus Profit Centers
One internal transaction cost in multiple-division companies is how to coordinate the divisions that make internal exchanges so they will achieve what is best for the overall corporation. This challenge is not merely a matter of communication but of providing proper motivation for the individual units.
Large vertically integrated companies often have at least one upstream division that creates a product and a downstream division that distributes it or sells it to consumers. One design for such companies is to have a central upper management that decides what activities and activity levels should be provided by each division. These instructions are given to the division managers. With the output goals of each division established, each division will best contribute to the overall profitability of the corporation by trying to meet its output goals at minimum cost. As such, divisions operating under this philosophy are called cost centers.
Although the cost center design may sound workable in principle, there is some risk in the division having an overall objective of minimizing cost and divisional management evaluated in terms of that objective. The response to this objective is that the firm may cut corners on quality as much as possible and avoid considering innovations that would incur higher initial costs but ultimately result in a better product for the long run. Unless the top-level management is aware of these issues and sets quality requirements properly, opportunities may be missed.
Another problem with cost centers, particularly in the nonprofit and public sectors, is that the compensation and prestige afforded to division managers may be related to the size of division operations. Consequently, the incentive for managers is to try to justify larger cost budgets rather than limit costs.
An alternative to the cost center approach is to treat a division as if it were like a business that had its own revenues and costs. The goal of each division is to create the most value in terms of the difference between its revenues and costs. This is known as a profit center. Division managers of profit centers not only have incentives to avoid waste and improve efficiencies like cost centers but also have an incentive to improve the product in ways that create better value.
5.9 Transfer Pricing
The profit center model treats a corporate division as if it were an autonomous business within a business. However, often the reason for having multiple divisions in an enterprise is because there is vertical integration, meaning that some divisions are providing goods and services to other divisions in the enterprise. If the two divisions in an exchange are to be treated as if they were separate businesses, what price should be charged by the supplying division? Even if there is no actual cash being tendered by the acquiring division, some measurement of value for the exchange is needed to serve as the revenue for the selling division and the cost for the acquiring division. The established value assigned to the exchanged item is called a transfer price.
One possibility for establishing a transfer price is for the two divisions to negotiate a price as they would if they were indeed independent businesses. Unfortunately, this approach sacrifices one of the benefits of vertical integration—namely, the avoidance of the transaction costs that are incurred on external changes—without avoiding all the internal transaction costs.
Another approach to the problem of pricing interdivision exchanges is to base prices on principles rather than negotiation. Academic research has concluded a number of principles for different kinds of situations. In this section, we will limit our consideration to two of these situations.
Suppose two divisions in an enterprise, Division A and Division B, exchange a good that is only produced by Division A. More specifically, there is no other division either inside or outside the enterprise that currently produces the good. Division B is the only user of this good, either inside or outside of the enterprise. Under these conditions, theoretically the best transfer price is the marginal cost of the good incurred by Division A.
No formal proof of this principle will be offered here, but a brief defense of this principle would be as follows: Suppose the price charged was less than the marginal cost. If Division A decides on the production volume that would maximize its internal divisional profit, then by reducing its volume somewhat, Division A would avoid more cost than it loses in forgone transfer revenue. So Division A would elect to provide fewer units than Division B would want.
On the other hand, suppose the transfer price was set at a level higher than the marginal cost. Since the transfer cost becomes a component of cost to receiving Division B, in determining its optimal volume of production, Division B will see a higher marginal cost than is actually the case (or would be the case if Divisions A and B functioned as a single unit). As a result, Division B may decide on a production level that is not optimal for the overall enterprise. By setting the transfer price equal to Division A’s marginal cost, the decision by Division B should be the same as it would be if the two divisions operated as one.
Although the principle is reasonably clear and defensible in theory, the participating divisions in an actual setting may raise objections. If the average cost of the item to Division A is less than the marginal cost, Division B may complain that they should not need to pay a transfer price above the average cost because that is what the actual cost per item is to Division A and the enterprise overall. If the average cost per item exceeds the marginal cost, Division A may complain that setting the transfer price to the marginal cost requires their division to operate at a loss for this item and they should be credited with at least the average cost. Nonetheless, the best decisions by Divisions A and B for the overall profit of the enterprise will occur when the transfer price is based on the marginal cost to Division A in this situation.
As a second case situation, suppose the good transferred from Division A to Division B is a good that is both produced and consumed outside the enterprise and there is a highly competitive market for both buyers and sellers. In this instance the best internal transfer price between Division A and Division B would be the external market price.
A supporting argument for this principle is this: If the transfer price were higher than the outside market price, Division B could reduce its costs by purchasing the good in the outside market rather than obtaining it from Division A. If the outside market price were higher than the set transfer price, Division A would make higher divisional profit by selling the good on the outside market than by transferring it to Division B.
5.10 Employee Motivation
Earlier we considered how to motivate divisions within a large organization with appropriate transfer pricing. How about motivation within the divisions? As noted in the introduction to this chapter, in recent decades economists have addressed this matter from a new perspective.
The traditional approach to motivation inside a division or modest-sized business was typically regarded as matters of organizational design and organizational behavior. Once the employee agreed to employment in return for salary or wages and benefits, his services were subject to direction by management within the scope of human resource policies in terms of hours worked and work conditions. Ensuring good performance by employees was basically a matter of appropriate supervision, encouragement, and feedback. In cases where employees were not performing adequately, they would be notified of the problem, possibly disciplined, or even dismissed and replaced. From this perspective, managing employees is much like managing military troops, differing largely in terms of the degree of control on the individual’s free time and movements.
The new perspective on employee motivation is to consider the employee more like an individual contractor rather than an enlisted soldier. Just as microeconomics viewed each consumer as an entity trying to maximize the utility for his household, an individual employee is a decision-making unit who agrees to an employment relationship if he believes this is the best utilization of his productive abilities. The challenge for business management is to structure compensation, incentives, and personnel policies that induce employees to contribute near their productive capacities but not overreward employees beyond what makes economic sense for the business.
One contribution from this economic perspective is the notion of an efficiency wage.See Milgrom and Roberts (1992). The classical approach to setting wages is that the wage paid to an employee should be no more than the marginal revenue product corresponding to her effort. However, if an employee is paid barely what her efforts are worth to the firm at the margin and if there is a competitive market for the employee’s services in other firms, the employee may not be motivated to work at maximum capacity or avoid engaging in behaviors that are detrimental to the firm because she can earn as much elsewhere if she is dismissed. An efficiency wage is a wage that is set somewhat above the marginal revenue product of the employee to give the employee an incentive to be productive and retain this job because the employee would sacrifice the difference between the efficiency wage and marginal revenue product if she sought employment elsewhere. This incentive is worthwhile to the firm because it avoids the transaction costs of finding and hiring a new employee.
Another contribution of this economic viewpoint of employee motivation is an examination of employee contracts to deal with what is called the principal-agent problem. In this context, the hiring business is a principal that hires an employee (agent) to act on its behalf. The problem occurs when the agent is motivated to take actions that are not necessarily what the employer would want, but the employer is not able to monitor all the activities of the employee and has insufficient information.
In the employment relationship the employer evaluates the employee on the basis of her contribution to profit or other objective of the firm. However, the employee evaluates her activities based on the amount of effort involved. To the degree that employees see their compensation and incentives connected to the intensity of effort, the more likely the employee will invest additional effort because there is reduced risk that her efforts will go unrewarded.
For example, if employee incentives are based on the overall performance of a team of employees without any discrimination between individual employees, there is an incentive for employees to shirk in performance of their jobs because they still benefit if others do the work and they do not risk putting in an extra effort to see the reward diminished by sharing the incentives with others who did not put in the same effort. The informativeness principle suggests that measures of performance that reflect individual employee effort be included in employee contracts.A good description of the informativeness principle appears in Samuelson and Marks (2010).
A third interesting contribution of this perspective on employee motivation is the concept of signaling.Nobel laureate Michael Spence (1974) introduced the economics of signaling. When employers hire, they face a pool of possible employees. Some employees will perform well, whereas others will not due to either lack of skills or lack of character. In the interview process, the employer will try to assess which applicants will be good employees, but these evaluation processes are imperfect. The real intentions of the applicant if and when he becomes an employee are largely private information until the person is actually hired and on the job for a while. As a result, employers face an adverse selection problem similar to what was discussed earlier in the context of vertical integration and will often protect against the risk by lowering the compensation offered, even though they would be willing to pay a motivated, qualified employee more.
One response to the adverse selection problem by the employee is to take actions on his own that will help distinguish him from others in the applicant pool, which are observable and serve as a signal to the employer. Seeking a college degree has been cited as a kind of signal. Even though much of what the employee learned as part of obtaining the college degree may be of little use in the prospective employment relationship, the fact that the applicant was willing to endure the cost and effort for a college degree, particularly a degree supported with good grades, is evidence that the applicant is more likely to be a dedicated and competent employee.
Applicants for employment or hire often have several employment relationships over time. By attaching importance to reputation, employers can both motivate employees to be more diligent in their current positions and establish a mechanism to help distinguish high-quality workers from low-quality workers in future hiring.
5.11 Manager Motivation and Executive Pay
In businesses where the manager is not the owner, there is another manifestation of the principal-agent problem. For example, in a typical corporation, the owners are stockholders, many of whom are not involved in the actual production activities. The board of directors hires executive management to act as the agents of the shareholders, who are the principals in this context. The intent of the arrangement is that the executives will manage the corporation in the best long-term interests of the shareholders. However, the executives, though they may own some of the corporation’s shares, are largely rewarded via salaries, bonuses, and other perquisites. Structuring executive contracts that both motivate the executive and represent the owners’ interests is a challenge.
The executives in corporations are often paid highly, certainly well above the opportunity cost of their labor in a nonexecutive setting. There are multiple theories for these high executive salaries. One argument is based on economic rent, namely, that talented executives are like star athletes and art performers, being in relatively short supply, so corporations must pay well above their opportunity cost to have their services.
Another argument for high executive pay is that they need to be not only compensated for their effort but rewarded for the value they create on behalf of the owners. So part of the higher salary is a share of the profits resulting from their execution of management duties.
A third argument for high executive salaries is that firms must often take significant risks to succeed in competitive markets and uncertain conditions. If the firm fails or falls short when its performance is assessed after the fact, the executive may lose his job. In response to this, the executive may avoid bold moves that have a significant risk of failure. In paying an executive highly, the executive is compensated for the additional personal risk he assumes by being willing to take reasonable chances that the corporation must tolerate.
Another interesting argument for high executive pay is called tournament theory.See Milgrom and Roberts (1992). This applies to large enterprises with a sizeable team of executives, with a highly paid chief executive officer (CEO), along with several other vice presidents who are in line for consideration to become a future CEO. By paying the CEO generously and well beyond what is economically justifiable on the basis of the CEO’s contributions per se, there is a strong incentive for the other executives to put in extra effort so they will become that chief executive, with all the high pay and perquisites, in the future. From the perspective of the shareholders, the gain from those collective extra efforts is worth the high salary to the last winner of the CEO “tournament.”