CLASS 10 OUTLINE Economics of Business Harvard University Extension School Instructor: Bob Wayland...

CLASS 10 OUTLINE

Economics of Business

Harvard University Extension School Instructor: Bob WaylandTeaching Assistant: Natasha Wambebe

incomplete without oral presentation

2

The Critical Importance of Contracts

The Firm is a Nexus of Contracts (HaroldDemsetz*)Powerful metaphorEnables connection to firm relationships and

valueIdentifies the managerial levers to increase

“residual”

* Phrasing is from Demsetz although Jensen and Meckling used similar language in an earlier paper


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Alchian Output Programs and Contracts

Integration of output program and nexus of contracts permits valuation of management effort and contribution to firm value

First, define costs as the change in shareholder equity. (You can also define revenue net of all costs as a change in shareholder equity.)

Output program is defined by three parameters; the date of delivery, planned volume of output, and the rate of output.

Much more useful than the Jacob Viner LRAC and LRMC geometry


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Vinerian Long Run Average Costs


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Output Program

The basic idea behind an output program is thatcontracting parties have three degrees of freedom. They can select any combination of date and duration of

delivery, volume to be delivered, and the rate of delivery. Any two of the parameters determines the third. More casually, parties can contract for, say, a volume of

100 cars in an almost infinite number of ways or programs. They might want a rate of 10 cars a day for delivery over 10 days or 50 cars at two distinct dates, etc

The graphical model for a given delivery schedule and for various combinations of volume, V, and rate, x, is shown below.


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Output Program


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Output Program

The output program determines the cost of meeting the contract. By altering the contract, for example extending the schedule, the overall cost might be lowered. Compressing the schedule or raising the rate of output for a given delivery schedule will usually raise the costs.

Alchian’s concept of an output program is much closer to the way that engineers and plant managers think about production over time and the change in inputs and costs than is the Viner representation.

More importantly it provides a straightforward way of defining contracts and assessing the determinants of their value.

Although Alchian’s original article focused on costs, the same parameters can be used to define revenue programs and hence the change in the NPV of the firm’s equity due to an increase in revenues (net of costs).

If we can value contracts as Alchian programs, we can determine the value of management actions and then estimate the change in the residual they create and thus have a notion of what their compensation should be.


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Contracts (Administrative Features)

The firm desires to achieve its inputs efficiently. It has a number of contract options for acquiring inputs including. Buy the inputs on the open market – a “spot” contract, Make a longer term arrangement with a supplier – a

negotiated contract, or Produce the input itself – vertical integration with internal

“contracts”The choice of contracting method depends upon the

nature of the input, the associated transactions costs, the investment necessary to exploit the input contract, and the cost of enforcing contract performance.


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Spot market transactions and exchanges

Spot market transactions or exchanges are typically the least costly and overwhelmingly the choice for standardized goods (commodities).

Modern exchanges for everything from pork bellies, corn, and crude oil make it simple and efficient to buy standardized goods with no costs of identifying sellers or negotiating contracts.

For our purposes, futures markets involving options to buy or sell at contract prices are “spot” contracts (the options have an immediate or spot price and are standardized).


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Negotiated Contracts: Three Big Reasons

Spot market volatility and uncertainty. Specificity of investment on the part of

buyer, seller or bothSome protection against bad behavior.


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Spot market volatility and uncertainty


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Specificity of investment on the part of buyer, seller or both

Supplier protection for transaction specific investment Buyer protection for investment in the capability to use a particular

supplier’s product or system may want protection exploitation of their “locked-in” position.

Oliver Williamson distinguished among a number of types of investmentspecificity such as: Site specificity or “cheek-by-jowl” where the supplier or buyer locates near

or adjacent to the other, thus reducing transportation, inventory and communication cost but at a loss of flexibility and increase in costs of accessing alternative suppliers.

Dedicated asset specificity occurs when one party has to invest in specialized capital equipment or resources well in advance of anticipated deliveries. Supplier, may invest in production capacity or materials with the prospect of a major sale Very large ticket items like airliners and yachts typically require large down payments

before the producer will commit to acquiring resources. In effect, the buyer is contracting for a place in the production queue and the final

good


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Williamson’s forms of specificity, cont.

Physical asset specificity. One or both parties invest in equipment that involves design characteristics peculiar to the transaction and has a lower value, if any, in alternative uses.

Human asset specificity. Investment in relationship-specific human capital may arise from specific training or a learning-by-doing process. Recall Simon’s point about the importance of practice and the hours necessary to

become truly expert. An expert often exemplifies human asset specificity. Recall also Nelson and Winter’s point about “routines as genes” and the

importance of routine in enabling complex behaviors and addressing the “competency paradox.”

Relationship between the challenges of contract negotiation and business strategy. Strategists look for ways to capture markets, frustrate rivals, and avoid detection

by regulators and anti-trust authorities using the same sort of devices that are of concern in one-on-one contracting.


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Protection against bad behavior

The “hold-up problem.” Many Ramirez (case of contract failure)

Manny shirked on the Red Sox Forced a trade to L.A. Performed well in L.A. that year

Hold-ups often occur when suppliers or buyers make a substantial investment in the capacity to do business with one another.

Holding up your customer or supplier can, like a bad credit rating, influence your future contracts with other parties (reputational effects).

Supplier abuse can also trigger or reinforce longer-term changes in industry organization that may prove expensive for the abuser

Hold-up problem often occurs when unanticipated changes in the marketplace or within firms causes one of the parties to seek a change in the terms.

Opportunism is usually a post-contract phenomenon


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Lock-In

Lock-in is similar to hold-up in that it exploits asset specificity but

is often not as disruptive and may not really be a “bad” behaviorflowing from a bad faith contract. Suppliers often seek to “build customer relationships” by “locking-

in” or “increasing exit costs” for customers Customer is often locked-in after walking through a door marked,

“low introductory offer” or “first month free.” Similar “low ball” bids are encountered in commercial and

industrial procurement. Free training and supporting software to increase customer

investment in a particular system and hence, exit costs. Lock-in may also occur as a result of the increasing returns to scale

and path dependence nature of some products and services (discussed previously)


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Ecosystems, California and Roach Hotels

Consultant product differentiation leads to new names for old concepts and practices

Above are new terms for old ideas of lock-in and can be explained by economics of vertical integration

Firms have long tried to extract “rents” from one segment of a value chain by exploiting market power in another (vertical foreclosure)

Apple, Google, and Amazon are popular examples of “ecosystems” in which customers and third parties are subject to lock-in through switching costs.


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Non Performance

A contract has to be enforceable to be of any value. But enforcement is not costless. Enforceability is partly

a function of: The content of the contract (courts don’t enforce illegal contracts and can be sympathetic to

some forms of non-performance), The costs of litigation relative to the value of performance, and The quality of the judicial system (many contracts contain an agreement to litigate within a

particular jurisdiction). Since litigation is expensive, time consuming, and unpredictable many contracts allow for

arbitration over disputes about performance under clearly defined conditions. To head off disputes, many contracts contain rights of audit and surveillance for the parties. This

offsets to some extent the information advantage enjoyed by the seller. Penalty clauses are useful if the facts are readily determined and both parties consider the

penalty reasonable. Requirements that one or both parties post performance bonds can discourage opportunistic

non-performance. Self-healing and run-flat terms are frequently inserted to maintain a contract’s operation till it

can be overhauled by the lawyers or renegotiated. The terms most likely to be covered by adjustment clauses are those believed beyond the control

of either party, and those for which reliable and visible proxy measures are available. Any sort of automatic or semi-automatic contract adjustment introduces a form of moral hazard.


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Complete and incomplete contracts

A complete contract is one that anticipates every possible contingency and provides an agreed remedy to every future problem. Complete contracts are rarely if ever encountered and are primarily an abstract fiction to simplify analysis.

An incomplete contract is one that covers less than 100 per cent of conceivable situations. Almost all real world contracts are incomplete, the question is where do the parties stop and declare it “complete enough.”

We expect that negotiation costs are proportional to a) the significance of the issue and b) the divergence in the positions of the parties. At some point, both parties feel that the marginal negotiating costs of resolving

remaining potential issues outweighs the benefits of tackling them. At this point they may simply ignore the remaining issues or Adopt an adjudication or arbitration mechanism for conflicts not explicitly

covered by the contract.


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Complete and incomplete contracts

Assuming we can order the terms by value and cost


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Contract Length

Significant contracts are almost always expensive and time consuming to negotiate and represent an investment or asset to both firms. Each would like to avoid both unnecessary future contracting costs maintain flexibility in light of the uncertainty

Each party may have to make the sort of specific investments discussed above and wants to ensure a contract length sufficient to recover its investment.

In the graphic (next slide) the parties reached agreement on terms, including duration, at the intersection of the lower marginal benefit curve and the upper marginal cost curve, which is shown as d0.

If the marginal benefit curve shifts up for some reason, say, due to more contract specific investment, and the marginal cost of negotiation declines, say, due to better negotiating technology, the new contract duration may increase to d1. The final resting place for d depends on the direction and magnitude of the marginal cost and marginal benefit curves and the resulting intersection.


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Contract Length


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Contracting Environment

Different contracting environments are more costly

and difficult to work within. The more complex and uncertain the environment,

the shorter the typical contract length. The less complex the environment, say, due to

standardization of products, settled precedents, etc. the longer the contracts.

One of underappreciated economic benefits of decent legal system


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Financial Asset and Option Approach

The expected future level of any contract variable may be thought of as a series of distributions about the expected value. We know the current wage rate and the level of productivity of workers and have some notion of the trends in productivity and demand for labor. In general we are more confident (anticipate a tighter distribution around the expected value) of near term projections than of estimates of longer-term conditions.

When the buyer agrees to a contract schedule of input prices and quantities, she is basing her decision on the prices and quantities she expects to receive from her customers. Conversely the supplier is agreeing to deliver the inputs (his outputs) at prices and quantities that he believes will provide a profit based on expectations of his future input and production costs.

When the future conditions are too uncertain or murky to commit to a longer contract but there is a preference for continuing the contract if things look favorable, firms (and individuals) may include renewal options in the original contract.

The most prominent of these “option” contracts are those for professional athletes that give the club the right but not the obligation to renew the contract or the player the right to “opt-out” after a period of time. (Recall discussion of Manny above.)

The compensation in the contract will reflect the value of the option on the player’s services beyond the guaranteed portion.

Assignable or transferable contracts may be sold, usually by the purchasing party, to someone who wasn’t a party to the original contract. This reduces the quantity risks of the buyer and may be desirable to a supplier by reducing his re-contracting costs.

Econometricians describe this situation with the delightful word heteroscedasticity which means, roughly, that the variance about the mean varies at different points in time.


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Financial Asset and Option Approach

Heteroscedasticity


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Contracting and Negotiating Strategies

Both parties believe they may gain from the contract or they would not enterinto negotiations. But, there is no guarantee that either will realize the fullbenefit possible. Negotiating strategies are often looked at today in gametheoretic terms. One common negotiating strategy is to run the clock out with patience and

obstreperous behavior. This is essentially an attempt to increase the other party’s cost of

negotiating and forcing him to settle for lesser level of contract completeness.

Of course, being a jerk only works if what you possess is worth the trouble to the other party. [think about Kim Jung Il (Korean for crazy, platform-shoe-wearing weasel) and his negotiations with various countries over his nuclear program.]

Most modern negotiating texts are full of advice for “win-win” strategies. The Prisoner’s Dilemma is invoked ad nauseam.

Most current economic treatments of negotiation are based largely on game theory. We do not cover game theory in this course.


26

Oliver Williamson on Transaction-Cost Economics and its Relationship to Organization and Contracting

Williamson (1979) sought to integrate the insights oftransaction cost economics with a taxonomy ofcontractual types and applications: Opportunism, self-interest seeking with or without guile, is a central

concept in the study of transaction costs Opportunism is especially important when transaction specific

physical and human investments are involved (the more the potential for lock-in, the greater the concern for reneging or exploitation)

The efficient processing of information is closely related to transaction cost

Assessing transactions cost involves comparative institutional analysis

Williamson focuses on intermediate goods and seeks to “dimensionalise” the factors to align governance structures with transaction characteristics.


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Ian McNeil’s Contract Framework

Ian McNeil’s distinguishes discrete and relational contracts and thecategories of classical contract law, neoclassical contract law andrelational contracts. The evolution of contract law in many respectsparallels that of economic perception of negotiating and contracting. Classical contract law attempts to very clearly delineate the nature of the

transaction, emphasizes formal over informal, and remedies are narrowly prescribed. Classical contract law sought to achieve a high degree of certainty about outcomes and consequences.

Neoclassical contract law provides for more flexibility in the face of uncertainty. Various means such as arbitration of settling unforeseen and unforeseeable conditions are introduced so that contracts can be executed and people be comfortable with the prospects for equitable settlement.

Relational contracting applies when transactions extend over long periods, involve complex interactions that are not easily solved even by the adaptive tools of the neoclassical contract. There may or not be a formal contract or “original agreement’ and, if present, it may not be given a lot of weight.


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Contracts, Idiosyncrasy, Governance

McNeil’s discussion reveals that contracting is more complex and differentiated than is commonly appreciated

Williamson introduces a confusing term, economics of idiosyncrasy Transactions in which the specific identity of the parties has important

cost-bearing consequence. In a purely competitive market, the identity of the parties is immaterial. Idiosyncrasy refers to behavior peculiar to a specific individual or thing. This is a class of goods or services in which maximum production

economies can be achieved only by tailoring physical and human capital investment to their specifications.

Williamson defines governance structure as the institutional matrix within which contracts are negotiated and executed He argues that the appropriate structure follows from the degree of

asset and transaction specificity of investment.


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Specificity and Opportunistic Behavior

Williamson notes (recall previous Williamson and Gibbons readings) that the more specific the investment is, the greater the potential for lock-in and opportunistic behavior by one of the parties.

Parties are reluctant to be trapped in this manner and generally seek contractual protections before making asset or transaction specific investments.

Since the most important class of idiosyncratic goods are recurring in nature and span significant periods of time, the governance structure (one element of which is the contract) must assure both parties that unforeseen and unforeseeable issues that arise over time will be resolved in an efficient (low cost) and equitable manner.

This might be unnecessary but for the human tendency to opportunism


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Production and Transactions Cost

Williamson emphasizes that the sum of production

and transactions costs matters.In general if, transactions costs are low or

negligible, buying is preferred over making because the market can often realize economies

If production cost economies are small and external transactions costs are significant, internal production is often more attractive


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Frequency – Investment Specificity

Recall Williamson’s three dimensions for contractual relations: uncertainty, frequency, and

asset- or transaction- specificity (referred to as idiosyncratic in this context). To these he

adds three degrees of investment-specificity: non-specific, mixed, andidiosyncratic to produce the taxonomy illustrated below


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Governance Structures

Williamson considers three types of governance structures: (1) non-transactionspecific, (2) semi specific, and (3) highly specific. These correspond to theinvestment categories defined earlier and to the contracting models introducedfrom Ian McNeil. Market Governance: Classical Contracts. The market itself is the main governance

structure for non-specific (standardized) transactions, both recurrent and occasional. Legal framework is useful but not the critical factor, contract theory distinguishes between sales and transactions.

Trilateral Governance: Neoclassical Contracting. Trilateral governance is applied to occasional transactions of both mixed and idiosyncratic character. Investments in mixed and idiosyncratic transactions are not easily recovered but forging and maintaining bi-lateral arrangements may not be practical for occasional transactions. Third party arbitration is often employed to leverage an existing source of expertise rather than resort to litigation or create a new structure.

Transaction-specific Governance: Relational Contracting. Specialized governance structures are often devised for recurring mixed and highly idiosyncratic transactions. The recurrent nature of the transactions supports investment in special structures of two kinds (next slide)


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Transaction-specific Governance: Relational Contracting- Two forms

Bilateral Governance: Obligational Contracting. The nature of highly idiosyncratic transactions, involving very specific investments in physical or human assets, commonly precludes any economies of scale being available to either the buyer or seller

Unified Governance: Internal Organization. “Incentives for trading weaken as transactions become progressively more idiosyncratic.” Where there is no factor price, tax or other considerations favoring outside production, highly idiosyncratic transactions frequently move inside to take advantage of lower governance costs. Thus vertical integration may be expected in cases where the stage of production involves highly idiosyncratic production.


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Governance Matrix

Williamson captures the relationship between investment types and contract governance structures using the framework we discussed earlier:


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Uncertainty and Governance

Having discussed transactions under certainty at some length, Williamson then declares them uninteresting and suggests that almost any governance structure will meet the needs in a world of certainty. (Recall Knight’s point about uncertainty.) But some changes are needed to accommodate uncertainty: The characteristics of standardized transactions in large, well developed markets

are not greatly affected by uncertainty so classical contracts are still appropriate. Adding uncertainty to transactions contracts makes it even more imperative to

devise “machinery” to “work things out.” With mixed transactions under uncertainty things might go one of two

ways, One is to reduce the degree of uniqueness so that standardized and market rules prevail,

or Surround the transaction with a more elaborate governance framework.

Uncertainty affecting idiosyncratic investments may act to push them into the unified or internal governance camp, resulting in more vertical integration.

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CLASS 10 OUTLINE Economics of Business Harvard University Extension School Instructor: Bob Wayland...

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