BUSI 620 Week 3 DB Forum 3 Example

Discussion Board Forum 3: The Theory of Production and the Organization of the Firm

BUSI 620 Global Economic Environment, Discussion Board Forum 3 (thread and 1 reply)

Thread by [Student Name]

The forum questions, the van maker and the classmate's thread are composites standing in for the course's own; the research cited is real, and the requirements follow Liberty's public course guide for BUSI 620.

Thread

Chapter 6 of Baye and Prince (2017) gives managers three ways to obtain an input: buy it on the spot market, buy it under a contract or make it inside the firm. The right choice depends on transaction costs, and especially on whether the input requires specialized investments that would leave one side open to hold-up after the investment is made.

Consider a composite maker of electric delivery vans deciding whether to make or buy its batteries. A battery has two very different parts. Cells are standardized, produced by a handful of global suppliers in plants that cost billions of dollars, and sold to many customers. The pack, which arranges cells into modules, cools them and manages them with software, is designed around the van's frame and drivetrain. A supplier who builds the pack needs dedicated engineering know-how about this one vehicle, a classic specialized investment.

Monteverde and Teece (1982) tested this logic in the U.S. automobile industry. They found that components requiring more application-specific engineering effort were more likely to be produced in-house, because the know-how developed in designing them is costly to transfer and gives a supplier bargaining power the automaker would rather not concede. A component whose design know-how lives only inside one buyer-supplier relationship is a risky thing to buy.

Applied to the van maker, the answer splits. The pack should be made in-house, since its design knowledge is specific to the vehicle and improves with each model. Cells should be bought, because building a cell plant would require enormous capital and volume the firm lacks, and because many buyers keep the market competitive. A multiyear contract with price adjustments tied to raw-material indexes would protect against both a supplier's opportunism and swings in lithium prices without the cost of integration. Several large automakers have chosen a middle route, joint ventures with cell makers, which suggests the cell decision depends partly on scale.

Reply to Marcus

Marcus, your thread argued that the plant managers at your company take too few risks because their bonuses are tied to avoiding cost overruns. That is a good example of the principal-agent problem in chapter 6: the owners want profit, but the manager is paid for something narrower, so the manager's effort follows the bonus rather than the owners' goal (Baye & Prince, 2017).

The textbook's remedy is to tie part of pay to profit, but I would add one caution. A plant manager controls costs and output but not prices or sales, so a bonus tied entirely to company profit would reward and punish the manager for things outside the plant. A mix might work better: part of the bonus on plant cost per unit, part on quality and on-time output and part on company profit. The mix also reduces a risk the chapter mentions, that agents shift effort toward whatever is measured. A manager paid only on cost per unit may delay maintenance to hit the number, while one paid partly on on-time output and quality has a reason to keep equipment running. Did your company try anything like that, and how did the managers respond?

References

Baye, M. R., & Prince, J. T. (2017). Managerial economics and business strategy (9th ed.). McGraw-Hill Education.

Monteverde, K., & Teece, D. J. (1982). Supplier switching costs and vertical integration in the automobile industry. The Bell Journal of Economics, 13(1), 206-213. https://doi.org/10.2307/3003441