Contracting and Specific Assets

Earlier we discussed the decision rule for the optimal combination of inputs.  That is, firms should hire resources until

                        MP_L /Price of labor    =          MP_K/Price of capital

This rule suggests two important issues : 

(a) Is the firm obtaining resources efficiently as possible?  Clearly, the firm will suffer inordinately high costs if this condition is not met. 

(b) Are inputs working efficiently?   In many instances the incentives of individuals and firms do not naturally overlap.  Compensation schemes may in many instances be altered to make incentives more compatible.

Let's start with the first issue.  Basically, this will lead us back to the "make or buy" decision -- integrate or not?

Methods of Obtaining Inputs: 

1.  There are three generic ways to acquire inputs:

            a. Spot purchases (market contract mode but without a continuing agreement).  This is purchasing on an as needed basis at the then prevailing market price.  Spot exchanges allow firms to avoid vertical integration, and to concentrate on their primary specialty. 

Homogenous inputs that are available at a competitive price are often purchased on a spot basis.

            b. Contract purchases (market contract mode but with a continuing agreement).  This is an agreement to purchase inputs under some continuing arrangement that specifies the terms of exchange.  In many instances, particularly when the arrangement is fairly complicated, terms of the exchange are not entirely spelled out.  These areas are a problem of incomplete contracts and are a basis for negotiation.  More on this later.

            c. Internal production (internalization).  Occurs when firms decide to go into the production of the needed input.  Internal production can come at the cost of administrative overhead, and requires development of a specialization in production of the input.

            Example.  Suppose I sell ice cream cakes.  I need ice cream as an input. 

            -If I go to a food wholesaler and make purchases as needed, I make a spot purchase.

            -If I strike a one-year deal with Breyer’s, to use only their products, I have made a contractual arrangement.

            -If I decide to make ice cream myself, I have gone into internal production.

Specialized Investments and Transactions Costs. 

If spot purchases are the easiest, allow the most efficient specialization, why aren’t all inputs acquired on a spot basis? The reason is that not all inputs are available on an essentially competitive basis (the market).  Rather, firms frequently must make specialized investments either to use or to produce particular inputs.  Contracting could surmount this problem.  However, in some instances the contract negotiation costs are too high, and internal production is necessary.  Consider these terms in more detail:

            a. Specialized investment or a specific asset:  An expenditure that must be made in order for production and trade to take place that has little or no value in any alternative use (opportunity cost approaches or is zero).

                       Example:  Suppose you invest in a machine that only produces logos for your firm.  This machine would not be useful to anyone else. 

Types of Specific Assets:

            1. Site Specificity: The asset is site-specific - can't be moved to another location.   For example: Locating an electricity plant close to a coal mine since it is less expensive to ship electricity than coal.  The arrangement would make little sense if coal from the mine was not purchased by the electricity plant).

                        2. Physical-Asset Specificity: The production or acquisition of specialized physical capital in order to use an input.  For example, for a bicycle maker, a special machine needed to make wheel rims that work with a particular tire would be a specialized physical asset.

                        3. Human Capital Specificity: Workers learning specific skills to use a particular product. (Example, learning how to use products on the MS office suite)

                        4.  Capacity Specificity.  A firm increases capacity in order to serve a specific customer.

A relationship-specific exchange. This occurs when the parties to a transaction have made specialized investments. 

The presence of specialized investments can create a need for making special contracts - why?.

            Transactions Costs.  The costs of contracting are different when there are specialized investments for three reasons:

                        1.  Costly Bargaining. Specialized investment means that there are only a few parties that may efficiently engage in a buyer/seller relationship.  In fact, there is often a lot of difference between the minimum price necessary to induce supply, and the maximum acceptable purchase price, creating considerable room for bargaining.

                        2.  Underinvestment. Either the buyer or the seller may under-invest in the specialized inputs.  (Who would spend a lot of time learning how to use a certain computer program - that is specific and can't be used with other programs, for example, if the university might shift exclusively to another program that professors must use?)

                        3.  Opportunism.  Once a firm has engaged in a specialized investment, the firm on the other side of the bargain has an incentive to take advantage of the sunk cost expenditure.  (Suppose you spend $300 for three nights in an isolated resort hotel, meals not included.  How much do you think they will charge for meals?)

My student's fish investment example:

Hold-Up Potential - A comment on opportunism:  When one side of a bargain tries to take advantage of the specific investment made by another, a hold-up problem or potential is created.  Avoiding hold-up problems is often a reason for more formal arrangements, such as contracts or even integration.

Optimal Input Procurement. Now we consider factors affecting the optimal input method.  In general, more formal arrangements are called for as the relationship-specific capital is increased.

1. Spot Exchange. This is the most straightforward purchasing method.  Given many buyers and sellers, a homogenous input, and no relationship-specific capital, input prices are determined by the intersection of market supply and market demand schedules.

            However, reasons often exist that would induce a manager to bear the expense of drafting a contract:  Specialized investments are insidious.  For example, suppose you retail fresh fish in a cafe/restaurant store, and you need 500 pounds of fresh fish at 8:00 a.m. each day.  Even though fish are homogenous, the size of the input need creates “hold-up” opportunities for both the buyer and the seller.

            -The fish seller, with a truck full of fish may refuse to unload the product unless a premium is paid.

            - The fish buyer (the restaurant owner), may call several trucks to deliver fish at once, and then bargain with the one offering the lowest price.

2. Contracts. When hold-up opportunities become high relative to the costs of negotiating a contract, contracting becomes best (even necessary).  Despite the costs of contract negotiation, formalizing a relationship into a contract can resolve numerous problems. 

A good contract, for example, eliminates the incentives to skimp on specific investments in capital and labor. (e.g., You will spend more on training workers that will be around for three or four years).

            a. Optimal contract length. Once the decision has been made to negotiate a contract, the question of optimal contract length becomes a question.  Optimal length is determined by the marginal cost of writing the contract, and the marginal benefit of extending contract terms.

                        Marginal costs increase with time (the length of the contract).  As the timeframe expands, more contingencies must be considered, increasing the negotiation costs.

                        Marginal benefits include avoided transactions costs or bargaining and opportunism.  These may be related to time, but for the present, assume that they are constant. 

            Then a graphical representation of the optimal contract term problem is illustrated as follows:

Notice:

-Optimal contract length will increase if the level of specialized investment increases.  (As could be seen by an upward shift of the MB schedule).

-Changes in the costs of writing contracts would also affect the optimal length.  For example, an increasingly uncertain environment would shift MC up.  On the other hand, an increasingly standardized product and a more established market for the final product would shift MC down, extending the optimal contract.

3. Vertical Integration. When specialized investments generate transactions costs, and when the economic environment is plagued by uncertainty, vertical integration becomes necessary.  The advantage of vertical integration is that the “middleman” is avoided, reducing the latitude for opportunism.  The cost is that the firm must develop expertise in development of an earlier stage of the production process for its product.  This often involves building a costly production facility, and often requires that the firm engage in some process that has little to do with their primary area of expertise.

So therefore:

Spot exchange is optimal when there are few “hold-up” opportunities, or where the costs of those opportunities are small relative to contracting costs. 

When specialized investments become large, contracting or vertical integration is desirable.  The choice among these latter alternatives depends on the complexity of the economic environment relative to the costs of integration.

Transactor Reputations:

            When a contract is called for, a formal contract is not always necessary., Despite considerable specific investment, it is not always necessary to resort to written contracts.  Buyers, for example often can “punish” opportunistic behavior by not purchasing from a seller again, and by spreading the word that they were treated badly.  These reputation considerations can play a large role in unwritten, but highly efficient contracts.

This is what Klein calls the "self-enforcing range" in the Fisher case.