Methods+of+Procuring+Inputs

Jason Strachman and Todd Mehringer This information was acquired from //Management Economics and Business Strategy// by Michael R. Baye pages 206-218.

When inputs are needed to produce the final product, management has three different options on how to acquire them. A manager can use **spot exchange, contracts, or vertical integration**.


 * Spot Exchange**

This is an informal relationship between a buyer and a seller in which neither party is obligated to adhere to specific terms for exchange. The buyer and seller are basically anonymous and there is not a legal relationship between the buyer and seller.

This is your typical purchasing of consumer goods and services. For example, when you go to the grocery store to buy a gallon of milk, you are not required to meet any special terms to purchase the milk. You pay the cashier for the milk and you go on your separate ways.

__Real World Example__ An example of a service spot exchange would be a car wash. When you go to the car wash, you pay the company money, and you drive through the car wash. Then you leave. There is no legal agreement or any special terms that must be met.

The key advantage with spot exchange is that the firm gets to specialize in doing what it does best, which is producing the final product once it receive the inputs. Spot exchange is often used when the inputs are standardized, and you can purchase the inputs from many suppliers with equal quality. With the milk example, there are many places you can buy a gallon of milk, and the quality of the milk is the same regardless if you buy it from Marsh, Kroger, Wal-mart, or a gas station convenience store. Since the input is standardized, the price is set at the equilibrium point where supply and demand intersect. If a supplier charges more than the market price, the buyer would decline the price and purchase it from another supplier.


 * [|Contracts]**

Unlike spot exchange, this is a formal and legal relationship between a buyer and a seller that obligates both to exchange at specified and agreed upon terms. The agreement identifies what each party will be responsible for and defines the time requirement, and a contract is used for both tangible goods as well as services rendered.

Like spot exchange, contracts allow the firm to concentrate on what it does best. The buyer gets to focus on producing the final product and acquires the inputs needed for suppliers. Contracts work well when they are easy to write, but they are unfortunately costly to write because it takes a lot of time to negotiate the terms which usually requires legal assistance on both sides of the negotiation. It also is difficult to cover all of the contingencies that may occur. __Real World Examples__ For example, Gary McGregor owns a farm that grows corm. He wants to sell his corn to a local grocery store. McGregor contacts the store owner and begins negotiation on a contract to sell the corn. McGregor says he will provide 100 pounds of corn to the store per week for $0.50 per pound for the next 12 weeks. The store says those terms are unreasonable and counters with 150 pounds of corn per week for $0.33 per pound for 10 weeks. After discussing the terms for a while, both parties agree to the 125 pounds of corn per week for 10 weeks at $0.45 per pound. After 10 weeks, McGregor and the store owner will discuss if they want to continue the relationship. This example shows that creating a contract takes at least two parties and both parties must receive some gain or they will not participate and agree to the terms. Contracts are legally binding so neither party can afford to agree to it if they do not like the terms.

An example of a contract in regards to a service, XYZ Corp. needs to buy a new copy machine for the company. It contacts Copiers R Us and purchases on the new Xerox R12 machine. Copiers R Us offers XYZ a service agreement for $1,000, which says that the machine will be serviced for 12 months. After the agreement ends, XYZ Corp. can purchase another 12 month contract for $1,000. A month later, the machine stops working. XYZ Corp. calls Copiers R Us to come and fix the machine. After looking at the machine, Copiers R Us tells XYZ that the reason it stopped working was because it ran out of toner. Copier R Us charges XYZ Corp. $50 for the service call. XYZ Corp. refuses to pay the service fee because it purchased the service contract, but Copiers R Us says that machine was not broken and the service agreement only covers the fixing of broken machines. This example shows that is very important for both parties especially the buyer of service contracts to understand all of the contingencies associated with the agreement.

Some contracts have an out clause as a part of the terms which allows you to void the contract after a period of time for a certain amount of money. Cell phone plans allow you to void the agreement, but you must pay a large amount of money in which to do so.

Determining how long a contract should be reflects the trade-off between marginal costs and marginal benefits of extending the length of the contract. Marginal costs increase as contracts become longer because as the time increases more time and money is spent writing contingencies into the agreement. Contract length will increase when the level of specialized investment required in an exchange increases. As an input becomes more common and the future becomes more certain, the marginal cost decreases which leads to a longer contract. However, if the input becomes more complex and uncertain, more detail must be included into the contract which increases the marginal cost and requires a shorter term. Shorter terms means a new contract must be written after each short one ends. This of course leads to more time and money spent to negotiating new deals. Therefore firms may determine that contracts are not the best way to acquire the necessary resources.


 * [|Vertical Integration]**

This occurs when a firm decides to produce not only the final product but at least one of the inputs that are needed for the product. Firms may choose to take this direction because they no longer have to rely on other firms to provide the desired inputs. Companies decide vertical integration is the best approach when specialized investments generate high transaction costs and when inputs are too complex or the economic future of the input is so uncertain that writing a contract proves too costly and time consuming.

Vertical integration has some disadvantages too. By taking this approach, firms lose the gains in specialization it realizes when the inputs are purchased for a supplier. The firm must now learn to manage both the production of the final product and the product of the inputs. The company will likely need more production space and employees to produce the input. Typically larger companies also have more bureaucracy and the over lapping of job responsibilities which lead to higher costs.

__Real World Examples__ For example, if Dell Computers decides that it wants to produce not only the final personal computer but also the computer chips, then it must set up a vertical integrated production plan.

Another example of vertical integration is when automobile manufacturers make their own fenders out of steel.


 * Test questions on this portion:**

1. Vertical integration occurs when a firm produces what in addition to the final product?


 * 1) a formal document identifying the terms two parties much meet
 * 2) the production facility
 * 3) the inputs
 * 4) All of the above

Answer is 3

2. Which is an example of spot exchange?


 * 1) Computers R Us is legally obligated to purchase 300 computer chips every year for three years.
 * 2) Computers R Us purchased 300 computer chips from a company that ran an advertisement in the back of a magazine.
 * 3) Computer R Us decides to manufacturer the computer chips in addition to the final product.

Answer is 2

3. The trade off between what two things works to determine the optimal length of a contract?


 * 1) marginal costs and marginal benefits
 * 2) projected revenue and variable costs
 * 3) projected profit and marginal benefit
 * 4) sales and fixed costs

Answer is 1

4. What will happen to the marginal cost of writing longer contracts when the input becomes more complex?


 * 1) decrease
 * 2) maintain the same
 * 3) increase
 * 4) none of the above

Answer of 3

5. True or False – vertical integration occurs when two companies negotiate a legal agreement for input exchange?

Answer is False – vertical integration occurs when one company decides to produce both the inputs and final product.

Some times exchanges between two parties require **specialized investments**. These investments are expenditures that must be made to allow two parties to exchange but have little or no value in any alternative use.

__Real World Example__ Far Best Foods is a turkey processing plant in southern Indiana. Several farmers in the local area have built turkey houses on their farmland to raise turkeys for Far Best Foods. This is a Relationship-specific exchange because the farmers give up the opportunity cost of planting crops on the farmland and build the turkey houses specifically to exchange the goods with Far Best Foods.
 * [|Relationship-specific exchanges]** are types of exchanges that occur when the parties to a transaction have made specialized investments. The important point is that the two parties are tied together because of the specific investments made to facilitate the exchange between them.

Specialized investments increase transaction costs because they lead to **costly bargaining**, **underinvestment, and opportunism**.


 * Costly Bargaining**

Costly bargaining is the process of negotiating pricing between a buyer and a seller of a special input. The parties may behave strategically to enhance their bargaining position.

__Real World Example__ For example, the buyer may refuse to accept delivery to force the seller to accept a lower price. When both parties have made specialized investments they are locked into a relationship with each other. If one backs out of the relationship both are hurt. An organic farmer plants a specific crop to sell only to a local restaraunt. It is a special lettuce that only this restaraunt uses for a special organic salad. The normal price for the lettuce is $20 per pound. The restaraunt refuses to accecpt delivery unless the price of the lettuce is reduced to $15 a pound. The farmer has no other demand for the lettuce, but the restaraunt has no other supplier either.


 * Underinvestment**

Since specialized investments are only good for the relationship between two parties (there is no value in any alternative use), then the parties are likely to under invest.

__Real World Example__ For example, if company XYZ purchases a special machine to make parts for company ABC and the parts are no good to any other company. Company XYZ may under invest in the machine or purchase a cheaper machine that produces lower quality parts because it knows that if company ABC ever backs out of the relationship then the machine is worthless.


 * [|Opportunism]**

After a company makes a specialized investment the other party involved in the exchange will likely try to be opportunistic and take advantage of the situation by raising prices or lowering quantity demands to better their position. The company that made the investment is held up and has little option other than to accept the current state because the specialized investment is no good if the exchange does not take place. __Real World Examples__ For example, Wheels, Inc. makes wheels for airplanes. Boeing is in production of a new airplane, but Boeing’s usual wheel supplier ran short on inventory so it calls Wheels, Inc. in a panic if it can provide Boeing with the wheels for the new airplane. Wheels, Inc. tells Boeing that it can provide the wheels but at double the normal price. In this case the seller is acting opportunistic and holding up the buyer. Boeing doesn’t have much choice since it already made a significant investment in the new airplane production and it must build 1,000 airplanes by the end of the week. This example shows that sellers are encouraged to partake in opportunistic behavior.

An example of a buyer partaking in opportunistic behavior would be: Boeing’s seat manufacturer learns of Boeings new airplane produce and hurries to produce 5,000 seats in preparation of the airplane production. When Boeing is ready for the seats, it calls the manufacturer and says that it needs 5,000 sets, but the only pricing is no longer acceptable and will only pay 10% less than before. Boeing is holding up the seat manufacturer. The manufacturer has already invested in the seats made. If it could sell them to another airplane producer then maybe it would get full money for the seats, but if Boeing is the only company that will buy the seats then the manufacturer may have to accept the new lower price in order to not lose everything invested.

There are four examples of specialized investments – **site specificity, physical-asset specificity, dedicated assets, and human capital**.


 * Site Specificity**

This occurs when the buyer and the seller of an input must locate their plates close to each other to be able to engage in an exchange.

__Real World Examples__ For example, paper mills may locate closer to a tree cutting company and a forest because the output (paper) is less expensive to ship than the input (wood). The cost of building the two plants close to each other represents a specialized investment that would have little value if the parties were not involved in an exchange.

Another example, there would be no value in a movie producer building a new movie studio next to a gas station because there would be no value in the parties being next to each other since there is no exchange between the two.


 * Physical-asset Specificity**

This refers to a situation where the capital equipment needed to produce an input is designed to meet the needs of a particular buyer and cannot be readily adapted to produce inputs needed by other buyers.

__Real World Example__ For example, if an automobile engine requires a special part that is useful only for producing the engine for a particular buyer, the part is a specific physical asset for producing the automobile engines.


 * Dedicated Assets**

These are general investments made by a firm that allows it to exchange with a particular buyer.

__Real World Example__ For example, a military weapon producer opens a new assembly line to manufacturer guns for the United States Department of Defense. If opening the assembly line is only profitable if the government actually purchases the guns, the investment represents a dedicated asset.

Workers must lean specific skills to work for a particular firm. If these skills are not useful or transferable to other employers, they represent a specialized investment. __Real World Example__ Sending your only Network Engineer to be certified in Cisco productus is a human capital specialized investment. The indiviual becomes a CCNE (Certified Cisco Network Engineer), and becomes extremely marketable outside your organization, and extremely valuable to your organization.
 * [|Human Capital]**
 * Test questions for this portion:**

6. Specialized investments increase transaction costs because they lead to costly bargaining, opportunism, and what?


 * 1) high inventory costs
 * 2) employee turnover
 * 3) underinvestment
 * 4) all of the above

Answer is 3

7. What is a dedicated asset?


 * 1) A formal relationship between a buyer and a seller that obligates the buyer and the seller to exchange at terms specified in a legal document.
 * 2) General investments made by a firm that allow it to exchange with a particular buyer.
 * 3) Mechanism used to enhance workers’ effort.
 * 4) None of the above

Answer is 2

8. Site specificity occurs when both the buyer and seller of an input must do what to each other to be able to engage in exchange?


 * 1) Locate their plants close to each other
 * 2) Locate their plants as far away as possible from each other
 * 3) Merge the two companies
 * 4) None of the above

Answer is 1

9. Company A needs a widget for its production process. There are many companies that sell the widgets but each sells it for $100. Company A purchases a sample of widgets from Widgets R Us for $10 to test the quality before making a large purchase. After doing this, Company A calls Widgets R Us to order 1,000 widgets. Widgets R Us says that the new price is $105 per widget. Has Widgets R Us engaged in opportunistic behavior – Yes or No? Why or Why not?

Answer is Yes. If after paying the $10 which is a sunk cost, Company A wants to buy from Widgets R Us then it must pay 405 for the widget. If Company A refuses to pay the higher price then it would have to pay $100 to another company ($10 for the sample + $100 for the widget) assuming the new manufacturer doesn’t engage in opportunistic behavior to and raise its price.

10. Which are examples of specialized investments?
 * 1) site specificity
 * 2) physical asset specificity
 * 3) dedicated assets
 * 4) human capital
 * 5) all of the above

Answer is 5