Managerial Economics - the decision of firms to make or buy products.

by houssamzreik (student)

University Degree Business and Administrative studies

Ref: ME/July11/1, Houssam Zreik, Student Number: 8219652

Managerial Economics

Introduction

The early neo-classical paradigm treat the firm as a black box and studying only the production function in term of input materials and output as goods and services, the focus was only on profit maximization. Today's firms are seen as more complex organization with nexus of activities and contracts, the early question was why do firm exist and why organizations doesn't use the market? The answer was described By Ronald Coase in his paper "the Nature of the Firm.", Coase highlight that firm exist because using the market impose a cost " Transaction Cost

Identify the Key Concepts/Terms in the question

Economics- TCE" such as contracts, control and most exchanges are happening within the organization .Therefore using the market may lead to increase the productivity of the firm but also require more coordination and control, the source of TCE come from the potential of negotiating terms and contracts in addition to monitoring and controlling those contracts, therefore firms can be more cost efficient when TCE are high. Such decision to use the organization, firms needs to be aware on how to organize the vertical chain and how it will affect the efficiency of production. Management decision to perform activities itself or to purchase it from the market is called make-or-buy.

Define the concepts

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Define the concepts

The old traditional question raised by management inside organization was about how can maximize the profit and perform better in the market, today game is about what market the organization should be in, moreover the trade-off they take in each decision, the main focus is to define a strategy by the management based on the framework Tn=3. The first T is time, the focus is when the decision is taken by management and the available time for this decision, and if the organization take the second mover at time t+1 by watching the market "playing the game to avoid losing rather to win" (McNutt, P., "Game Embedded Strategy." 2010, pp. 7), the second T is Technology and how using technology to improve the productivity, the last T is Type which focus on the trade-off and the signals depart by the management behavior.

Here we can highlight more the role of management inside the organization to increase the efficiency and to minimize the cost and maximize the profit, how management behaves and designs their strategy? Management should observe the behavior of competitors and identify the rival's economics signals depart based on managerial behavior. Maximizing the sales revenue by lowering the prices of goods and services can act as a signal for competitors "Baumol Type", organic growth trough product diversification by using capital in R&D in trade off with less dividends today for more dividends in the future can act as a signal for the shareholders and rivals "Maris Type", In Maris Type transferring a positive learning about the management behavior and plans to shareholders is highly important in coordination.

Historical perspective Evolution off the firm

Economics is a subject that started early 18 century by the classical economics Adam Smith "The Wealth of Nations", the focus was only on the firm as a black box, later Ronald Coase in "The Nature of the Firm" develop the theory that firms exist because using the market can impose transaction cost, Coase and his followers such as Williamson. Traditional economic model known as neo-classical profit maximization model assume the rationality of decisions, Simon introduces the notion of bounded rational

Body

Firm Vs Market

Several reasons that drive firms to use the market firms "buy" instead of doing in-house activities "make" , one important aspect is by avoiding bureaucracy that have big influence on costs and by enjoying economics of scale alongside with the learning curve. Market firms possess more experience in production; moreover they have the proprietary knowledge that allow them to produce more efficiently and at lower cost by aggregating several firms needs and then enjoy the economics of scale. During the "buy" process there is many factors that affects the transaction cost, among those factors the incomplete contracts which is related to management bounded rationality and the difficulties in controlling and measuring the performance plus the asymmetric information.

Without proper and good coordination in between the firms tied by contracts may raise serious problems and affect the production and efficiency. Therefore contracts are very important aspect in "buy" process to ensure agent is committed to contract terms.

Some firms rely on independent firms to ensure the coordination in the vertical chain and link them to suppliers and manufactures or retails. And some firms relay on their own control to achieve the proper coordination.

Decision Tree

Managers should consider several aspects prior to take the decision of make or buy, managers need to follow the decision process and assess if the market can provide alternatives to vertical integration, many questions raised by managers to do this assessment. does the current market-firms or agents can save cost by attaining the economics of scale that the organization cannot attain in-house, moreover they can ask if there is coordination issues that may arise and affect the productivity and managers should take it in consideration while making the make-or-buy decision or if the supplier possess private information that managers will lose control

References

Coase, R., "The Nature of the Firm." Economica, 4, 1937, pp. 386-405.

McNutt, P., "Game Embedded Startegy." 2010, pp. 7.