Managing Business Transactions

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9780029275962: Managing Business Transactions

The transaction, the basic unit of business has been studied by theoretical economists for decades. Rubin has translated their research into basic principles for managers at all levels to structure transactions to best achieve both individual and company goals. Rubin analyzes and offers strategies for transactions of all kinds. This is the first book on the principles of a "new managerial economics, " based on transaction cost economics.

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About the Author:

Paul H. Rubin is professor of economics at Emory University and vice-president of Glassman-Oliver Economic Consultants in Washington, D.C. He is the author of Business Firms and the Common Law and over fifty articles in the economics literature.

Excerpt. © Reprinted by permission. All rights reserved.:

Chapter 1

Make or Buy?

The make-or-buy decision is a classic management concern. Every firm uses thousands of inputs, and for each there is a potential to either manufacture the input itself or acquire it on the market. In its broadest interpretation, this decision includes choices like hiring a consultant or employing internal labor to perform a given task. If a firm decides to make an input, it will transact internally with a division or another part of the firm. If it decides to buy, it will contract with another organization. In either case, it is important to understand the principles behind the structure chosen and behind the transaction. The make-or-buy decision is sometimes treated as an accounting or financial decision. While it is obviously important to perform accounting analyses and to choose the low-cost method, it is more important to understand the managerial basis of the decision.

One advantage of such understanding is that it will economize on decision-making time. There are virtually thousands of products that a firm will use, and each of them could potentially be produced internally. Managers need some method of deciding which products are good candidates for internal production and are worth a detailed internal cost analysis. Of course, some of the decisions are obvious -- a messenger firm will not go through a complex analysis in order to decide whether or not to build its own cars. But other decisions are less obvious -- if the messenger firm gets large enough, should it make its own uniforms or buy them? (Answer: Buy them.) The principles in this chapter will enable a manager to quickly and easily eliminate a whole host of products from consideration and analysis as potential products to make internally. (As seen below, the analysis of the messenger firm and its uniforms was an immediate consequence of the principles set forth in the remainder of this chapter.) This itself will save considerable managerial and accounting time.

The make-or-buy decision is often analyzed in terms of either capital market issues or technology. As indicated later, analysis of make-or-buy choices cannot be done correctly if only technological or financial criteria are considered, although of course both are important to the decision. Rather, the correct analysis is a management analysis. The decision should depend on particular managerial elements, and the purpose of this chapter is to elucidate these elements.

USE OF THE MARKET

Subject to certain availability constraints, the firm wants to acquire inputs as cheaply as possible. When a competitive open market exists, this usually offers the most powerful method of controlling costs. If a product is made internally, then the firm must spend substantial managerial resources monitoring costs and efficiencies. In the market, on the other hand, simple shopping or seeking bids can easily and cheaply control costs. The best way to control costs is through the market. Provision of inputs by sellers facing competition provides powerful obvious incentives for low-cost, reliable production. Therefore, the first presumption should always be for purchasing inputs on the market. This conclusion should not be startling. After all, most firms buy most of their inputs, from office furniture to paper clips to automobiles to steel. It is only in special cases that the firm vertically integrates and makes its own inputs.

The analysis of the make-or-buy decision should therefore depend on examining factors which interfere with market provision of the inputs. Ultimately, these factors have to do with the cost and availability constraints mentioned above. However, the issue is not the existence of these constraints, but rather the reasons why the constraints may come into play. We must ask why the market will not provide the product cheaply, or why something may happen to make the input unavailable.

AVOID EXPLOITATION

The answer turns out to rest on the possibility that suppliers will be in a position to exploit the firm. This occurs when buying an input will subject the firm to a holdup problem which will potentially exist when the firm is subject to opportunistic behavior. When this happens, suppliers will be in a position to increase prices of inputs, or to demand additional payments before making needed inputs available in a timely manner.

Opportunistic behavior may occur when one firm can take advantage of its position with respect to another firm, as either a customer or a supplier. If a manager puts his firm in a position where someone can exploit it, the manager has laid the firm open to the risk of being the victim of opportunistic behavior. To avoid this, it is important to understand conditions under which this kind of behavior can occur.

The important point to keep in mind here is that there is a difference between the return needed on an investment before it is undertaken and the smaller return needed to maintain and operate an investment once it has been finished and the sunk costs are sunk. A manager will undertake an investment only if she can predict a return high enough to cover the firm's cost of capital. After the investment is undertaken it will often pay to continue to operate it at a rate of return which would not have been high enough to justify undertaking the investment in the first place. This difference -- the difference between the amount which would be needed to justify an investment and the amount which justifies operating it after it is undertaken -- is potentially available to be exploited from the firm. (Economists have given this quantity the particularly unpleasant name quasirents. ) A good manager will be aware of the possibility of having quasirents exploited from his firm and will not place the firm in such a position for this to occur.

For an example which shows what is involved, consider a firm planning to get into the municipal garbage business. There are two major parts of the business -- inputs needed to pick up the refuse and a landfill for disposal. First, the firm has to consider the purchase of trucks and bid for a contract in a city. The current price for landfill capacity is $5 per ton and the firm plans to dispose of 1 million tons per year if it receives the contract. Trucks will cost $5 million (scrap value of $2.5 million) and the firm must invest $1 million in learning the local market and establishing contracts. Both the trucks and the goodwill of the initial investment will last fifteen years. Therefore, the amortized cost of this investment at 10 percent is about $800,000 per year. Drivers, maintenance, and other variable costs and the profit needed to make the endeavor worthwhile are $1.2 million per year. Therefore, for the 1 million tons involved, the firm must be able to charge at least $7 million ($5 million for landfilling, $1.2 million for variable costs, $800,000 return on fixed costs), or $7 per ton. (See Table 1.) If it cannot charge at least this amount, it will not bid on the contract.

But woe betide the manager who bids the job at $7 per ton and buys a fleet of trucks on the basis of these calculations. He has laid his firm open to severe exploitation by the owner of the landfill. The landfill owner can raise his price to $5.45 per ton and the truck operator will be better off paying it than shutting down. If he shuts down, he can sell the trucks for $2.5 million but he will still owe the rest of the cost of the trucks, another $2.5 million, plus the $1 million invested in establishing the business. If he sells the trucks and shuts down, he will still owe $460,000 per year to pay off the debt incurred in buying the trucks and setting up the business. If he continues to operate, he will lose $450,000 per year. In other words, the truck company loses $10,000 more by shutting down than by operating. Note, however, that the company would never have gone into the trash business if it had expected to pay $5.45. The $.45 per ton represents the quasirent which can be exploited from the company by the landfill operator behaving opportunistically.

CONTRACTUAL SOLUTION?

A manager potentially facing this situation could try to draw up a contract in advance specifying the landfill price at $5.00 per ton. A sensible businessman would want such a contract, but it may not be enough. (In the next chapter, we discuss ways of structuring a transaction which will give the maximum protection when vertical integration -- here a decision to buy the landfill -- is not feasible.) A general principle is that all complex contracts are incomplete. It is impossible to specify a contract which will cover all eventualities.

First, of course, in times of inflation the landfill owner would not agree to a contract with a price fixed in money terms, so the contracting process becomes more complex. This issue, however, creates no particular difficulties. Prices may be tied to some general index, such as the Consumer Price Index, or to a narrower index of input prices. (In landfilling, it might be an index related to the minimum wage, the price of gasoline, and truck prices. This index will be more appropriate for this transaction than would be a general price index such as the Consumer or Producer Price Index, but since it will have to be designed and calculated specifically for this contract it will also be more expensive.)

The second, more substantial, difficulty is writing a contract with enough specificity to avoid any opportunistic behavior. While it may not appear so, landfilling is nonetheless a complex task. There are many ways in which the landfill can "hold up" the truck company for additional revenue. For example, it can make the trucks wait longer for their turn to dump their trash, thus increasing costs borne by the hauling company. It can also allow the company to use only relatively inaccessible parts of the landfill. It would be very difficult to specify the contract in enough detail to eliminate any possibility for exploitation. As environmental concerns regarding landfilling increase, and as liability for toxic waste disposal becomes more of a problem, holdup possibilities also increase.

This is not a legal problem. The difficulty is not that the lawyers are not clever enough to draw up a contract. If the businessman can tell them what types of opportunistic behavior might be involved, the lawyers can probably eliminate these behaviors by contract. The attorneys might even be able to suggest additional types of opportunistic behavior to avoid contractually -- if they have seen other contracts or been party to litigation regarding such contracts or holdup situations.

But there remains a business problem. It is unlikely that a businessman can be clever enough to think up all the ways in which a landfill could exploit its position, and the lawyers will not have been exposed to contracts or litigation involving all forms of opportunism. Some events may be of such low probability that it does not pay to spend the resources to anticipate their occurrence, to decide what should happen if they occur, or to draft the rules which are appropriate for achieving these goals. (Most likely, more contracts in California than in Iowa specify the consequences of earthquake damage.) In certain situations, contracts will not be adequate to eliminate all possibilities of opportunism because they are incomplete in some way, and it may not be possible or worthwhile to make them complete

Even if a contract could be written with sufficient specificity, enforcement would be difficult. In many of the cases where exploitation is possible, time is important, so that the delay associated with litigation over a contract breach might itself impose substantial costs on the firm. In the garbage example, landfills by definition fill up, so that by the time the truck company might win a suit, there may be no space left for dumping. Whatever damages can be collected may not be adequate to compensate for the lost quasirents.

VERTICAL INTEGRATION

What is the solution? As the story is told, the best solution is for the truck company to buy the landfill before bidding the hauling contract. (Actually, an option on the landfill contingent on getting the municipal hauling business would probably be the chosen method.) If the same company owns the landfill and the trucks, there is no possibility for exploitation of the quasirents. This is a case where the firm should clearly consider seriously "making," not "buying." Ownership, what economists call vertical integration, is the answer. The landfill and the trucking company are worth more under joint ownership than they are worth if owned separately.

What features of this example make ownership compelling? The answer is the close relationship between the capital needed for trash hauling and the capital needed for landfilling Once the city contract is awarded, the hauling business is dependent upon the landfill. The landfill is a specific asset for the hauling business. The two sets of assets are closely linked, and therefore a possibility for opportunistic behavior exists if they are separately owned.

This dependence, however, may be symmetric. It is quite possible that the hauling company will be able to hold up the landfill. This is particularly true if the hauling company is one of the major users, or the sole user, of the landfill. Just as the landfill is a specific asset for the truck company, the trucking business is a specific asset for the landfill. The hauling company can perhaps offer too low a payment to the landfill, threatening to use another landfill further away, and exploit some of the quasirent invested by the landfill owner.

The key point is not that vertical integration will save haggling costs; it is much more fundamental. If holdup possibilities exist, then efficient transactions may not occur. Socially and privately desirable investments may :not be undertaken, and some efficient deals will not be done.

The possibility of holdup will deter the landfill owner as well as the truck company from undertaking otherwise desirable investments. For example, if the truck company asks the landfill to undertake some additional investment, such as building new access roads, the landfill owner will hesitate because this will then give the truck company a holdup possibility over the landfill. After the road is built, there are quasirents associated with it, and these can be exploited by the truck company just as easily as the quasirents on the truck business can be exploited by the landfill. The trucks are a specific asset for the landfill, just as the landfill is a specific asset for the trucks.

If the landfill and the truck company are owned by the same party, only then will neither party be subject to holdup. Common ownership will eliminate the possibility of opportunistic behavior being used to exploit quasirents. Moreover, it does not really matter who buys whom. The landfill owner could just as easily own the truck company as the other way around. The only important point is that both inputs be under common ownership. When the two assets are under joint ownership, all efficient investments will be undertaken. When they are not, some efficient deals will not be clone. Some economists would even say that separate ownership can lead to market failure.

The two assets together are worth more if they are owned by one party than if they are separately owned, and this is the fundamental requirement for vertical integra...

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