Reasons for outsourcing:
If you outsource, the company you’re buying from may have a cost advantage when
producing your supplies because they make plastics for toys, cars, etc. they have a
much higher lever of production – scale economies.
It could also be scope economies, they make a variety of products. Scope economies
often lowers their average cost curve because they’re resources are spent more
efficiently, sometimes there’s a byproduct can aid other production of goods, such as
the by product of heat encourages agricultural growth. Economies of scope often
creates synergy; thus encouraging consumers to buy other goods.
There could also be learning economies. The company has been producing say ink
for a very long time, so they have the leading ink production technology.
And there is enough competition between the suppliers, this will help drive down
If it was perfect competition, then price will be average cost.
These are direct reasons for why the suppliers charge at this price.
There’s also indirect reasons to outsource.
-you could be a smaller firm by outsourcing..
-say if you had a factory for producing ink, you could close it and then use the spare
money to be more specialized in the plastic and leave the ink production to someone
-another indirect cost saving is agency costs. Now that you’ve closed that production
facility, you wont lose so much money from people slacking off
-and it’ll be more easier to manage people under one factory.
-another is influence costs. If you had one factory, you wont need two managers.
-theres also coordination and info costs. By being in one factory, or being smaller,
it’s easier to coordinate and communicate between one another.
Advantages of vertical integration
1) entry deference. If the company is very vertically large, then it deters people from
joining in and competing/taking away your profits. Cause if people see that they can
easily do what you’re doing, then they will join in as well.
2) avoid monopoly distortions.
Sometimes you go down the production chain, there will be multiple firms with
monopoly power. So on level 1, you may face one monopoly, then you go further
down the chain of production at like level 3, you will find another monopoly that
will charge P>MC.
Each monopoly firm has dead weight loss. Now if those 2 monopolies merge to
become one, P>MC & DWL > 0 => therefore, eco profit increases and smaller dead
weight loss. So they actually harm society less when they are one entity.
So firms and society does worse when they outsource.
If a firm is more vertically integrated, then they can choose where to maximize the
most profits, depending on the elasticity of that stage of production.
So like gas filling stations aren’t very profitable, so they don’t bother maximizing
there, but at oil refineries, they will try their best to maximize there.
3) leakage of private information 4) transaction costs 5) poor coordination % better
These 3 are all related to contract problems.
Contracts are called ‘incomplete contracts’. No contracts are ‘complete’. Often
they’re negotiated. And the contract holds true in every state of the world. And this
just isn’t feasible in real life. Every contract will have missing parts. We write down
the various outcomes of the world that is most probable. And important.
But sometimes we’ll leave things out, as we never expected something like a
tsunami from happening, etc.
=>negotiate – refinements, clarifications, etc. because sometimes there’s a lot of
back and forth of the 3 stages. At some point, both parties will be satisfied with the
negotiated/written contract and sign it voluntarily.
when there’s a lot of secrecy, you want to keep it inhouse. Like if you got a secret
formula for ink, you would’nt want to outsource it cause they might steal your
Transaction cost: additional cost above the cost is the $1 + the tax. So like driving to
that loblaws to buy it. Now if you were buying a billion bottles of water, then you’re
probably going to need a contract because there’s a lot of money at stake.
Rent = economics profit expected from our business relationship.
Rent is greater or equal to zero. You won’t sign a contract where you know you
won’t lose money. Quasi rent – ‘sort of rent’. It is related to your first best and second best. The
contract you sign is your first best.quasi rent is the rent between your first best and
your second best.
Your rent is your 1 best eco profit.
Quasi rent = 1 best eco profit – 2 best eco profit
Quasi rent is not forward looking (ex ante). It’s ex post.
The quasi rent could be bigger than the rent.
If the 2 best eco profit is –ve.
Then it’ll be rent – (-ve) = +ve.
Relationship specific investment
1) site specificity
2) 2) physical asset specificity
3) 3) dedicated assets
4) human asset specificity.
Hold-up is if the guy tries to renegotiate the contract because there’s now a financial
And you’re the only customer of the guy.
So you tell him, a cheaper customer is better than no customer.
Only when the quasi rent is +ve can you hold someone up.
So if the RSI > 0 QR >0 which allows for ‘hold-up’
June 11, 2012
Negative of outsourcing: poor coordination – design attributes.
Suppose you made a laser pointer and you’re outsourcing the battery makers. And
it’s a standardized battery, so there’s a lot of standardized battery makers out there.
So if your contractor fails to provide, you can move on. But if it’s not standardized,
then the coordination issue is larger. So if your contractor decides to go on strike,
then it’s a much larger issue for you.
If the design has a tremendous influence on the economic value of the production,
then it’s a design attribute.
When you lower the output like during the financial crisis, the price per unit starts
to rise because there’s large scale economies on the production of parts/assembly of
vehicles. Because the AC curve is a U, so we’re moving backward on the U.
So then the auto firms are like, you need to lower the price during this crisis, but
then the parts said that they should pay more for the parts.
“hold-up” is when the company demands for a lower or a higher price.
These are all issues of incomplete contracts. No contracts protects us perfectly
from coordination issues. So that’s why the design attributes of the products, you keep internally, like apple.
If the firm was investing inhouse, then the relationship investment would be a lot
June 18, 2012
The middle ground between monopolies and perfect competition is imperfect
-oligopoly – small numbers of firms. (n>=2) because of entry barriers.
These firms are non cooperative – there are competition. They are rivals.
They are selling a perfect substitute. Their products are identical. You’re making
bottle water, I’m making bottle water.
They have market power. And they’re aware of the rivals out there. If you increase
quantity, it will drive price down, and the competitor know that.
So, their market strategy is like your market strategy. This is strategic interaction.
Your optimal behaviour is my optimal behaviour. You’re thinking what your rival is
going to do.
Courtnot model – cournot quantity picking.
Bertrand model – price picking.
Picking quantity is very different from picking price.
In a monopoly, picking quantity/price is the same. Market’s demand curve is the
We assume that players in an oligopoly move simultaneously and once and for all.
Meaning once you know the other firm’s quantity, you can’t revise it. If you pick a
price, they cant revise their price. Once and for all and visa versa.
Everybody has perfect/symmetric information.
June 25, 2012
1) Strategic commitment -> simultaneous vs sequential games.
Rock paper scissors is a game that is play simultaneously.
To win the game doesn’t necessarily to defeat/destroy your competition, it’s to
make big profits.
2) strategic substitutes & compliments.
->tough and soft commitment.
-> direct & strategic effects.
Tough doesn’t necessarily mean it was easy to make but it was tough on something.
Direct and strategic effects – impacts of commitments.
->list of players – you need to know who’s your competition, who’s playing the
game. Is it an oligopoly?
->list of all their choices/strategies – all the types of choices out there.
Once we know the list of players and the strategies possible, you look at the payoffs.
->Is it a one shot game? Vs is it repeated? We’ll stick to a one shot game.
->is the game played simultaneously vs sequentially. Some games can have whole different outcomes depending if it’s simultaneously or
->perfect (complete/symmetric) information.
You need to know all the choices/moves possible.
->is the game cooperative vs non-cooperative? Are we rivals?
->rationality (of players). Are the players optimizing their payoffs?
->pure vs mixed strategies? We stick to pure strategies in this class. We choose a
particular price and stick to it. So, it’s not like 50% of the time I charge a high price
and 50% of the time I charge a lower price.
If you were a soccer player kicking the ball in the same place, this would be a pure
->equilibrium concept/definition. Was there a solution or not?
Strategic commitment – it can alter the nature of the game. It takes a simultaneous
game and make it sequential.
It refers to decisions that have lasting effects and difficult to reverse.
Generally, we’ll be talking about non cooperative games.
In strategic commitment, you can change the game by releasing your product first,
making a simultaneous game into a sequential game. You do this if you will be
Things that will help with this commitment:
These are necessary conditions.
The commitment won’t work without these conditions.
Credibility can be supported
->irreversibility (you’ve already spent some money and you can’t get them back), \-
You have a commitment here, and you are hoping that by your commitment, you
want your competition to alter their behaviours because that means you’re making
a lot of money.
e.g. Hyundai saw they were making a lot of money in the 1980’s, so then they made a
commitment in making a factory in Canada. But they never followed through
because following Hyundai’s press release, Toyota decided to open factories here.
Since Toyota is a lot bigger, Hyundai pulled out.
A dominant strategy is where one always has the best response to all possible
strategies their rivals might play. Both firm has access to all information, so firm 2 knows what firm 1 will pay. Firm 1
wouldn’t be envious if firm 2 got a better yield, so long as you are going to get a
higher yield from your decision.
Firm 1 has experienced a 1 mover advantage.
By moving first, they raised their profits, which is why they moved first. So, it’s not
because it changed the competitive landscape and what not, but it’s because it
increased their profits..
i.e. this explains why they undertook this commitment.
They got higher payoffs than if they did not 1move 1 . st
There isn’t always a first mover advantage. Like in rock paper scissors, you have a
second mover advantage.
Final exam question:
If we define first mover advantage as if you change the game, and you raise profits.
If firm 2 moves first and goes for (15,6.5), so they chose aggressive, so what will firm
1 do? Read up on this.
Strategic substitutes refer to if your firm and my firm are rivals, if I play
aggressively, you play less aggressively. So a strategic substitutes, the strategies
move against each other.
They occur when one firm decides to act more (less) aggressively causes/induces
their rivals to all act les