Section I: Basic managerial economics

dout 1          Professor Tom K. Le

Section I: Basic managerial economics

Part 1: What is managerial economics?

(CH 1)

Basic organizational architecture questions

   -How to assign decision rights & decision rules within the organization?

   -How to bundle tasks into jobs and jobs into division units?

   -How to recruit and retain qualified members of the organization for specific jobs?

   -How to reward & share risk with members of an organization?

   -How to design a system to evaluate objectively and/or subjectively the performance of

    members and division units of an organization?

Basic managerial questions

   -What is the optimality condition of promotion spending for a revenue center?

   -What is the cost minimizing input mix for a cost center?

   -What is the profit maximizing output mix for a profit center?

   -What is the optimality condition of diversification for an investment center?

   -What is a winning strategy of a business game?

Three implications of Economic Darwinism

   -successful firms in an industry are not random.

   -firms’ success is relative and not absolute.

   -to remain successful a firm must adapt to new technology, competition, or regulation


Benchmarking is identifying the best firm in an industry or the best business unit in a

   firm & imitating it

Part 2: Basic economic principles(CH 2)

Basic economic principles

   -people are non-satiated, self-interest, and smart.

   -resources are limited.

   -prices economize on the cost of transferring information to coordinate decisions.

   -people do tradeoff, e.g. monetary and non-monetary rewards are both important.

   -people react to incentives.

   -information is costly & there is imperfect, asymmetric & incomplete information

    leading to adverse selection and moral hazard.

   -people are risk-averse: certainty equivalence & risk premium.

   –diversify but don’t diversify for the sake of diversification

   -marginal analysis

   –opportunity cost is the relevant cost.

   –Free Rider Problem

   rent-seeking behavior

   -Coase Theorem, property rights, and Common Pool Problem

   -three elements of decision theory and five elements of game theory

   -fairness: efficiency versus equity

Economics 308          Handout 2          Professor Tom K. Lee


Part 3: What is a firm and why it exists?

(CH 3)

General knowledge is free to transfer, while specific knowledge is expensive to transfer,   

   e.g. idiosyncratic knowledge of particular circumstances, scientific knowledge and

   knowledge from learning-by-doing.

Firms are constantly taking ideas & specific knowledge of their employees that are their

   “wetware” (ideas) & converting them into general knowledge that is “software

   (instructions and formulas) that can be employed to produce products & services.

Economic transactions involve transaction costs, including search, information,

   bargaining, decision, monitoring & enforcement costs. The optimal method of

   organizing an economic transaction is the one that minimizes transaction costs.

A firm is a focal point of a set of implicit and explicit contracts.

A contract is an agreement to facilitate deferred exchange.

Implicit contracts are not enforceable in a court of law but legal contracts are.

Firms exist -to minimize transaction costs and to achieve information specialization

                   -to enjoy economies of scale and scope

                   -to diversify risk

                   -to solve coordination problem of specific assets

                   -to pose bond to trading partners through reputation

Specific assets are assets that are worth more in their current use than in alternative uses.


Section II: Organizational theory of the firm

Part 4: Micro-Microeconomic Theory of the Firm

(CH 10)

Facts of a firm

    -There are many decision makers within a firm.

    -The primary objective of most decision makers is not to maximize the value of a firm.  

    -Firms often use internal pricing and market to allocate internal resources.

Separation of ownership and management

Principal Agent Problem involves a principal who wants an agent to exert effort to

   benefit the principal, and how the principal design an incentive and risk sharing

   compensation to induce the agent to exert an optimal level of effort.

Seven sources of conflict between owners and managers

   –Efforts are costly to managers but increase the value of a firm.

   -Once compensation package is given to managers, they try to increase perquisites

    which are costly to a firm but tax-free to the managers.

   -Managers typically have substantial human and financial capital invested in the firm

    that they might be excessively risk averse.

   -Managers with large controlling ownership interests in a firm might involve with self-

     dealing  to enrich themselves at the expense of the general shareholders.

   –Horizon problem: Managers’ tenure with a firm has a finite horizon but a firm

    presumably has an infinite horizon.

   -Managers bear personal cost of decision-making but not the firm leading to oversizing.

   -Members of a firm are grouped to form teams leading to Free Rider Problem.

Economics 308          Handout 3          Professor Tom K. Lee


Shareholders might enrich themselves at the expense of bondholders & vice versa.

Large shareholders might enrich themselves at the expense of small shareholders.

Costs of contracts -legal costs for writing, interpreting, monitoring & enforcing contracts

                             -information cost and contingencies

                             -uncertainty and incomplete contracts

                             -contract negotiation & renegotiation

Pre-contracting informational asymmetries can cause bargaining failure (e.g. strikes) and

   adverse selection.

Adverse selection is the tendency of an individual with superior information over a

   potential trading partner to extend an offer that would be detrimental to that trading


Solutions to adverse selection

   -reduce or remove information asymmetry

   -introduce deductibles and co-payments

   -introduce variety of contracts to sort out trading partners with different private


   -allow trading partners to signal their private information.

Post contract problems –agency (moral hazard) problems (one solution is bonding)

                                      -information cost, e.g. monitoring cost

                                      -enforcement cost

                                      -legal cost of recourse

Solutions to implicit contract and reputation

   -provide historical tract records to the public

   -introduce third party verification, e.g. J.D. Power

Reputation concerns in implicit contracts are more likely to be effective if

   -the gain from cheating is small.

   -the likelihood of detecting cheating is high.

   -the expected sanction imposed if cheating is detected is high.


Part 5: Organizational architecture (solution to principal agent problem)

(CH 11)

The primary goal of an economic organization is to produce & sell to consumers what

   they want at the lowest cost of production & to extract the consumers’ value as profit.

Three important aspects of organizational architecture of a firm

   -the assignment of decision rights within the firm (administrative decisions versus

    transfer prices) & an information  system to transfer the right info to the right person.

   -the design of reward system(incentives & risk sharing) for members of the firm

   -the design of subjective & objective performance evaluation system of members and business

    units of the firm to monitor & control

The challenge is how to get the relevant information from so many different members of

   the firm to the right person to make the right decisions and to provide the incentive for

   the right person to use the information productively.


Economics 308          Handout 4          Professor Tom K. Lee


Organizational change should be undertaken only if expected marginal benefit exceeds

     expected marginal cost.

Three costs of changing organizational architecture

   -direct costs of informing the members of the firm of the change

   -indirect costs of redistributing wealth within the firm thus generating proponents and

    opponents within the firm for the change

   -frequent changes can backfire by shortening decision horizon of members of the firm

    leading to less incentive to acquire specific human capital, to devise more efficient

    production process, and to develop effective relations with coworkers.

Corporate culture is the passing of practices from one generation of owner &  

   employees to those in the next generation such as  the way job are assigned, decision

   rights are assigned, the way members of the firm are rewarded and controlled, and

   organizational features such as customs, taboos, company slogans, heroes, public

   recognition and social rituals.


      Business environment: technology, markets & regulation


                    Strategy                            Value of the firm


      Organizational architecture: incentive, decision (information) & structure


Part 6: assigning decision rights

(CH 12)

An important element of organizational architecture of a firm is partitioning all tasks

   within the firm to smaller blocks of tasks & assigning them to individuals and/or teams.

Two dimensions of a job -variety of tasks to be completed

                                         -decision authority to determine when & how to best complete

                                           the tasks

Decisions are made at the top management level –if firms are small,

                                                                               -if market shares of firms are stable.

Decisions are decentralized –if firms are large,

                                              -if market shares of firms experience rapid changes

                                               in business environment, new product and/or market

                                               expansion and introduction of new product varieties.

Benefits of decision decentralization

   -effective use of local knowledge

   -conserve top management time while reduce middle management

   -attract talents to junior management positions in business units to prune for future

     senior management positions in corporate headquarters

   -successful use of local knowledge in one business unit might be transfer to other

    business units leading to new process and/or new products

   -reduce rent-seeking costs within the firm



Economics 308          Handout 5         Professor Tom K. Lee


Costs of decision decentralization

   -incentive conflicts increase as decision rights are delegated to lower level of the firm

   -coordination costs and failure, e.g. airline hub-and-spoke organization

   -less effective use of central information

One solution to high cost of decision decentralization is to develop a Rapid Response

   Team, which responds to requests of corporate information and know how from low

   level by providing ready access to data, documents, and experienced consultants

   from headquarters.

Lowering information cost eliminates middle management for controlling information


New roles of middle management include identifying and assembling a team, helping

   subordinates to design winning strategies, and providing motivation to members of the


Firms grant decision rights to teams for four reasons

   -to manage a project

-to design and make a new product

-to study a problem and to recommend actions

-to transfer wealth among team members

Benefits of team decision-making

   -improve use of disperse specific knowledge

   -broaden the support base among employees for changes

Costs of team decision-making

   -costs of arriving a consensus or a rational decision

   -free rider problem increases with team size.

Optimal team size is between two to twenty five.

Two determinants of team size -purpose of the team

                                                  -complexity of the problem

Collective decision-making, cyclical preference, voting rules, agenda manipulation,

   power of a committee chair and power of the purse

Four steps of decision-making process

   –initiation: proposal of decision initiatives

   –ratification: choice of alternative decision initiatives

   –implementation: execution of ratified decision initiative

   –monitoring: measure performance of executed decision and allocate rewards

Decision management refers to initiation and implementation and is executed at a lower

   level of the firm.

Decision control refers to ratification and monitoring and is executed at a higher level of

   the firm.

Whenever there is principal-agent relationship, separating decision management and

   decision control limits conflict of interest, e.g. Baring Bank of London.






Economics 308          Handout 6          Professor Tom K. Lee


In large corporations, decision management are done by managers while decision control

    is done by the board of directors, who in turn is monitored by large shareholders and

    takeover specialists. In some cases an empowered employee might have explicit rights

    to initiate and implement decisions, but managers will still ratify and monitor the


One potential benefit of limiting discretion in making decisions is that it reduces rent-

    seeking cost in influencing decisions.


Part 7: Bundling tasks into jobs and subunits
(CH 13)

Under the Hay System, each job within an organization is evaluated on factors such as

   required knowledge, skills, the number of people supervised, and accountability. Based

   on this evaluation, each job is assigned a total number of points and placed in a position

   within the firm’s hierarchy. Jobs at a given level of the hierarchy have similar pay

   ranges depending on experience and qualifications. This is useful for a new industry.

Specialized task assignment is to have each employee specialize in one function.

Broad task assignment is to have each employee perform multiple functions.

Benefits of specialized task assignment

   -enjoy comparative advantage and specialization

   -achieve learning curve effect: increasing cumulative output reduces cost

   -lower training cost

   -remove monitor costs of how employees allocate effort to which task

Costs of specialized task assignment

   -forgo complementarities of tasks and economies of scope

   -higher coordination costs and hold-up costs

   -boredom, functional myopia and losing sight of total system delivery

   -reduce flexibility for relief and temporary replacement due to sickness or vacation

   -higher cost of performance evaluation when output depends on multiple tasks success

    and yet it is hard to observe individual task success

Corporations are moving towards broad task assignment and away from specialized task


Four structural forms of organization

   –Unitary form (U form) is to group jobs by functional specialty.

   –Multidivisional form (M form) is to group jobs into a collection of business units

    based on product or geographic area.

   –Matrix organization has employees from different functional departments assigned to

    product or geographical area teams on temporarily basis, e.g. defense, construction and

    management consulting. Employees report to both a functional manager and a business

    unit manager. In-fights & rent seeking among functional groups are more intense.

   –Network organization has an affiliation of independent subsidiaries that together

    enjoy economies of scale & scope but separately avoid diseconomies of scale &

    scope, for example, a theme park, hotels, restaurants and transportation.

Economics 308          Handout 7          Professor Tom K. Lee


Benefits of U form organization

   -it promotes functional expertise

   -it incurs lower costs to recruit, retain and evaluate functional members.

   -there is lower costs of communicating and share results among members of the same

    functional specialty.

   -there is well defined promotion path for employees.

Costs of U form organization

   -higher senior management costs of coordinating functions

   -higher communicating costs across functional departments

   -too much functional expertise and not overall customer satisfaction

   -in-fights among functional groups

U form organization works best in small firms with homogeneous products and markets,

   and more stable technological environment.

Benefits of M form organization –creates internal competition

   -in a dynamic environment, it is best to have decentralized decision making.

   -it frees up managerial time for higher level decision making.

   -it encourages system (supply chain) thinking in a business unit.

   -in a dynamic environment, different business units can experiment alternative

    organizational architectural or product changes.

Costs of M form organization

   -if there are interdependence of business units, there may be decision conflicts across

    business units to the extent lowering overall value of the firm.

   -business unit managers need cross functional training

Large multinational corporations tend to organize their international divisions around the

   matrix concept, but to organize their domestic divisions around U form or M form.

Corporations are moving towards product-oriented organizations with caseworkers with

   broad decision authority and multiple task assignment and away from functional



Part 8: Attracting and retaining qualified employees

(Ch 14)

In a perfectly competitive labor market, a competitive firm will hire workers until wage

   equals to their value marginal product of labor, and a monopolistic firm will hire

   workers until wage equals to their marginal revenue product of labor.

Marginal product is incremental output due to the last unit of an input.

Value marginal product is competitive price of a product time marginal product.

Marginal revenue product is marginal revenue of a product time marginal product.

General human capital is training and education that are of general value to many firms.

Specific human capital is training and education that are of value to a particular firm.

In general employees pay for general human capital, and firms pay for specific human


Jobs differ according to skill and education training, quality of work environment,

   geographical location, length of commute, risk of injury and death, characteristics of

   coworkers, and degree of monotony associated with the tasks.

Economics 308          Handout 8          Professor Tom K. Lee


Compensation wage differential is the extra wage that is paid to attract a worker to a

   less desirable job. This is how unpleasant jobs got filled. It also shows that it pays for a

   firm to invest to improve non-wage attractiveness of a job.

Why different industries have different period of probation for new hires?

Why some industries offer life time employment and others don’t?

Job satisfaction at a firm is indicated by -number of new qualified applicants

                                                                -the quit rate of existing employees

Firms have to tradeoff between incremental compensation and turnover costs of workers.

Sometimes employees leaving a firm take customers and knowledge to competing firm.

Matching all outside offers generates incentive for employees to take time and effort to

   generate outside offers, but discretionary matching generates rent-seeking.

An internal labor market exists in a firm when outside hiring focuses primarily on

   filling entry-level jobs and most other jobs in the firm are filled from within the firm.

Firms can have multiple internal labor markets, e.g. white-collar & blue-collar workers.

Firms are more likely to use internal labor markets where specific training of employees

   is important, e.g. steel, petroleum, chemical industries.

Benefits of an internal labor market

   -increase incentive to invest in specific human capital

   -better align employees’ interest with interest of owners of the firm

   -over time more information of employees’ skill, capability, attitude, intelligence are

    revealed to employers.

   -reduce turnover costs

   -establish career paths and the prospect of promotions for employees

   -provide job stability to employees through long-term relationships

Costs of an internal labor market

   -may not get the best person for the job

   -pay, job assignment and promotions are determined by administrative decisions

   – increase rent-seeking cost in influencing decisions

Efficiency wage is a wage premium above market rate for two reasons: to reduce

   incentive to shirk by employees and to reduce turnover costs.

Firms are typically partitioned into hierarchical levels, with a higher pay limit at each

   higher level in the job hierarchy. Promotion is the only way to move up the job

   hierarchy. Promotions can be viewed as contests or tournaments among employees

   who exert extra efforts if they perceive close chances of promotion.

Costs of contest and tournament

   -undermine workers cooperation

   -less flexible compared to bonus pay, pay raise or profit sharing

   –Peter Principle: employees keep getting promotion until they reach a job that they

    cannot handle. This is a serious conflict between matching people for jobs and

    providing incentives.

   -employees value more than just promotion and higher pay, e.g. job security

   -intensify rent-seeking costs

   -if workers don’t perceive a chance of winning, they maximize shirking.

Job seniority and pay are usually positively correlated because of learning-by-doing.

Economics 308          Handout 9          Professor Tom K. Lee


Wage Compression is the situation when new hires are paid more than experienced

   workers. One explanation is that new hires bring in new ideas that are potentially

   valuable, while on-going workers on routine tasks gain minimal value from experience.

Back-loaded compensation is when compensation increases faster than productivity as

   an employee ages, for example, professional services such as law & accounting firms.

Workers choose back-loaded compensation jobs as bonding and signaling.

Firms offer back-loaded compensation if productivity of workers increases rapidly over

   time but with uncertainty.

Firms frequently offer attractive retirement packages to encourage older employees to

   retire and often have mandatory retirement age.

A typical American worker receives 75% of total compensation in the form of pay for

   work and 25 % in fringe benefits. The most important fringe benefits are medical

   insurance and pension plans.

Different workers have different preferences in the tradeoff of pay versus fringe benefits.

In designing compensation package, management should consider the total tax bill for the

   employee and the firm.

Fringe benefits such as sick leave and disability insurance can be costly to the firm

   beyond direct cost of insurance premium, e.g. absenteeism.

Some firms offer cafeteria plans of fringe benefits for employees to choose from at a

   fixed fringe benefit allowance.

Costs of cafeteria plans

   -higher administrative costs

   -adverse selection


Part 9: Incentive compensation

(CH 15)

Examples of incentive compensation -piece rate and commission

                                                            -bonuses or promotion for good performance

                                                            -prizes for winning contests, e.g. a free vacation

                                                            -stock option and profit sharing plans

                                                            -demotion and firing upon poor performance

Incentive conflicts are not a problem when efforts of employees are observable and   

   verifiable, i.e. efforts are contractible.

In some cases, incentive conflicts can be resolved even when efforts are not observable.

   One way is to “sell” the output to the employees so that both benefits and costs are

   internalized by employees and thus employees will choose the optimal efforts.

Three important factors that limit the use of ownership to resolve incentive problems

   -employees have limited wealth to buy a significant share of the company

   -uncontrollable random events and employee risk aversion towards ownership

   -team production and free rider problem

From risk sharing standpoint it is better to pay employees fixed salaries and let the total

   risk of random income flows be borne by the shareholders.

From incentive standpoint it is better to tie pay to performance, e.g. stock option.

An optimal compensation contract must strike a balance between these two standpoints.

Economics 308          Handout 10          Professor Tom K. Lee


Incentive compensation contract works best when

   -marginal productivity of employees are high

   -the lower is risk aversion of employees

   -uncontrollable random events are minimal

   -the lower is the marginal cost of effort

   -the lower is the cost of observing and verifying the output of employees

Group incentive plans are incentive pay to an employee based on group performance,

   such as overall profitability of a firm as reflected by stock prices.

Benefits of group incentive plans

   -group performance measure is less costly than individual performance measure

   -encourage cooperation and teamwork

   -motivate mutual monitoring and enforcement among employees

A problem with group incentive plans is the free rider problem.

Managers have to be concerned not only with how hard employees work but also with

   how they allocate their time among assigned tasks.

Compensating employees only on measurable tasks encourages them to exert effort on

   the measurable tasks and to shirk on the other tasks.

By offering a menu of incentive compensation contract for employees to choose from can

   induce employees to reveal private information.


Part 10: Individual Performance Evaluation

(CH 16)

Employee performance is evaluated

   -to provide employees with feedback on job achievement to improve performance

   -to determine rewards & sanctions

Informativeness Principle states that improvement in the precision of measuring

   employees’ effort by incorporating more information of employees’ effort reduces the

   cost of inefficient risk sharing and leads to a more efficient effort choice by employees.

The informativeness principle implies that information about other employees’ effort

   and/or output should be included in an incentive compensation, i.e. a relative

   performance evaluation. It also implies that there is a tradeoff between the costs of

   developing and implementing better performance measures, and the benefits of 

   improving effort motivation and more effective risk sharing.

Relative performance evaluation is the using of other employee’s performance to adjust

   the compensation of an employee. This makes sense if common random factors affect

   the performance of different employees.

Shortcomings of relative performance evaluation

   -collusion to under-perform

   -electing a poor performer to be the standard

   -sabotage on coworkers’ work performance

   -admit low quality new hires

When objective performance evaluation leads employees to exert effort on measurable

   performance attributes and de-emphasize on non-measurable performance attributes,

   subjective performance evaluation is supplemented to yield a comprehensive

Economics 308          Handout 11          Professor Tom K. Lee


   performance evaluation.

Two subjective performance evaluation methods

   -standard rating scale system rank employee on a number of different performance

    factors using a five point scale to size up the shortcomings of an employee,

   -goal based system requires employees to set goals for the year and the supervisor

    evaluates the extent to which each goal has been met at the end of the year, after which

    the employees have a chance to respond. This serves as remedy to worker’s shortfall.

Specific, measurable, agreed-upon, realistic, and time-bound (SMART) goals

Problems of subjective performance evaluation

   -shirking among evaluators

   -rent-seeking to influence decision

Federal and state legislation requires employers to document their compensation and

   promotion decisions to demonstrate their actions are related to performance and are not

   related to race, sex, age, physical handicap, religion and national origin.

Ratchet effect refers to basing next year’s target performance on this year’s actual

   performance leading to a perverse incentive for employees not to exceed this year’s

   target performance to avoid raising next year’s target performance.

Methods to reduce the ratchet effect

   -set next year’s target based on this year’s peer actual performance

   -introduce more frequent job rotation at the cost of losing learning curve effect

   -make a commitment not to change next year’s target

The more incentive pay in the employee’s compensation package, the more risk the

    employee bears and the more the firm should spend on measurement of performance.

Opportunism is the non- or counter productive activities engaged by employees to

   improve their performance evaluation leading to gaming & horizon problem.

Gaming occurs when employees are rewarded according to some measured output and

   yet measured output is not perfectly correlated with firm value leading employees to

   engage in dysfunctional activities to improve their performance evaluations.

Horizon problem: short-run, objective performance measures can cause employees

   (especially those about to change jobs or retire) to concentrate their efforts on

   producing results to reap short term benefits at the expense of sacrificing long term

   profit of the firm.


Part 11: Divisional Performance Evaluation

(CHS 17, 5, 7)

Cost center is used when headquarter can measure quantity & quality of output, knows

   the cost function, and can set the profit maximizing output and rewards, while the cost

   center has knowledge to choose the optimal input mix to minimize cost subject to an

   output target, for example: manufacturing units.

Expense Center is used when headquarter has difficult to observe and measure output,

   while the expense center has knowledge to choose the optimal input mix to minimize

   cost subject to a fixed level of service satisfaction, for example: personnel, accounting, 

   & research centers.


Economics 308          Handout 12          Professor Tom K. Lee


Optimality condition for output-constrained cost minimization:

   Incremental cost due to the last unit of output through the usage of any input should be

   the same across all inputs.

Revenue Center is used when headquarter has knowledge of demand to set the profit

   maximizing price for an optimal product mix, while the revenue center has

   knowledge to choose the optimal input mix (such as advertising and product

   promotion) to maximize revenue for given price targets and cost budget, for example:

   retail and wholesale units.

Optimality condition for cost-constrained revenue maximization given product price:

   Incremental revenue due to the last dollar spent on each promotion activity should be

   the same across all promotion activities.

Profit center is used when the profit center has the knowledge to choose the optimal

   input mix & the price or quantity of an optimal product mix to maximize profit, e.g.

   Cadillac division of GM. Profit center consists of revenue, cost & expense centers.

Profit maximization requires marginal revenue equals marginal cost. For the special case

   of a competitive firm, price is equal to marginal revenue. For firms with market power,

   price is greater than marginal revenue.

Five sources of market power -essential inputs (strategic assets)

                                                -economies of scale and scope

                                                -product differentiation: quality, warranty, brand name

                                                -government regulation

                                                -entry barrier

Third degree price discrimination is the situation where a firm can sell to different

   consumers (possibly in different markets) at different prices. Profit maximization

   requires marginal revenue in each market equals to marginal cost. This leads to the

   inverse demand elasticity rule, for example, movie ticket prices, dry cleaners, best price

   policy, coupons, and senior citizen, student and group discount.

Inverse demand elasticity rule requires a firm to sell a product to consumers with

   higher own-price demand elasticity at a lower price and to consumers with lower

   own-price demand elasticity at a higher price.

There are three examples where firms with market power can lead to efficient outcome by extracting all consumer surpluses to become monopoly profits:

   –first degree price discriminating monopolist: every unit at a different price

   –two-part tariff monopolist: membership fee plus price per unit

   –all-or-nothing contract monopolist: fixed quantity plus price per unit

Product bundling requires buyers to buy two or more products at a set price or no deal.

Second degree price discrimination is selling different blocks of units to the same

   consumer at different prices.

Fourth degree price discrimination is selling to different consumers at the same price

   but the cost of providing the product to different consumers are different.

Peak load pricing occurs when firms discriminate consumers by selling to them at

   different prices at different time for the same quality product.

Dominant firm price leadership model can explain coexistence of a low-cost large firm

   with many high-cost fringe firms.  

Economics 308          Handout 13         Professor Tom K. Lee


Transfer Pricing is the pricing of an intermediate good sold from one division of a firm

   to another division of the firm.

From the managerial point of view, transfer price should be set to the competitive market

   price of the intermediate good if a competitive market for the product exists, or to the

   marginal cost of producing the intermediate good by the firm so as to clear the internal

   market for the intermediate good if a competitive market for the product does not exist.

Downsizing (reengineering) refers to divesting unrelated businesses to focus on the core

   business. Since the early 1990s, downsizing is common business policy. Downsizing

   means job cutting especially middle management jobs, partly due to technological

   change. However majority of firms that went downsizing enjoyed an initial drop in

   accounting cost but in six months to a year accounting cost went up. The explanation is

   that work from the dismissed employees are piled up on the remaining employees

   causing lower productivity and decline in morale.

Spin-off means distributing on a pro rata basis all the shares a firm owns in a subsidiary

   to its shareholders, e.g. Tyco International spin-off to three distinct companies.

Split-off means some parent firm shareholders receive the subsidiaries shares in return

   for relinquishing their parent firm shares.

Divestiture means selling a segment of a firm to a third party.

Equity carve-out means distributing on a pro rata basis some of the shares a firm owns

   in a subsidiary to its shareholders while the rest of the shares are sold to the general

   public to raise cash to the parent firm, e.g. Altria equity carve-out Kraft Food.

Outsourcing is the switching from make to buy parts and services. The most common

   outsourcing activities are information system, pension management and facility


Supply chain management ensures that each transaction in the process of producing a

   product from raw materials to the final product is efficient. It requires the exchange of

   technical and managerial knowledge between upstream and downstream firms. It may

   also require coordination to achieve just-in-time inventory control. Since 1990s three

   successful cases standout in the application of the concept, for example, Dell, Baxter,

   and Proctor and Gamble.

Strategic alliance refers to two or more firms that share common interest in expanding

   into new products, services and/or markets to avoid duplication of efforts, e.g. GM & GE.

Joint ventures are entities created out of the cooperative efforts of a small part of two or

   more corporations for a limited time period, for example, joint contract bidding,

   research and development, and new market penetration. (GM-Toyota’s NUMMI)

Investment center is used when investment center has knowledge to choose the optimal

   input mix of the price or quantity of an optimal product mix and investment opportunity

   to maximize risk adjusted return on asset(ROA) or economic value added(EVA). An

   investment center consists of several profit centers, e.g. GM & its many divisions.

When it comes to investment center with several profit centers competing for investment

   funds, a portfolio approach might prove to be useful. One should diversify into a

   portfolio of profit centers to maximize expected investment returns subject to a level of

   risk tolerance. Diversification reduces the importance of variance risk and increase the

   prominence of covariance risk.

Economics 308         Handout 14          Professor Tom K. Lee


Part 12: Legal forms of Organization

(CH 18)

There are two legal forms of organization: nonprofit and for-profit.

A nonprofit organization prohibits persons who control the organization from receiving

   the organization’s residual profits. Residual profits must be used for the arts, education,

   or charity. Nonprofit organizations are private and self-governing. They are exempted

   from federal, state, and local taxes. They must be financed through debt, internally

   generated funds, and donations. Nonprofit organizations cannot pay top managers

   equity-based compensation. Board members are typically community leaders and major


For-profit organizations have owners to receive the residual profits. Advantages of

   for-profit organizations are that they can gain access to capital funds from publicly

   traded equity markets and use equity based compensation to motivate workers.

Nonprofit and for-profit organizations co-exist in certain sectors of an economy, such as

   hospital, nursing homes, and education.

There are seven legal forms of for-profit organization:


                                  Owners            Decision              Taxes                  Owner’s           

                                                          Control                                           Liability


   –Individual            Proprietor        Proprietor             Pass through      Unlimited



   –general                  Partners           Partners               Pass through      Unlimited



   –limited liability     Partners           Partners              Pass through       Limited

     partnership (LLP)


   –limited                  Partners           General                Pass through      Unlimited for

    partnership                                   partners                                         general partners,

                                                                                                                  Limited for

                                                                                                                  Limited partners


   -limited liability    members          members              Pass through/     Limited

    company               (one or more)                               as corporation


   –S corporation       Shareholders   Shareholders        Pass through      Limited

                                                          & board


   –C corporation      Shareholders    Shareholders       Both corporate   Limited

                                                           & board               & shareholder

                                                                                       levels: double


Economics 308         Handout 15          Professor Tom K. Lee


Pass through means business income would only be taxed once at the owner’s personal

    income tax level.

An owner of proprietorship loses liquidity and faces high risk.

Large professional service organizations often are organized as partnership (usually as

   LLPs). In recent years, some of the large consulting firms have converted to publicly

   traded corporations to take advantage of capital funds from publicly traded exchanges.

S corporations were created in 1959 to help small business. The number of shareholders

   are limited to no more than 100. In practice, the shareholders/managers and the

   boards in small S corporations are the same people.

C corporations have no restriction on number and type of shareholders making them easy

   to raise capital.


Part 13: Markets for Corporate Control


Shares of closely held corporations are held by a few shareholders and are not freely

   traded, while shares of publicly traded corporations are held by the general public

   and are exchange traded. Reorganization of publicly traded corporations to closely held

   corporations typically enjoy positive stock returns upon the announcement. Such

   reorganization initiated by the existing management is called management buy-out

  (MBO), and if it is financed by debt it is called a leverage buy-out (LBO). Kohlberg,

  Kravis, Roberts & Co. is an example of buy-out specialist.

Some corporations have dual-class voting shares, where one class of share has primary

   claim to the residual profits and few voting rights, while the other class of share has

   smaller claim to the residual profits but retains more of the voting rights, e.g. Google.

   Typical limited voting right stock sells at a discount of over five percent relative to its

   superior voting right counterpart.

Corporate governance refers to organization structure of a firm to monitor and direct

   the performance of the firm.

There are five important internal control mechanisms to limit agency problems in

   publicly traded corporations: large shareholders (blockholders), shareholder voting

   (proxy contest), board of directors with outsiders, management compensation where

   straight salary account for only twenty percent of total compensation , and (internal &

   external) auditing.

In a proxy contest, an outside group seeks to obtain representation on the firm’s board of

   directors. Proxy contest are usually directed against the existing management.

There are three important external control mechanisms to limit agency problems in

   publicly traded corporations: market of corporate control (takeovers of poorly managed

   firms), managerial labor market (track record of managers affecting future executive

   income and employment), and product market competition (Economic Darwinism).

In a tender offer, an outside group request existing shareholders of a corporation to sell

    their shares to the outside group at a pre-set tender price to gain control of the

    corporate management.

A bear hug is a tender offer where the outside group first seek approval from the

   corporate management and board of directors.

Economics 308          Handout 16         Professor Tom K. Lee


A hostile takeover is a tender offer where the corporate management and board of

   directors reject the offer but the outside group continue to proceed with the tender offer

   to win corporate control.

A greenmail is a premium repurchase of stocks owned by the takeover party to prevent a

   takeover usually with an agreement from the takeover party not to pursue another

   takeover of the corporation in the future, e.g. Occidental Petroleum paid greenmail to

   David Murdoch $60 million in 1984 and Goodyear Tire and Rubber Company paid Sir James

   Goldsmith $93 million in 1986.

A white knight is a third party sought by the corporate management and board of directors

   to take over the corporation that is subject to a hostile takeover, e.g. Nissin paid $314m to buy

   Myoto Foods after US hedge fund Steel Partners wanted a hostile takeover.

A poison pill is restructuring by a corporation subject to a hostile takeover to reduce

   the attractiveness of the takeover.

Examples of poison pill (anti-takeover defenses):

   -an immediate large cash dividend financed by debt,

   -a cash refund to customers in the event of a takeover, e.g. Peoplesoft against Oracle,

   –golden parachutes: to award large severance pay to existing management if a takeover

     is successful and the existing management are terminated, e.g. Robert Nardelli walked

    away with $210 million to resign as chairman and CEO of Home Depot in 2007, James J.

    Mulva stepped down as CEO of ConocoPhillips for about $156 million, and Edward D. Breen     

    who stepped down as CEO of Tyco International for $55.8 million in 2012 but remained as

    chairman, will receive $30 million in 2016.

   –poison put allows bondholders to sell bonds back to the firm at a premium in the event

     of a takeover of the firm, e.g. a note issued by Grumman Corporation that mature in


   –poison call allows management to buy back bonds of the firm at a premium in the

    event of a takeover of the firm, e.g. a $300 million note issued by Mesa, LP in May 1989,

   -move the corporate headquarters to a state with strong anti-takeover laws, e.g.


   -change corporate governance to require absolute majority to approve a takeover vote.

In general, defensive strategies of existing management lead to lower stock returns.

Fifty percent of top management of target firms are gone within three years of takeover.

Organization capital comes from three sources:

   -learning by doing: production, management, customer/government relations &


   -learning by matching: workers to job, workers to team

   -learning by cooperating: team work

Other corporate capital -liquid assets, e.g. cash and money market instruments,

                                      -real assets, e.g. real estates and expensive equipment,

                                      -patents, trademark, copyrights, e.g. Pfizer, MacDonald, Capital Records

                                      -reputation: with consumers, suppliers, workers, and gov’t

                                      -earning power, e.g. cable companies

                                      -market access, e.g. Walmart

                                      -funds access, e.g. GE Capital