Your lecturer today and tomorrow:

Dr Alfred Kleinknecht

CV:

1972-77: Study of Economics in Berlin

1977-84: Junior researcher, Wissenschaftszentrum Berlin and Free University of Amsterdam

1984-88: Lecturer in economics at Univ. of Maastricht

1988-94: Researcher at Univ. of Amsterdam

1994-97: Professor of Economics, Free Univ. of Amsterdam

Since 1997: Professor, Economics of Innovation, TU Delft

2006: Visiting Professor, Università la Sapienza, Rome

2009: Visiting Professor, Université Panthéon Sorbonne, Paris I

Structure of lectures:

• Introduction to some basic micro-economic principles

• Application of micro-economic principles to management decisions

• From micro-economics to innovation theory• Measuring innovation• Labour relations and innovation• Macro-economic aspects of innovation

What is economics (1)?

General Economics:

• Micro-economics (choices made by individual firms, households or persons)

• Macro-economics (aggregate economy)• International economics (including

development economics)• Economics of the public sector (Efficient

taxing and public spending)• Evolutionary and institutional economics:

innovation

What is economics (2)?

Management economics:

• Accounting (balance sheets, cost estimates, etc.)

• Finance and investment• Organisation and strategic management• Marketing and market research• Human Resource Management• Innovation management

Values and political preferences

Positive economics:• Factual or predictive statements• (e. g.: "During a hot day, we sell more ice cream")

Normative economics:• Value judgments (e. g.: "Income distribution should be more

equal")

Is economics a "value-free" science?• Not in the selection of topics for research (a scarce resource!)• Political/ideological views can play an (often hidden) role• Economists involved in policy advice may be too closely

engaged with the subject of their research and with vested interests

A key difference between economics and natural sciences:

Economists can not do physical experiments!

Alternative: Economic models

Economic models:• Concentrate on features considered essential for

understanding reality (ignoring details; using simplifying assumptions)

• Outcomes from models can be confronted with observed statistical data → A good 'fit' gives confidence on the model's suitability for predictions (typical research path: interaction between data analysis and model building)

• There can be competing models! The choice between models should not depend (but often it does) on ideological preferences of the economist

Micro-economics as a theory of choices:

Typical questions:• How can I spend my money in a way that I get

maximum satisfaction/utility from it?• How can I distribute my time between work (=

utility of money) and free time (= utility of leisure)?

• How can I best spend my study time: Reading a book in a library or attending this lecture?

• How can I distribute my income between immediate consumption and future consumption (savings)?

• Etc.

Basic question: How to maximise my utility, using scarce resources efficiently?

Some standard assumptions:• Wants are unlimited but resources are

limited• Self-interested behaviour: I maximise my

individual utility (or my company's profits)• Personal/individual preferences• Rational behaviour• Responsive to incentives (e.g. price change)• Simplified models with ceteris paribus

assumption ('everything else unchanged')• Decision in the margin: important is the

decision about the "last unit" (produced / bought / invested) → "marginal utility versus marginal costs …"

Opportunity costs: Utility foregone …

Choosing between alternatives:• A certain quantity of energy can be used for

warming your house or for driving your car → the opportunity cost of using it for driving is that you can not warm your house

• This principle applies to every factor of production • This also applies to allocating your scarce time• This also applies to the choice between current

consumption and future consumption (consume now or save?)

• Your choice will be influenced by (changes in) relative prices, taxes etc.

Demand and supply for apples:

D

SEquilibrium Price:

the market can "clear"

Equilibrium (market clearing) quantity: all apples are sold; no

unsatisfied demand

Pri

ce

Quantity

Demand and supply for apples

D

SEquilibrium Price:

the market can "clear"

Equilibrium (market clearing) quantity: all apples are sold; no

unsatisfied demand

The demand curve (D) stands for peoples' "willingness to pay" which depends on personal preferences. People on the

dark green part of the curve have a high preference for apples and are willing the pay the equilibrium price (they

would have paid even more!)

People on this red part of the curve are

not willing to pay the equilibrium price as they have a lower

preference for apples

Producers on the green part of the

supply curve (S) are not willing to supply

as their marginal costs of production

are higher than marginal revenues

(= the market equilibrium price)

Suppliers on this part of the curve are

willing to supply: their marginal costs

of production are below the

equilibrium price

Price

Demand

Supply

Quantity

Pe

Qe

Consumer Surplus: surface PeBC. People on part C - B

of the demand curve are lucky as the market price is lower than what they would

have been willing to pay!

Producer surplus:

surface PeAB.

Firms on part A-B of the

supply curve are lucky as

they could have supplied at

prices below the market

price! A

B

C

Two types of efficiency:

1. Productive efficiency: production at lowest possible costs

2. Allocative (Pareto) efficiency: Not more and not less than the amount of goods or services desired by consumers is produced: the market is fairly democratic!

How is allocative efficiency achieved?

Allocative efficiency: firms produce what consumers want

Assume the market for pea nuts is in equilibrium at q e and P e.Suddenly, sales rise strongly, as newspapers report that pea nuts are good for your hart.

And what happens if newspapers report that pea nuts cause cancer?

Supply of pea nuts

D = Original demand For pea nuts

q e

p e

A

B

q *

"Pea nuts are good

for your hart" → demand curve

shifts from D to D *

D *Extra demand

makes prices rise

As prices rise, producers move

along their supply curve from A to B

If pea nuts

cause cancer …

p *

Demand & Supply: Movement along versus shift of the curves

.

Price

Quantity

A producer's willingness to supply increases with price

S

D

A buyer's willingness to pay

declines due to income and

substitution effects

S*

A shift from S to S* can be due to a lower numbers of sellers or higher prices of production factors, or some exogenous shock (e. g. a bad harvest).

D*

A shift from D to D* can be due to lower income, changing preferences

or price reduction of substitute goods

Demand & Supply: The market disturbed by government

→What happens if government imposes minimum or maximum prices?

Examples: • Minimum prices for agricultural goods in the

European Union to protect peasants• A maximum milk price to protect poor children• A minimum wage against excessive exploitation of

labour?

If government imposes maximum prices: People have to queue up!

D

S

q e q D*q S*

Chronic shortage of goods as supply shrinks and demand expands

Equili-brium Price

Maxi-mum Price

If government imposes minimum prices: Chronic over-production!

D

S

q e q S*q D*

Overproduction as supply expands and demand shrinks

Equili-brium Price

Minimum Price

The perfect competition model: An ideal market

Assumptions behind the model:• A very large number of buyers and sellers: Nobody

has a notable influence on supply, demand or price• Homogeneous products: All produce the same thing

in the same quality• Free entry to and exit from markets (resources are

mobile)• Everybody has adequate knowledge of prices and

technology• Technology is given exogenously

The perfect competition model: implications

• Nobody has market power • Everybody is a 'price taker' (accepting the market

price, you can sell as much as you want) • Demand curves are horizontal (to individuals)• Everybody tends to earn a 'normal' profit (above-

normal profits lead to entry of new firms; below normal profits lead to exit)

Question: Are there markets that fulfil these assumptions?

Summarizing:

• Allocation of scarce resources will be more efficient to the degree that the assumptions behind the model of perfect competition are fulfilled

• If the assumptions are fulfilled, markets will always tend towards equilibrium (no clients queuing up; no unsold goods: "market clearing")

• If an equilibrium is disturbed (e.g. by a bad harvest), the market will "from alone" move towards a new equilibrium → markets are "stable" (=always striving towards equilibrium)

• Note: Markets not only "clear"; the way this happens is also efficient (= welfare maximizing!)

• → How?

An example of efficient market clearing: A bad harvest drastically reduces the supply of apples (Supply curve S shifts to S *)

D

S

q e

S *

q *

These people derive so little utility from apples that they are

not willing to pay the equilibrium price!

These people derive enough utility from apples to buy at

the equilibrium price, but not enough utility to pay price P *

These are the true apple lovers! They derive so

much utility from apples that they are willing to

pay Price P *

Efficient solution: thanks to a higher price, the "right" people will stop buying apples!

P e = Initial equilibrium

price

P * = New equili-brium price

Efficient (welfare maximizing) solution: Scarce apples go to those that derive the highest utility from them!

Imagine, the harvest was abundant; the market is flooded by apples! How will the market solve this?

S

S *P e

Q e

P *

Q *

The abundant harvest shifts supply from S to S *. Prices decline from P e to P *.At price P *, people on the green part of the Demand curve become willing buying apples, hence the extra supply (Q e - Q *) can be sold

Extra apples from marvellous harvest

People deriving lower utility from

apples start buying, thanks to

the lower price

Another example: the market for savings and credit. The market is in equilibrium (at i e and q e), but suddenly people become scared about the future and start saving excessively → the supply curve shifts to the right (from S to S *)

Quantity

Initial supply of savings

Demand for credit

q e

New supply of savings

S

S *

q *

Initial interest rate i e

New interest rate i *

These people have a high

preference for credit: They are

willing to pay interest rate ie

These people have a moderate preference for credit. As the interest rate declines, they start taking credit

and absorb the extra savings

Low preference for credit: they are not even willing to pay

the new interest rate

An opposite example: there is suddenly a great demand for credit (shift from D to D *)

Quantity

Banks' supply of credit

Initial demand for credit

q e

New demand for credit

D

D *

q *

Initial interest rate i e

New interest rate i *

Due to rising interest rates, banks supply more credit

Another example: The labour market for professors in full employment equilibrium

S = Supply of professors

D= Demand for professors

Quantity of professors to be traded

As wages rise, more people exchange the utility

of free time against the utility of earning a professor's salary

As professors become cheaper, universities buy more of them (as

with apples!)Profes-sors' Wages

Equilibrium wage W e

Market clearing equilibrium quantity: Every professor who is willing to work at wage We can be employed; every

university ready to pay We can find professors

Question: How could we get long-lasting (mass) unemployment among

professors?

?

Professors get unemployed as their wages are too high!

Qq e

Profes-sors'

wages deter-

mined by aggres-

sive trade unions

Due to high wages, universities demand

fewer professorsDue to too high wages, supply of

professors is too high Unemployed professors

Market clearing wage for

professors

Overcoming unemployment? Follow the green arrows!

S = Supply of professors

D = Demand for professors

Summarizing (continued)

• We think of an economy as a large number of markets (so-called 'partial' markets)

• There are markets for (almost) everything: steel and potatoes, savings and credit; labour; shares and bonds, land, houses, art, services, marriages, etc.

• Micro-economics tends to analyse these markets in isolation from each other (interaction between markets → macro-economics)

• Under perfect competition, all markets tend towards equilibrium → general equilibrium

• Problem: How to explain major crises (business cycles; depressions; financial crises)?

Discussion: More revenues through lower prices?

The London city council discusses about how to reduce the public transport company's losses by raising more revenues:

→The Tories argue that ticket prices should be increased in order to raise more revenues

→The Labour Party suggests the opposite: Attract more people to public transport with cheaper tickets!

How to decide who is right or wrong?

Price Elasticity of Demand (PED): Percentage change in quantity demanded divided by percentage change in price

Inelastic demand (or low elasticity of demand): • Weak reaction of quantity sold to price change

Highly elastic demand: • Strong reaction of quantity to price change

Note: →As a rise in prices usually leads to a decline in

demand, PED has a negative sign)

Effects of price changes on Total Revenues (TR = P x Q) depend on Price Elasticity of Demand (PED)!

P

Q

P

Q

D

S

Po

P*

TR gained through price increase

TR lost through price increase

Highly inelastic demand: The Tories are right!

Highly elastic demand: Labour is right!

S

D

P *

TR lost through lower price

TR gained through lower price

P 0

What influences price elasticities of demand?

• Availability of (close) substitutes

• Time needed by consumer to adjust to price change (long-run PED is higher than short-run PED)

• Costs incurred for switching to a substitute product (lock-in through standards? Earlier investments that may be lost?)

• Relative importance of a good (as a percentage of your total budget)

Income elasticity of demand

→Percentage change in goods demanded divided by percentage change in income

→Note that income growth will lead to more demand. Other than the price elasticity of demand, income elasticity for typical goods has an upward slope

→Law on diminishing marginal utility: increasing consumption of a good will lead to lower utility from the last unit consumed

→You arrange your consumption such that the last Euro spent on each good gives you the same utility as the last Euro spent on any other good (this explains why the demand curve slopes down: with falling prices you rearrange your choices)

Cross (price) elasticity of demand

→Demand of a good not only depends on its 'own' (positive) income elasticity of demand and it's 'own' (negative) price elasticity of demand, but also on prices of other (substitute or complementary) goods

Example:• Rising prices for potatoes will lead to more demand

for rice and pasta (cross elasticity is positive)

Definition: • Percentage change in demand for potatoes, divided

by percentage change in price of (substitute) good (rice or pasta).

The opposite holds for complementary goods:

• Complementary goods: e.g. automobiles and motorways

→If the price of one good increases (e.g. higher road tolls), the complementary good will also be less in demand (higher road tolls lead to lower car sales)

→The cross price elasticity of complementary goods is negative

→The cross price elasticity of substitute goods is positive

Choices in using scarce resources – e. g. allocating scarce health services

→Suppose you are a doctor in a jungle hospital, and you have medicines for treating 5 people, but 10 heavily sick people reached your hospital: How to decide which of the 5 people you treat and which you let die?

• On a first-come, first-served basis? ('bureaucratic solution')

• Auctioning to the highest bidder? ('market solution')

• Other criteria? (e.g. discrimination by age, sex or education?)

Reasons for market failure

Market failure due to externalities:

→Positive external effects: somebody else takes advantage from your effort without paying for it (e.g. costless imitation of your invention)

→Negative external effects: somebody else has a disadvantage from your activities without being compensated for it (e.g. you pollute the environment for free)

An example of positive external effects: vaccination

Crucial assumption: vaccines are traded on a free market; in your decision to pay for vaccination, you only think of your own individual utility derived from being vaccinated (you do not take into account that your vaccination also protects others!)

.

S

D

D*

P

D = Willingness to pay for vaccination, based on individual

benefits

D * = Desired demand curve for vaccinations from

society's viewpoint (taking account of

individual and social benefits)

Amount of vaccinations individuals would choose

Welfare maximizing amount of vaccinations

Under-investment in vaccination

Q

An example of a negative external effect: Pollution

N.B.: In your individual decision to pollute, you do not take into account that your pollution has a negative utility for others!

S

D

Supply curve of firms that can pollute for free

Quantity of production if costs of pollution are charged to the firm

Quantity of production if pollution is for free

S*

Optimum supply curve for society if

costs of pollution are charged to the firm

Price when

pollution is for free

Price when

pollution is

charged to firm

Overproduction if pollution is for free

Economic effects of externalities:

• Positive external effects lead to under-production (or under-investment)

• Negative external effects lead to over-production (or over-investment)

Cures?• Regulation by governments (emission standards, fees, tradable

emission rights)• Pigouvian subsidies or taxes• Negotiation (only among small groups; Coase)

"Over-production" from society's viewpoint – for the individual firm

it's the right amount as pollution is for free

"Under-production" from society's viewpoint – for the individual firm it's the right amount as it receives no compensation for externality

Another source of market failure:"Asymmetric information" (= one party in a market knows much more than the other)

Examples:• Doctors know more about treatments and health than

patients → as suppliers they can largely determine demand for their services!

• Insurance companies can be easily cheated by their clients (e.g. with travel insurances)

• Lawyers know more than their clients know and they want to maximize their declarations …

• Second hand cars: the seller knows about hidden deficiencies of the car - but will he tell the buyer?

• Noisy flats: the seller knows it but for the buyer it's hard to know

Market failure through asymmetric information: Consequences and cures

• Markets for automobiles and flats can become "lemon" markets! (Cure: Guarantee rules)

• As clients cheat, there will be overproduction of insurance services (Cure …?)

• Profit maximizing doctors may "over-treat" their patients; the same holds for lawyers (unnecessary law suits). (Cures …?)

Adverse selection: The problem of "good" and "bad" risks

• Mainly people with high risks (e.g. chronically sick people) buy insurances; healthy people may choose to carry risks themselves → insurances may become too expensive for those who really need them.

• 'Bad' goods drive out 'good' ones: mainly noisy flats, or Monday-morning cars are offered for sale ('lemon markets')

Cures?• Everybody is obliged to take an insurance and

insurance companies have to accept everybody• Guarantees for cars

Moral hazard

• There may be over-supply of insurance services (e.g. for theft insurances) since people (once insured) become less careful against theft

• Patients will not complain against over-treatment by doctors, as their insurance will pay for it

• People with an insurance for lawyers' costs will more easily sue somebody

Types of costs

Fixed costs (FC):• FC do not vary with output (e. g. start-up costs,

costs of fire insurance or lease contracts)

Variable costs (VC): • FC vary with output (e. g. raw materials, energy

costs)

Total costs (TC): FC + VC

Note: Variable costs (VC) change according to the "law of increasing costs": given a certain level of fixed costs (FC) incurred, adding more and more VC will (in the short-run) result in diminishing returns to VC (VC will grow more quickly than production)

Illustration:• Assume, there is one machine (FC), and the

management can choose how many workers to add to the machine → There will be diminishing returns to adding more and more workers; each worker added may still increase production, but at a diminishing rate (see illustration in Heather p. 100)

Average costs:

Average Fixed Costs (AFC) = FC / Q

(Q = quantity produced)

Average Variable Costs (AVC) = VC / Q

Average Total Costs (ATC)

= TC / Q = AFC + AVC

Marginal Costs (MC) and Marginal Revenues (MR)

Marginal Cost (MC):

Extra costs per additional unit of output, i.e.:

MC = change in Total Costs / change in Q

Marginal Revenue (MR):

Extra revenue per additional unit of output, i.e.:

MR = Change in Total Revenue / change in Q

Short-run costs of a hypothetical firm. Hint: Study this table carefully and try to draft the figures in a plot

TVC MC (=∆TVC)

AVC (TVC/q)

TFC TC (TVC+

TFC)

AFC= (TFC/q)

ATC (TC/q)

0 0 -- -- 1.000 1.000 -- --

1 10 10 10 1.000 1.010 1.000 1.010

2 18 8 9 1.000 1.018 500 509

3 24 6 8 1.000 1.024 333 341

4 32 8 8 1.000 1.032 250 258

5 42 10 8.4 1.000 1.042 200 208.4

… … … … … … … …

500 8000 20 16 1.000 9.000 2 18

Choosing the profit maximizing output: The relevance of one more unit of product ('decision in the margin').

A firm's marginal cost

curve (= costs of one extra unit of

product)Marginal Costs;

Marginal Revenues

A firm's marginal revenue curve = revenues from

one extra unit of product =

(market price under perfect competition)

Profit-maximizing output (marginal costs = marginal revenues): the costs of producing one more unit are equal to the revenues of that unit

Stop expanding production!

Output

Broader applications of the MR = MC rule:

• Protecting the environment: The marginal revenues ( = marginal utility) derived from the last Euro spent on abatement of pollution should at least equal one Euro (= marginal costs)

• Training & education: The marginal costs of an extra investment (e.g. hiring one extra teacher) should at least be equal to the marginal revenue (= marginal utility) of the extra education & training

Question for discussion: Why is it, from an economic viewpoint, not desirable that criminality is reduced to zero?

From short-run to long-run costsN.B.: In the long run, labour and capital can be changed (short-run: only labour can be changed, capital is fixed)

Co

sts

per

un

it

Units of output

Long-run average

cost curve (combining the sort-run

curves)

Firm enjoys economies of

scale!

Firm suffers from diseconomies of

scale!

Short-run average total cost curves

Economies of scale:

• Constant costs: An expansion of output does not lead to changes in costs

• Economies of scale: An expansion of output leads to lower costs

• Diseconomies of scale: An expansion of output leads to higher costs

Note that in the previous figure, the firm first enjoys economies and then diseconomies of scale

Reasons for economies of scale:

In larger plants (or a chain of plants):• Specialization and division of labour• Indivisibilities: certain investments require a minimum

scale (e.g. combine harvester in agriculture; R&D)• The container principle: the larger, the cheaper per

unit• Greater efficiency of large machines• By-products: With large-scale production there may be

sufficient waste products to make by-products• Market power (discounts) when buying inputs• Economies of scope: A 'family' of related products

allows to spread costs of R&D, marketing etc. over more products

Reasons for diseconomies of scale:

• Managerial diseconomies: Coordination problems increase as the organization becomes larger and more complex and lines of communication get longer

• Personnel may feel 'alienated' as they become an invisibly small part of a large organization→ Motivation? Shirking?

• Complex interdependencies in a mass-production system can lead to great disruptions through hold-ups in any part

Minimum efficient scale (MES)

Long-run average

total costs (LRAC)

Output

MES = Minimum Efficient Scale: The point where

further extension of production gives hardly any further cost savings

½ MES = Smaller scale of production at higher costs

LRAC

An illustration: MES in Great Britain.Note that MES has an impact on market structure!

Product:

MES as % of production in

UK:

MES as % of production in

EU:

% additional costs at ½

MES:

Cellulose fibres 125 16 3

Rolled aluminium semi-manufactures 114 15 15

Refrigerators 85 11 4

Steel 72 10 6

Electric motors 60 6 15

TV sets 40 9 9

Cigarettes 24 6 1.4

Ball bearings 20 2 6

Beer 12 3 7

Nylon 4 1 12

Bricks 1 0.2 25

Tufted carpets 0.3 0.04 10

Shoes 0.3 0.03 1

Source: C.F. Pratten: 'A survey of the economies of scale' in: Research on the 'Costs of non-Europe', Vol. 2 (Office for Official Publications of the European Community, 1988).

Another application of the "marginal cost versus marginal benefit" principle: Sunk costs

Remember we had two types of costs:

• Variable costs (total, average, marginal): they vary as your production varies

• Fixed costs (total, average, marginal): they are independent of what you produce → these fixed costs can still be split into two types

Fixed costs can be sunk (= specific, irreversible)

Two types of Fixed Costs

Costs that are fixed but not sunk: they can be recovered if the project fails (or if the business relationship is terminated) e.g. a factory building

Fixed costs that are sunk are irreversible as they are specific to a project (e.g advertising): They can only be recovered it the project succeeds or if the business relationship is maintained (e.g. sunk costs by a subcontractor)

Sunk costs have implications for decision-making, applying again the "decision in the margin" principle

→Imagine that you and your partner are planning a holiday in Spain or Greece. In a spontaneous impulse, you book an arrangement for two persons in Greece for 500 euro, all-in. In the evening, your partner tells you that he also booked something similar in Spain (for 800 euro) – unfortunately in the same week! The booking cannot be cancelled and you cannot sell it to somebody else, as the airplane tickets are on your names. You both feel that Greece, although cheaper, is probably nicer, as the hotel seems to look better.

You are free to choose: Greece or Spain?

Let bygones be bygones!

Another example of decision-making with the sunk cost principle:

→As a subcontractor, you bought a special machine to produce front windows for the new Volkswagen Golf. You estimate that, at a price of 400 euro per window, you can regain your full (fixed and variable) costs, and earn a satisfactory profit. Your variable costs (raw materials, energy, wages, etc.) are 200 euro per window. In a tough price negotiation, Volkswagen offers you 220 euro per window ('take it or leave it!').

• You take it or leave it?Let bygones be

bygones!

Yet another example of decision-making with the sunk costs principle:

→You are responsible for a Research & Development project with a budget of 2 million euro. The sales expectations of the new product to be developed would justify a maximum of 2.5 million spending on R&D. In the meanwhile, half of the budget is consumed and it turns out that, due to unforeseen difficulties, the project is more expensive than expected. A reliable estimate says that, above the one million that is already consumed, you need another two million euro to finalise the project.

• Make a 'stop or go' decision! Let bygones be bygones!

General conclusion:

Let bygones be bygones! (accept your loss!)

• Sunk investments from the past should play no role in your decision about the future! Just ignore them!

• The only rational consideration is: What are the costs and revenues from now on?

• In fact, this is a version of decision-making "in the margin": What counts is the decision about the next units.

Transaction costs can make market transactions inefficient

Definitions:

External transaction costs: • All costs of transactions via the (external) market.

These include all costs of collecting relevant market information, negotiating and preparing contracts, monitoring whether partners fulfil contracts, and the taking of sanctions if they do not.

Internal transaction costs: • Costs of coordination and management of

transactions within hierarchical organisations

The problem behind transaction costs:

→In principle, every activity of a firm could be contracted out

Question: →Which activities should be contracted out (market

transaction) or done internally (hierarchical transaction?) →The famous 'make-or-buy?' problem

Questions: • Why not contracting out everything?• Why do (large) organizations exist at all? • Why does not everybody have her own company?

A simple criterion for handling the 'make-or-buy' problem:

• If costs of internal, hierarchical transaction are higher than external (market) transaction costs, then contract out ('buy')

• In the opposite case: 'make'

But this requires some refinements …

Factors favouring 'make' (instead of 'buy'):

• The existence of uncertainty (e.g. in judging the quality of a good or service) creates strong possibilities of opportunistic behaviour which increase costs and risks of market transactions

• Asset specificity: Assets can have higher economic value inside than outside a particular transactional relationship, e. g. sunk costs by a subcontractor; or dependence on a specialised supplier who achieves some monopoly power. Opposite case: if there are many suppliers of standardized goods, market transactions are to be preferred.

Factors favouring 'make' (instead of 'buy'):

• Frequency of transaction: Frequency influences the relative costs of market versus hierarchical governance. Repeated market transactions among a small number of participants offer wide possibilities of opportunistic behaviour

• Turbulence in an environment may require frequent changes of contracts for market transactions and struggle about how to interpret incomplete contracts

• Incentives: Where other contract parties have incentives to act against the interests of the contracting firm, costs of contracting, control and sanctions can multiply (e.g. contracting out R&D)

Summarizing: Is there an imperfect market?

… In other words, is there:• Information asymmetry? (quality of product)• Turbulence? (incompletely specified contracts)• Has the other party some market power?• … or possibilities for opportunistic behaviour?• Are you vulnerable as you made sunk costs?• Has the other party a motive to act against your

interests? (e.g. leaking of knowledge to your competitor?)

→ If yes, do not contract out!

… and when should you choose for contracting out?

Ideal situation: • The other party operates in a market with

transparent quality• There are many suppliers• They deliver standardized products• They are fiercely competing (e.g. cleaning or

catering)

An important motive for "buy" instead of "make":If you choose for "make", you often experience the principal-versus-agent problem!

A typical example: Supporting services in large conglomerates:

Heads of supporting services tend towards budget maximization → they want to have large "Royal Courts" of personnel!

Painstaking problems for you: Are they indeed doing their best? (How can we curb overhead

costs?) Heads of departments benefit from information asymmetry!

(they know more about their work than you can know)

Benchmarking through contracting out can help!

Forms of collaboration

Type of collabora-tion:

Typical dura-tion

Advantages (rationale) Disadvantages (transaction costs)

Subcon-tracting

Short term

Cost and risk reduction, reduced lead time

Search costs; quality?

Licensing Fixed term

Technology acquisition Contract costs and constraints

Consortia Medium term

Expertise, standards, share funding

Knowledge leakage

Strategic alliance

Flexible Low commitment; market access

Potential lock-in; knowledge leakage

Joint Venture

Long term

Complementary know-how; dedicated management

Strategic drift; cultural mismatch

Network Long term

Dynamic learning potential Static inefficiencies