Chapter 1

● One standard definition for

economics is the study of the Horizontal Integration
production, distribution, and ● A firm either increases the volume of
consumption of goods and services. current production activities or
expands to similar kinds of
● A second definition is the study of production activities.
choice related to the allocation of ● Can create an advantage for large
scarce resources. firms in demanding lower prices for
goods/services they purchase
Vertical Integration
● Occurs when a firm expands into a
Chapter 5 - Economics of Organization different stage of a value chain in
which it already operates
Reasons to Expand an Enterprise ● Upstream Integration - business
1. concepts of economies of scale and expands into an earlier stage in the
economies of scope value chain
2. sellers possess an advantage over ● Downstream integration -
buyers in commanding higher prices expansion is to a later stage of the
3. many businesses sell products that value chain
are intermediate rather than final ● potential for improved profitability
goods (products that can be ● Double marginalization - 2 stages
combined and enhance then provide of value chain performed by 2
other goods/services) divisions of same company rather
4. Large firms can reduce some of their than 2 diff companies, there’s less
risk by producing unrelated products haggling over price and other
or services. conditions of sale
● Risk Reduction - firms may be
Value Chains jeopardize if they are completely
dependent to one seller/supplier
● Value chain for the product -
creation of a product, a sequence of Adverse Selection (in economic
stage literature) - parties
that are aware of their limited information
Horizontal Integration - new activity in about the other party will tend to be more
same stage, similar value chain conservative in their agreement terms by
Vertical Integration - new activity in same assuming pessimistic circumstances and
stage but different stage will not be
Conglomerate Merger - new activity is part able to reach an agreement
of a quite different value chain
Free Rider Problem - take advantage of
easily obtained information
 Transfer Pricing
Conglomerates ● some measurement of value for the
- participates in multiple value chains that exchange is needed to serve as the
are different in nature revenue for the selling division and
- ability to diversify so that the firm can the cost for the acquiring division.
withstand difficult
times in one industry by having a presence Employee Motivation
in other kinds of markets. based on new perspective of economics:
- that companies with very talented 1. consider the employee more like an
management staff may be capable individual contractor rather than an
of excelling in more than one type of enlisted soldier.
business. 2. notion of an efficiency wage. the
wage paid to an employee should be
Transaction Cost no more than the marginal revenue
- cost involved in making an exchange product corresponding to her effort.
(can be external/internal) 3. examination of employee contracts
- introduced by Nobel Prize laureate to deal with what is called the
Ronald Coase, known as the principal-agent problem.
Coase Hypothesis 4. concept of signaling. adverse
- Coase Hypothesis - firms should selection in employees - One
continue to expand as long as response to the adverse selection
internal transaction costs are less problem by the employee is to take
than external transaction costs for actions on his own that will help
the same kind of exchange. distinguish him from others in the
applicant pool, which are observable
Cost Centers and serve as a signal to the
● each division will best contribute to employer.
the overall profitability of the
corporation by trying to meet its Tournament Theory -
output goals at minimum cost
● The response to this objective is that
the firm may cut corners on quality
as much as possible and avoid
considering innovations that
would incur higher initial costs but
ultimately result in a better product
for the long run.

Profit Centers
● The goal of each division is to create
the most value in terms of the
difference between its revenues and
costs.