Question

2.         Explain how each of the following affect the optimal method of acquiring an input i.e., make or buy:

            a.         A complex contracting environment (4 points)

            b.         An investment in a specialized machine (4 points)

            c.         Opportunistic behavior (4 points)

            d.         Timing in the production process (4 points)

            

Answer 1

a. A complex contracting environment

The method of contracting is where the engaged parties try to identify, utilize and allocate risks associated with different projects. There are high risks involved in acquiring inputs especially for long term projects. The various supply and demand factors tend to make it all the more complex which requires the producer to think of innovative ways to deal with risk. The optimality of acquiring inputs may be affected in complex contracting environment because it leads to an increase of costs of acquiring that input which essentially means budgeting and funding inputs.

There are essentially three methods of acquiring input:

1. Spot Exchange is when there is immediate transaction between the buyer and seller and have no future commitments and no contracting costs.

2. Contracts are created when there is a long term relationship between the parties and it can become increasingly complex in certain situations. But, it helps in specialisation and reduces oppurtunism.

3. Vertical integration is when a firm decides to produce an input internally rather than acquiring it from suppliers. There are no organisational costs involved.

b. An investment in a specialised machine

An investment in a specialzed machine can help increase the production of a firm but this might mean that the firm specializes in only one part of the production process. It might increase costs for the firm to complete the entire production process at one point. Also, the returns from the investment is an important scenerio and must be taken into consideration. In any case, if the machines fails, then it might lead to a loss in the quantity of production which will lead to increased costs for the firm,

Example: There are also business risks associated with this investment because if a company is classifies as specialty in garment, however most of its revenue is derived from dyeing, in that case it might be risky to invest in an input which is specifically for the garment production and not dyeing.

c. Oppurtunistic behaviour

Oppurtunistic behaviour while taking into consideration the cognitive aspect of humans is justifies for the most part of profit maximising behaviour. It essentially means that a profit maximising firm will internalise the production of some inputs if it is profitable to do so i.e that the costs of acquiring that input from outside exceed the cost of producing it internally. This way, the cost minimization onjective of the firm is also fulfilled. While acquiring an input from outside, there are costs in addition to the actual cost of the input i.e transaction cost. However, oppurtunistic behavior is also seen when there is assymetric information between the parties and if some party deliberately hides the information. In this case, it will adversely affect the parties involved. many economic schools study oppurtunistic behavior in firms because it is how firms function in the real world.

d. Timing in production process

Timing is the most important element in investment process because it determines whether a particular input is required, is so, then how much investment is required whether it should be in the spot rate or contract form. It is the main aim of the production process to produce the right quantity of the right good and in the right time. A lot of things have to be planned according to the timing of the production process so that the optimum amount of goods can be produced with the minimum of costs. The implementation of production plans in the right time is very important for a firm to be successful. There are many steps involved in the production of a good: marketing, transportation, logistics etc and if these processes are delayed the firm loses out on its profit. Therefore, firms should fix a target in relation to the timing and functyion accordingly.