Optimal+input+procurement

>>>> =**Optimal Input Procurement**=

Optimal input procurement is a cost-minimizing method of acquiring inputs. Managers want to obtain desired inputs at the lowest cost, thus maximizing the input procurement. The figure below depicts the want to operate at this lower cost ($80) while achieving the same quantity of input (10) as at a higher cost ($100).



To minimize costs, firms must wisely choose which procurement method to use. There are three main methods of procurement: spot exchanges, contracts, and vertical integrations. Determining which method of procurement to use depends on the input's characteristics. If the inputs are standardized, the spot exchange method would be used. Some product characteristics that may influence using the contract method include "the expected duration of demands, the storability of the product and the costs of supply disruptions." In order to ensure regular supply of an input, firms will likely commit to a long-term arrangement - such as a contract - if they expect the demand for their product to continue, there are storage issues with their product, or the disruption of supply would be costly (Gordon). For vertical integration, firms may look at characteristics such as the costs of "learning about market conditions, negotiating a transaction and monitoring its execution." These costs can be avoided by the use of vertical integration (Gordon).

Characteristics other than those of the input must also be looked at when considering which method of procurement to use. The chart below shows the decision flow that firms should use to help decide which method is appropriate. Knowing the basic definitions of each method and some of their risks and opportunities can also aid in the decision process.



=__Spot Exchanges__= A spot exchange is “an informal relationship between a buyer and a seller in which neither party is obligated to adhere to specific terms for exchange” (Baye, 206). Simply put, it is a meeting of a buyer and a seller to exchange some input and then part ways. This method of procuring inputs is the most straightforward, but it can be costly. Reasons for high transaction costs include opportunism, bargaining, and underinvestment costs.

//Risks and Opportunities//
Opportunism refers to a buyer or a seller's attempt to profit on a "sunk" situation. For example, suppose that, as a buyer, you want to purchase a cellular phone. Many retailers are selling their phones for $50. However, prior to purchasing any phone, you must buy a $5 non-refundable membership card to the retailer you wish to purchase the phone from. After choosing a retailer and paying the membership fee of $5, the retailer of your choice informs you that the price of the phone is $54. For you, the buyer, it is less expensive to spend the extra $4 on the phone than it is to spend another $5 on a different retailer's membership card.

Transaction costs for spot exchanges are also driven up by [|bargaining]. If a specialized investment, or investment that cannot be recovered, is not required, little time and money is spent on bargaining in spot exchanges. However, if this type of investment is required, a firm price is usually not available and the cost spent on negotiating a final price can become very high.

A third risk to spot exchanges is underinvestment. This refers to investing at a less than optimal level. Underinvestment can lead to lower quality inputs and thus higher transaction costs.

Spot exchanges, when used with standardized inputs, do allow the firm to specialize in the conversion of inputs into outputs because there is less time and money spent on the exchange. However, if a substantial specialized investment is needed, a firm should consider another method of procurement.

//Examples//
One well know example of a spot exchange is the foreign exchange market. "London is the world’s largest foreign exchange centre: average daily turnover is $637 billion. This is approximately the same as the combined level of trading in the United States, Japan and Singapore" (ForexSpot).

=**__Contracts__**= A second resource for obtaining inputs is a contract. By definition, a contract is “a**:** a binding agreement between two or more persons or parties; //especially// **:** one legally enforceable b**:** a business arrangement for the supply of goods or services at a fixed price ” (Merriam-Webster). Although costly to draft and negotiate up front, contracts offer several advantages – the price is agreed upon prior to investment and a timeline is set.

//Risks and Opportunities//
Contracts specify a price for the transaction before the transaction occurs. This reduces the risk of opportunism discussed above. The risk of underinvestment is also minimized with a set timeline. Both parties have agreed to a commitment for a set period of time, thus ensuring full participation (investment).

Contracts, however, do pose the risk of being incomplete. "It can be extremely difficult to cover all of the contingencies that could occur in the future. Thus, in complex contracting environments, contract will necessarily be incomplete" (Baye, 207). This brings up the risk of renegotiation. If the terms of a contract are in question, "one general approach often taken is to provide for renegotiation when either side feels that the contract has become grossly unsatisfactory" (Gordon).

One characteristic to explore with the use of contracts is the length of the actual contract. The best, or optimal, length "reflects a fundamental economic trade-off between the marginal costs and marginal benefits of extending the length of a contract" (Baye, 215). "If one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided" (Coase, 391). For example, when a contract expires, transaction costs increase due to the drafting and negotiating of a new contract. With longer contracts, expirations will not happen as frequently. However, the risk of expiration, high costs, and renegotiation can cause firms to turn to the final method of procurement.

//Examples//
According to a study by Richard L. Gordon, 87.1% of the market for electric utilities in the US uses long-term or short-term contracts in the procurement of coal. The heavy use of contract in the electric utility industry can be traced back to the early 1900s: > The reliance on contracts can be traced to Samuel Insull. As early as 1903, he had decided that long-term contracts provided a means to insure reliable fuel supply for his [|Commonwealth Edison Company]…companies wanted assurance of the availability of the required amounts of coal (Gordon).

=__Internal Production (Vertical Integration)__= Vertical integration is a method of procurement that is most often turned to when “specialized investments generate transaction costs…and when the product being purchased is extremely complex or the economic environment is plagued by uncertainty” (Baye, 217-18). Defined as “the extent to which an organization controls its inputs and the distribution of its products and services” (12Manage), vertical integration lessens transaction costs and opportunism but brings forth set up costs for production facilities.

//Risks and Opportunities//
As stated above, the risks of opportunism and other transaction costs are greatly lessened - if not eliminated with the use of vertical integration. However, the firm is no longer specializing in the conversion of an input into an output. They now provide the input and the output. The cost of set up and the time, effort, and money spent on replacing "the discipline of the market with an internal regulatory mechanism" can make this method very difficult to institute (Baye, 218).

//Examples//
Car manufactures like [|Ford] and [|General Motors] internally produce "highly specific inputs that must be tailored to car manufactures' particular technical requirements" such as engines and automatic transmissions (Thiele).

Andrew Carnegie vertically integrated his steel company, [|Carnegie Steel Company], "by purchasing the coke fields and iron-ore deposits that furnished the raw materials for steelmaking, as well as the ships and railroads that transported these supplies to his mill" (DeLong).

>>>>> =**Multiple Choice Questions**=

1. Which method of procurement can be costly up front but brings the opportunity of a set timeline? > a. vertical integration > b. contract > c. spot exchange > d. both a and b > e. none of the above The correct answer is b. A contract is costly to draft and negotiate up front, but gives a set timeline and price.

2. Which of the following is an input characteristic that needs to be considered when choosing a procurement method? > a. Storability > b. cost of input > c. duration of demand > d. both a and c > e. none of the above The correct answer is d. Both the storability of the product and the expected duration of demand are characteristics of the input that can influence the choice of procurement method.

3. The optimal input procurement cost falls on which curve? > a. demand curve > b. supply curve > c. cost curve > d. AVC curve > e. LRAC curve The correct answer is c. The firm wants to obtain the desired amount of inputs at the lowest cost. "The cost curve defines the minimum possible cost of producing each level of output" (Baye, 205).

4.Which of the following is not a risk of spot exchange? > a. legal fees > b. opportunism > c. bargaining > d. underinvestment > e. none of the above The correct answer is a. Spot exchanges are straightforward transactions. There are no legal fees involved.

5. What term defines the following situation: A buyer or seller is trying to profit on a "sunk" situation? > a. bargaining > b. unsunk > c. corruption > d. underinvestment > e. opportunism The correct answer is e. Opportunism refers to a buyer or seller's attempt to profit on a "sunk" situation.

>>>>>>> =**References**=

12 Manage: Rigor and Relevance in Management, 2007. > http://www.12manage.com/methods_vertical_integration.html

Baye, Michael R., //"Managerial Economics and Business Strategy"//, McGraw-Hill Irwin. 2006.

Coase, R. H., //"The Nature of the Firm"//, //Economica//, Vol. 4, Issue 16, (Nov., 1937), pp. 386-405. > http://www.blackwell-synergy.com/doi/full/10.1111/j.1468-0335.1937.tb00002.x?cookieSet=1

Delong, Brad, Berkley. > http://econ161.berkeley.edu/TCEH/andrewcarnegie.html

ForexSpot, 2003 - 2005. > http://www.forexspot.com/

Gordon, Richard L., //"Optimization of Input Supply Patterns in the Case of Fuels for Electric Power Generation", The Journal of Industrial Economics//, Vol. 23, No. 1. (Sep., 1974), pp. 19-37 > http://links.jstor.org/sici?sici=0022-1821%28197409%2923%3A1%3C19%3AOOISPI%3E2.0.CO%3B2-A

Merriam-Webster Dictionary Online > http://www.m-w.com/dictionary/contract

Thiele, Veikko, "//The Demand for Tailored Goods and the Theory of the Firm"//, Sauder School of Business, 12 March 2007. > http://papers.ssrn.com/sol3/papers.cfm?abstract_id=936447 (abstract site, paper downloadable)

>>>>>> =**External Links**=

http://en.wikipedia.org/wiki/Bargaining http://en.wikipedia.org/wiki/Commonwealth_Edison [|www.ford.com] [|www.gm.com] http://en.wikipedia.org/wiki/Andrew_Carnegie

>>>> Paper written by Diana Tracy, Ball State University, MBA 651, Oct 2007.