Economic Firms

But it seems to us altogether reasonable that long -- term contracting must be grounded in factors other than culture and affluence. One economic explanation may start with a recognition of the extent to which firms are integrated in Japan. The fact of the matter is that in some industries Japanese production is far less integrated into identified “firms” than, say, in the United States and other countries. In the United States and Western Europe, for example, 50 to 60 percent of the automobile manufacturing costs are incurred “in -- house.” In Japanese firms, on the other hand, only 25 to 30 percent of the automobile production costs are typically incurred “in -- house,” or inside Japanese firms. 16 Only 20 percent of Honda’s production costs are incurred inside, which means it buys 80 percent, or $6 billion, of its inputs from outside suppliers.17 Because of the lack of integration, Japanese firms may need to develop long -- term buyer -- supplier relationships to a much greater degree than more highly integrated firms do just to overcome the potential last-period problems, if nothing else.
Put another way, Japanese firms are able to engage in what is called strategic outsourcing, and do so competitively, because they are willing and able to develop long ¬
- term working relationships. If they didn’t, they would have to endure the added costs associated with the ever -- present closing of those relationships. It doesn’t surprise us that many buyer -- supplier relationships in Japan give the “look and feel” of integrated firms with buyers and suppliers helping each other and investing in each other (which is what happens, to more or less degree, within unified firms).
When Honda signs a contract with a supplier, it expects the working relationship to continue for 25 to 50 years, which effectively means that the last-period problem is set back considerably.18 Moreover, the permanence of the buyer -- supplier relationship is two -- way, with commitments on the parts of both buyers and suppliers. Buyers agree to stay with the suppliers, and vice versa, through ups and downs (at least up to a point). Hence, Honda can justify incurring the costs associated with helping its suppliers increase productivity, even provide the needed technology and specialized equipment. Moreover, such expenditures, plus investments in the specific assets of the suppliers, by Honda have the added advantage of being a bond, the value of which is forgone if Honda does not abide by its agreement. Managers at Honda are basically saying to suppliers, “Look at what we are doing. We are serious in our commitment. If we renege, our up -¬front investment will be worth very little. We will lose our projected income stream from the investment. Because of those costs, you can count us in for the long run.” Such tie -¬ins aid in making the contracts self -- enforcing and durable; they help to make the long run a viable perspective.

Should production be rigidly integrated as in American firms or more loosely integrated as in Japanese business consortiums? We surely cannot answer that question with the certitude that many readers will want. Japanese firms obviously gain the benefits of keeping their suppliers in a position that is marginally more tenuous and, maybe, more competitive with other potential suppliers, but they have to deal with the marginally more severe last-period problems. Many factors, which are offsetting and subject to change with the costs associated with contracting and with principal/agency problems we have discussed, are involved. We suspect that different organizational forms will suit different situations and eras (as has obviously been the case in Japan where relational contracting has not always been prevalent19).
Answers will come from real -- world experimentation in the marketplace. We suspect that competition will press firms to adjust their organization forms, and the inherent incentive structures, as some variation of organizational form is relatively more successful. Many American firms have had to seriously consider and, to a degree, duplicate the added organizational flexibility of Japanese firms. Why? Their management methods have obviously worked in some industries, most notably the automobile industry. It takes 17 hours to assemble a car in Japan and 25 to 37 hours to assemble a comparable car in the United States and Europe. Japanese firms can develop a new car in 43 months, whereas it takes American and European firms over 60 months, and Japanese cars come off the production lines with 30 percent fewer defects. The worst American -- made air conditioning units have a thousand defects for every defect in the best Japanese -- made units.20
Firm integration and relational contracting are hardly the only means of moderating last-period problems. Joint ventures, which more often than not require up -¬front investments by the firms involved, can also be seen as extensions of firm efforts to reduce last-period problems, with the potential of enhancing the quality of the goods and services produced and lowering production costs. Joint ventures might lower production costs because they give rise to economies of scale and scope through the application of technology, but they also can lower production costs by lowering the potential costs associated with opportunistic behavior and monitoring. They make the future income streams of each party a function of the continuation of the relationship.
* * * * *
The “last-period” problem is nothing more than what we have tagged it, a “problem” that businesses must consider and handle. It implies costs. At the same time, firms can make money by coming up with creative ways of making customers and suppliers believe that the “last period” is some reasonable distance into the future. Failing firms have a tough time doing that, which is one explanation why the pace of The “hollow corporation,” in which everything is “outsourced,” or nothing is produced directly, is sometimes viewed as the organizational ideal, given that the firm owners can rely on competitive forces to keep the prices of what they sell as low as possible. We doubt that the “hollow corporation” will ever dominate the economic landscape of any country for a simple reason that comes out of the analysis of this “Manager’s Corner”: The absence of the continuing association of employees under one roof would mean that the last-period problems would arise in spades. This is because the direct association of people under one roof has an unappreciated benefit: as in the keiretsu in Japan, the firm permits the creation of abiding relationships that reduce the incentive individuals have to behave opportunistically in the short run and enhance their incentives to work with their long -- term goals in mind. “Bonding” is something that firms do.
Concluding Comments
The concept of rational behavior means that the individual has alternatives, can order those alternatives on the basis of preference, and can act consistently on that basis. The rational individual will also chose those alternatives whose expected benefits exceed their expected costs.
Traditionally economics has focused on the activities of business firms, and much of this book is devoted to exploring human behavior in a market setting. The concept of rational behavior can be applied to other activities, however, from politics and government to family life and leisure pursuits. No matter what the activity, we all tend to maximize our well -- being. Any differences in our behavior can be ascribed to differences in our preferences and in the institutional settings, or constraints, within which we operate.
Institutional settings affect people’s range of alternatives and thus the choices they make. It makes sense to examine the constraints of institutional settings. In this part of the book we will investigate the specific characteristics of the market system, the subject of microeconomic theory. Later we will look at the constraints of government. In both cases the range of choices open to individuals affects the ability of the system to produce the results expected of it.
We have also indicated in this chapter how individual rationality can give rise to a nontrivial problem for managers, the last-period problem, which can make deals costly. At the same time, we have indicated how thinking in terms of rational precepts can suggest ways managers can deal with their last-period problems to lower firm costs and raise firm profitability.
Review Questions
What are the costs and benefits of taking this course in microeconomics? Develop a theory of how much a student can be expected to study for this course. How might the student’s current employment status affect his or her studying time?
Some psychologists see people’s behavior as determined largely by family history and external environmental conditions. How would “cost” fit into their explanations?
Why not base a course on an assumption of widespread “irrational” behavior?
Okay, so no one is totally rational. Does that undermine the use of “rational behavior” as a means of thinking about markets and management problems?
How could drug use and suicide be considered “rational”?
If your firm were consistently dealing with “irrational behavior” among the owners and workers, what would happen to correct the problem? More to the point, what might you do to correct the problem?
Analyse these questions and think.............its not too late...!

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