Spot exchange: an informal relationship between a buyer and seller in which neither party is obligated to adhere to specific terms for exchange. It occurs when the buyer and seller of an input meet, exchange, and then go their separate ways. It is used when inputs are “standardized”. Spot exchange refers to informal relationship between buyer and seller. When a buyer acquires inputs from a seller through an informal relationship, it is called spot exchange. In the presence of specialized investments, spot exchange does not insulate a buyer from opportunism. Disadvantages of contracts are that they are unable to cover all contingencies and costly to write. Spot exchange is the optimal method for procuring a modest number of standardized inputs that are sold by many firms in the marketplace. Contract: a formal relationship between a buyer and seller that obligate the buyer and seller to exchange at terms specified in a legal document. Contracts reduce underinvestment and reduce costly opportunism. It is optimal to acquire an input through a contract when the contracting environment is simply and the cost of the contract is less than the transaction costs. Contracts require costly, up-front expenditures. Performance-based reward programs for firm managers are typically called incentive contracts. Using a contract to procure inputs tends to work well when the contract is simple. Contract is the optimal method for procuring inputs that have well-defined and measurable quality specifications and require highly specialized investments. Vertical integration: a situation where a firm produces the inputs required to make its final product. When a firm produces its own inputs it engages in vertical integration. Vertical integration mitigates transaction cost and reduces opportunism. A firm manager should consider vertical integration if there are substantial specialized investments and the inputs has characteristics that are hard to specify in a contract. Producing inputs internally firms don’t rely on other firms for materials. Spot exchange, contracts, and vertical integration are all methods of procuring inputs. Transaction costs: costs associated with acquiring an input that are in excess of the amount paid to the input supplier. Including: the cost of searching for a supplier willing to sell a given input, the costs of negotiating a price at which the input will be purchased. These costs may be in terms of the opportunity cost of time, legal fees, and so forth, other investments and expenditures required to facilitate exchange. Transaction costs incurred in the acquisition of an input that exceed the cost of the input itself . Specialized investment: an expenditure that must be made to allow two parties to exchange but has little or no value in any alternative use. Specialize investment increase transaction costs.
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