Question

Discuss the Optimal method for procuring inputs that have well-defined and measurable quality specifications and require highly specialized investments.

What are the primary advantages and disadvantages of acquiring inputs through this means?

Give an example that's not used in the textbook that uses this method of procurement.

Answer 1

Answer:

There are various methods for procuring inputs such as Spot Exchange, Contracts and Vertical Integration. An organization must select an approach that helps in acquiring quality input at least cost.

In spot exchange the buyer and seller just meet for the exchange of input and than separate off. There is no buyer seller relation building in this method and no binding terms and conditions.

Contracts are the legal documents that bound the buyer and seller in a legal relationship with well defined terms and conditions of buying and selling(in a legal document called contract).

Vertical Integration is the when the firm decides to produce some of its inputs on its own and avoid the suppliers.

The Optimal method for procuring inputs that have well-defined and measurable quality specifications and require highly specialized investments are contracts.

This is because input has well defined and measurable quality requirements and cant be obtained from any supplier. The buyer does not have lot of supplier options providing the quality input required. Also, highly specialized investments are to be made which means high expenditure.

Therefore, contracts is the optimal method to procure input since it comes with legal terms which are enforceable in court of law and buyers and sellers are bound to follow exchanges terms mentioned in the contract.

Since, the buyers and sellers are obligated to legal exchange terms , the primary advantage of this method is reduction of opportunism and reducing on specialized investments as committed initially.

The possibility of the supplier taking advantage of the manufacturer is nullified(opportunism).The supplier on sensing the need of buyer cant take undue advantage of the situation and raise the price or lower the quality of input.

Also, there is specialization benefits as the buyer can focus on producing products (which he is best at) and supplier can focus of producing inputs(which he is best at)

The disadvantage being it is costly method as contracting costs are involved. Also specialized investments lead to greater transaction costs. The buyer cant avail the benefits of lower cost of production when the input cost falls in the market or some other supplier is able to provide same quality input at lower cost. The seller is also not in a position to supply inputs to the producers ready to buy the input at a higher price.

.Example: A flour meal that needs to provide high quality flour(made of wheat from a specific state) to a bakery(for making breads) and this bakery is his biggest and most profitable customer. Here the flour meal owner would use contract method to procure the wheat from that specific state wheat supplier so that he is able to maintain his quality standards committed to the bakery and continue earning profits. The quality commitment to bakery and bakery being most profitable customer is the specialized investment of flour meal. The supplier on knowing this fact can charge him more for the wheat and be opportunist or later on starts mixing lower quality wheat in overall supply. So, in order to avoid this, it is best for the meal to enter into a contract with the supplier.