Optimal Size of Firms

How big should firms get? Should companies like General Motors make all the parts for their cars, or should they purchase components from other manufactures? While most of the answers to this question are beyond the scope of Game Theory at Work, an understanding of holdups provides some help in determining the optimal size of a firm. This chapter has discussed what holdups are and how they can sometimes be stopped. Occasionally, however, dependencies are necessary, and potential holdups can’t be avoided. In these special situations, your only solution might be to purchase the company that will have an artificial monopoly over you.

For example, imagine you are considering building a new product that will require a subcomponent made by Acme. No other firm but Acme can make this critical subcomponent. Obviously, building the factory without first coming to an agreement with Acme would make you extremely vulnerable. Unfortunately, if you can’t be certain of what you will need from Acme, then even a long-term contract wouldn’t eliminate this vulnerability.

Perhaps the exact nature of your needed subcomponent will change over time in ways that you can’t predict. Even if Acme agrees contractually to supply you with a certain subcomponent, you will be vulnerable when your needs change. If you’re not sure what you will need, you can’t specify your needs in a contract.

Assume, for example, that today you buy the subcomponents for $12.95 each. If you will always need this exact same subcomponent for 15 years, you could get Acme to agree contractually to always supply you with this subcomponent for $12.95 plus inflation. What if, however, you will need a slightly different kind of component in five years, but you’re not exactly sure what this component will look like? Obviously, Acme would never agree to give you anything you wanted at $12.95 each, because you would then demand platinum-plated, jewel-encrusted subcomponents. A contract forcing Acme to always charge you a reasonable price might not be enforceable because courts have difficulty with reasonableness. Even a contract mandating that Acme charge you its costs plus 10 percent would leave you vulnerable since Acme would have an incentive to inflate costs to maximize their 10 percent. Your only solution to this holdup dilemma might be to acquire Acme. But make sure you buy it before it gets an artificial monopoly over you.