This chapter develops the optimal choice for input procurement and the principalagent problem, as it relates to managerial compensation and worker incentives. The manager must decide which inputs the firm will purchase from other firms via spot exchange or contract and which inputs it will manufacturer itself. Spot exchange generally is the most desirable alternative when there are many buyers and sellers and low transaction costs associated with using a market.

When market transaction costs are high and specific assets are important, the manager may wish to purchase inputs from a specific supplier using a contract or, alternatively forego the market entirely and have the firm set up a subsidiary to internally produce the required input. In a relatively simple contracting environment, a contract may be the most effective solution. But, as the contracting environment becomes more complex and uncertain, internal production through vertical integration becomes an attractive managerial strategy.

The chapter also demonstrates a solution to the principal-agent problem. Rewards must be constructed so as to induce the activities desired of workers. For example, if all a manager wants from a worker is for the worker to show up at the work place, an hourly wage rate and a time clock form an excellent incentive scheme. If it is desirable to produce a high level of output with very little emphasis on quality, piece-rate pay schemes work well. However, if both quantity and quality of output are concerns, profit sharing is an excellent motivator.