Managerial Economics (20/10/2009)

Lecture 2
In lecture 1, we have seen the way how technology is characterised with economics
framework, through production function and isoquants. For any kind of operation or
service, whether it be an office, business, government etc., decision has to taken on whether
to adopt a new technology or not for production, depending upon the economy related to
that technology. Obviously what to produce (of what quality) has to be known before hand.
The unknown parameters are
a) How much to produce (Q) (a product of a particular quality)?
b) How to produce (so that total cost is minimum)?
c) What is the technology or level of technology to be adopted (what combination of
labour (L) and capital (K) is to be used)?

Economic tools used to analyse and find solutions to these questions are described here
with a mathematical approach. Decisions related to e-governance are not market based, but
we need to understand market bench-mark, so that we can see how e-governance related
decision deviate from these benchmarks.

K
Isoquant

It is a function of the form F(K, L) = Q0

K, L – inputs to the function
Q0 - given and constant output

Total Cost (TC) = Cost of Capital + Cost of Labour

(Price of Capital x K units of Capital) + (Price of Labour x L units of
Labour)
 = PK K + PL L
Minimise TC subject to the constraint F(K, L) = Q0

The objective is , for producing Q0, minimise TC.

constraint

The constraint F(K, L) - Q0 = 0 has to be incorporated into the minimising function

i.e L = P K K + P L L + λ ( F(K, L) - Q0 )

For minimising the function,

take the first derivative and equate it to zero

dL (L K) = P K + λ ( F’K ) = 0 (1) slope=differential

dK
dK (L L) = P L + λ ( F’L ) = 0 (2) slope of tangent = 0
dL
P K = - λ ( F’K ) (3)

P L = - λ ( F’L ) (4)
Eq 3 P K = F’K
Eq 4 PL F’L
F’K - how much more product is produced by increasing 1 more unit of capital keeping
labour constant (marginal product of capital)
F’L - how much product is produced by increasing 1 more unit of labour keeping
capital constant (marginal product of labour)
i.e Depending on P K & P L , how much of capital and labour has to be used. In other words
use of capital in relation to the price of labour and viceversa
Ratio of P K : P L = F’ K : F’ L

How much to produce?

Depends on market demand:

Based on market signals, decide on how much to produce so as to maximise profit.

First Possibility:
Profit (π) = PQ – C(Q) ; P – Price (does not change due to the production of Q) ,
 C – Cost (vary with production i.e C is a function of Q),
Q – Quantity

Objective is to maximise profit. For maximisation, first derivative is equated to zero

dπ = P – C’Q = 0 slope of tangent = 0
dQ ( first derivative of cost
function w.r.t Q )
P – price or marginal revenue
C’Q – Marginal cost , increase in cost
when one more unit is produced

Decision on quantity of production: Production will continue as long as the cost of final
unit of produce is less than or equal to the price.

C’Q C’Q C’Q

loss
Q Q profit Q

Second Possibility
π = P(Q)xQ –C(Q) It is monopolistic like condition where P is a function of Q
P(Q)xQ – Total Revenue (TR)
Maximising the function
d π = P(Q) + QP’(Q) – C’Q = 0
dQ derivative of TR derivative of TC
or marginal revenue

P Demand Curve
 Demand curve is given by
P = a – bQ ( like y = c+ mx form)

TR = P x Q
= (a-bQ) x Q = aQ- bQ2
MR = dTR = a-2bQ
dQ

P = a-bQ (Slope is b)

MR = a-2bQ (Slope is 2b)

If somebody is operating in a market , there can be 2 cases : either he can influence

the price of the product or he accepts the existing price. What ever be the case, the interest
is to maximise profit. (i.e Total revenue –Total Cost). Marginal Revenue is compared with
Marginal Cost for profit maximisation. The quantity to be produced will be decided in such
a way that the cost of producing last output can get a price higher than the cost.

Once Q0 is known then the attempt is to minimise the cost to produce that much
quantity. (TC is minimised subject to the condition that he produces Q0.)
 Managerial Economics (27/10/2009)
Lecture 3
In Lecture 2 we have a basic understanding of Technology in Economics. Let us see the
Economics of Government. Understanding of the functions of government,
Why do we need a Government?
Is there any reason for having a government?
Let us take two examples
Issue of passport and appointment of required number of police officers timely.
Delay in the whole process of appointment of police officers can be significantly reduced
by having an e-Governance system in this process. The delivery of passport also can be
made quicker by having an e-Governance system. Definitely these two services are
governmental services.
Let list out the basic differences between these two services

Issue of Passport Appointment of police

Individual problem For society as whole
Personal Interest Social problem
Benefit is getting to only one person Benefits are getting to all simultaneously

There are a lot of examples which belongs to the second category. In the case of of
a street light, all people in a locality are getting the benefit. We cant exclude any one from
getting this service. That is why it is a PUBLIC GOOD characterized by non-excludability
and non-rivalry.
But in the issue of passport, there is no public good issue but still it is provided by the
government,
There are some services which will be available cheaply by having only one
provider due to natural monopoly. Examples: landline telephony or electricity supply Only
one provider is desirable due to cost considerations. This can become a monopoly, these
services may be provided by government, or government can go for licensing the provider.
Third important reason for government intervention is externality. Example
someone is polluting a river if government places no restriction against it. Then the public
will be forced to object or take action against it.
There is also the problem of asymmetric information, and there is a role for
government to solve this problem. Reputation can solve it up to some extent but not fully.
(Example: Ayurvedic medicines - there is no common standard for the quality of these
medicines but still people use it).
The next reason for having government intervention is merit of goods/bads.
That is people are compelled to do or not to do something whether they like it or not.
Example primary education is compulsory and use of alcohol is restricted.
The last reason for having a government is to address inequality and poverty.
These are the specific reasons for government interventions.
1. Public good
2. Govt. intervention due to monopoly
3. For solving Asymmetric information
4. Merit of goods/bads
5. Inequality/poverty
 Managerial IS Economics
Lecture Note:4

In previous lecture we have discussed the specific reasons for Govt. intervention in several
areas. We have identified some characteristics of Governmental Services. How is the
decision on technology taken in the case of the good/service produced/delivered by the
government. As in the case of any good/service produced by a private firm, there are two
questions regarding the choice of technology (ex. IT for the provision of Governmental
service):

1. How Much to Produce? (i,e Demand Assessment)

2. What is the Technology(Combination of K & L)

Demand Assessment:

Consider the following example

6. Deliver passport within 3 days OR

7. Deliver 15000 passport per month

These targets are expected to be achieved through some demand assessment.

By know how many people arrive at Passport Office per day or at the Motor Vehicle
Department for licence or a Local Body Authority for Birth Certificate, etc., we can have
some understanding of the demand for that government service.

In the previous lecture we have discussed about Passport Delivery Service. It doesn't have
that the public good character. It's a private service provided by the government, that there
are no issues of non-rivalry or non-excludability here.

How quickly, Government have to appoint police officers? How many police officers are
needed? Do we need a port here? (How many traffic policemen are required in a junction?
Traffic is heavy in the morning and evening time. If accidents occur frequently in that
particular junction, then it signals more demand.)
However it is clear that demand assessment is not straight forward in Govt. Service.

In Western Countries, there may be cases for which demand is assessed by a conducting
referendum.

Technology Choice Based on Cost Minimisation

Suppose Govt. has decided to issue of some certificate in 3 days. What is the kind of
technology combination to be used for this purpose?

What are the Challenges that Govt faces for minimising cost?

When compared with a factory manufacturing soap with a govt. Service

• Pvt. Company owner decides the minimum cost of the production But in public this
is slightly different.
• Pvt. Company may distribute his products wherever he can. The customer will
reach the place where it is available? But in the case of Public service, there is a
cost on the part of the customer to access the service. Hence minimisation of cost
include not only the cost of production and delivery, but also the cost of accessing
the service.

• Hiring labour is different in Govt.

It is difficult to hire an expert labour at the market rate. The appointment is based
on a predefined procedure. A private company can hire an expert at market rate.

• Procurement Issue.
Same is the case with government procurement. Complex procedures are set in
place so that the employee does not gain from the purchase. On the other hand
private company can buy a product of given quality from the market

• Soft-Budget Constraints
As an entrepreneur if he does not minimise the cost, losses will appear in the
balance sheet, and after sometime he may have to close down the organisation.
Losses of a particular government dept. will be reflected only in the balance sheet
 of the government and the operational expenses of the office will be given from the
state budget. So the loss due to that particular govt organisation is not going to
affect its operation. The gains and losses are not of the employee.

• Manager’s Discretion
Chief Executive Officer of a government organization need not be interested in
cost minimisation but may be interested in supervising a bigger organisation.
Maximizing sales is also another incentive in such a case. An Assistant Manager
wants to become Manager, so that he can supervise and manage more employees
under him. Bigger size of the organization, higher sales, bigger workforce, etc.
could be some of the objectives of a manager who is not operating in a profit
making organization. Private sector also has this problem to some extent (due to the
difficulty of share holders to monitor the activities of the paid executives).

Principal-Agent Problem in Economics:

The agent is expected to work as per the principal's wish. In the private
sector, Chief Executive Officer (CEO) will be acting as an agent on behalf of
the shareholders. In the govt. this problem is more complex. For a citizen who is
the principal, the elected representative is the agent, and the legislature hires the
officials as the agent (he is not directly responsible to the citizen). In the official
hierarchy one official is responsible to another and he is to the next, etc. In fact,
all these add to the complexity to the problem. In the case of govt, the person
who minimises the cost is not the owner of the balance and hence there is no
incentive to minimise the cost under normal conditions.

• Appropriate risk taking

Suppose a person who has good contacts in the particular area plans to start
a Travel agency. But before starting this venture he knows the risk of the
investment. But he takes an ultimate decision to start the business. In the case of
private party, it is a relatively simple task. But in the case of Govt., it is more
complex.
 Corporatisation of Government Organisation

Government is the owner. Board of Directors are elected by the

Government. An important feature of Corporation is limited liability. If a
corporation fails, shareholders normally only stand to lose their investment and
employees will lose their jobs, but neither will be liable for debts that remain owing
to the corporation's creditors unless they have separately varied this, e.g. with
personal guarantees. Making cooperation is the first step of privatisation.

Business organisations may also be organised in terms of profit centres. The

profit centre’s revenues (actual and imputed) and expenses are held separate from
the main company in order to determine its profitability. Usually different profit-
centres are separated for accounting purposes so that the management can follow
how much profit, each centre makes and compare their relative efficiency and profit

Unbundling

For reducing the complexity of the function processes can be disaggregated into different
units. For example, Motor Vehicle Department can be disaggregated based on different
services: Testing, Registration, Inspection, etc.,
 Managerial IS Economics
Lecture Note: 5

Different people approach a new technology in different ways. For example, numerous
agricultural innovations were generated by scientists, like the high yielding hybrid seed
corn, chemical fertilizers, and weed sprays. Questions were being asked about why some
farmers adopted these innovations while others did not, and also about why it takes such a
long time for these seemingly advantageous innovations to diffuse. The idea of studying
how people respond to new ideas/technology came about by early 20th century. Everett M.
Rogers is one of the scientists who have worked on this issue. He is a sociologist,
communications scholar, and a pioneer on studying diffusion of innovations.

3 sets of characteristics are likely to influence the adoption of a new technology:

● Economic Characteristics
● Non-Economic factors
● Historical Reasons

Economic Characteristics: This we have discussed in the previous lectures.

Non-economic factors: Some of these are

a) Age:.
b) Education:
c) Demonstration Effect:
Demonstration effects are effects on the behavior of individuals caused by
observation of the actions of others

Historical Reasons:

Why QWERTY in keyboard

The QWERTY is introduced in typewriter in order to minimize the possibility of the

jamming of mechanical levers. This is not relevant in the age of digital word processors.
But we were accustomed to older one. There are sunk costs in training, standards, etc. Thus
we cannot change the key board arrangement. This is called path dependence or lock-in.
 Roger's 'S' theory of diffusion of innovations

Diffusion of Innovations is a theory of how, why, and at what rate new ideas and
technology spread through cultures. Rogers proposes that adopters of any new innovation
or idea can be categorized as innovators, early adopters, early majority, late majority and
laggards. These categories, based on standard deviations from the mean of the normal
curve, provide a common language for innovation researchers. Each adopter's willingness
and ability to adopt an innovation depends on their awareness, interest, evaluation, trial,
and adoption. He defines diffusion as "the process by which an innovation is
communicated through certain channels over time among the members of a social system."
The key elements in diffusion research are: the innovation, types of communication
channels, time or rate of adoption, and the social system which frames the innovation
decision process.

Fig : The diffusion of innovations according to Rogers. With successive groups of consumers adopting
the new technology (shown in blue), its market share (yellow) will eventually reach the saturation level.
Rogers suggests a total of five categories of adopters in order to standardize the usage of
adopter categories in diffusion research. Adoption of an innovation follows an S curve
when plotted over a length of time.
Innovators:
Innovators are the first individuals to adopt an innovation. Innovators are willing to take
risks, youngest in age, have the highest social class, have great financial lucidity, very
social and have closest contact to scientific sources and interaction with other innovators.
Early Adopters:
This is second fastest category of individuals who adopt an innovation. These individuals
have the highest degree of opinion leadership among the other adopter categories. Early
adopters are typically younger in age, have a higher social status, have more financial
lucidity, advanced education, and are more socially forward than late adopters
Early Majority:
Individuals in this category adopt an innovation after a varying degree of time. This time of
adoption is significantly longer than the innovators and early adopters. Early Majority tend
to be slower in the adoption process, have above average social status, contact with early
adopters, and show some opinion leadership
Late Majority:
Individuals in this category will adopt an innovation after the average member of the
society. These individuals approach an innovation with a high degree of skepticism and
after the majority of society has adopted the innovation. Late Majority are typically
skeptical about an innovation, have below average social status, very little financial
lucidity, in contact with others in late majority and early majority, very little opinion
leadership.
Laggards:
Individuals in this category are the last to adopt an innovation. Unlike some of the previous
categories, individuals in this category show little to no opinion leadership. These
individuals typically have an aversion to change agents and tend to be advanced in age.
Laggards typically tend to be focused on “traditions”, have lowest social status, lowest
financial fluidity, oldest of all other adopters, in contact with only family and close friends,
very little to no opinion leadership.
 Managerial economics Lecture 6
In the previous lecture we have discussed the various characteristics that influence
the adoption of new technology. That is, Economic characteristics, Non-economic factors,
Historical reasons etc. We have to consider some more economic characteristics.

Economy of scale?
Economies of scale are the cost advantages that a business obtains due to
expansion. They are factors that cause a producer’s average cost per unit to fall as scale is
increased. Economies of scale are a long run concept and refer to reductions in unit cost as
the size of a facility, or scale, increases.
Suppose we are ordering to print any greeting or invitation card in bulk quantity. As
the number of orders is increasing, the cost per unit is coming down.

There are two typical ways to achieve economies of scale:

8. High fixed cost and constant marginal cost

9. Low or no fixed cost and declining marginal cost

Take the following example:

Unit of production MC AC(Average cost)

1 50 50
2 40 45
3 30 40
4 24 36
5 20 32.8

Here marginal cost and average costs are coming down. But average cost is higher than the
marginal cost. For a relation between marginal cost and average cost, ie., For any function,
f(x) is the cost and the marginal cost will be f|(x). The average cost is AC= f(x)/x. The
curves that show average cost and marginal cost are given below:
As long as the price in the economy is little greater then the marginal cost, it is rational for
the company to produce that quantity. This is a problem when there is economy of scale. If
the marginal cost is declining, then price at marginal cost will not help to recover the
average costs.

The pricing strategy should be to retain as much consumers as possible. For

example, in the case of centralised water distribution system they usually have the
economy of scale issue. If anybody decides to leave from that system, the cost of servicing
the remaining customers will go up. Instead when more and more people join the system,
the unit cost will come down.

Challenges when there is economy of scale

1. Normal price is equal to marginal cost is not working.
2. Recover the cost that was spent to built up the system.

Externality
Externalities are costs (or benefits) that are not borne by the parties to the economic
transaction. A producer may, for example, pollute the environment, and others may bear
those costs. A consumer may consume a good which produces benefits for society, such as
education; because the individual does not receive all of the benefits, he may consume less
than efficiency would suggest. Alternatively, an individual may be a smoker or alcoholic
and impose costs on others. In these cases, production or consumption of the good in
question may differ from the optimum level.

One form of Production externality

When a system is producing for one more customer, everybody else in the system
get benefited because the cost is coming down. Ex. Centralised water distribution system
provided by the Government authority to a loality. ie., when one more customer joined the
system, everybody in the system get benefited because the cost is coming down.

Demand externality
When one more person started consuming, all others get benefited. Example.Twitter
Crowding

When one more person join the system, the existing consumer is bearing an extra cost.
Ex. mobile SERVICE, connection problems increase as more and more consumers
join.
 PRICING ISSUES (Lecture - 7)

Charging or pricing is a general economic problem in every sector. Several issues are there
in this pricing problem.

In many typical economic situations two features are important : supply and demand.
Demand can be represented by a line in a graph. What is demand? Consider the demand
curve below.
P

Graph p1 x(p1,q1)

12345 ... Q

Consider a point on the line x (P1,Q1). What does this mean? For the Q1th quantity people
are willing to pay P1 price. The demand curve essentially means the marginal willingness
to pay.

Consumer surplus : Consider that a consumer purchases 5 units. He was willing to pay a
higher price for the first item, second one, etc. But here he buys 5 units for the value of the
5th quantity. There is some gain for the consumer gained for purchasing five units (in
addition to the fact that he got five units). This is consumer surplus, and is represented by
the marked triangular portion.

A
B
C

We may have to draw demand curves for different people separately, and get an aggregate
curve for the whole society. What we have seen s far is the customers point of view.
Now let us see it from the suppliers’ point of view.

Supply

1 2 3 4 5 6 7. .

Consider a supply curve. Each point represents his/her marginal willingness to supply.
Suppose that at the point no. 7 the supply curve and the demand curve meets.

In the figure below, supply curve or marginal cost line is sloping downwards. In this case,
there will be loss to the producer, if quantity supplied is equal to the point where demand
and supply curves meet and at a price equals to marginal cost.

SC

The challenge is to address the losses up to the meeting point. This challenge is there for
many enterprises. Theoretically this problem can be solved in a couple of ways.
Identification of the different points is one solution. This is called price discrimination.

Examples of water supply system, electricity generating system, Mobile tower setting up
etc.
Two-Part tariff: There is a fixed cost, and a charge varying with use. For telephone
connection, there is a connection charge and there is usage charge. Similarly for electricity
too, there is connection and usage charge.
Demand externality:

Let us consider the demand curve for a single person - his willingness to spend time in a
park. If somebody known to him also arrives at the park then he is willing to spend more
time in the park. Think about mobile phone. When more friends are having mobile
phones, people will be more keen to use mobiles. The demand curve of the person is
depending upon the number of people participating.

Is there a pricing problem for a seller of this problem?

Demand increases when more and more people are participating. So the pricing strategy in
this case should be to have an initial minimum price at the beginning so as to encourage
more and more people and later on have a higher pricing. This is the pricing strategy for
what is called demand externality.

Golf club membership is an example where this feature is seen.

 Managerial Economics
Lecture 8  notes

The diminishing marginal cost in creativity based Products or Services

Example .
 When the author writes a novel he takes lot of pains , involves several costs like 
opportunity cost, traveling cost etc and the cost incurred in producing the novel is very 
high for the first and foremost reader. But later on for the subsequent readers the cost is 
very very low. Lakhs of copies can be produced with minimum expense. The marginal cost 
of supplying it to subsequent readers declines. Even though the publisher may earn profits 
the author is not properly rewarded.

 How can the author recover the cost?
The author can enter into a contract with the publisher saying that he will write the novel, 
the publisher has to publish it and sell it for a particular fee and the author gets the share. 
But once the manuscript is exposed he may not have the incentive to buy it. This happens 
in the case of software also. This is a problem in all innovative jobs. Once it is produced it 
is cheaper to produce further copies.

Another eg: Marginal cost of producing a copy of music CD is very meagre.

This is a problem in almost all innovative products and some kind of intervention is 
necessary. If there is no intervention then the person who produces music or the author who 
writes novels or a software engineer who creates new programmes cannot recover the cost 
neither he has got the incentive to produce it.
Ex­Ante  contract  is   not  possible  in  such  cases  because  the  person  who pays   is 
unable   to   assess   the   quality   prior   to   production.   There   is   a   high   level   of   asymmetric 
information. Innovative or knowledge based or creativity based products face this problem.
How to solve this problem?
In historic times certain things like treatment for snake bites etc were kept as a 
secret. Some Vaidya will pass on the information only to their successors or heirs. 
 Coca cola recipe is still a secret. Software companies also provide technical barriers 
to restrict the dissemination of know how of innovative products.
Photo   based   magazines   are   put   inside   covers   or   are   sealed   to   prevent   the 
diminishing marginal cost after it got exposed to readers. Once the photos are viewed, there 
will be no incentive to buy the magazine.

Intellectual Property Rights

This problem is solved using the concept of intellectual property rights. The different types 
prevailing are

1. Patents
2. Copyrights 
3. Trademarks

 Patent:     First of all one gets the patent only if he/she reveals the innovation. He has 
to file a patent application to authority giving full information about the product or content. 
The innovation is made public by the patent authority but with legal restrictions and a time 
period for filing objections to granting patent. If someone else had already invented the 
product, he should be given an opportunity to contest within a reasonable period of time. 
Such objections received within the stipulated time will be considered and decided upon by 
the authority and if found appropriate patent will be granted.
  Patenting means he/she has the exclusive right to use or give the right to somebody 
else or if somebody wants to use it then he/she has to consult the holder of the patent. He 
has an exclusive right only for a fixed duration. In India it is 20 years. After that anybody 
can use it. 

Why the duration is kept as 20 years?

The owner gets the incentive to go for such innovative production. Moreover 
He gains sufficiently enough profits. It is not kept for more than 20 years because if an 
infinite   period   is   set   then   the   society   is   losing   the   chance   for   diffusion   of   valuable 
information. But it can be seen that the additional gain of patent holder may reduce with the 
passage of time and may become very small in the long run.
    
                    
  

time

   The benefits an innovator gains as time passes by will follow a pattern as shown in 
the graph. With the passage of time the additional incentive he gains reduces. Beyond a 
certain point of time it is not rewarding for the innovator. Quite a lot of companies create 
innovative products or ideas but they don't want to reveal them. It may be known to only a 
few or sometimes they make some technical barriers against accessing the knowledge.
                                                                              
 Copyrights:    
   In the case of paintings, music, etc., we go for copyrights. Period of 
copyright is usually till the death of a person. Giving him an incentive and an infinite 
period may create another problem. If someone is writing a novel today he/she may like to 
know whether there is a similar one written earlier (to avoid the allegation of copying). So 
there is a search cost involved here. If the period is too long the search cost is too high. The 
search cost for others will increase if the period is kept too high. In ordrer to minimize the 
search cost the period is fixed. 

Therefore in patent, the trade off is between the incentive to the producer and 
the cost of diffusion. Whereas in the case of copyright the tradeoff is between the 
incentive to the producer and the search cost.
Trademark:

Only if the company has built up a reputation then the company would use the 
trademark. So the trademark is a kind of solidification of reputation. Some companies are 
interested  in building  up reputation.  This  is essentially  due to asymmetric  information. 
Reputation building is a way of solving asymmetric information problem.

Govt.’s role in trademark

  Trademark is registered by a legal authority and is owned by the company. It is 
often called a brand name. Somebody else cannot use the registered trademark. Patent, 
copyright and trademark serve different purposes. IPR is not the only way through which 
rights over intellectual properties are asserted. There are technical barriers and trade secrets 
and contract related solutions. 

Contracts

Factors determining the type of contracts:
10. Asset Specificity
11. Level of Asymmetric information on the quality of product or service
12. Whether user already has information about the usefulness of the product

 
If we want to make something which is very specific to our firm, then we go for hiring 
people.   Sometimes   an   announcement   is   made   inviting   applications.   It   may   be   highly 
specific to the organization. So applicants may not have the incentive to produce the thing 
first and try to sell us because they are not sure whether their product will be accepted or 
not.

If 1 million rupees is the reward and if the probability of getting it accepted is only 20% 
then the expected is only 0.2 million. Even though the company is paying 1 million rupees, 
application producers are willing to spend only 0.2 million Rs. They cannot sell the product 
elsewhere. If there were 1000 firms requiring the same product then there would not be any 
problem.
The firm may ask the companies to prepare some concept note etc and based on that 
they select the firm. Here the firm is entering into an ex­ante contract.
 
  A manager must have clear knowledge that the product is useful for the company 
before getting into an ex­ante contract. If one can measure the quality of service provider 
then it may go for ex­ante contract, otherwise it may go for buying the product after it is 
produced and verifying the quality. 
 MANAGERIAL ECONOMICS LECTURE 9 NOTES
20thNovember 2009

CONTRACTS & TRANSACTIONS

13.Contract is important as a part of business and e-Governance / IT

enabling.
14.Before getting into a contract one must understand the transaction cost
and its implications in our e-Governance project or business.
15.Improved governance or e-Governance should aim at reducing the
transaction cost.

Fundamentals of Exchange
16.The basic benefit of exchange is the creation of wealth in the society.
17.How is wealth created?
1. Soppose A is willing to sell a bike for not less than Rs.6000/- and B is
ready to buy it at not more than Rs.8000/-.
2. Both A and B will bargain on the rate of sale of the bike. A reasonable
deal is one which has a rate in between Rs.6000/- and Rs.8000/- (say
Rs.7000/-).
3. Wealth in the society before transaction = Rs.8000 + Rs.6000
= Rs.14000/-
Wealth in the society after transaction = Rs.7000 + Rs.1000 + Rs.8000
=Rs.16000/-
3. Value is in perception and also wealth increases only after the real
transaction. It has nothing to do with resale value.
4. The trust is very important but more important is the verification of the
authenticity of the ownership of the property.
5. After the verifying that the property is safe to buy and has no mortgages
on it, we can decide to buy the property and should register the property
in our name to protect our property from future legal complications.
6. Government takes charge (registration charge) so as to provide social
and legal security for the property.
7. Thus the buyer has to incur some transaction cost and get legal security.
8. If the transaction is greater than the net gain there will be no
transaction.
9. E-Governance aims at reducing the cost, time of transactions so as to
allow maximum exchanges to occur in the economy.

What is a contract?
 • Contracts are necessary when there is a delay in transaction
• Unlike other transactions contracts have a time period associated with
it, over which the parties are supposed to follow certain rules.
• Eg: Warranty for an electrical or electronic item for a given period of
time.
• And in case one of the parties violate the contract, the other can go to
court for taking legal action against them.
• But in diamond business, transactions worth millions of dollars are
done without any formal documented contract.
• Here diamond traders ensure the contract is enforced by blacklisting the
violators and any other associated with them in their closed trade
system.

Types of transactions through informal contracts

• One model of transaction follows placing relatives in various places to

carry out long distance trade and commerce.
• Another model of transaction follows trade by `membership within
particular clubs’, and club members support each other to carry out
trade in network by punishing cheaters.

Every contract is imperfect or incomplete as it cannot include all the clauses

and future possibilities.

Every contract has two costs associated with it:

• Transaction cost: the cost for documenting, registering and enforcing
the contract.
• Also the cost the parties have to bear due to the incompleteness of the
contract.
 Managerial Economics (21/11/2009)
Lecture 10

Organization Theory is a modern theory of the firm which states that the goals and
activities of a firm are the results of its organizational structure.This theory challenges the
traditional assumption of profit maximization by management, which is now seen as
content to earn just satisfactory profits.

Organizations depends on:

 Transaction Cost

 Incomplete Contract

 Easiness to monitor

 Coordination

 Need for complementary assets

 Residual right

 Alienable asset

A transaction cost is a cost incurred in making an economic exchange. For example, most
people, when buying or selling a stock must pay a commission to their broker; that
commission is a transaction cost of doing the stock deal. Or consider buying a banana from
a store; to purchase the banana, your costs will be not only the price of the banana itself,
but also the energy and effort it requires to find out which of the various banana products
you prefer, where to get them and at what price, the cost of traveling from your house to
the store and back, the time waiting in line, and the effort of the paying itself; the costs
above and beyond the cost of the banana are the transaction costs. When rationally
evaluating a potential transaction, it is important to consider transaction costs that might
prove significant.

The term "transaction cost" is frequently thought to have been coined by Ronald Coase,
who used it to develop a theoretical framework for predicting when certain economic tasks
would be performed by firms, and when they would be performed on the market. Arguably,
transaction cost reasoning became most widely known through Oliver E. Williamson's
Transaction Cost Economics. Today, transaction cost economics is used to explain a
number of different behaviors. Often this involves considering as "transactions" not only
the obvious cases of buying and selling, but also day-to-day emotional interactions,
informal gift exchanges, etc.
According to Williamson, the determinants of transaction costs are frequency, specificity,
uncertainty, limited rationality, and opportunistic behavior

Some of the fundamental characteristics affecting transactions:

[Easiness to monitor and Coordination]

18. How easy is to monitor somebody’s action?

Example: If you take an example of a car manufacturing unit (FORD), each stage is
segmetised and every stage is monitored.

19. If somebody’s work is easy to monitor, will that have an impact on the decision on
hiring him as a worker or do they need to outsource?
Example: Medical Transcription…..In this business mostly the managers know what to
be done. Each step can be monitored. Moreover they get into a contract (within the
person who is outsourcing and who is taking it).

OR

In some business their will be a certain degree of ambiguity and in such cases they need
an expert’s advise and it’s very difficult for the principal to monitor the agent.

20. How easy is to coordinate the movements of the hired people?

If the cost of coordination goes up, it’s much likely to monitor the organization in large
groups or clusters.
If the cost of coordination goes down, it’s much likely to monitor the organization in
small groups or clusters.

Extend of transaction cost depends on development of market. According to Oliver

Williams “Organization is a form evolved to minimize transactions”.
SIZE OF AN ORGANIZATION

Let’s take an example of production of car wipers for a car company.

They have three ways or possibilities …
• The car company can have an in-house wiper production
• The car company can hire a subcontractor to manufacture the wipers according to
their interest
• Purchase the wiper from market.

Here the car company chose to hire a subcontractor to manufacture wipers and the
problems they faced were
- product was not available in time and in sufficient quantity
- costly (due to price hike in raw materials etc)

Due to all these problems the company has decided for an in-house production. Which
implies…..The size of the company gets larger or becomes big. Market situations,
contingency and exigency situations too determine the size of an organization.

Vertical Integration

Raw Material

Intermediate Output/Input

Final Product

Example: Reliance [synthetic textile production].They needed petro-chemical product

as the raw material .Inorder to get the raw materials regularly and cheaply, they started
to manufacture the raw materials.

Horizontal Integration
Example: Merging of mobile telephony and landline telephony.
 INCOMPLETE CONTRACTS

In economics, contract theory studies how economic actors can and do construct
contractual arrangements, generally in the presence of asymmetric information.
Contract theory also utilizes the notion of a complete contract, which is thought of as a
contract that specifies the legal consequences of every possible state of the world. More
recent developments known as the theory of incomplete contracts, pioneered by
Oliver Hart and his coauthors, study the incentive effects of parties' inability to write
complete contingent contracts, e.g. concerning relationship-specific investments.

Contracts can never specify all kinds of possibilities, kind of loss due to contingency,
future outcomes or natural disasters.

RESIDUAL RIGHT

By taking the very same example of a car company hiring a subcontractor to

manufacture car wipers….sometimes the cost of the wiper could rise…these kind of
issues are not envisaged in a contract. In this issue the subcontractor (or the person who
owns the machine to manufacture the product) is the Residual Right.
Residual Right is not a part of a contract.
The key point which we have to note is “who should have the residual right”.

ALIENABLE ASSET

These are saleable assets. These assets are products that could be sold to any company/
dealer. Dependency is lesser in alienable assets.

These are the two factors that affect the size of the organization.
 Role of Information Technology

Transaction Cost

Implementing a new information technology is generally seen as a means for reducing

the transaction costs of an organization. However, in practice, implementing new IT
often results in higher transaction costs. This is because the amount of information that
needs to be processed by the organization increases. This can result in information
overload. If these costs exceed the benefits of IT, then the implementation becomes
something negative and expensive.
To reduce coordination costs, organizations can do one of two things

10. Improve information processing capabilities. This can be done either through
implementing new information systems or creating lateral relations.
11. Use IT to reduce the need for coordination through increased slack resources
(which reduces the need for extreme precision) or increased reliance on self-
contained tasks which provides more of the information to a single point of contact
rather than requiring communications and coordination among multiple units.

Incomplete Contract

As search costs and other coordination costs decline, theory predicts that firms 
should   optimally   increase   the   number   of   suppliers   with   which   they   do 
business. Despite recent declines in these costs due to information technology, 
there   is   little   evidence   of   an   increase   in   the   number   of   suppliers   used. 
Information   technology   increases   the   importance   of   non   contractible 
investments by suppliers, such as quality, responsiveness, and innovation; it is 
shown   that   when   such   investments   are   particularly   important,   firms   will 
employ   fewer   suppliers,   and   this   will   be   true   even   when   search   and  
transaction costs are very low. 
 Managerial Economics Lecture 11 (24-11-09)

Government organizations are supposed to carry out interventions in society. For

example having a single police system in the country is a Government
intervention.When Govt services are examined like police ,space research , railwys
etc ,closely ,there are two fundemental funtions .
1.Decision making of how much to be produced
2.Is there is any need of charging the service, on account of cost of production.

Broadly we call this by regulation.

Compare telephone service today, provideed by both public and private
companies. TRAI(Telephone Regulatory Athority of India) decides the price, based
on recommendation of all the stakeholders .

Let us look at electicity tarif in states This is to some extent determined by the
opinion of the Electricity regulatoy commissions .There are two specific functions
by the Authorities
1.Regulatory functions
2.Service functins

Consider the function of Public Work Department .Thre are Secretaries in the
Government who decide which are the new roads to be consructed. Once decided
the construction is carried out by PWD. Advantages are that in doing the servie
delivery as a monopoly, if they are given with all freedom to price their service it
would not be in the interest of the people in general. ie why electricity regulatory
commisswion is seperate from KSEB.
After independence a lot of engineers argued that what is the need of a
secretariate control over the department on functins like public works. This was not
welcome.
In the case of department of Atomic energy and space technology there are no these
seperate dividions
Eg. Electricity regulatory commission has around thre members a judicial officer,
Engineer and a Finance officer.. They have different roles there. The objective of
the arrangement is provide justice to all stakeholders. Here the judicial office may
be acting as a neutral arbitrator among the other members on their arguments.

In fact this Secretariate -Department division is not that effective since the
Ministers have their own agenda and their interventions are a concern . For example
the Electricity minister may think that people should get electricity on even cheaper
rate. This may affect the cost estimations of KSEB.

There is an argument to seperate the regulatory function from the service

delivery system. e-Governance also has to be defined in this dimension .Think about
the service delivery function and e-Governence .This is not as good as in the case of
a private company most of the time. The use of technology in service delivery of a
public company is same as that of a private company.But in public sector people
expect services on cheaper rate with quality.

E-Governance in the regulatory role is different.Greater part of the

Government is is regulation .The duty of a regulator is to see whether people get the
quality service at cheaper rate.In the case of Electricity regulatory commission they
verify matters involved inthe electricity production .And decides whether a price
hike is reasonable or not.
Three conventional models are there
1 Government own the company.

One company

2. Govt /independent regulator

One or fewer private

companies

3.No regularor required

Many companies

Take the case of public bus transport system in kerala

Why the private buses should also be brought under a regulation as described below
1.Route regulation
2.Tarif regulation
Government think that this provide the maximum help to the people. Here the
regulation in price is done to prevent overcharging . In the US model when they
start regulation these companies they found that the regulation are not getting any
valuable information or ground realities. If the regulator is an outsider he is not in a
position to estimate ground realities.

1. How to have better information for the regulator

2.Private companies can influence the regulatory
3.There are mechanism ot appeal against the decisions taken by any regulator
How e-Governance can improve transparecy in regulation .What ICT can do in
effective regulation process.

1.Provide as much information to as much as people as possible.

2.Information transparency is an important thing in proper regulation
3.Role of e-Governanec in this case is to provide as much as information as possible
to the stakeholders

*******************************************************************
 ECONOMIC RECESSION
Lecture 12

What is Recession? – If economic growth rate continues as negative for more than two
quarters, it is considered as recession. The issue recession is closely related to the
regulation. This particular recession is related to IT in the sense that the lack of use of IT in
regulation or the use of IT by the companies that make regulation/governance little more
difficult or complex.
Economic growth means more and more production of commodities/services. If the
production/services contracts for a reasonable period, we say it is recession. Lack of
economic growth in a poor country and economic recession in a developed country is
different.
Economic recession will have impact on people. If people do not have adequate
income to buy goods, it reduces the demand for commodities and services and it leads to
accumulation of inventory and leads to further contraction of economy.
In a Capitalist economic system, the decisions on how much to produce and
consume, what are the commodities to be consumed etc., are supposed to be decided by the
individuals. But in socialist system these are determined by a central authority. The central
authority should have higher level of information to optimize the production, consumption
etc. It is more difficult to get the whole information to a central authority and this may be a
reason for the failure of socialist system.
But in capitalist economy the centralized information gathering is not needed. In
this case the information is generated instantaneously from the market. A producer can
easily update the information and regulate the production.
In the capitalist economy the investment/production is based on expectations. If
more and more people invest in a particular commodity, the price of that will go up. If
adequate people are not there to buy this, the price will come down and people may loose
money and corrective mechanism will work automatically (Negative expectation).
Growth can also be due to some excessive expectations. Positive expectations
driving up the production of goods and services will be accompanied by a negative
expectation in the economy and this can lead to a contraction of commodity and services.
This can happen in a single market, but can also be happen in many markets together. This
is inevitable to some extent, ie., there will be recessions in future too.
 There is another important reason for the current economic recession and that is
somewhat unprecedented in the history of economic growth. Let us look the story of sub
prime crisis. There was a financial crisis happened in Asian countries like China, South
Korea, Thailand, Indonesia etc., in the nineties. Foreign investors withdraw their money
from above countries drastically and this led to the devaluation of currencies and
unemployment and economic problems in these Asian countries.
From the above experience, these countries and Middle East countries start to invest
money in US dollars, when the economic growth starts to grow. This will help these
countries to maintain their economy even if foreign investors withdraw the investment in
bulk. Even though US economy is a vulnerable one, many countries invested in US dollars.
A part of the investment reached in US Banks and the banks invested a part of the money
in real estate. The bank loan in real estate was in mortgage basis. In mortgage, 95% of cost
of house is given by the bank and the interest rate is very low. During mortgage period
bank will be the owner of the house. As the interest rate is very low, the lower middle class
people started to acquire 2nd or 3rd house and the demand for house went up and
subsequently price of the house also goes up. Then bank forced to give more money for the
same type of house comparing to earlier loan.
Also there is high competition between banks to give loans and they failed to access
the repayment capacity of loanees. Also another development started within the banking
section of US. i.e., some banks starts to sell their assets/business to another bank through
second level or third level securitization . But this level of securitization fails to access the
information from primary level (repayment capacity of customer) i.e actual information
between buyer and bank getting diluted and thus many people did not repay their loan and
the price of properties come down and obviously the higher level bank lost their money.
Banks’ income is the difference between the interest gain from loan and interest
given to depositors. If there is a bulk withdrawal from bank, bank cannot survive. To avoid
this it is supposed to put a part of money to the Reserve Bank and if there is a sudden
withdrawal Reserve Bank will extend their support from the reserved money.
If there is sudden contraction in economy or finance transaction, the value of the
bank may come down and the business associated with them will also collapse.
The current recession didn’t affect the Asian countries very much in terms of
financial thing but the contraction of goods and services took place. i.e the real impact is on
the export of commodities.
 Nationalization helps to start branches in every part of the country and thus more
people started to use bank and people deposited more money in the banks. The present
recession did not affect the banks of India, Canada etc. But China and Russian Banks were
affected.
Currency value depends on demand for currency. If currency demand is high, the
value will also be high. Some countries do not allow to change the currency value
according to market condition. Devaluation comes only when artificial control on value of
currency is over. Earlier Governments have artificial control over the value of rupee. Now
there is lesser governmental control and there is somewhat automatic regulation of the
value of currency.
In China they kept its currency value lower than the actual value; which benefits its
exporters and at the same time importers is suffering. The actual value of the China
currency should be much higher than the current level. i.e one debate going on between
China and US.
If primary banks can sell business at secondary and tertiary level to other banks and the
banks which buy secondary or tertiary level transactions they have very little information
on the quality of this kind, how can we regulate business? How to make regulator capable
in this context? IT is used within the business transaction. This is also related to e-
governance –overseeing decisions between the banks and the Central Government, the
regulators and the firms which are being regulated. How does governance address this
challenge? Information technology poses new a challenge in this regard.
Banks can collapse even without any reason. There have to be certain level of
support by the Central banking authority on banks. Central bank can take away money
when they are good shape and give when they are in difficulty. Instead of central banking
doing this can be given to an insurance mechanism. This is to an extent done in US. When
banks collapse it will also have an impact on other parts of an economy. When banks
collapse a crisis occurs there will be contraction in demand for goods and services, and
then there will be high unemployment. If you have set up a machine and producing in a
full level and suddenly there is a reduction in demand, the machine cannot be utilized fully.
Recession is different from lack of economic development. Poor country has a low
economic growth. Challenges to Economic growth in a poor country are is different from
those needed to recover from economic recession. Poor country will have less capital. The
country will not be able to produce things and the people do not have the ability to buy
things.
 In an economic recession situation capitalist stock well developed, suddenly lack of
demand in the commodities and hence the capital stock cannot be utilized fully. If money is
given to people they can consume, then there will be more employment, more money is
obtained as wages. The initial way is for Government to spend money and this is seen as a
mechanism to restart the system. John Maynard Keynes, an economist in UK, developed
this Model when economic recession happened in 1930 and 1940s. If there is sudden
unemployment due to recession, Government spend money so that the money goes to
people, people demanding commodities so the production can be increased.