Universitat Pompeu Fabra

Facultat de Ciències Econòmiques i Empresarials. Curs 2019-2020

Business Economics (First trimester)
Problem Set 2
Seminar no.: ....................... 2
Topics ................................. 2. Specialization and exchange
Seminar week: .................... October 28 to October 31

Rules:
i. Answers must not exceed 2000 words. (Use the integrated word count tool.) Any text
exceeding the first 2000 words will not be considered.
ii. The filename should be the last name of the author. (E.g., “Rodriguez_PS1.pdf”)
iii. The deadline for submitting answers via Aula Global is Friday, October 25, at 23:59h.

1. Organization of production
In a market there are 10 consumers. Each of these consumers needs a unit of a product. This product
needs to be assembled with 5 different pieces. Each piece is produced and sold by an independent
supplier. There are two forms of organization of production:

i. In the market solution, each consumer buys these five pieces and assembles them on his own.
Every time a consumer buys a piece the consumer pays an exchange or transaction cost t = 2
€ and also pays the cost of the piece that is k = 3 € (to simplify, each piece costs the same).
The assembly cost is c = € 5.

ii. In the organizational solution, Anna sees a business opportunity and creates a company. She
buys the parts from each independent supplier, assembles them, and then sells a complete
product to each of the 10 consumers. Each time she makes a transaction with someone, she
pays the transaction cost t=2€, which does not depend on the quantity exchanged. The
transaction cost of selling a finished product to each consumer is also t = 2 €.

a) With the information given, calculate the total cost per unit of product in the market solution
and in the organizational solution. Which is less of the two?

b) Imagine now that for consumers assembling does not suppose any cost but a benefit b > 0,
since they enjoy creating the product themselves. How large does it have to be b to make
Anna's business inefficient?

c) How many transactions or exchanges are made in the market solution? How many
transactions or exchanges are made in the organizational solution? Use this argument to
explain in which situations the organizational solution can reduce the costs of coordination
and motivation with respect to the market solution.

d) Suppose that the demand for Anna's company products starts to increase due to the great
success of her idea. To supply the demand Anna begins to hire a large number of workers.

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 Using the concepts from the course, explain how this phenomenon could imply a decrease in
the transformation costs associated with cost "c" and, on the other hand, how this
phenomenon could imply an increase in transaction costs associated with cost "c".

2. Political solution to the economic problem

Spain has 3.400 kilometers of AVE train tracks operating and more under construction. With much
of the current network clearly underused, some economists argue that future construction plans
should be cancelled. Explain whether you agree with the following statements:

a) “A public investment can be justified since high-speed trains generate clear negative
externalities.”
b) “Most of the voters do not have the right incentives to invest more resources in gaining better
information about the value of these infrastructure.”

3. The tragedy of the commons

Excerpt from “La tragedia del bien comunal” by Xavier Sala i Martín (La Vanguardia, October 17,
2009):

"Have you noticed that when we go to the restaurant in a group and the bill is divided among all, it
is much higher than when each person would pay on his/her own? If we pay individually, we all
evaluate the benefits and cost of ordering a lobster. If the cost is too high, we favor the chicken,
which is cheaper. However, if the cost of lobster is split between fifteen, it would not be so
expensive, so that is why we would end up ordering it. The problem is that all the guests feel the
same way, so we all end up buying lobster (and drinks, and cigars) and the common bill ends up
being stratospheric. This is an economic problem known as "the tragedy of the commons." The
common goods are those that many people can use at once: a park, the sea, forest and parking on
the streets of the city. They all share a curious phenomenon: the benefit is for the user, but the costs
are shared among all" (...) "The privatization of the common goods is sometimes complicated by
the nature of the good in question. For example, it is very difficult to divide the sea into private
plots. For these cases, the companies have found another solution: government intervention. The
State appropriates the common good (the sea), decides each fish fee and punishes with fines those
with higher prices. For the restaurant, the solution would be to establish a rule prohibiting groups of
more than six people for ordering lobster..."

a) Why would building concrete walls in the sea separating different areas and assigning owners
not be an appropriate way to solve the "tragedy of commons" that threatens the sustainability of
fisheries?

b) Imagine that the sea could indeed be privatized into private plots, how would this affect the
incentives for fishermen to use resources efficiently?

4. Specialization, organizations and markets

Comparing the transactions in the market with those inside the organization, the economist George
Stigler commented: "Those too numerous people who believe that transactions between firms are
expensive and those within firms are free will do well to study the organization of England during

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this period of eminence. In Birmingham, the center of the metal trades, specialism was carried out to
an almost unbelievable extent. Consider the small-arms industry in 1860, when Birmingham was still
the leading production center of the world:
Of the 5800 people engaged in this manufacture within the borough's boundaries in 1861 the
majority worked within a small district round St Mary's Church.... The reason for the high degree of
localization is not difficult to discover. The manufacture of guns, as of jewellery, was carried on by a
large number of makers who specialized on particular processes, and this method of organization
involved the frequent transport of parts from one workshop to another. The master gun-maker -the
entrepreneur- seldom possessed a factory or workshop.... Usually he owned merely a warehouse in
the gun quarter, and his function was to acquire semi-finished parts and to give these out to
specialized craftsmen, who undertook the assembly and finishing of the gun. He purchased materials
from the barrel-makers, lock-makers, sight-stampers, trigger-makers, ramrod-forgers, gun-furniture
makers, and, if he were engaged in the military branch, from bayonet-forgers. All of these were
independent manufacturers executing the orders of several master gun-makers.... Once the parts had
been purchased from the "material-makers," as they were called, the next task was to hand them out
to a long succession of "setters-up," each of whom performed a specific operation in connection with
the assembly and finishing of the gun. To name only a few, there were those who prepared the front
sight and lump end of the barrels; the jiggers, who attended to the breech end; the stockers, who let
in the barrel and lock and shaped the stock; the barrel-strippers, who prepared the gun for rifling and
proof; the hardeners, polishers, borers and riflers, engravers, browners, and finally the lock-freers,
who adjusted the working parts." (From G. C. Allen, The Industrial Development of Birmingham
and the Black Country, 1860-1927 (London, I929), pp. 56-57, 116-17).

Commenting on a later period, Allen says:

"On the whole, it can be said that specialization was most apparent in the engineering industries in
which output was rapidly expanding; while the policy of broadening the basis product line was
found, mainly, either in the very large concerns, or in industries in which the decline of the older
markets had forced manufacturers to turn part of their productive capacity to serve new demands"
(ibid., pp. 335-36).

The later history of the gun trade, in which American innovations in production techniques were
revolutionary, suggests that the organization in Birmingham was defective in its provision for
technical experimentation. (The Essence of Stigler, edited by Kurt R. Leube and Thomas Gale
Moore, The Hoover Institution, 1986)

a) Give two examples of coordination costs and two examples of motivation costs that you think
may have arisen in the system of economic organization described by GC Allen.

b) Is this organization efficient? Why?

c) Eventually, over time, would all transactions described in this market be carried out within
one or several large industrial companies? Why? Are there any drawbacks to mass production
within a large industrial company?