Chapter 3: Markets, Organizations, and The Role of Knowledge

Managerial Economics and Organizational Architecture, 5e
Managerial Economics and

Organizational Architecture, 5e
Chapter 3: Markets,
Organizations, and the Role
of Knowledge
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
McGraw-Hill/Irwin
The Goals of an Economic System

• To satisfy human needs and wants
• What to produce
• How to produce it
• Who gets it
• The answer depends on the allocation
mechanisms
• Free markets
• Central planning
3-2
Comparing Effectiveness of
Economic Systems
• Resource allocation is Pareto efficient if no
alternative helps at least one person
without harming anyone else
• In free markets, economic decisions are
decentralized to individuals
• In centrally planned economies,
government officials make economic
decisions 3-3
Markets, Property Rights

and Exchange
• A property right is a legally enforced right
to select use of an economic good
• Private rights are assigned to a specific
entity
• private rights are alienable in that they can be
transferred to another individual, within limits
• individuals have use rights within limits
3-4
Gains From Trade

• Individuals trade something they value
less for something they value more
• Trade creates value
• Sources of trade gains
• differences in preferences
• comparative advantage
• specialization
3-5
Specialization
• Individuals specialize in producing goods
for which they have a comparative
advantage
• Comparative advantage occurs when an
individual has a lower opportunity cost of
producing a good
• Specialization and trade make both parties
better off
3-6
Basics of Supply and Demand

• Demand curve—shows the quantity of a
good that consumers are willing to buy at
various prices
• Supply curve—shows the quantity of a
good sellers are willing to offer at various
prices
• Interaction of supply and demand yields a
market-clearing price
3-7
Supply and Demand in the PC Industry

$
Supply
When prices are high, the
quantity supplied is greater
Surplus
than quantity demanded and a PHI
surplus exists.
Price (in dollars)

When prices are low, the
quantity demanded is greater P*
than quantity supplied and a
shortage exists. PLO Shortage
Only the market-clearing price
avoids surpluses or shortages.
Demand
Q
Q*
Quantity of PCs 3-8
An Increase in Demand – shift right

P
S0
P1
P0
D1
D0
Q0 Q1 Q of PCs 3-9
A Decrease in Demand – shift left

P S0
P0
P1
D0
D1
Q1 Q0
Q of PCs 3-10
An Increase in Supply – shift right

P S0
S1
P0
P1
D0
Q0 Q1 3-11
Q of PCs
An Decrease in Supply – shift left

P S1
S0
P1
P0
D0
Q1 Q0 Q of PCs 3-12
The Nature and Function of Prices
• Coordinate consumption and production

decisions
• prices give suppliers incentives to shift
production to high priced products
• prices give consumers incentives to reduce
quantity of high price products
• goods are rationed to those willing to pay
3-13
Gains From Trade

• Consumer surplus - the difference
between what consumers are willing to
pay and what they actually pay
– measured as the area below the demand
curve and above the price
• Producer surplus - the difference between
the price received and willingness to
produce
– measured as the area above the supply curve
and below the price 3-14
Consumer and Producer Surplus

P
$20
Consumer surplus Supply

(Triangle A)
$10 Producer surplus

(Triangle B)
B
Incremental production
Costs (Triangle C)
C
Demand
Q
10 3-15
Government Intervention
• Consumer and producer surplus can be
used to examine the effects of government
intervention on gains from trade
• Price caps limit the maximum price that
can be charged
• Price floors are a legally set minimum
price at which goods can be traded
3-16
Government Price Cap on Gasoline

$/Gallon
Supply
Lost gains
from trade
A
$3.00 Excess demand
B (shortage) for gasoline
$2.00 $2.00 price cap
Demand
Q 3-17
QS QD
Minimum Wage Laws

Unemployment
(excess supply
Labor Supply
of labor)
$5.15 Minimum Wage
A
$4.00 Lost gains from
B trade
Labor Demand
QS Q* QD 3-18
Quantity of labor
Externalities and the Coase Theorem

• Externalities occur when the actions of
one party impose a benefit or cost on
another party outside the exchange
• Pollution, noise, graffiti
• Markets may not be efficient
• Coase argued market exchange will be
efficient if:
– Property rights can be traded
– Transactions costs are sufficiently low
3-19
Free Markets versus Central Planning

• General knowledge is freely transferable
• Specific knowledge is expensive to
transfer
• Centrally planned economies fail because
specific knowledge is not used in the planning
process
• Prices convey general knowledge
3-20
Specific Knowledge
• Examples
• idiosyncratic knowledge of particular
circumstances
• scientific knowledge
• assembled knowledge
• Free markets make superior use of
specific knowledge dispersed among
many participants
3-21
Why do Firms Exist?

The role of transaction costs
• Types of transaction costs
• search and information costs
• bargaining and decision costs
• policing and enforcement costs
• opportunity cost of inefficient resource
allocation
• Optimal economic organization minimizes
transaction costs 3-22
Firms Can Reduce Transaction Costs

• Advantages of firms over markets
• fewer transactions
• information specialization
• reputational concerns
3-23
Appendix
3-24
Benefits of Assuming Shareholder

Wealth Maximization
• Identifies what managers should do to
meet fiduciary responsibilities
• Describes what good managers actually
do, given appropriate incentives
3-25
Present Value of Risk-Free Investment
CFt
Present Value  
(1  r) t
Where
CFt is the cash flow in period t
r is the discount rate
3-26
Current Value of Share of Stock

D1 D2 D
P0    ... 
(1  k ) (1  k ) 2
(1  k ) 
D1
P0 
kg
Where each Dt is the expected dividend at

time t, k is the risk-adjusted discount rate,
and g is a constant growth rate
3-27
Determination of Stock Value

• Not just current dividend
but
• Expected future dividends
3-28
Stock Market Efficiency

• Share prices respond quickly and
rationally to new information
• Prices reflect present values of expected
future net cash flows to shareholders
• Investors should not expect to “beat the
market” on a systematic basis
3-29
Efficient Financial Markets

Management Implications
• No ambiguity about firm’s objective function
• Management decisions that do not affect current
or future cash flows are wasted effort
• New securities issued at market prices do not
threaten current shareholders
• Security returns are meaningful measures of firm
performance
3-30

Chapter 3: Markets, Organizations, and The Role of Knowledge

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Chapter 3: Markets, Organizations, and The Role of Knowledge

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Managerial Economics and Organizational Architecture, 5e

Managerial Economics and

The Goals of an Economic System

Markets, Property Rights

Gains From Trade

Basics of Supply and Demand

Supply and Demand in the PC Industry

Price (in dollars)

An Increase in Demand – shift right

A Decrease in Demand – shift left

An Increase in Supply – shift right

An Decrease in Supply – shift left

The Nature and Function of Prices

• Coordinate consumption and production

Gains From Trade

Consumer and Producer Surplus

Consumer surplus Supply

$10 Producer surplus

Government Price Cap on Gasoline

$2.00 $2.00 price cap

Minimum Wage Laws

$5.15 Minimum Wage

Externalities and the Coase Theorem

Free Markets versus Central Planning

Why do Firms Exist?

Firms Can Reduce Transaction Costs

Benefits of Assuming Shareholder

Present Value of Risk-Free Investment

Current Value of Share of Stock

Where each Dt is the expected dividend at

Determination of Stock Value

• Expected future dividends

Stock Market Efficiency

Efficient Financial Markets

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