Managerial Economics and Organizational Architecture, 5e

Managerial Economics and

Organizational Architecture, 5e

Chapter 3: Markets,
Organizations, and the Role
of Knowledge
McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights

Reserved.

Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Basics of Supply and Demand

Demand curveshows the quantity of a
good that consumers are willing to buy at
various prices
Supply curveshows the quantity of a
good sellers are willing to offer at various
prices
Interaction of supply and demand yields a
market-clearing price
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Managerial Economics and Organizational Architecture, 5e

Supply and Demand in the PC Industry

$
Supply
Surplus

HI

Price (in dollars)

When prices are high, the

quantity supplied is greater
than quantity demanded and a
surplus exists.
When prices are low, the
quantity demanded is greater
than quantity supplied and a
shortage exists.
Only the market-clearing price
avoids surpluses or shortages.

P*
PLO

Shortage

Demand

Q
Q*
Quantity of PCs

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Managerial Economics and Organizational Architecture, 5e

An Increase in Demand shift right

P

S0

P1
P0
D1
D0
Q0

Q1

Q of PCs

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Managerial Economics and Organizational Architecture, 5e

A Decrease in Demand shift left

P

S0

P0
P1

Q1

Q0

D1

D0
Q of PCs

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Managerial Economics and Organizational Architecture, 5e

An Increase in Supply shift right

P

S0
S1

P0
P1

Q0

Q1

D0
Q of PCs

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Managerial Economics and Organizational Architecture, 5e

An Decrease in Supply shift left

S1

S0

P1
P0

Q1

Q0

D0
Q of PCs

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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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

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Managerial Economics and Organizational Architecture, 5e

Consumer and Producer Surplus

P
$20
Consumer surplus
(Triangle A)

Supply

A
Producer surplus
(Triangle B)

$10

Incremental production
Costs (Triangle C)

C
Demand

10

Q
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Government Price Cap on Gasoline

$/Gallon

Supply
Lost gains
from trade

$3.00

Excess demand
(shortage) for gasoline
$2.00 price cap

$2.00

Demand

QS

QD

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Managerial Economics and Organizational Architecture, 5e

Minimum Wage Laws

Unemployment
(excess supply
of labor)

Labor Supply

Minimum Wage

$5.15

A
$4.00

Lost gains from

trade

Labor Demand

QS

Q*

QD

Quantity of labor

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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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

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Managerial Economics and Organizational Architecture, 5e

Specific Knowledge
Examples
idiosyncratic knowledge of particular
circumstances
scientific knowledge
assembled knowledge

Free markets make superior use of

specific knowledge dispersed among
many participants
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Managerial Economics and Organizational Architecture, 5e

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

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Managerial Economics and Organizational Architecture, 5e

Firms Can Reduce Transaction Costs

Advantages of firms over markets
fewer transactions
information specialization
reputational concerns

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Managerial Economics and Organizational Architecture, 5e

Appendix

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Managerial Economics and Organizational Architecture, 5e

Benefits of Assuming Shareholder

Wealth Maximization
Identifies what managers should do to
meet fiduciary responsibilities
Describes what good managers actually
do, given appropriate incentives

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Managerial Economics and Organizational Architecture, 5e

Present Value of Risk-Free Investment

CFt
Present Value
t
(1 r)
Where
CFt is the cash flow in period t
r is the discount rate
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Managerial Economics and Organizational Architecture, 5e

Current Value of Share of Stock

D1
D2
D
P0

...
2
(1 k ) (1 k )
(1 k )
D1
P0
kg

Where each Dt is the expected dividend at

time t, k is the risk-adjusted discount rate,
and g is a constant growth rate
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Managerial Economics and Organizational Architecture, 5e

Determination of Stock Value

Not just current dividend
but
Expected future dividends

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Managerial Economics and Organizational Architecture, 5e

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

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Managerial Economics and Organizational Architecture, 5e

Efficient Financial Markets

Management Implications
No ambiguity about firms 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