Internal Markets CHAPTER 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market as a Collector of Information Market process A path of discovery Price system and free competition Trade-offs of scarce resources are clarified Lowest-cost solutions are reached Feedback about success and failure are provided through profit and loss Price - incorporates all the information buyers and sellers use to determine tastes, preferences, beliefs and expectations © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market as a Collector of Information A change in market price When the information that buyers and/or sellers have changes Central planning Doesn’t work for nations Central planners Could not know what price to set on items to be traded © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market as a Collector of Information Central planners Don’t have all of the information the buyers and sellers in a market have Couldn’t know the tastes, preferences, beliefs, and expectations of buyers and sellers Price set: too high or too low Shortages of some items Surpluses of others Resources were misallocated © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transfer Prices Transfer price Price at which one division provides goods or services to another Both divisions (production and distribution) want to maximize profit The overall firm doesn’t maximize profit © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transfer Prices Set transfer price At a level that maximizes the overall value of the firm Rather than the profits of the production division When the production division produces where Its marginal cost = firm’s net marginal product Net marginal product = firm’s marginal revenue - marginal cost of the distribution division © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Allocation within the Firm Internal market Determine the most efficient allocation of resources BP, 1990s, tradable pollution permits CO2 targets – among divisions 2001, BP business units Traded more than 4.5 million tons of emissions rights among themselves Average price of about $40 per ton Met its original goal, nine years ahead of schedule © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Prediction Markets Prediction markets Iowa Electronic Markets website - to forecast the outcome of U.S. presidential elections Anyone with access to the Internet can participate with up to $500 of real money People purchase contracts that say who will win the election If you hold contracts for the winner once the election is over, then you receive a share of total money in the market © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 18.1 Prediction Market vs. Opinion Polls, 2008 Presidential Election The IEM (Iowa Electronics Market) prediction did better than any of the major polls. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Prediction Markets Internal prediction markets To solicit information about events that are important to the firm Eli Lilly Which drug candidates were likely to be approved / rejected by the FDA Yahoo - Tech Buzz Game Which technology consumers will use the most © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Prediction Markets Internal prediction markets Google HP Labs Product launch dates, new office openings HP Labs Quarterly sales forecast Price of DRAM memory chips in one, three, or six months What computer sales would be in a month © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Prediction Markets Internal prediction markets GE’s computing and decision sciences group - enter and rank product ideas Microsoft - Product ship dates GE - Discovering new ideas Intel - allocating computer chip production Siemens AG Improving the accuracy of product developments © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Collect Dispersed Information Prediction markets Estimate the effect on stock price of different major decisions A check on the accuracy of information a CEO is receiving © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Collect Dispersed Information Creating a prediction market Well-defined good or service Question being posed Private property rights that are well defined and enforced Private property – the contract or share representing an answer to the question being posed People expect to gain from trading © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Collect Dispersed Information Internal Market Failure Externalities Public goods Free riding Asymmetric information Monopolization © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Internal Markets in Academia, an Aside Typical academic institution Command-and-control hierarchy Budgets come from the legislature or Board of Directors University central administration Various colleges Individual departments © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Internal Markets in Academia, an Aside Typical academic institution Faculty – free access to supplies Need permission to travel to conferences Department head Assign offices, teaching assignments Annual budgets Widespread inefficiencies © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Internal Markets in Academia, an Aside 1980s, Economics Department at Arizona State University - internal markets Individual faculty - given budgets Office allocation – auction Teaching assignments – market Class times – bidding and trading © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Internal Markets in Academia, an Aside 1980s, Economics Department at Arizona State University – Results Faculty budgets – more travel Faculty – happy with teaching assignments Intertemporal trades Significant rent seeking © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Internal Markets in Academia, an Aside Louisiana State University Departments – allocate budgets as desired Increase the size of their budgets by attracting more students Saved money: firing the custodial staff provided by Physical Facilities and hiring a private contractor Budgets – determined by student credit hours Departments - compete with each other for students © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Management Firm’s internal exchange Human resources, education and training, legal aid Accessible to anyone in the firm Arbitrary allocation of overhead expenses Internal service providers Weak incentives to listen to their customers Budget comes from top management © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Management Firm’s internal exchange Business units using internal services Few incentives to compare the value they receive with the costs to the company Capital costs Allocated as a central cost Charged to business units as a percentage of total capital costs No incentives for divisions to economize on the use of capital © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Management Market-based firm Relies on internal markets Creates profit centers Enables divisions to utilize external or internal resources Each division Handle personnel issues; hiring and firing Responsible for legal and accounting © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Management Market-based firm Headquarters, boss or CEO Some decisions regarding resources Allocate capital costs Higher transaction costs Invisible hand of the market Replace the visible hand of a central planner Collection of distributed knowledge In the most efficient manner © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Management Headquarters Assigns property rights within the firm Decision rights – assigned by someone Have to be owned Ensure that the decision rights are owned by the right people Ensuring that governance is not violated Handling financial reporting Reporting to government and other relevant agencies © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Management Monitors the team aspects of the firm Manager and headquarters Create incentives and provide approaches to minimizing standard market failures Headquarters - creates the culture of the firm Managers and employees – communicate the culture to future employees © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.