1 Business Economics I Markets and Organizations II

2 Specialization & Costs I As specialization increases – transformation costs decrease Example: Which is the faster way to produce a car? a) each car is produced by one person who knows how to perform all the activities needed for the production of the car or b) by several persons each of whom knows to do very well just a small number of activities (one paints, another assembles the body and the engine, etc.)?

3 Specialization & Costs II As specialization increase – transaction/exchange costs (coordination + motivation costs) increase Examples: Is it easier to coordinate when Miguel both makes and sells web pages or when Miguel only searches for clients and Maria only designs web pages? Should Miguel control the quality of Maria’s work? Should Maria control the quality of Miguel’s work?

4 Specialization & Costs III Transaction/Exchange Cost Optimum without Exchange Costs Costs Specialization Transformation Cost Total Cost = Exchange + Transformation Costs Optimum with Exchange Costs

5 Solving The Economic Problem We want to solve the economic problem in the best possible way – we want to solve it at the lowest total cost possible. There are two basic ways to approach the economic problem: The market The political decision making process Both systems are subject to exchange costs.

6 The Market Solution I What to produce? Determined by the decisions of the consumers to buy. In a market system, the decision to buy an article transmits orders to the distributors and the producers, because customer satisfaction determines not only the profits but eventually the very survival of the firms. The decision making is a decentralized Examples: to buy analogous or digital cameras? Customers more and more prefer digital cameras: What are the consequences for Kodak and Olympus?

7 The Market Solution II How to produce? Competition between firms ensures efficiency because inefficient firms and, in general, any inefficient producer tend to be driven out of market Examples: Car manufacturing in the US (end of 19 th – beginning of 20 th century)

8 The Market Solution III For whom to produce? The market of production factors establishes wages and other income in terms of shortages and productivity. This determines how the product will be distributed amongst the owners of the resources for production. Illustration: IT solutions – customers, programmers, firms, shareholders.

9 What is Pareto Efficiency? An exchange is efficient when it is mutually advantageous. When all efficient exchanges have taken place, the allocation of resources and goods is Pareto-efficient. Maria exchanges her job in the shop for her job with Miguel. If Miguel pays her more than 300 Euros, the exchange is efficient

10 Prices as an Information System I Price transmits a minimum amount of information due to the decentralized decision making in the market. Why minimum? Think about what does a price of a product reflect – shortages of resources as well as the current and future preferences of individuals The information is received only by the persons who are interested and able to use it. What does it mean? – if you don’t want to buy a diamond ring, would you know the price of such a jewel?

11 Prices as an Information System II The transmission of the information occurs through a series of chain effects and the amount of information that needs to be transmitted is limited. Illustration: the book publishing company does not observe the changes in the price of steel BUT receives the relevant information from such a change via the effect of steel prices on the price of the machines they use for printing books.

12 Property Rights I Property right is the right of an individual to freely dispose of the good, asset or resource (s)he owns to his/her own benefit. A property right is alienable if it can be exchanged. Examples: Your mobile phones The flat of your parents The mortgage on the flat The computer software we use

13 Property Rights II The price system works efficiently only because it is based on a system of alienable property rights. Why? Property rights provide the incentives to the right holders to search, produce, and use relevant information because The right holders bear the consequences of their own decisions about the use of their resources and it is in their interest to make the best decisions possible. Are you going to leave your mobile phone unattended in a disco? And if this was a common mobile phone?

14 The Political Solution I The political solution is based on centralized, collective decisions ( think about the difference with the market ). Democracy: Simultaneous decision making – voting. The preferences of the citizens are expressed through their votes. Costs: the cost of direct voting vs. the transaction costs of having representatives.

15 The Political Solution II (Democracy Continuation) Generality in the political decisions: Pay attention that in this case both users and non users vote. People with different degree of knowledge and interest in the issue vote. Incentive problems – voters don’t have incentives to get more information: the individual benefit could be smaller than the individual cost. The cost of satisfying minorities vs. the cost of informing better majorities.

16 The Political Solution III Planned economies (USSR) Decisions are centralized Prices exist but don’t have the functions they have in the market The lack of private property rights distorts the efficient use of resources What to produce – political decision How – plan For whom – political decision

17 The Political Solution IV Social Market Economies – a mixture between market and political interventions. Pay attention that in reality we don’t observe “pure” market or political solutions. In Western countries markets are given “rules” that have to be followed by the political system.

18 The Organizational Solution – The Firm Why does the firm exist? The firm emerges in order to reduce high transaction costs. In other words, the firm is the least costly way to organize certain economic activities. The choice between market and firm is based on the comparison of their costs Example: Is Miguel going to contract Maria every time he needs somebody to do an additional web page?

19 The Coase Theorem If property rights are clearly assigned, well defined, and exchangeable at low cost (low transaction costs), then efficiency does not depend on the initial allocation of property rights. Everything is supposed to be exchangeable, including the rules that organize social relations. The only organization of the society is exchange and society is reduced to a system of prices. Example:Everyone has a right to pollute that he can exchange at low cost with somebody else.

20 Externalities I Externalities arise when the actions of the individuals have consequences that are not reflected in the price of their exchange. These consequences can be positive or negative. They are limitations of the functioning of the market. Example: Repsol sells gasoline to car owners. They drive their cars due to the burning of the gasoline. This, however, also pollutes the air and this affects many parties that have nothing to do with the exchange (buying gasoline)

21 Externalities II In practice, the society attempts to organize the internalization of externalities. This can be done with laws and constraints, with taxes, or with the creation of new property rights that have to be exchangeable. Example: Chemical factory and a fishery.

22 Market or Firm? Transaction/Exchange Cost in firm Costs Specialization Transaction/Exchange Cost in the market Market Firm