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 $ 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. Supply Surplus PHI Price (in dollars) P* PLO Shortage 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 D0 Q0 Q1 Q of PCs 3-11

An Decrease in Supply – shift left 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 $20 Consumer surplus (Triangle A) Supply A Producer surplus (Triangle B) $10 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 (shortage) for gasoline B $2.00 $2.00 price cap Demand Q 3-17 QS QD

Minimum Wage Laws A B QS Q* QD Unemployment (excess supply of labor) Labor Supply $5.15 Minimum Wage A $4.00 Lost gains from trade B 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 Where CFt is the cash flow in period t r is the discount rate 3-26

Current Value of Share of Stock 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