1. Internal Markets CHAPTER 18
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2. 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
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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.
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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
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15. Collect Dispersed Information
Internal Market Failure
Externalities
Public goods
Free riding
Asymmetric information
Monopolization
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16. 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
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17. 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
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18. 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
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19. 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
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20. 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
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21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.