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 3-2 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 3-3 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 3-4 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 3-5 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 3-6 Managerial Economics and Organizational Architecture, 5e 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 Managerial Economics and Organizational Architecture, 5e Supply and Demand in the PC Industry $ Supply Surplus P 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 3-8 Managerial Economics and Organizational Architecture, 5e An Increase in Demand – shift right P S0 P1 P0 D1 D0 Q0 Q1 Q of PCs 3-9 Managerial Economics and Organizational Architecture, 5e A Decrease in Demand – shift left P S0 P0 P1 Q1 Q0 D1 D0 Q of PCs 3-10 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 3-16 Managerial Economics and Organizational Architecture, 5e Government Price Cap on Gasoline $/Gallon Supply Lost gains from trade A $3.00 B Excess demand (shortage) for gasoline $2.00 price cap $2.00 Demand QS QD Q 3-17 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 B Labor Demand QS Q* QD Quantity of labor 3-18 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 3-19 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 3-20 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 3-21 Managerial Economics and Organizational Architecture, 5e Why 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 Managerial Economics and Organizational Architecture, 5e Firms Can Reduce Transaction Costs • Advantages of firms over markets • fewer transactions • information specialization • reputational concerns 3-23 Managerial Economics and Organizational Architecture, 5e Appendix 3-24 Managerial Economics and Organizational Architecture, 5e Benefits of Assuming Shareholder Wealth Maximization • Identifies what managers should to meet fiduciary responsibilities • Describes what good managers actually do, given appropriate incentives 3-25 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 3-26 Managerial Economics and Organizational Architecture, 5e Current Value of Share of Stock D1 D2 D∞ P0 = + + + (1 + k ) (1 + k ) (1 + k ) ∞ D1 P0 = k−g 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 Managerial Economics and Organizational Architecture, 5e Determination of Stock Value • Not just current dividend but • Expected future dividends 3-28 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 3-29 Managerial Economics and Organizational Architecture, 5e Efficient Financial Markets Management Implications • No ambiguity about firm’s objective function • Management decisions that not affect current or future cash flows are wasted effort • New securities issued at market prices not threaten current shareholders • Security returns are meaningful measures of firm performance 3-30 ... Shortage Demand Q Q* Quantity of PCs 3-8 Managerial Economics and Organizational Architecture, 5e An Increase in Demand – shift right P S0 P1 P0 D1 D0 Q0 Q1 Q of PCs 3-9 Managerial Economics and Organizational. .. 3-11 Managerial Economics and Organizational Architecture, 5e An Decrease in Supply – shift left S1 P S0 P1 P0 Q1 Q0 D0 Q of PCs 3-12 Managerial Economics and Organizational Architecture, 5e The... producing a good • Specialization and trade make both parties better off 3-6 Managerial Economics and Organizational Architecture, 5e Basics of Supply and Demand • Demand curve—shows the quantity