Managerial economics and organizational architecture 5e ch003

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

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 .

The Goals of an Economic System

• To satisfy human needs and wants

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

• 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

Demand

$

Q Q*

3-8

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

A

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

Lost gains from trade

Supply

Excess demand (shortage) for gasoline

Q

Minimum Wage Laws

$4.00

$5.15

Unemployment (excess supply

of labor) Labor Supply

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

• 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

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

r) (1

CF Value

Present

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

g k

D P

k

D k

D k

D P

+ +

1 0

2

2

1 0

) 1

(

) 1

( )

1 (

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