Markets, Organizations, and the Role of Knowledge

Why do markets out perform command and control economies?Why does do much economic activity in market economies occur in

large firms instead of the marketplace?

Professor SpryUniversity of St. Thomas

•Economics 600 •6:00pm-9:00pm

Boxes Ltd. in isolated Sunrise Beach Texas• Shrinking working age population• Problems with hiring enough workers, despite $10

per hour wage (twice local going rate)• Needs to increase hours worked to meet its

growing demand for boxes and production targets.• The new manager launched a daily overtime wage

of $15 per hour for hours worked in excess of 8 per day?

• Why did the new manager institute the overtime plan instead of simply raising the wage rate in an attempt to attract more workers to the firm?

Boxes Ltd. in isolated Sunrise Beach Texas

• Use Consumer Theory– Place leisure hours on x-axis

• (0 to 24 hours per day)– Place all other goods on y-axis– Slope of Budget constraint is the relative price

of leisure time in terms of other (consumption) goods

Boxes Ltd. in isolated Sunrise Beach Texas

The goals and organization of an economic system

• Basic Economic Issues• What to produce?• How to produce?• For whom to produce?

• Alternative mechanisms• Markets• Central Planning

• Command and Control• Hierarchies

Comparing effectiveness of economic systems

• Resource allocation is Pareto efficient if no alternative helps at least one person without harming anyone else• This is a normative, value judgement about the

properties of a “good” allocation of goods.• In free markets, economic decisions are

decentralized to individuals• In firms and planned economies, economic

decisions are made by hierarchies

Property rights

• A property right is a socially enforced entitlement to select use of an economic good

• Private rights are assigned to a specific entity• private rights are alienable within limits• Individuals have use rights within limits

• The sad story of the widow without property rights for “her” house.

Why do people trade?• Buyer places higher value on item than does seller• Voluntary trade is mutually advantageous• Comparative Advantage – The ability to perform a

given task at a lower cost.• More efficient – Able to perform a given task at

lower cost; having a comparative advantage.• Specialization - Lower cost of focusing on

production of one set of goods.• You can’t have a comparative advantage at everything!!!!• People (nations) produce the goods that that have a

comparative advantage in producing.

Supply and demand

Effects of demand shifts

Effects of supply shifts

Free markets versus central planning

• General knowledge is freely transferable• Specific knowledge is expensive to transfer• Factors influencing costs of information

transfer• characteristics of sender & receiver• available communications technology• Nature of knowledge itself

Specific knowledge

• Examples• Idiosyncratic knowledge of particular

circumstances• Scientific knowledge• Assembled knowledge

• Free markets make superior use of specific knowledge dispersed among many participants

Costs of transferring knowledge

Discussion: The Oakland A’s• What is the role of information in the

selection and compensation of baseball players?

• What is the A’s advantage in drafting and trading players?

• Should Beane have revealed his “stuff” to a reporter?

• Additional Lessons thus far from Moneyball??

The nature and function of prices• Coordination• Incentives• Rationing• Signaling• “I, Pencil” by L. Read

• http://www.econlib.org/library/Essays/rdPncl1.html “I am a lead pencil—the ordinary wooden pencil familiar to all boys

and girls and adults who can read and write... You may wonder why I should write a genealogy. Well, to begin with, my story is interesting. And, next, I am a mystery—more so than a tree or a sunset or even a flash of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere incident and without background...not a single person on the face of this earth knows how to make me.”

Externalities• Externalities occur when the actions of one

party impose a benefit or cost on another party outside an exchange relationship• pollution• Bach at bus stops• Lojack - positive effects through less car theft• Peer effects in education and business

The Coase Theorem• The Coase Theorem: When transaction, or

contracting costs are sufficiently low, property rights are well defined, and readibly exchanged, than the resulting allocation of resources will be efficient, regardless of the assignment of property rights• When the are transaction costs, the assignment

of property rights will affect the efficiency of the allocation.

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

• Optimal economic organization minimizes transaction costs• General Motors and Fisher Body• Isolated Coal Mine and Power Plant• Husbands and Wives????

Firms can reduce transaction costs• Advantages of firms over markets

• Fewer transactions• Information specialization• Reputational concerns

• But firms can become large and unwieldy, foregoing advantages• Managerial lesson: If you can buy it on a spot market

you are generally better off getting the input in a market, than through a subsidiary.

• Management needs incentive in order to align management’s interests with owner’s interest.

Discussion: hsx.com and Iowa Electronic Markets

• HSX is just like the real stock market, only way more fun! Buy shares of your favorite actors and their new movies. Watch their values rise or fall based on their success. Prices soar with a blockbuster opening at the box office and plummet with a bomb no one went to see.

• Insider Trading: It's absolutely legal on the Hollywood Stock Exchange. In fact, it's encouraged!

Examples : 2000 Popular Vote

The Iowa Electronic Market Predictions

Name Description

FRup1003     $1.00 if the fed-funds rate target set at the FOMC meeting scheduled for October 28, 2003 is higher than it was the day after the September 2003 FOMC meeting; $0 otherwise

FRsame1003    

$1.00 if the fed-funds rate target set at the FOMC meeting scheduled for October 28, 2003 is the same as it was the day after the September 2003 FOMC meeting; $0 otherwise

FRdown1003    

$1.00 if the fed-funds rate target set at the FOMC meeting scheduled for October 28, 2003 is lower than it was the day after the September 2003 FOMC meeting; $0 otherwise

FRup1203     $1.00 if the fed-funds rate target set at the FOMC meeting scheduled for December 9, 2003 is higher than it was the day after the October 2003 FOMC meeting; $0 otherwise

FRsame1203    

$1.00 if the fed-funds rate target set at the FOMC meeting scheduled for December 9, 2003 is the same as it was the day after the October 2003 FOMC meeting; $0 otherwise

FRdown1203    

$1.00 if the fed-funds rate target set at the FOMC meeting scheduled for December 9, 2003 is lower than it was the day after the October 2003 FOMC meeting; $0 otherwise

The fundamental problem within firmsKnowledge and Incentives

• Profit maximization may face information limitations – controlled by many individuals– may be costly to transfer

• Individuals may have incompatible incentives

• Organizational architecture must overcome these limitations

Discussion: The Navy• How did the Navy traditionally assign

human capital to tasks?• Today, why does the Navy care about

whether sailors like their location?• What changes did the Navy make?• Should this program be terminated or

expanded into other services?• Are there lessons for your business?

• How are prices and information related?

Basic Tenets of Economic Approach to Organizations

• Self interest– Of employees, managers, even CEOs– Present to some extent

• Architecture influences behavior– Behavior shaped by incentives

• Implications for increasing value– Balance the 3-legged stool– Decision makers need specific knowledge to make

appropriate decisions and the incentives to use the information productively

Components of architecture“three legs of the stool”

• Decision-right assignment– empowering employees– who makes what decisions in

organization• What knowledge/information does

the decision maker have access to?

• Reward system– compensating employees

• Pecuniary; non-pecuniary– sets incentives

• Performance-evaluation system– evaluating employees– accountability

Corporate culture• Culture is the set of explicit and implicit expectations of

behavior within the firm• Culture includes formal organizational architecture• Communicating culture

– slogans, rituals, role models

Lincoln Electric• Identify the objective and subjective components of

the evaluation system.• How did the subjective components of the evaluation

system add to the integrity of Lincoln's rewards/evaluation scheme? (Hint: discuss problems that may have occurred if the subjective components had not been included)

• What value-enhancing decisions and behaviors were motivated by Lincolns rewards/evaluation scheme?

• Did these decisions and behaviors support Lincoln's competitive strategy in its US business environment?

Lincoln Electric

• What sort of risk bearing was inherent in the compensation of workers?

• What evidence can you provide of a compensating differential, that is greater employee pay because of employee risk-bearing?

• What advice would you give to Lincoln when it considers expanding into overseas markets with different historical labor practices and regulations?

Looking Forward

• Assignment #1 Due Sept. 30, Oct. 4 and 5– Due at start of class!– Only two weeks left

• Read Managerial Economics Chapter 4– Try to finish Moneyball– Handout on Demand Estimation with Excel is

be posted on Blackboard• Very detailed, great for students with forecasting

interests• Perhaps more challenging for some