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Markets, Organizations, and the Role of Knowledge Why do markets out perform command and control eco


Place leisure hours on x-axis (0 to 24 hours per day) Place all other goods on y-axis ... is the relative price of leisure time in terms of other (consumption) goods ... – PowerPoint PPT presentation

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Title: Markets, Organizations, and the Role of Knowledge Why do markets out perform command and control eco

Markets, Organizations, and the Role of
KnowledgeWhy 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
  • 600pm-900pm

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
  • 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)

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
  • 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 cant have a comparative advantage at
  • 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
  • Scientific knowledge
  • Assembled knowledge
  • Free markets make superior use of specific
    knowledge dispersed among many participants

Costs of transferring knowledge
Discussion The Oakland As
  • What is the role of information in the selection
    and compensation of baseball players?
  • What is the As advantage in drafting and trading
  • Should Beane have revealed his stuff to a
  • Additional Lessons thus far from Moneyball??

The nature and function of prices
  • Coordination
  • Incentives
  • Rationing
  • Signaling
  • I, Pencil by L. Read
  • http//
  • I am a lead pencilthe 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
    mysterymore 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 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

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
    managements interests with owners interest.

Discussion 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

Examples 2000 Popular Vote
The Iowa Electronic Market Predictions
(No Transcript)
(No Transcript)
The fundamental problem within firmsKnowledge
and Incentives
  • Profit maximization may face information
  • controlled by many individuals
  • may be costly to transfer
  • Individuals may have incompatible incentives
  • Organizational architecture must overcome these

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 architecturethree legs of the
  • 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
  • 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

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

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