But, can both sides gain by a buyout deal? That may not always be so easy to do. The owners would have to be willing to pay workers more than they, the workers, are willing to accept. There are several reasons such a deal may be possible in many, but not necessarily all, cases. First, the workers could have a higher discount rate than the owners, and this may often be the case because the owners are more diversified than their workers in their investments. Workers tend to concentrate their capital, a main component of which is human capital, in their jobs. By agreeing to a buyout and receiving some form of lump-sum payment in cash (or even in a stream of future cash payments), the workers can diversify their portfolios by scattering the cash among a variety of real and financial assets. Hence, workers might accept less than the current (discounted) value of their overpayments just to gain the greater security of a more diversified investment portfolio. Naturally (and we use that word advisedly), the workers cannot be sure how long they will be around to collect the overpayments. By taking the payments in lump-sum form, they reduce the risk of collection and increase the security of their heirs.
Second, sometimes retirement systems are overfunded, that is, they have greater expected income streams from their investments than are needed for meeting the expected future outflow of retirement payments. This is true, for example, of the California State Employee Retirement System. Therefore, if the company can tap the retirement funds, as the State of California did in the mid-1990s, it can pay workers more in the buyout than they would receive in overpayments by continuing to work. In so doing, they can move those salaries “off budget,” which is what California has done in order to match its budgeted expenditures with declining funding levels for higher education.
We should also expect that workers’ fears will vary across firms and will be related to a host of factors, not the least of which will be the size of the firm. Workers who work for large firms may not be as fearful as workers for small firms, mainly because large firms are more likely to be sued for any retaliatory use of their discretionary employment practices (and efforts to adjust the work of older workers in response to any law that abolishes mandatory retirement rules). Large firms simply have more to take as a penalty for what are judged to be illegal acts. Moreover, it appears that juries are far more likely to impose much larger penalties on large firms, with lots of equity, than their smaller counterparts. This unequal treatment before the courts, however, suggests that laws that abolish mandatory retirement rules will give small firms a competitive advantage over their larger market rivals.
However, we hasten to stress that all we have done is to discuss the transitory adjustments firms will make with their older workers, who are near the previous retirement age. We should expect other adjustments for younger workers, not the least of which will be a change in their wage structures. Not being able to overpay their older workers in their later years will probably mean that the owners will have to raise the pay of their younger workers. After all, the only reason the younger workers would accept underpayment for years is the prospect of overpayments later on.
There are three general observations from this line of inquiry that are interesting:
1 The abolition of mandatory retirement will tend to help those who are about to retire.
2 Abolition might help some older workers who are years from retirement, who work for large firms, and who can hang on to their overpayments. It can hurt other older workers who are fired, demoted, not given raises, or have their pay actually cut
The market is a system that provides producers with incentives to deliver goods and services to others. To respond to those incentives, producers must meet the needs of society. They must compete with other producers to deliver their goods and services in the most cost-effective manner.
A market implies that sellers and buyers can freely respond to incentives and that they have options and can choose among them. It does not mean, however, that behavior is totally unconstrained or that producers can choose from unlimited options. What a competitor can do may be severely limited by what rival firms are willing to do.
The market system is not perfect. Producers may have difficulty acquiring enough information to make reliable production decisions. People take time to respond to incentives,
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Wednesday, April 22, 2009
Product Markets
n the heart of New York City, Fred Lieberman’s small grocery is dwarfed by the tall
buildings that surround it. Yet it is remarkable for what it accomplishes. Lieberman’s
carries thousands of items, most of which are not produced locally, and some of which come thousands of miles from other parts of this country or abroad. A man of modest means, with little knowledge of production processes, Fred Lieberman has nevertheless been able to stock his store with many if not most of the foods and toiletries his customers need and want. Occasionally Lieberman’s runs out of certain items, but most of the time the stock is ample. Its supply is so dependable that customers tend to take it for granted, forgetting that Lieberman’s is one small strand in an extremely complex economic network.
How does Fred Lieberman get the goods he sells, and how does he know which ones to sell and at what price? The simplest answer is that the goods he offers and the prices at which they sell are determined through the market process- the interaction of many buyers and sellers trading what they have (their labor or other resources) for what they want. Lieberman stocks his store by appealing to the private interests of suppliers -- by paying them competitive prices. His customers pay him extra for the convenience of purchasing goods in their neighborhood grocery -- in the process appealing to his private interests. To determine what he should buy, Fred Lieberman considers his suppliers prices. To determine what and how much they should buy, his customers consider the prices he charges. The Nobel Prize-winning economist Friedrich Hayek has suggested that the market process is manageable for people like Fred Lieberman precisely because prices condense into usable form a great deal of information, signaling quickly what people want, what goods cost, and what resources are readily available. Prices guide and coordinate the sellers’ production decisions and consumers’ purchases.
How are prices determined? That is an important question for people in business simply because an understanding of how prices are determined can help business people understand
the forces that will cause prices to change in the future and, therefore, the forces that affect their businesses’ bottom lines. There’s money to be made in being able to understand the dynamics of prices. Our most general answer in this chapter to the question is deceptively simple: In competitive markets, the forces of supply and demand establish prices. However, there is much to be learned through the concepts of supply and demand. Indeed, we suspect that most MBA students will find supply and demand the most useful concepts developed in this book. However, to understand supply and demand, you must first understand the market process that is inherently competitive.
The Competitive Market Process
So far, our discussion of markets and their consequences has been rather casual. In this section we will define precisely such terms as market and competition. In later sections we will examine the way markets work and learn why, in a limited sense, markets can be considered efficient systems for determining what and how much to produce.
The Market Setting
Most people tend to think of a market as a geographical location -- a shopping center, an auction bar, a business district. From an economic perspective, however, it is more useful to think of a market as a process. You may recall from Chapter 1 that a market is defined as the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods to be bought and sold.
In this process, individual market participants search for information relevant to their own interests. Buyers ask about the models, sizes, colors, and quantities available and the prices they must pay for them. Sellers inquire about the types of goods and services buyers want and the prices they are willing to pay.
This market process is self-correcting. Buyers and sellers routinely revise their plans on the basis of experience. As Israel Kirzner has written,
The overly ambitious plans of one period will be replaced by more realistic ones; market opportunities overlooked in one period will be exploited in the next. In other words, even without changes in the basic data of the market, the decision made in one period onetime generates systematic alterations in corresponding decisions for the succeeding period.1
The market is made up of people, consumers and entrepreneurs, attempting to buy and sell on the best terms possible. Through the groping process of give and take, they move from relative ignorance about others’ wants and needs to a reasonably accurate understanding of 1 Israel Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), p. 10.
how much can be bought and sold and at what price. The market functions as an ongoing information and exchange system.
Competition Among Buyers and Among Sellers
Part and parcel of the market process is the concept of competition. Competition is the process by which market participants, in pursuing their own interests, attempt to outdo, outprice, outproduce, and outmaneuver each other. By extension, competition is also the process by which market participants attempt to avoid being outdone, outpriced, outproduced, or outmaneuvered by others.
Competition does not occur between buyer and seller, but among buyers or among sellers. Buyers compete with other buyers for the limited number of goods on the market. To compete, they must discover what other buyers are bidding and offer the seller better terms -- a higher price or the same price for a lower-quality product. Sellers compete with other sellers for the consumer’s dollar. They must learn what their rivals are doing and attempt to do it better or differently -- to lower the price or enhance the product’s appeal.
This kind of competition stimulates the exchange of information, forcing competitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before the bidding begins, buyer look over the merchandise and the other buyers, attempting to determine how high others might be willing to bid for a particular piece. During the auction, this specific information is revealed as buyers call out their bids and others try to top them. Information exchange is less apparent in department stores, where competition is often restricted. Even there, however, comparison-shopping will often reveal some sellers who are offering lower prices in an attempt to attract consumers.
In competing with each other, sellers reveal information that is ultimately of use to buyers. Buyers likewise inform sellers. From the consumer’s point of view,
The function of competition is here precisely to teach us who will serve us well: which grocer or travel agent, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face.2
From the seller’s point of view -- say, the auctioneer’s -- competition among buyers brings the highest prices possible.
Competition among sellers takes many forms, including the price, quality, weight, volume, color, texture, poor durability, and smell of products, as well as the credit terms offered to buyers. Sellers also compete for consumers’ attention by appealing to their hunger and sex drives or their fear of death, pain, and loud noises. All these forms of competition can be divided into two basic categories -- price and nonprice competition. Price competition is of particular interest to economists, who see it as an important source of information for market University of Chicago Press, 1948), p. 97.
participants and a coordinating force that brings the quantity produced into line with the quantity consumers are willing and able to buy. In the following sections, we will construct a model of the competitive market and use it to explore the process of price competition. Nonprice competition will be covered in a later section.
Supply and Demand: A Market Model
A fully competitive market is made up of many buyers and sellers searching for opportunities or ready to enter the market when opportunities arise. To be described as competitive, therefore, a market must include a significant number of actual or potential competitors. A fully competitive market offers freedom of entry: there are no legal or economic barriers to producing and selling goods in the market.
Our market model assumes perfect competition-an ideal situation that is seldom, if ever, achieved in real life but that will simplify our calculations. Perfect competition is a market composed of numerous independent sellers and buyers of an identical product, such that no one individual seller or buyer has the ability to affect the market price by changing the production level. Entry into and exit from a perfectly competitive market is unrestricted. Producers can start up or shut down production at will. Anyone can enter the market, duplicate the good, and compete for consumers’ dollars. Since each competitor produces only a small share of the total output, the individual competitor cannot significantly influence the degree of competition or the market price by entering or leaving the market.
This kind of market is well suited to graphic analysis. Our discussion will concentrate on how buyers and sellers interact to determine the price of tomatoes, a product Mr. Lieberman almost always carries. It will employ two curves. The first represents buyers’ behavior, which is called their demand for the product.
The Elements of Demand
To the general public, demand is simply what people want, but to economists, demand has much more technical meaning. Demand is the assumed inverse relationship between the price of a good or service and the quantity consumers are willing and able to buy during a given period, all other things held constant.
Demand as a Relationship
The relationship between price and quantity is normally assumed to be inverse. That is, when the price of a good rises, the quantity sold, ceteris paribus (Latin for “everything else held constant”), will go down. Conversely, when the price of a good falls, the quantity sold goes up. Demand is not a quantity but a relationship. A given quantity sold at a particular price is properly called quantity demanded.price is properly called quantity demanded.
Both tables and graphs can be used to describe the assumed inverse relationship between price and quantity.
Demand as a Table or a Graph
Demand may be thought of as a schedule of the various quantities of a particular good consumers will buy at various prices. As the price goes down, the quantity purchased goes up and vice versa. Table 2.1 contains a hypothetical schedule of the demand for tomatoes in the New York area during a typical week. The middle column shows prices that might be charged. The column on the right shows the number of bushels consumers will buy at those prices. Note that as the price rises from zero to $11 a bushel, the number of bushels purchased drops from 110,000 to zero.
Demand may also be thought of as a curve. If price is scaled on a graph’s vertical axis and quantity on the horizontal axis, the demand curve has a negative slope (downward and to the right), reflecting the assumed inverse relationship between price and quantity. The shape of the market demand curve is shown in Figure 2.1, which is based on the data from Table 2.1. Points a through l on the graph correspond to the price-quantity combinations A through L in the table. Note that as the price falls from P2 ($8) to P1 ($5), consumers move down their demand curve from a quantity of Q1 (30) to the larger quantity Q2 (60).3
The Slope and Determinants of Demand
Price and quantity are assumed to be inversely related for two reasons. First, as the price of a good decreases (and the prices of all other goods stay the same -- remember ceteris paribus), the purchasing power of consumer incomes rises. More consumers are able to buy the good, and many will buy more of most goods. (This response is called the income effect.)
In addition, as the price of a good decreases (and the prices of all other goods remain the same), the good becomes relatively cheaper, and consumers will substitute that good for others. (This response is called the substitution effect.) Supply may be described as a schedule of the quantity producers will offer at various prices during a given period of time. Table 2.2 shows such a supply schedule. As the price of tomatoes goes up from zero to $11 a bushel, the quantity offered rises from zero of 110,000, reflecting the assumed positive relationship between price and quantity.
Supply may also be thought of as a curve. If the quantity producers will offer is scaled on the horizontal axis of a graph and the price of the good is scaled on the vertical axis, the supply curve will slope upward to the right, reflecting the assumed positive relationship between price and quantity. In Figure 2.3, which was plotted from the data in Table 2.2, points a through l represent the price-quantity combinations A through L. Note how a change in the price causes a movement along the supply curve.4
The Slope and Determinants of Supply
The quantity producers will offer on the market depends on their production costs. Obviously the total cost of production will rise when more is produced because more resources will be required to expand output. The additional or marginal cost of each additional bushel produced also tends to rise as total output expands. In other words, it costs more to produce the second bushel of tomatoes than the first, and more to produce the third than the second. Firms will not expand their output unless they can cover their higher unit costs with a higher price. This is the reason the supply curve is thought to slope upward.
Anything that affects production costs will influence supply and the position of the supply curve. Such factors, which are called determinants of supply, include:
Change in productivity due to a change in technology
Market Equilibrium
Supply and demand represent the two sides of the market—sellers and buyers. By plotting the supply and demand curves together, as in Figure 2.5 we can predict how buyers and sellers will be inconsistent, and a market surplus or shortage of tomatoes will result.
Market Surpluses
Suppose that the price of a bushel of tomatoes is $9, or P2 in Figure 2.5. At this price the quantity demanded by consumers is 20,000 bushels, much less than the quantity offered
Our discussion has assumed free entry into the market. If entry is restricted by monopoly of a strategic resource or by government regulation, the variety of products offered will not be as great as in an open, competitive market. If there are only two or three competitors in a market, everything else being equal, we would expect them to cluster in the middle of a bell-shaped distribution. That tendency has been seen in the past in the broadcasting industry, when the number of television stations permitted in a given geographical area was strictly regulated by the Federal Communications Commission. Not surprisingly, stations carried programs that appealed predominantly to a mass audience—that is, to the middle of the distribution of television watchers. The Public Broadcasting System, PBS, was organized by the government partly to provide programs with less than mass appeal to satisfy viewers on the outer sections of the curve. When cable television emerged and programs became more varied, the prior justification for PBS subsidies became more debatable.
Even with free market entry, product variety depends on the cost of production and the prices people will pay for variations. Magazine and newsstand operators would behave very much like past television managers if they could carry only two or three magazines. They would choose Newsweek or some other magazine that appeals to the largest number of people. Most motel operators, for instance, have room for only a very small newsstand, and so they tend to carry the mass-circulation weeklies and monthlies.
For their own reasons, consumers may also prefer such a compromise. Although they may desire a product that perfectly reflects their tastes, they may buy a product that is not perfectly suitable if they can get it at a lower price. Producers can offer such a product at a lower price because of the economies of scale gained from selling to a large market. For example, most students take pre-designed classes in large lecture halls instead of private tutorials. They do so largely because the mass lecture, although perhaps less effective, is substantially cheaper than tutorials. In a market that is open to entry, producers will take advantage of such opportunities.
If producers in one part of a distribution attempt to charge a higher price than necessary, other producers can move into that segment of the market and push the price down; or consumers can switch to other products. In this way, an optimal variety of products will eventually emerge in a free, reasonably competitive market. Thus the argument for a free market is an argument for the optimal product mix. Without freedom of entry, we cannot tell whether it is possible to improve on the existing combination of products. A free, competitive market gives rival firms a chance to better that combination. The case for the free market becomes even stronger when we recognize that market conditions—and therefore the optimal product mix—are constantly changing.
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buildings that surround it. Yet it is remarkable for what it accomplishes. Lieberman’s
carries thousands of items, most of which are not produced locally, and some of which come thousands of miles from other parts of this country or abroad. A man of modest means, with little knowledge of production processes, Fred Lieberman has nevertheless been able to stock his store with many if not most of the foods and toiletries his customers need and want. Occasionally Lieberman’s runs out of certain items, but most of the time the stock is ample. Its supply is so dependable that customers tend to take it for granted, forgetting that Lieberman’s is one small strand in an extremely complex economic network.
How does Fred Lieberman get the goods he sells, and how does he know which ones to sell and at what price? The simplest answer is that the goods he offers and the prices at which they sell are determined through the market process- the interaction of many buyers and sellers trading what they have (their labor or other resources) for what they want. Lieberman stocks his store by appealing to the private interests of suppliers -- by paying them competitive prices. His customers pay him extra for the convenience of purchasing goods in their neighborhood grocery -- in the process appealing to his private interests. To determine what he should buy, Fred Lieberman considers his suppliers prices. To determine what and how much they should buy, his customers consider the prices he charges. The Nobel Prize-winning economist Friedrich Hayek has suggested that the market process is manageable for people like Fred Lieberman precisely because prices condense into usable form a great deal of information, signaling quickly what people want, what goods cost, and what resources are readily available. Prices guide and coordinate the sellers’ production decisions and consumers’ purchases.
How are prices determined? That is an important question for people in business simply because an understanding of how prices are determined can help business people understand
the forces that will cause prices to change in the future and, therefore, the forces that affect their businesses’ bottom lines. There’s money to be made in being able to understand the dynamics of prices. Our most general answer in this chapter to the question is deceptively simple: In competitive markets, the forces of supply and demand establish prices. However, there is much to be learned through the concepts of supply and demand. Indeed, we suspect that most MBA students will find supply and demand the most useful concepts developed in this book. However, to understand supply and demand, you must first understand the market process that is inherently competitive.
The Competitive Market Process
So far, our discussion of markets and their consequences has been rather casual. In this section we will define precisely such terms as market and competition. In later sections we will examine the way markets work and learn why, in a limited sense, markets can be considered efficient systems for determining what and how much to produce.
The Market Setting
Most people tend to think of a market as a geographical location -- a shopping center, an auction bar, a business district. From an economic perspective, however, it is more useful to think of a market as a process. You may recall from Chapter 1 that a market is defined as the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods to be bought and sold.
In this process, individual market participants search for information relevant to their own interests. Buyers ask about the models, sizes, colors, and quantities available and the prices they must pay for them. Sellers inquire about the types of goods and services buyers want and the prices they are willing to pay.
This market process is self-correcting. Buyers and sellers routinely revise their plans on the basis of experience. As Israel Kirzner has written,
The overly ambitious plans of one period will be replaced by more realistic ones; market opportunities overlooked in one period will be exploited in the next. In other words, even without changes in the basic data of the market, the decision made in one period onetime generates systematic alterations in corresponding decisions for the succeeding period.1
The market is made up of people, consumers and entrepreneurs, attempting to buy and sell on the best terms possible. Through the groping process of give and take, they move from relative ignorance about others’ wants and needs to a reasonably accurate understanding of 1 Israel Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), p. 10.
how much can be bought and sold and at what price. The market functions as an ongoing information and exchange system.
Competition Among Buyers and Among Sellers
Part and parcel of the market process is the concept of competition. Competition is the process by which market participants, in pursuing their own interests, attempt to outdo, outprice, outproduce, and outmaneuver each other. By extension, competition is also the process by which market participants attempt to avoid being outdone, outpriced, outproduced, or outmaneuvered by others.
Competition does not occur between buyer and seller, but among buyers or among sellers. Buyers compete with other buyers for the limited number of goods on the market. To compete, they must discover what other buyers are bidding and offer the seller better terms -- a higher price or the same price for a lower-quality product. Sellers compete with other sellers for the consumer’s dollar. They must learn what their rivals are doing and attempt to do it better or differently -- to lower the price or enhance the product’s appeal.
This kind of competition stimulates the exchange of information, forcing competitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before the bidding begins, buyer look over the merchandise and the other buyers, attempting to determine how high others might be willing to bid for a particular piece. During the auction, this specific information is revealed as buyers call out their bids and others try to top them. Information exchange is less apparent in department stores, where competition is often restricted. Even there, however, comparison-shopping will often reveal some sellers who are offering lower prices in an attempt to attract consumers.
In competing with each other, sellers reveal information that is ultimately of use to buyers. Buyers likewise inform sellers. From the consumer’s point of view,
The function of competition is here precisely to teach us who will serve us well: which grocer or travel agent, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face.2
From the seller’s point of view -- say, the auctioneer’s -- competition among buyers brings the highest prices possible.
Competition among sellers takes many forms, including the price, quality, weight, volume, color, texture, poor durability, and smell of products, as well as the credit terms offered to buyers. Sellers also compete for consumers’ attention by appealing to their hunger and sex drives or their fear of death, pain, and loud noises. All these forms of competition can be divided into two basic categories -- price and nonprice competition. Price competition is of particular interest to economists, who see it as an important source of information for market University of Chicago Press, 1948), p. 97.
participants and a coordinating force that brings the quantity produced into line with the quantity consumers are willing and able to buy. In the following sections, we will construct a model of the competitive market and use it to explore the process of price competition. Nonprice competition will be covered in a later section.
Supply and Demand: A Market Model
A fully competitive market is made up of many buyers and sellers searching for opportunities or ready to enter the market when opportunities arise. To be described as competitive, therefore, a market must include a significant number of actual or potential competitors. A fully competitive market offers freedom of entry: there are no legal or economic barriers to producing and selling goods in the market.
Our market model assumes perfect competition-an ideal situation that is seldom, if ever, achieved in real life but that will simplify our calculations. Perfect competition is a market composed of numerous independent sellers and buyers of an identical product, such that no one individual seller or buyer has the ability to affect the market price by changing the production level. Entry into and exit from a perfectly competitive market is unrestricted. Producers can start up or shut down production at will. Anyone can enter the market, duplicate the good, and compete for consumers’ dollars. Since each competitor produces only a small share of the total output, the individual competitor cannot significantly influence the degree of competition or the market price by entering or leaving the market.
This kind of market is well suited to graphic analysis. Our discussion will concentrate on how buyers and sellers interact to determine the price of tomatoes, a product Mr. Lieberman almost always carries. It will employ two curves. The first represents buyers’ behavior, which is called their demand for the product.
The Elements of Demand
To the general public, demand is simply what people want, but to economists, demand has much more technical meaning. Demand is the assumed inverse relationship between the price of a good or service and the quantity consumers are willing and able to buy during a given period, all other things held constant.
Demand as a Relationship
The relationship between price and quantity is normally assumed to be inverse. That is, when the price of a good rises, the quantity sold, ceteris paribus (Latin for “everything else held constant”), will go down. Conversely, when the price of a good falls, the quantity sold goes up. Demand is not a quantity but a relationship. A given quantity sold at a particular price is properly called quantity demanded.price is properly called quantity demanded.
Both tables and graphs can be used to describe the assumed inverse relationship between price and quantity.
Demand as a Table or a Graph
Demand may be thought of as a schedule of the various quantities of a particular good consumers will buy at various prices. As the price goes down, the quantity purchased goes up and vice versa. Table 2.1 contains a hypothetical schedule of the demand for tomatoes in the New York area during a typical week. The middle column shows prices that might be charged. The column on the right shows the number of bushels consumers will buy at those prices. Note that as the price rises from zero to $11 a bushel, the number of bushels purchased drops from 110,000 to zero.
Demand may also be thought of as a curve. If price is scaled on a graph’s vertical axis and quantity on the horizontal axis, the demand curve has a negative slope (downward and to the right), reflecting the assumed inverse relationship between price and quantity. The shape of the market demand curve is shown in Figure 2.1, which is based on the data from Table 2.1. Points a through l on the graph correspond to the price-quantity combinations A through L in the table. Note that as the price falls from P2 ($8) to P1 ($5), consumers move down their demand curve from a quantity of Q1 (30) to the larger quantity Q2 (60).3
The Slope and Determinants of Demand
Price and quantity are assumed to be inversely related for two reasons. First, as the price of a good decreases (and the prices of all other goods stay the same -- remember ceteris paribus), the purchasing power of consumer incomes rises. More consumers are able to buy the good, and many will buy more of most goods. (This response is called the income effect.)
In addition, as the price of a good decreases (and the prices of all other goods remain the same), the good becomes relatively cheaper, and consumers will substitute that good for others. (This response is called the substitution effect.) Supply may be described as a schedule of the quantity producers will offer at various prices during a given period of time. Table 2.2 shows such a supply schedule. As the price of tomatoes goes up from zero to $11 a bushel, the quantity offered rises from zero of 110,000, reflecting the assumed positive relationship between price and quantity.
Supply may also be thought of as a curve. If the quantity producers will offer is scaled on the horizontal axis of a graph and the price of the good is scaled on the vertical axis, the supply curve will slope upward to the right, reflecting the assumed positive relationship between price and quantity. In Figure 2.3, which was plotted from the data in Table 2.2, points a through l represent the price-quantity combinations A through L. Note how a change in the price causes a movement along the supply curve.4
The Slope and Determinants of Supply
The quantity producers will offer on the market depends on their production costs. Obviously the total cost of production will rise when more is produced because more resources will be required to expand output. The additional or marginal cost of each additional bushel produced also tends to rise as total output expands. In other words, it costs more to produce the second bushel of tomatoes than the first, and more to produce the third than the second. Firms will not expand their output unless they can cover their higher unit costs with a higher price. This is the reason the supply curve is thought to slope upward.
Anything that affects production costs will influence supply and the position of the supply curve. Such factors, which are called determinants of supply, include:
Change in productivity due to a change in technology
Market Equilibrium
Supply and demand represent the two sides of the market—sellers and buyers. By plotting the supply and demand curves together, as in Figure 2.5 we can predict how buyers and sellers will be inconsistent, and a market surplus or shortage of tomatoes will result.
Market Surpluses
Suppose that the price of a bushel of tomatoes is $9, or P2 in Figure 2.5. At this price the quantity demanded by consumers is 20,000 bushels, much less than the quantity offered
Our discussion has assumed free entry into the market. If entry is restricted by monopoly of a strategic resource or by government regulation, the variety of products offered will not be as great as in an open, competitive market. If there are only two or three competitors in a market, everything else being equal, we would expect them to cluster in the middle of a bell-shaped distribution. That tendency has been seen in the past in the broadcasting industry, when the number of television stations permitted in a given geographical area was strictly regulated by the Federal Communications Commission. Not surprisingly, stations carried programs that appealed predominantly to a mass audience—that is, to the middle of the distribution of television watchers. The Public Broadcasting System, PBS, was organized by the government partly to provide programs with less than mass appeal to satisfy viewers on the outer sections of the curve. When cable television emerged and programs became more varied, the prior justification for PBS subsidies became more debatable.
Even with free market entry, product variety depends on the cost of production and the prices people will pay for variations. Magazine and newsstand operators would behave very much like past television managers if they could carry only two or three magazines. They would choose Newsweek or some other magazine that appeals to the largest number of people. Most motel operators, for instance, have room for only a very small newsstand, and so they tend to carry the mass-circulation weeklies and monthlies.
For their own reasons, consumers may also prefer such a compromise. Although they may desire a product that perfectly reflects their tastes, they may buy a product that is not perfectly suitable if they can get it at a lower price. Producers can offer such a product at a lower price because of the economies of scale gained from selling to a large market. For example, most students take pre-designed classes in large lecture halls instead of private tutorials. They do so largely because the mass lecture, although perhaps less effective, is substantially cheaper than tutorials. In a market that is open to entry, producers will take advantage of such opportunities.
If producers in one part of a distribution attempt to charge a higher price than necessary, other producers can move into that segment of the market and push the price down; or consumers can switch to other products. In this way, an optimal variety of products will eventually emerge in a free, reasonably competitive market. Thus the argument for a free market is an argument for the optimal product mix. Without freedom of entry, we cannot tell whether it is possible to improve on the existing combination of products. A free, competitive market gives rival firms a chance to better that combination. The case for the free market becomes even stronger when we recognize that market conditions—and therefore the optimal product mix—are constantly changing.
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Tuesday, April 14, 2009
Economics
The discipline of economics is divided into two main parts—microeconomics and macroeconomics. As the term micro (as in microscope) suggests, microeconomics is the study of the individual markets—for corn, records, books, and so forth—that operate within the broad national economy. When economists measure, explain, and predict the demand for specific products such as bicycles and hand calculators, they are dealing with
microeconomics. Much of the work of economists is concerned with microeconomic analysis—that is, with the interpretation of events in the marketplace and of personal choices among products. This book, which has been designed with MBA students in mind, will deal almost exclusively with microeconomic theory, policy implications, and applications inside firms.
Questions of interest to microeconomists include:
What determines the price of particular goods and services?
What determines the output of particular firms and industries?
What determines the wages workers receive? The interest rates lenders receive? The profits businesses receive?
How do government policies—such as minimum wage laws, price controls, tariffs, and excise taxes—affect the price and output levels of individual markets?
Why do incentives matter inside firms and how can economic theory be used to properly structure a firm’s incentives to increase worker productivity and firm profitability?
Economists are also interested in measuring, explaining, and predicting the performance of the economic system itself. To do so, they study broad subdivisions of the economy, such as the total output of all firms that produce goods and services. Macroeconomics is the study of the national economy as a whole or of its major components. It deals with the “big picture,” not the details, of the nation’s economic activity.
Instead of concentrating on how many bicycles or hand calculators are sold, macroeconomists watch how many good and services consumers purchase in total or how much money all producers spend on new plants and equipment. Instead of tracking the price of a particular good in a particular market, macroeconomics monitors the general price level or average of all pric es. Instead of focusing on the wage rate and the number of people employed as plumbers or engineers, macroeconomists study incomes of all employees and the total number of people employed throughout the economy. In short, macroeconomics involves the study of national production, unemployment, and inflation. For that reason it is often referred to as aggregate economics.
Typical macroeconomic questions include:
What determines the general price level? The rate of inflation? What determines national income and production levels? What determines national employment and unemployment levels? What effects do government monetary and budgetary policies have on the general
price, income, production, employment, and unemployment levels?
These and similar questions are of more than academic interest. The theories that have been developed to answer them can be applied to problems and issues of the real world. They clearly have application to business, given that firm sales are often affected by “macro variables” such as national income and the inflation rate. Throughout this
book, as well as in specific chapters on topics such as regulation and deregulation, and price controls and consumer protection, we will examine the practical applications of economic theory.
However, we hasten to add that this book and course are devoted primarily to “microeconomic” theory and applications. We make microeconomics our focus because the issues at stake are more relevant to the interests of MBA students and because the microeconomic theory is generally viewed as being sounder than macroeconomic theory. Besides, we are firmly convinced that an understanding of the “macroeconomy” is necessarily dependent on an understanding of the “microeconomy.”
In microeconomics we start with the proposition that all actions are constrained by the fact of scarcity. That is to say, in some basic way, scarcity—and the economic question of how to deal with it—touches all of us in how we do business and conduct our lives. We now turn to a study of property rights. Private “property rights” are one of the institutional mechanisms people have devised to help alleviate the pressing constraints of scarcity, which is why we take them up at this early stage in the course.
The Meaning and Importance of Property Rights
Property rights pertain to the permissible use of resources, goods, and services; they define the limits of social behavior and, in that way, determine what can be done by individuals in society. They also specify whether resources, goods, and services are to be used privately or collectively by the state or any smaller group.
Property rights are a social phenomenon; they arise out of the necessity for individuals to “get along” within a social space in which all wish to move and interact. Where individuals are isolated from one another by natural barriers or are located where goods and resources are abundant, property rights have no meaning. In the world of Robinson Crusoe, shipwrecked alone on an island, property rights were inconsequential. His behavior was restricted by the resources found on the island, the tools he was able to take from the ship, and his own ingenuity. He had a problem of efficiently allocating his time within these constraints—procuring food, building shelter, and plotting his escape; however, the notion of “property” did not restrict his behavior—it was not a barrier to what he could do. He was able to take from the shipwreck, with immunity, stores that he thought would be most useful to his purposes.5
After the arrival of Friday, the native whom Robinson Crusoe saved from cannibals, a problem of restricting and ordering interpersonal behavior immediately emerged. The problem was particularly acute for Crusoe because Friday, prior to coming to Tibago, was himself a cannibal. (Each had to clearly establish property rights to his body.) The system that they worked out was a simple one, not markedly different from
5 The absence of human beings affected also his idea of what was useful. Crusoe, in going through the ship, came across a coffer of gold and silver coins: “Thou art not worth to me, no, not taking off the ground; one of these knives is worth all this heap [of gold].” At first, he evaluated the cost of taking the coins in terms of what he could take in their place and decided to leave them. But on second thought, perhaps taking into consideration the probability of being rescued, he took the coins with him! See Robinson Crusoe by Daniel Defoe.
that between Crusoe and “Dog.” Crusoe essentially owned everything. Their relationship was that of master and servant, Crusoe dictating to Friday how the property was to be used.
The notion of property rights is broadly conceived by economists. Property rights are most often applied to discussions of real estate and personal property (bicycles, clothes, etc.); they are also applicable to what people can do with their minds, their ability to speak, how they wear their hair, and if and when they must wear their shoes.
In common speech, we frequently speak of someone owning this land, that house, or these bonds. This conventional style undoubtedly is economical from the viewpoint of quick communications, but it masks the variety and complexity of the ownership relationship. What is owned are rights to use resources, including one’s body and mind, and these rights are always circumscribed, often by prohibition of certain actions. To “own land” usually means to have the right to till (or not to till) the soil, to mine the soil, to offer those rights for sale, etc., but not to have the right to throw soil at a passerby, to use it to change the course of a stream, or to force someone to buy it. What are owned are socially recognized rights of action. 6
Property rights are not necessarily distributed equally, meaning that people do not always have the same rights to use the same resources. Students may have the right to use their voices (i.e., a resource) to speak with friends in casual conversation in the hallways of classroom buildings, but they do not, generally speaking, have the right to disrupt an English class with a harangue on their political views. However, the English professor, although his behavior is circumscribed, has the right to “allow” his or her political views to filter into the English lectures. And if the President of the United States walked into the same English class and began speaking extemporaneously on his (or her) political views, it is not likely that anyone would object. A person has the right to go without shoes on a beach, but one does not always have the right to enter a restaurant without shoes. On the other hand, the restaurant owner’s best friend may have that right. By the same token, although undergraduate students generally pay a fraction of their educational expenses at state universities, they have the right to university facilities such as tennis courts and the university bookstore, but nonstudent taxpayers do not have the same rights to these facilities.
In other words, property rights can be recast in terms of the behavioral rules, which effectively limit and restrict our behavior. Behavioral rules determine what rights we have with regard to the use of resources, goods, and services. The rights we have may be the product of the legislative process and may be enforced by a third party: usually the third party is the government or, more properly, the agents of government. In this case property rights emerge from laws.
On the other hand, rules that establish rights may not have third-party enforcement. In this case they carry weight in the decisions of individuals simply because individuals recognize and respect behavioral limits for themselves and others. They may do this because of the value they attach to “living up” to their contractual agreements, which may be implied in their associations with others, and because their
6 Armen A. Alchian and Harold Demsetz, “The Property Rights Paradigm,” Journal of Economic History, vol. 33, p. 17, March 1973.
own rights may be violated if they violate the rights of others. Two neighbors may implicitly agree to certain modes of behavior, such as not mowing their lawns on Sunday mornings or playing their stereo equipment late at night.7 Their behavior may be in recognition of what it means to be a “good neighbor” and of what life can be like if limits to their behavior are not observed. The neighbor who starts his mower early Sunday morning may hear music late at night or may find his rights invaded in other ways. More will be said on this, but for now we mean only to point out that the behavior of each through “offensive and counteroffensive” maneuvers may deteriorate into a state in which both parties are worse off than they would have been if restrictions on their own behavior were commonly observed. From this we see the bases for behavioral rules or, what amounts to the same thing, property rights.
Property rights are important to any inquiry of social order because it is on the basis of such rights that the terms individual and state are given social meaning, that actions are delimited, and that a specific social order will emerge. The existing property rights structure is predicated upon specific social and physical conditions. Changes in those conditions can cause a readjustment in the nature of social order.
Property Rights and the Market
In the private market economy people are permitted to initiate trades with one another. Indeed, when people trade, they are actually trading “rights” to goods and services or to do certain things. For example, when a person buys a house in the market, he is actually buying the right to live in the house under certain conditions, for example, as long as he does not disturb others. This market economy is predicated upon establishing patterns of private property rights; those patterns have legitimacy because of enforcement by government and, perhaps just as important, because of certain precepts regarding the limits of individual behavior that are commonly accepted and observed.8 Without recognized property rights there would be nothing to trade—no market.
How dependent are markets on government enforcement for the protection and legitimacy of private property rights? Our answer must of necessity be somewhat speculative. We know that markets existed in the “Old West” when formally instituted governments were nonexistent. Further, it is highly improbable that any government can be so pervasive in the affairs of people that it can be the arbiter of all private rights. Cases in which disputes over property rights within college dormitories are settled by student councils are relatively rare, and the disputes that end up in the dean’s office or at police headquarters are rarer still. Most conflicts over property rights are resolved at a local level, between two people, and many potential disputes do not even arise because of generally accepted behavioral limits.
Finally, the concept of property rights helps make clear the relationship between the public and private sectors of the economy—that is, between that section of the
7 This is an example used by James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975), p. 20.8 In addition, there is considerable private enforcement of property rights. Almost all people take some measures to secure their own property. They put locks on their doors, leave lights on at night, and alert their neighbors to take their newspapers in when they are out of town.
economy organized by collective action through government and that section which is organized through the actions of independent individuals. When government regulates aspects of the market, it redefines behavioral limits (in the sense that people can no longer do what they once could) and can be thought of as realigning the property rights between the private and public spheres. When the government imposes price ceilings on goods and services, as it did during the summer of 1971, it is redefining the rights that sellers have with regard to the property they sell. One of the purposes of economics is to analyze the effect that a realignment of property rights has on the efficiency of production.
Anarchy: A State of Disorder
Property rights are so much a part of our everyday experience that we are inclined to think of them as being “natural,” a part of our birthright. The Declaration of Independence speaks of “certain unalienable rights.” Indeed, it is hard to imagine a world in which people interact within a defined social space without the existence of property rights. The purpose of this section is to envision such a state in order to gain some insight into the origins of property rights and, therefore, social order.
Thomas Hobbes, a seventeenth-century political scientist philosopher, envisioned a state in which there was a complete absence of property rights, either those rights that have legitimacy because of their social acceptability or those that exist because of legal enforcement. He called this “the state of nature,” and his analysis was not very attractive. Because Hobbes gave very little credence to social acceptance as a basis for property rights, his attention was on the role of the state. He believed that “during the time men live without a common Power to keep them in awe,” every man will be pitted against another in continual struggle for dominance and protection. Life will be “solitary, poore, nasty, brutish, and short.” Where there is no state, he argued, there will be no law and therefore, “no Property ... no Mine and Thine distinct, but only that to be every man’s that he can get, and for so long as he can keep it.”9
One of Hobbes’ purposes in writing Leviathan was to justify the sovereign state as an absolutely necessary political entity. He tried to convince his contemporaries of the potential for conflict among men without the state; that it is necessary to hand over considerable political power to the state in order that internal conflicts may be minimized. He argued that it is in man’s self-interest to swear full allegiance to the state.
In order to make his argument as convincing as possible, it was somewhat natural for Hobbes to describe “the state of nature” in the worst possible terms. One can accept the criticism that Hobbes exaggerated the need for the state without ignoring a cornerstone of his argument: Without legally defined property rights, there is considerable potential for conflict among men. The life of man in the state of nature may not invariably be “solitary, poore, nasty, brutish, and short,” but it may be markedly less comfortable without property rights than with them.
9 Thomas Hobbes, Leviathan, ed. By C.B. Macpherson [Baltimore, Md.: Penguin Books, Inc., 1968 (first published 1651], pp. 185–88.
In an idealized world in which people are fully considerate of each other’s feelings and adjust and readjust their behavior to that of others without recourse to anything resembling a dividing line between “mine” and “thine,” property rights are no more necessary than they were for Robinson Crusoe alone on Tibago. But in the world as it now exists, there is the potential for conflict. Granted, the potential may not be present in all our interpersonal experiences. People have interests that, for all practical purposes, are independent of one another, and many of our interests are perfectly congruent with the interests of those around us. However, people have spheres of interests (described for two people by the circle in Figure 1.1) that extend outward from themselves and that intersect with the interests of others. A basic axiom of behavior (one to be developed in greater detail later) is that most people want more than they have, which means they have an interest in, or can benefit from, that which others have. In other words, they have competing interests—or, in terms of Figure 1.1, areas where their spheres of interests intersect. It is here that the potential for conflict arises, that a dividing line between “mine” and “thine” must be drawn.
Figure 1.1 Individuals have spheres of interest, which are illustrated, by the two circles. The intersection of the two circles represents the arc of potential conflict between two individuals; it is the area within which property rights (or behavioral limits) must be established.
Children at play provide us with a reasonably clear illustration of the absence of and potential for conflict among people in the larger community. Children can often play together for long periods of time without conflict. They each have interests that do not invade the interests of others (whic h may be described by the clear portions of the circles in Figure 1.1); for example, one may want to play with a truck, one with a bucket and shovel, and another with toy cowboys. For periods, their behavior may approximate the idealized society mentioned above. On the other hand, when two children want to play with the same toy or play the same role of mother or father in their game of “house,” or when one child wants to take over the entire sandbox, conflict is revealed, first with harsh words, possibly in fights, leading to a breakdown of their social interaction—play.
Conflict or the potential for conflict can be alleviated by the development of property rights, held either communally, by the state, or by private individuals. These rights can be established in ways that are similar but which can be conceptually distinguished: (1) voluntary acceptance of behavioral norms with no third-party enforcer, such as the police and courts, and (2) the specification of rights in a legally binding “social contract,” meaning that a third-party enforcer is established. Most of what we say for the remainder of this chapter applies to both modes of establishing rights. However, for reasons developed later in the book, the establishment of rights through voluntary
acceptance of behavioral norms, although important in itself, has distinct limitations, especially in relation to size. More specifically, many behavioral norms have a tendency to break down in large-group settings. Because most people hold to the behavioral norm that they should not pollute, and yet at least to some degree they pollute anyway, and because legal codes are filled with specifications of property rights, meaning something has failed, the limitations of behavioral norms may come as no surprise. Be that as it is, holding the discussion of voluntary behavioral rules until later in the book will permit us to narrow our attention and, perhaps, gain a deeper understanding of the basis of legal property rights. For now, let’s step back and consider in more detail the social basis for property rights.
The Emergence of Property Rights
To develop the analysis in the simplest terms possible, consider a model of two people, Fred and Harry, who live alone on an island. They have, at the start, no behavioral rules or anything else that “naturally” divides their spheres of interest. That is, they have nothing that resembles property rights. Further, being rational, they are assumed to want more than they can produce by themselves. Their social order is essentially anarchic. Each has two fundamental options for increasing his welfare: He can use his labor and other resources to produce goods and services or he can steal from his fellow man. With no social or ethical barriers restricting their behavior, they should be expected to allocate their resources between these options in the most productive way. This may mean that each should steal from the other as long as more is gained that way than through the production of goods and services.
If Fred and Harry find stealing a reasonable course to take, each will have to divert resources into protecting that which he has produced (or stolen). Presumably, their attacks and counterattacks will lead them toward a social equilibrium in which each is applying resources to predation and defense and neither finds any further movement of resources into those lines of activity profitable.10 This is not equilibrium in the sense that the state of affairs is a desirable one; in fact, it may be characterized as a “Hobbesean jungle” in which “every man is Enemy to every man.”
In an economic sense, the resources diverted into predatory and defensive behavior are wasted; they are taken away from productive processes. If these resources are applied to production, total production can rise, and both Fred and Harry can be better off—both can have more than if they try to steal from each other. It is only through winding up in a state of anarchy or seeing the potential for ending up there that they must question the rationality of continued plundering and unrestricted behavior; and it is because of the prospects of individual improvement that there exists a potential for a “social contract” that spells out legally defined property rights. Through a social contract they may agree to place restrictions on their own behavior, but they will do away with the restraints that, through predation and required defense, each imposes on the other. The fear of being attacked on the streets at night can be far more confining than laws that
10 For a rather difficult discussion of “equilibrium” under anarchy, see Winston C. Bush, “Individual Welfare in Anarchy,” in Gordon Tullock (ed.), Explorations in the Theory of Anarchy (Blacksburg, Va.: University Publications, Inc., 1972), pp. 5–8.
restrict people from attacking one another. This is what John Locke meant when he wrote, “The end of law is not to abolish or restrain but to preserve and enlarge freedom.”11
Once the benefits from the social contract are recognized, there may still be, as in the case of voluntary behavioral norms, an incentive for Fred or Harry to chisel on the contract. Fred may find that although he is “better off” materially by agreeing to property rights than he is by remaining in a state of anarchy, he may be even “better off” by violating the agreed-upon rights of the other. Through stealing, or in other ways violating Harry’s rights, Fred can redistribute the total wealth of the community toward himself.
To illustrate, consider Figure 1.2, which contains a chart or matrix of Fred and Harry’s utility (or satisfaction) levels if either respects or fails to respect the rights established for each as a part of the contract. (The actual utility levels are hypothetical but serve the purpose of illustrating a basic point.) There are four cells in the matrix, representing the four combinations of actions that Fred and Harry can take. They can both respect the agreed-upon rights of the other (cell 1), or they can both violate each other’s rights (cell 4). Alternatively, Harry can respect Fred’s rights while Fred violates Harry’s rights (cell 3), or vice versa (cell 2).
Clearly, by the utility levels indicated in cells 1 and 4, Fred and Harry are both better off by respecting each other’s rights than by violating them. However, if Harry respects Fred’s rights and Fred fails to reciprocate, Fred has a utility level of 18 utils, which is greater than he will receive in cell 1, that is, by going along with Harry and respecting the other’s rights. Harry is similarly better off if he violates Fred’s rights while Fred respects Harry’s rights: Harry has a utility level of 16, whereas he will have a utility level of 10 utils if he and Fred respect each other’s rights. The lesson to be learned: Inherent in an agreement over property rights is the possibility for each person to gain by violating the rights of the other. If both follow this course, they both will end up in cell 4, that is, back in the state of anarchy.
Seen in this light, the problem of the firm is the same as the problem of the general economy. As did Hayek, economists have argued for years that no group of government planners, no matter how intelligent and dedicated, can acquire all the localized knowledge necessary to allocate resources intelligently. The long and painful experiments with socialism and its extreme variant, communism, have confirmed that this is one argument that economists got right. But the freedom for people to use the knowledge that only they individually have has to be coupled with incentives that motivate people to use that knowledge in socially cooperative ways—meaning that the best way for individuals to pursue their own objectives is by making decisions that improve the opportunities for others to pursue their objectives. In a market economy these incentives are found primarily in the form of prices that emerge out of the rules of private property and voluntary exchange. Market prices provide the incentive people need to productively coordinate their decisions with each other, thus making it not only possible, but desirable, for people to have a large measure of freedom to make use of the localized information and know-how they have.
A perfect incentive system would assure that everyone could be given complete freedom because it would be in the interest of each to advance the interests of all. No such perfect incentive system exists, not within any firm or within any economy. In every economy there is always some appropriate mix of both market incentives and government controls that achieve the best overall results. The argument over just what the right mix is will no doubt continue indefinitely, but few deny that both incentives and controls are needed. Similarly, for any firm made up of more than one person, there is some mix of incentives and direct managerial control that best promotes the objectives of the firm; i.e., the general interests of its members.
Granted, incentives may not seem to matter much at any point in time, but even so, the power of incentives can accumulate with time. For example, suppose that without improved incentives firm profits will grow in real-dollar terms by 2 percent a year. Suppose that with more effective incentives firm profits can grow by 2.5 percent a year. The difference is not “much,” just a half of a percentage point per year. However, the compound impact of the higher growth rate will mean that after 30 years, real profits will
33F. A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960). Another problem in the management of incentives is that no set of incentives is ever perfect, nor could it be. But even if managers knew the best incentive structure and how best to implement it, a serious incentive problem would remain, What incentive should managers have to find the best set of incentives? That’s a tough but interesting question. An understanding of the structure of firms requires that we recognize the need to subject managers, as well as other employees, to the proper incentives. The need to impose the proper set of incentives on managers is also necessary for understanding firms’ financial structure. For example, the question of what combination of debt and equity instruments is best for financing a firm cannot be answered properly without a consideration of managerial incentives.
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microeconomics. Much of the work of economists is concerned with microeconomic analysis—that is, with the interpretation of events in the marketplace and of personal choices among products. This book, which has been designed with MBA students in mind, will deal almost exclusively with microeconomic theory, policy implications, and applications inside firms.
Questions of interest to microeconomists include:
What determines the price of particular goods and services?
What determines the output of particular firms and industries?
What determines the wages workers receive? The interest rates lenders receive? The profits businesses receive?
How do government policies—such as minimum wage laws, price controls, tariffs, and excise taxes—affect the price and output levels of individual markets?
Why do incentives matter inside firms and how can economic theory be used to properly structure a firm’s incentives to increase worker productivity and firm profitability?
Economists are also interested in measuring, explaining, and predicting the performance of the economic system itself. To do so, they study broad subdivisions of the economy, such as the total output of all firms that produce goods and services. Macroeconomics is the study of the national economy as a whole or of its major components. It deals with the “big picture,” not the details, of the nation’s economic activity.
Instead of concentrating on how many bicycles or hand calculators are sold, macroeconomists watch how many good and services consumers purchase in total or how much money all producers spend on new plants and equipment. Instead of tracking the price of a particular good in a particular market, macroeconomics monitors the general price level or average of all pric es. Instead of focusing on the wage rate and the number of people employed as plumbers or engineers, macroeconomists study incomes of all employees and the total number of people employed throughout the economy. In short, macroeconomics involves the study of national production, unemployment, and inflation. For that reason it is often referred to as aggregate economics.
Typical macroeconomic questions include:
What determines the general price level? The rate of inflation? What determines national income and production levels? What determines national employment and unemployment levels? What effects do government monetary and budgetary policies have on the general
price, income, production, employment, and unemployment levels?
These and similar questions are of more than academic interest. The theories that have been developed to answer them can be applied to problems and issues of the real world. They clearly have application to business, given that firm sales are often affected by “macro variables” such as national income and the inflation rate. Throughout this
book, as well as in specific chapters on topics such as regulation and deregulation, and price controls and consumer protection, we will examine the practical applications of economic theory.
However, we hasten to add that this book and course are devoted primarily to “microeconomic” theory and applications. We make microeconomics our focus because the issues at stake are more relevant to the interests of MBA students and because the microeconomic theory is generally viewed as being sounder than macroeconomic theory. Besides, we are firmly convinced that an understanding of the “macroeconomy” is necessarily dependent on an understanding of the “microeconomy.”
In microeconomics we start with the proposition that all actions are constrained by the fact of scarcity. That is to say, in some basic way, scarcity—and the economic question of how to deal with it—touches all of us in how we do business and conduct our lives. We now turn to a study of property rights. Private “property rights” are one of the institutional mechanisms people have devised to help alleviate the pressing constraints of scarcity, which is why we take them up at this early stage in the course.
The Meaning and Importance of Property Rights
Property rights pertain to the permissible use of resources, goods, and services; they define the limits of social behavior and, in that way, determine what can be done by individuals in society. They also specify whether resources, goods, and services are to be used privately or collectively by the state or any smaller group.
Property rights are a social phenomenon; they arise out of the necessity for individuals to “get along” within a social space in which all wish to move and interact. Where individuals are isolated from one another by natural barriers or are located where goods and resources are abundant, property rights have no meaning. In the world of Robinson Crusoe, shipwrecked alone on an island, property rights were inconsequential. His behavior was restricted by the resources found on the island, the tools he was able to take from the ship, and his own ingenuity. He had a problem of efficiently allocating his time within these constraints—procuring food, building shelter, and plotting his escape; however, the notion of “property” did not restrict his behavior—it was not a barrier to what he could do. He was able to take from the shipwreck, with immunity, stores that he thought would be most useful to his purposes.5
After the arrival of Friday, the native whom Robinson Crusoe saved from cannibals, a problem of restricting and ordering interpersonal behavior immediately emerged. The problem was particularly acute for Crusoe because Friday, prior to coming to Tibago, was himself a cannibal. (Each had to clearly establish property rights to his body.) The system that they worked out was a simple one, not markedly different from
5 The absence of human beings affected also his idea of what was useful. Crusoe, in going through the ship, came across a coffer of gold and silver coins: “Thou art not worth to me, no, not taking off the ground; one of these knives is worth all this heap [of gold].” At first, he evaluated the cost of taking the coins in terms of what he could take in their place and decided to leave them. But on second thought, perhaps taking into consideration the probability of being rescued, he took the coins with him! See Robinson Crusoe by Daniel Defoe.
that between Crusoe and “Dog.” Crusoe essentially owned everything. Their relationship was that of master and servant, Crusoe dictating to Friday how the property was to be used.
The notion of property rights is broadly conceived by economists. Property rights are most often applied to discussions of real estate and personal property (bicycles, clothes, etc.); they are also applicable to what people can do with their minds, their ability to speak, how they wear their hair, and if and when they must wear their shoes.
In common speech, we frequently speak of someone owning this land, that house, or these bonds. This conventional style undoubtedly is economical from the viewpoint of quick communications, but it masks the variety and complexity of the ownership relationship. What is owned are rights to use resources, including one’s body and mind, and these rights are always circumscribed, often by prohibition of certain actions. To “own land” usually means to have the right to till (or not to till) the soil, to mine the soil, to offer those rights for sale, etc., but not to have the right to throw soil at a passerby, to use it to change the course of a stream, or to force someone to buy it. What are owned are socially recognized rights of action. 6
Property rights are not necessarily distributed equally, meaning that people do not always have the same rights to use the same resources. Students may have the right to use their voices (i.e., a resource) to speak with friends in casual conversation in the hallways of classroom buildings, but they do not, generally speaking, have the right to disrupt an English class with a harangue on their political views. However, the English professor, although his behavior is circumscribed, has the right to “allow” his or her political views to filter into the English lectures. And if the President of the United States walked into the same English class and began speaking extemporaneously on his (or her) political views, it is not likely that anyone would object. A person has the right to go without shoes on a beach, but one does not always have the right to enter a restaurant without shoes. On the other hand, the restaurant owner’s best friend may have that right. By the same token, although undergraduate students generally pay a fraction of their educational expenses at state universities, they have the right to university facilities such as tennis courts and the university bookstore, but nonstudent taxpayers do not have the same rights to these facilities.
In other words, property rights can be recast in terms of the behavioral rules, which effectively limit and restrict our behavior. Behavioral rules determine what rights we have with regard to the use of resources, goods, and services. The rights we have may be the product of the legislative process and may be enforced by a third party: usually the third party is the government or, more properly, the agents of government. In this case property rights emerge from laws.
On the other hand, rules that establish rights may not have third-party enforcement. In this case they carry weight in the decisions of individuals simply because individuals recognize and respect behavioral limits for themselves and others. They may do this because of the value they attach to “living up” to their contractual agreements, which may be implied in their associations with others, and because their
6 Armen A. Alchian and Harold Demsetz, “The Property Rights Paradigm,” Journal of Economic History, vol. 33, p. 17, March 1973.
own rights may be violated if they violate the rights of others. Two neighbors may implicitly agree to certain modes of behavior, such as not mowing their lawns on Sunday mornings or playing their stereo equipment late at night.7 Their behavior may be in recognition of what it means to be a “good neighbor” and of what life can be like if limits to their behavior are not observed. The neighbor who starts his mower early Sunday morning may hear music late at night or may find his rights invaded in other ways. More will be said on this, but for now we mean only to point out that the behavior of each through “offensive and counteroffensive” maneuvers may deteriorate into a state in which both parties are worse off than they would have been if restrictions on their own behavior were commonly observed. From this we see the bases for behavioral rules or, what amounts to the same thing, property rights.
Property rights are important to any inquiry of social order because it is on the basis of such rights that the terms individual and state are given social meaning, that actions are delimited, and that a specific social order will emerge. The existing property rights structure is predicated upon specific social and physical conditions. Changes in those conditions can cause a readjustment in the nature of social order.
Property Rights and the Market
In the private market economy people are permitted to initiate trades with one another. Indeed, when people trade, they are actually trading “rights” to goods and services or to do certain things. For example, when a person buys a house in the market, he is actually buying the right to live in the house under certain conditions, for example, as long as he does not disturb others. This market economy is predicated upon establishing patterns of private property rights; those patterns have legitimacy because of enforcement by government and, perhaps just as important, because of certain precepts regarding the limits of individual behavior that are commonly accepted and observed.8 Without recognized property rights there would be nothing to trade—no market.
How dependent are markets on government enforcement for the protection and legitimacy of private property rights? Our answer must of necessity be somewhat speculative. We know that markets existed in the “Old West” when formally instituted governments were nonexistent. Further, it is highly improbable that any government can be so pervasive in the affairs of people that it can be the arbiter of all private rights. Cases in which disputes over property rights within college dormitories are settled by student councils are relatively rare, and the disputes that end up in the dean’s office or at police headquarters are rarer still. Most conflicts over property rights are resolved at a local level, between two people, and many potential disputes do not even arise because of generally accepted behavioral limits.
Finally, the concept of property rights helps make clear the relationship between the public and private sectors of the economy—that is, between that section of the
7 This is an example used by James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975), p. 20.8 In addition, there is considerable private enforcement of property rights. Almost all people take some measures to secure their own property. They put locks on their doors, leave lights on at night, and alert their neighbors to take their newspapers in when they are out of town.
economy organized by collective action through government and that section which is organized through the actions of independent individuals. When government regulates aspects of the market, it redefines behavioral limits (in the sense that people can no longer do what they once could) and can be thought of as realigning the property rights between the private and public spheres. When the government imposes price ceilings on goods and services, as it did during the summer of 1971, it is redefining the rights that sellers have with regard to the property they sell. One of the purposes of economics is to analyze the effect that a realignment of property rights has on the efficiency of production.
Anarchy: A State of Disorder
Property rights are so much a part of our everyday experience that we are inclined to think of them as being “natural,” a part of our birthright. The Declaration of Independence speaks of “certain unalienable rights.” Indeed, it is hard to imagine a world in which people interact within a defined social space without the existence of property rights. The purpose of this section is to envision such a state in order to gain some insight into the origins of property rights and, therefore, social order.
Thomas Hobbes, a seventeenth-century political scientist philosopher, envisioned a state in which there was a complete absence of property rights, either those rights that have legitimacy because of their social acceptability or those that exist because of legal enforcement. He called this “the state of nature,” and his analysis was not very attractive. Because Hobbes gave very little credence to social acceptance as a basis for property rights, his attention was on the role of the state. He believed that “during the time men live without a common Power to keep them in awe,” every man will be pitted against another in continual struggle for dominance and protection. Life will be “solitary, poore, nasty, brutish, and short.” Where there is no state, he argued, there will be no law and therefore, “no Property ... no Mine and Thine distinct, but only that to be every man’s that he can get, and for so long as he can keep it.”9
One of Hobbes’ purposes in writing Leviathan was to justify the sovereign state as an absolutely necessary political entity. He tried to convince his contemporaries of the potential for conflict among men without the state; that it is necessary to hand over considerable political power to the state in order that internal conflicts may be minimized. He argued that it is in man’s self-interest to swear full allegiance to the state.
In order to make his argument as convincing as possible, it was somewhat natural for Hobbes to describe “the state of nature” in the worst possible terms. One can accept the criticism that Hobbes exaggerated the need for the state without ignoring a cornerstone of his argument: Without legally defined property rights, there is considerable potential for conflict among men. The life of man in the state of nature may not invariably be “solitary, poore, nasty, brutish, and short,” but it may be markedly less comfortable without property rights than with them.
9 Thomas Hobbes, Leviathan, ed. By C.B. Macpherson [Baltimore, Md.: Penguin Books, Inc., 1968 (first published 1651], pp. 185–88.
In an idealized world in which people are fully considerate of each other’s feelings and adjust and readjust their behavior to that of others without recourse to anything resembling a dividing line between “mine” and “thine,” property rights are no more necessary than they were for Robinson Crusoe alone on Tibago. But in the world as it now exists, there is the potential for conflict. Granted, the potential may not be present in all our interpersonal experiences. People have interests that, for all practical purposes, are independent of one another, and many of our interests are perfectly congruent with the interests of those around us. However, people have spheres of interests (described for two people by the circle in Figure 1.1) that extend outward from themselves and that intersect with the interests of others. A basic axiom of behavior (one to be developed in greater detail later) is that most people want more than they have, which means they have an interest in, or can benefit from, that which others have. In other words, they have competing interests—or, in terms of Figure 1.1, areas where their spheres of interests intersect. It is here that the potential for conflict arises, that a dividing line between “mine” and “thine” must be drawn.
Figure 1.1 Individuals have spheres of interest, which are illustrated, by the two circles. The intersection of the two circles represents the arc of potential conflict between two individuals; it is the area within which property rights (or behavioral limits) must be established.
Children at play provide us with a reasonably clear illustration of the absence of and potential for conflict among people in the larger community. Children can often play together for long periods of time without conflict. They each have interests that do not invade the interests of others (whic h may be described by the clear portions of the circles in Figure 1.1); for example, one may want to play with a truck, one with a bucket and shovel, and another with toy cowboys. For periods, their behavior may approximate the idealized society mentioned above. On the other hand, when two children want to play with the same toy or play the same role of mother or father in their game of “house,” or when one child wants to take over the entire sandbox, conflict is revealed, first with harsh words, possibly in fights, leading to a breakdown of their social interaction—play.
Conflict or the potential for conflict can be alleviated by the development of property rights, held either communally, by the state, or by private individuals. These rights can be established in ways that are similar but which can be conceptually distinguished: (1) voluntary acceptance of behavioral norms with no third-party enforcer, such as the police and courts, and (2) the specification of rights in a legally binding “social contract,” meaning that a third-party enforcer is established. Most of what we say for the remainder of this chapter applies to both modes of establishing rights. However, for reasons developed later in the book, the establishment of rights through voluntary
acceptance of behavioral norms, although important in itself, has distinct limitations, especially in relation to size. More specifically, many behavioral norms have a tendency to break down in large-group settings. Because most people hold to the behavioral norm that they should not pollute, and yet at least to some degree they pollute anyway, and because legal codes are filled with specifications of property rights, meaning something has failed, the limitations of behavioral norms may come as no surprise. Be that as it is, holding the discussion of voluntary behavioral rules until later in the book will permit us to narrow our attention and, perhaps, gain a deeper understanding of the basis of legal property rights. For now, let’s step back and consider in more detail the social basis for property rights.
The Emergence of Property Rights
To develop the analysis in the simplest terms possible, consider a model of two people, Fred and Harry, who live alone on an island. They have, at the start, no behavioral rules or anything else that “naturally” divides their spheres of interest. That is, they have nothing that resembles property rights. Further, being rational, they are assumed to want more than they can produce by themselves. Their social order is essentially anarchic. Each has two fundamental options for increasing his welfare: He can use his labor and other resources to produce goods and services or he can steal from his fellow man. With no social or ethical barriers restricting their behavior, they should be expected to allocate their resources between these options in the most productive way. This may mean that each should steal from the other as long as more is gained that way than through the production of goods and services.
If Fred and Harry find stealing a reasonable course to take, each will have to divert resources into protecting that which he has produced (or stolen). Presumably, their attacks and counterattacks will lead them toward a social equilibrium in which each is applying resources to predation and defense and neither finds any further movement of resources into those lines of activity profitable.10 This is not equilibrium in the sense that the state of affairs is a desirable one; in fact, it may be characterized as a “Hobbesean jungle” in which “every man is Enemy to every man.”
In an economic sense, the resources diverted into predatory and defensive behavior are wasted; they are taken away from productive processes. If these resources are applied to production, total production can rise, and both Fred and Harry can be better off—both can have more than if they try to steal from each other. It is only through winding up in a state of anarchy or seeing the potential for ending up there that they must question the rationality of continued plundering and unrestricted behavior; and it is because of the prospects of individual improvement that there exists a potential for a “social contract” that spells out legally defined property rights. Through a social contract they may agree to place restrictions on their own behavior, but they will do away with the restraints that, through predation and required defense, each imposes on the other. The fear of being attacked on the streets at night can be far more confining than laws that
10 For a rather difficult discussion of “equilibrium” under anarchy, see Winston C. Bush, “Individual Welfare in Anarchy,” in Gordon Tullock (ed.), Explorations in the Theory of Anarchy (Blacksburg, Va.: University Publications, Inc., 1972), pp. 5–8.
restrict people from attacking one another. This is what John Locke meant when he wrote, “The end of law is not to abolish or restrain but to preserve and enlarge freedom.”11
Once the benefits from the social contract are recognized, there may still be, as in the case of voluntary behavioral norms, an incentive for Fred or Harry to chisel on the contract. Fred may find that although he is “better off” materially by agreeing to property rights than he is by remaining in a state of anarchy, he may be even “better off” by violating the agreed-upon rights of the other. Through stealing, or in other ways violating Harry’s rights, Fred can redistribute the total wealth of the community toward himself.
To illustrate, consider Figure 1.2, which contains a chart or matrix of Fred and Harry’s utility (or satisfaction) levels if either respects or fails to respect the rights established for each as a part of the contract. (The actual utility levels are hypothetical but serve the purpose of illustrating a basic point.) There are four cells in the matrix, representing the four combinations of actions that Fred and Harry can take. They can both respect the agreed-upon rights of the other (cell 1), or they can both violate each other’s rights (cell 4). Alternatively, Harry can respect Fred’s rights while Fred violates Harry’s rights (cell 3), or vice versa (cell 2).
Clearly, by the utility levels indicated in cells 1 and 4, Fred and Harry are both better off by respecting each other’s rights than by violating them. However, if Harry respects Fred’s rights and Fred fails to reciprocate, Fred has a utility level of 18 utils, which is greater than he will receive in cell 1, that is, by going along with Harry and respecting the other’s rights. Harry is similarly better off if he violates Fred’s rights while Fred respects Harry’s rights: Harry has a utility level of 16, whereas he will have a utility level of 10 utils if he and Fred respect each other’s rights. The lesson to be learned: Inherent in an agreement over property rights is the possibility for each person to gain by violating the rights of the other. If both follow this course, they both will end up in cell 4, that is, back in the state of anarchy.
Seen in this light, the problem of the firm is the same as the problem of the general economy. As did Hayek, economists have argued for years that no group of government planners, no matter how intelligent and dedicated, can acquire all the localized knowledge necessary to allocate resources intelligently. The long and painful experiments with socialism and its extreme variant, communism, have confirmed that this is one argument that economists got right. But the freedom for people to use the knowledge that only they individually have has to be coupled with incentives that motivate people to use that knowledge in socially cooperative ways—meaning that the best way for individuals to pursue their own objectives is by making decisions that improve the opportunities for others to pursue their objectives. In a market economy these incentives are found primarily in the form of prices that emerge out of the rules of private property and voluntary exchange. Market prices provide the incentive people need to productively coordinate their decisions with each other, thus making it not only possible, but desirable, for people to have a large measure of freedom to make use of the localized information and know-how they have.
A perfect incentive system would assure that everyone could be given complete freedom because it would be in the interest of each to advance the interests of all. No such perfect incentive system exists, not within any firm or within any economy. In every economy there is always some appropriate mix of both market incentives and government controls that achieve the best overall results. The argument over just what the right mix is will no doubt continue indefinitely, but few deny that both incentives and controls are needed. Similarly, for any firm made up of more than one person, there is some mix of incentives and direct managerial control that best promotes the objectives of the firm; i.e., the general interests of its members.
Granted, incentives may not seem to matter much at any point in time, but even so, the power of incentives can accumulate with time. For example, suppose that without improved incentives firm profits will grow in real-dollar terms by 2 percent a year. Suppose that with more effective incentives firm profits can grow by 2.5 percent a year. The difference is not “much,” just a half of a percentage point per year. However, the compound impact of the higher growth rate will mean that after 30 years, real profits will
33F. A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960). Another problem in the management of incentives is that no set of incentives is ever perfect, nor could it be. But even if managers knew the best incentive structure and how best to implement it, a serious incentive problem would remain, What incentive should managers have to find the best set of incentives? That’s a tough but interesting question. An understanding of the structure of firms requires that we recognize the need to subject managers, as well as other employees, to the proper incentives. The need to impose the proper set of incentives on managers is also necessary for understanding firms’ financial structure. For example, the question of what combination of debt and equity instruments is best for financing a firm cannot be answered properly without a consideration of managerial incentives.
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Friday, April 3, 2009
A Way to think about Ecomonic Business
Frank Knight was a wise professor. Through long years of teaching he realized that
students, even those in advanced business programs, beginning a study of
economics, no matter the level, face a difficult task. They must learn many things
in a rigorous manner that, on reflection and with experience, amount to common sense. To do that, however, they must set aside —or “unlearn”—many pre-conceived notions of the economy and of the course itself. The problem of “unlearning” can be especially acute for MBA students who are returning to a university after years of experience in industry. People in business rightfully focus their attention on the immediate demands of their jobs and evaluate their firms’ successes and failures with reference to production schedules and accounting statements, a perspective that stands in stark contrast to the perspective developed in an economics class.
As all good teachers must do, we intend to challenge you in this course to rethink your views on the economy and the way firms operate. We will ask you to develop new methods of analysis, maintaining all the while that there is, indeed, an “economic way of thinking” that deserves mastering. We will also ask you to reconsider, in light of the new methods of thinking, old policy issues, both inside and outside the firm, about which you may have fixed views. These tasks will not always be easy for you, but we are convinced that the rewards from the study ahead are substantial. The greatest reward may be that this course of study will help you to better understand the way the business world works and how businesses might be made more efficient and profitable. Much of what this course is about is, oddly enough, crystallized in a story of what happened in a prisoner¬of-war camp.
The Emergence of a Market
Economic systems spring from people’s drive to improve their welfare. R.A. Radford, an American soldier who was captured and imprisoned during the Second World War, left a vivid account of the primitive market for goods and services that grew up in his prisoner-of-war camp.1 A market is the process by which buyers and sellers determine what they
are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods that are to be bought and sold. Because the inmates had few opportunities to produce the things they wanted, they turned to a system of exchanges based on the cigarettes, toiletries, chocolate, and other rations distributed to them periodically by the Red Cross.
The Red Cross distributed the supplies equally among the prisoners, but “very soon after capture . . .[the prisoners] realized that it was rather undesirable and unnecessary, in view of the limited size and the quality of supplies, to give away or to accept gifts of cigarettes or food. Goodwill developed into trading as a more equitable means of maximizing individual satisfaction.”2 As the weeks went by, trade expanded and the prices of goods stabilized. A soldier who hoped to receive a high price for his soap found he had to compete with others who also wanted to trade soap. Soon shops emerged, and middlemen began to take advantage of discrepancies in the prices offered in different bungalows.
A priest, for example, found that he could exchange a pack of cigarettes for a pound of cheese in one bungalow, trade the cheese for a pack and a half of cigarettes in a second bungalow, and return home with more cigarettes than he had begun with. Although he was acting in his own self-interest, he had provided the people in the second bungalow with something they wanted—more cheese than they would otherwise have had. In fact, prices for cheese and cigarettes differed partly because prisoners had different desires and partly because they could not all interact freely. To exploit the discrepancy in prices, the priest moved the camp’s store of cheese from the first bungalow, where it was worth less, to the second bungalow, where it was worth more. Everyone involved in the trade benefited from the priest’s enterprise.
A few entrepreneurs in the camp hoarded cigarettes and used them to buy up the troops’ rations shortly after issue—and then sold the rations just before the next issue, at higher prices. An entrepreneur is an enterprising person who discovers potentially profitable opportunities and organizes, directs, and manages productive ventures. Although these entrepreneurs were pursuing their own private interest, like the priest, they were providing a service to the other prisoners. They bought the rations when people wanted to get rid of them and sold them when people were running short. The difference between the low price at which they bought and the high price at which they sold gave them the incentive they needed to make the trades, hold on to the rations, and assume the risk that the price of rations might not rise.
Soon the troops began to use cigarettes as money, quoting prices in packs or fractions of packs. (Only the less desirable brands of cigarette were used this way; the better brands were smoked.) Because cigarettes were generally acceptable, the soldier who wanted soap no longer had to search out those who might want his jam; he could buy the soap with cigarettes. Even nonsmokers began to accept cigarettes in trade.
This makeshift monetary system adjusted itself to allow for cha nges in the money supply. On the day the Red Cross distributed new supplies of cigarettes, prices rose, reflecting the influx of new money. After nights spent listening to nearby bombing, when Today, markets for numerous new and used products spring up spontaneously in much the same way. At the end of each semester, college students can be found trading books among themselves, or standing in line at the bookstore to resell books they bought at the beginning of the semester. Garage sales are now common in practically all communities. Indeed, like the priest in the POW camp, many people go to garage sales to buy what they believe they can resell—at a higher price, of course. “Dollar stores” have sprung up all over the country for one purpose, to buy the surplus merchandise from manufacturers and to unload it at greatly reduced prices to willing customers. There are even firms that make a market in getting refunds for other firms on late overnight deliveries. Many firms don’t think it is worth their time to seek refunds for late deliveries, mainly because there aren’t many late deliveries (because the overnight delivery firms have an economic incentive to hold the late deliveries in check). However, there are obviously economies to be had from other firms collecting the delivery notices from several firms and sorting the late ones out with the refunds shared by all concerned.
Today, we stand witness to what is an explosion of a totally new economy on the Internet that many of the students reading this book will, like the priest in the POW camp, help develop. More than two hundred years ago, Adam Smith outlined a society that resembled these POW camp markets in his classic Wealth of Nations (see the “Perspective” on Smith page after next). Smith, considered the first economist, asked why markets arise and how they contribute to the social welfare. In answering that question, he defined the economic problem.
The Economic Problem
Our world is not nearly as restrictive as Radford’s prison, but it is no Garden of Eden, either. Most of us are constantly occupied in securing the food, clothing, and shelter we need to exist, to say nothing of those things we would only like to have—a tape deck, a night on the town. Indeed, if we think seriously about the world around us, we can make two general observations.
First, the world is more or less fixed in size and limited in its resources. Resources are things used in the production of goods and services. There are only so many acres of land, gallons of water, trees, rivers, wind currents, oil and mineral deposits, trained workers, and machines that can be used in any one period to produce the things we need and want. We can plant more trees, find more oil, and increase our stock of human talent, but there are limits on what we can accomplish with the resources at our disposal.
In fact, most people want far more than they can ever have. One of the unavoidable conditions of life is the fundamental condition of scarcity. Scarcity is the fact that we cannot all have everything we want all the time. Put simply, there isn’t enough of everything to go around. Consequently, society must face several unavoidable questions:
1 What will be produced? More guns or more butter? More schools or more prisons? More cars or more art, more textbooks or more “Saturday night specials”?
2 How will those things be produced, considering the resources at our disposal? Shall we use a great deal of labor and little mechanical power, or vice versa? And how can a firm “optimize” the use of various resources, given their different prices?
3 Who will be paid what and who will receive the goods and services produced? Shall we distribute them equally? If not, then on what other basis shall we distribute them?
4 Perhaps most important, how shall we answer all these questions? Shall we allow for individual freedom of choice, or shall we make all these decisions collectively?
These questions have no easy answers. Most of us spend our lives attempting to come to grips with them on an individual level. What should I do with my time today— study or walk through the woods? How should I study—in the library or at home with the stereo on? Who is going to benefit from my efforts—me or my mother, who wants The problem of allocating resources among competing wants is not as simple as it may first appear. You may think that economics is an examination of how one person or a small group of people makes fundamental social choices on resource use. That is not the case. The problem is that we have information about our wants and the resources at our disposal that may be known to no one else. This is a point the late Leonard Reed made decades ago in a short article in terms of what it takes to produce a product as simple as a pencil (see the reading “I, A Pencil” at the end of the chapter), and it also is a point that F. A. Hayek stressed throughout all of his writings that, ultimately, gained him a Nobel Prize in economics (see the reading “The Use of Knowledge in Society” in your course packet). For example, you may know you want a calculator because your statistics class requires you to have one, and even your friends (much less the people at Hewlett-Packard or Casio) do not yet know your purchase plans. You may also be the only person who knows how much labor you have, which is determined by exactly how long and intensely you are willing to work at various tasks. At the same time, you may know little about the wants and resources that other people around the country and world may have. Before resources can be effectively allocated, the information we hold about our individual wants and resources must somehow be communicated to others. This means economics must be concerned with systems of communications. Indeed, the field is extensively concerned with how information about wants and resources is transmitted or shared through, for example, prices in the market process and votes in the political process. Indeed, the “information problem” is often acute within firms, given that the CEO often knows little about how to do the jobs at the bottom of the corporate “pyramid.” The information problem is one important reason that firms must rely extensively on incentives to get their workers (and managers) to pursue firm goals.
Markets like the one in the POW camp and even the firms that operate within markets emerge in direct response to scarcity. Because people want more than is immediately available, they produce some good and services for trade. By exchanging things they like less for things they like more, they reallocate their resources and enhance their welfare as individuals. As we will see, people organize firms, which often substitute command-and-control structures for the competitive negotiations and exchanges of markets, because the firms are more cost-effective than markets. Firms can be expected to expand only as long as they remain more cost-effective than competitive market trades. Jacob Viner, an economist active in the first half of this century, once defined economics as what economists do. Today economists study an increasingly diverse array of topics. As always, they are involved in describing market processes, methods of trade, and commercial and industrial patterns. They also pay considerable attention to poverty and wealth; to racial, sexual, and religious discrimination; to politics and bureaucracy; to crime and criminal law; and to revolution. There is even an economics of group interaction, in which economic principles are applied to marital and family problems. And there is an economics of firm organization and the structure of incentives inside firms. Thus, although economists are still working on the conventional problems of inflation, unemployment, international monetary problems, and pricing policies, they are also studying the delivery of housing to the disadvantaged or of health care to the very young and the elderly. In one way or another, today’s economists are tackling a wide variety of subjects, including committee structure, the criminal justice system, firm pay policies, ethics, voting rules, and the legislative process. Before this book and course have been completed, much will be said of how firms like General Electric, Microsoft, or Netscape can be expected to price their products, and we will touch on the conditions under which firms can be expected to give away their products (or even pay buyers to take their products). In fact, because we understand your professional goals for pursuing an MBA degree, we will never present theory for theory’s sake. We will, in each and every chapter, show you how the theory can be used in practice by managers.
What is the unifying factor in these diverse inquiries? What ties them all together and distinguishes the economist’s work from that of other social scientists? Economists take a distinctive approach to the study of human behavior. They employ a mode of analysis based on certain presuppositions about human behavior. For example, much economic analysis starts with the general proposition that people prefer more to fewer of those things they want and that they seek to maximize their welfare by making reasonable, consistent choices in the things they buy and sell. These propositions enable economists to derive the “law of demand” (people will buy more of any good at a lower price than at a higher price, and vice versa) and many other principles of human behavior. A theory is a model of how the world is put together; it is an attempt to uncover some order in the seemingly random events of daily life. Economic theory is abstract, but not in the sense that its models lack concreteness. On the contrary, good models are laid out with great precision. Economic theories are simplified models abstracted from the complexity of the real world. Economists deliberately concentrate on just a few outstanding features of a problem in an effort to discover the laws that govern the relationships among them. Generally, a theory is a set of abstractions about the real world in which we work. An economic theory is a simplified explanation of how the economy or part of the economy functions or would function under specific conditions.
Quite often the economist must also make unproved assumptions, called simplifying assumptions, about the parts of the economy under study. For example, in examining the effects of price and availability on the amount of food sold, the economist might assume that people eat only oranges and bananas in the model society in question. Such a simplifying assumption is permissible in constructing a model, for two reasons. First, it makes the discussion more manageable. Second, it does not alter the problem under study or destroy its relevance to the real world.
As following chapters will reveal, economic theorizing is largely deductive—that is, the analysis proceeds from very general propositions (such as “more is preferred to less”) to much more precise statements or predictions (for example, “the quantity purchased will rise when the price falls”).4 Economic theories sometimes vary in their premises and conclusions, but all develop through the following three steps.
First, a few very general premises or propositions are stated. “More is preferred to less” or “People will seek to maximize their welfare” are examples of such propositions. The premises tend to be so general that they are beyond dispute, at least to the economists developing the theory.
Second, logical deductions, which are tentative predictions about behavior, are drawn from the premises. From the premise “People will seek to maximize their welfare” we can deduce how people will tend to allocate their incomes at certain prices. We can then conclude that they will purchase more of a good when its price falls. Mathematics and graphic analysis are often very useful in deducing the consequences of premises. Although a theory is not a complete and realistic description of the real world, a good theory should incorporate enough data to simulate real life. That is, it should provide some explanation for past experiences and permit reasonably accurate predictions of the future. When you evaluate a new theory, ask yourself: Does this theory explain what has been observed? Does it provide a better basis for prediction than other theories?
Positive and Normative Economics
Economic thinking is often divided into two categories—positive and normative. Positive economics is that branch of economic inquiry that is concerned with the world as it is rather than as it should be. It deals only with the consequences of changes in economic conditions or policies. A positive economist suspends questions of values when dealing with issues suck as crime or minimum wage laws. The object is to predict the effect of changes in the criminal code or the minimum wage rate—not to evaluate the fairness of such changes. Normative economics is that branch of economic inquiry that deals with value judgments—with what prices, production levels, incomes, and government policies ought to be. A normative economist does not shrink from the question of what the minimum wage rate ought to be. To arrive at an answer, the economist weighs the results of various minimum wage rates on the groups affected by them—the unemployed, employers, taxpayers, and so on. Then, on the basis of value judgments of the relative need or merit of each group, the normative economist recommends a specific minimum wage rate. Of course, values differ from one person to the next. In the analytical jump from recognizing the alternatives to prescribing a solution, scientific thinking gives way to ethical judgment.
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students, even those in advanced business programs, beginning a study of
economics, no matter the level, face a difficult task. They must learn many things
in a rigorous manner that, on reflection and with experience, amount to common sense. To do that, however, they must set aside —or “unlearn”—many pre-conceived notions of the economy and of the course itself. The problem of “unlearning” can be especially acute for MBA students who are returning to a university after years of experience in industry. People in business rightfully focus their attention on the immediate demands of their jobs and evaluate their firms’ successes and failures with reference to production schedules and accounting statements, a perspective that stands in stark contrast to the perspective developed in an economics class.
As all good teachers must do, we intend to challenge you in this course to rethink your views on the economy and the way firms operate. We will ask you to develop new methods of analysis, maintaining all the while that there is, indeed, an “economic way of thinking” that deserves mastering. We will also ask you to reconsider, in light of the new methods of thinking, old policy issues, both inside and outside the firm, about which you may have fixed views. These tasks will not always be easy for you, but we are convinced that the rewards from the study ahead are substantial. The greatest reward may be that this course of study will help you to better understand the way the business world works and how businesses might be made more efficient and profitable. Much of what this course is about is, oddly enough, crystallized in a story of what happened in a prisoner¬of-war camp.
The Emergence of a Market
Economic systems spring from people’s drive to improve their welfare. R.A. Radford, an American soldier who was captured and imprisoned during the Second World War, left a vivid account of the primitive market for goods and services that grew up in his prisoner-of-war camp.1 A market is the process by which buyers and sellers determine what they
are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods that are to be bought and sold. Because the inmates had few opportunities to produce the things they wanted, they turned to a system of exchanges based on the cigarettes, toiletries, chocolate, and other rations distributed to them periodically by the Red Cross.
The Red Cross distributed the supplies equally among the prisoners, but “very soon after capture . . .[the prisoners] realized that it was rather undesirable and unnecessary, in view of the limited size and the quality of supplies, to give away or to accept gifts of cigarettes or food. Goodwill developed into trading as a more equitable means of maximizing individual satisfaction.”2 As the weeks went by, trade expanded and the prices of goods stabilized. A soldier who hoped to receive a high price for his soap found he had to compete with others who also wanted to trade soap. Soon shops emerged, and middlemen began to take advantage of discrepancies in the prices offered in different bungalows.
A priest, for example, found that he could exchange a pack of cigarettes for a pound of cheese in one bungalow, trade the cheese for a pack and a half of cigarettes in a second bungalow, and return home with more cigarettes than he had begun with. Although he was acting in his own self-interest, he had provided the people in the second bungalow with something they wanted—more cheese than they would otherwise have had. In fact, prices for cheese and cigarettes differed partly because prisoners had different desires and partly because they could not all interact freely. To exploit the discrepancy in prices, the priest moved the camp’s store of cheese from the first bungalow, where it was worth less, to the second bungalow, where it was worth more. Everyone involved in the trade benefited from the priest’s enterprise.
A few entrepreneurs in the camp hoarded cigarettes and used them to buy up the troops’ rations shortly after issue—and then sold the rations just before the next issue, at higher prices. An entrepreneur is an enterprising person who discovers potentially profitable opportunities and organizes, directs, and manages productive ventures. Although these entrepreneurs were pursuing their own private interest, like the priest, they were providing a service to the other prisoners. They bought the rations when people wanted to get rid of them and sold them when people were running short. The difference between the low price at which they bought and the high price at which they sold gave them the incentive they needed to make the trades, hold on to the rations, and assume the risk that the price of rations might not rise.
Soon the troops began to use cigarettes as money, quoting prices in packs or fractions of packs. (Only the less desirable brands of cigarette were used this way; the better brands were smoked.) Because cigarettes were generally acceptable, the soldier who wanted soap no longer had to search out those who might want his jam; he could buy the soap with cigarettes. Even nonsmokers began to accept cigarettes in trade.
This makeshift monetary system adjusted itself to allow for cha nges in the money supply. On the day the Red Cross distributed new supplies of cigarettes, prices rose, reflecting the influx of new money. After nights spent listening to nearby bombing, when Today, markets for numerous new and used products spring up spontaneously in much the same way. At the end of each semester, college students can be found trading books among themselves, or standing in line at the bookstore to resell books they bought at the beginning of the semester. Garage sales are now common in practically all communities. Indeed, like the priest in the POW camp, many people go to garage sales to buy what they believe they can resell—at a higher price, of course. “Dollar stores” have sprung up all over the country for one purpose, to buy the surplus merchandise from manufacturers and to unload it at greatly reduced prices to willing customers. There are even firms that make a market in getting refunds for other firms on late overnight deliveries. Many firms don’t think it is worth their time to seek refunds for late deliveries, mainly because there aren’t many late deliveries (because the overnight delivery firms have an economic incentive to hold the late deliveries in check). However, there are obviously economies to be had from other firms collecting the delivery notices from several firms and sorting the late ones out with the refunds shared by all concerned.
Today, we stand witness to what is an explosion of a totally new economy on the Internet that many of the students reading this book will, like the priest in the POW camp, help develop. More than two hundred years ago, Adam Smith outlined a society that resembled these POW camp markets in his classic Wealth of Nations (see the “Perspective” on Smith page after next). Smith, considered the first economist, asked why markets arise and how they contribute to the social welfare. In answering that question, he defined the economic problem.
The Economic Problem
Our world is not nearly as restrictive as Radford’s prison, but it is no Garden of Eden, either. Most of us are constantly occupied in securing the food, clothing, and shelter we need to exist, to say nothing of those things we would only like to have—a tape deck, a night on the town. Indeed, if we think seriously about the world around us, we can make two general observations.
First, the world is more or less fixed in size and limited in its resources. Resources are things used in the production of goods and services. There are only so many acres of land, gallons of water, trees, rivers, wind currents, oil and mineral deposits, trained workers, and machines that can be used in any one period to produce the things we need and want. We can plant more trees, find more oil, and increase our stock of human talent, but there are limits on what we can accomplish with the resources at our disposal.
In fact, most people want far more than they can ever have. One of the unavoidable conditions of life is the fundamental condition of scarcity. Scarcity is the fact that we cannot all have everything we want all the time. Put simply, there isn’t enough of everything to go around. Consequently, society must face several unavoidable questions:
1 What will be produced? More guns or more butter? More schools or more prisons? More cars or more art, more textbooks or more “Saturday night specials”?
2 How will those things be produced, considering the resources at our disposal? Shall we use a great deal of labor and little mechanical power, or vice versa? And how can a firm “optimize” the use of various resources, given their different prices?
3 Who will be paid what and who will receive the goods and services produced? Shall we distribute them equally? If not, then on what other basis shall we distribute them?
4 Perhaps most important, how shall we answer all these questions? Shall we allow for individual freedom of choice, or shall we make all these decisions collectively?
These questions have no easy answers. Most of us spend our lives attempting to come to grips with them on an individual level. What should I do with my time today— study or walk through the woods? How should I study—in the library or at home with the stereo on? Who is going to benefit from my efforts—me or my mother, who wants The problem of allocating resources among competing wants is not as simple as it may first appear. You may think that economics is an examination of how one person or a small group of people makes fundamental social choices on resource use. That is not the case. The problem is that we have information about our wants and the resources at our disposal that may be known to no one else. This is a point the late Leonard Reed made decades ago in a short article in terms of what it takes to produce a product as simple as a pencil (see the reading “I, A Pencil” at the end of the chapter), and it also is a point that F. A. Hayek stressed throughout all of his writings that, ultimately, gained him a Nobel Prize in economics (see the reading “The Use of Knowledge in Society” in your course packet). For example, you may know you want a calculator because your statistics class requires you to have one, and even your friends (much less the people at Hewlett-Packard or Casio) do not yet know your purchase plans. You may also be the only person who knows how much labor you have, which is determined by exactly how long and intensely you are willing to work at various tasks. At the same time, you may know little about the wants and resources that other people around the country and world may have. Before resources can be effectively allocated, the information we hold about our individual wants and resources must somehow be communicated to others. This means economics must be concerned with systems of communications. Indeed, the field is extensively concerned with how information about wants and resources is transmitted or shared through, for example, prices in the market process and votes in the political process. Indeed, the “information problem” is often acute within firms, given that the CEO often knows little about how to do the jobs at the bottom of the corporate “pyramid.” The information problem is one important reason that firms must rely extensively on incentives to get their workers (and managers) to pursue firm goals.
Markets like the one in the POW camp and even the firms that operate within markets emerge in direct response to scarcity. Because people want more than is immediately available, they produce some good and services for trade. By exchanging things they like less for things they like more, they reallocate their resources and enhance their welfare as individuals. As we will see, people organize firms, which often substitute command-and-control structures for the competitive negotiations and exchanges of markets, because the firms are more cost-effective than markets. Firms can be expected to expand only as long as they remain more cost-effective than competitive market trades. Jacob Viner, an economist active in the first half of this century, once defined economics as what economists do. Today economists study an increasingly diverse array of topics. As always, they are involved in describing market processes, methods of trade, and commercial and industrial patterns. They also pay considerable attention to poverty and wealth; to racial, sexual, and religious discrimination; to politics and bureaucracy; to crime and criminal law; and to revolution. There is even an economics of group interaction, in which economic principles are applied to marital and family problems. And there is an economics of firm organization and the structure of incentives inside firms. Thus, although economists are still working on the conventional problems of inflation, unemployment, international monetary problems, and pricing policies, they are also studying the delivery of housing to the disadvantaged or of health care to the very young and the elderly. In one way or another, today’s economists are tackling a wide variety of subjects, including committee structure, the criminal justice system, firm pay policies, ethics, voting rules, and the legislative process. Before this book and course have been completed, much will be said of how firms like General Electric, Microsoft, or Netscape can be expected to price their products, and we will touch on the conditions under which firms can be expected to give away their products (or even pay buyers to take their products). In fact, because we understand your professional goals for pursuing an MBA degree, we will never present theory for theory’s sake. We will, in each and every chapter, show you how the theory can be used in practice by managers.
What is the unifying factor in these diverse inquiries? What ties them all together and distinguishes the economist’s work from that of other social scientists? Economists take a distinctive approach to the study of human behavior. They employ a mode of analysis based on certain presuppositions about human behavior. For example, much economic analysis starts with the general proposition that people prefer more to fewer of those things they want and that they seek to maximize their welfare by making reasonable, consistent choices in the things they buy and sell. These propositions enable economists to derive the “law of demand” (people will buy more of any good at a lower price than at a higher price, and vice versa) and many other principles of human behavior. A theory is a model of how the world is put together; it is an attempt to uncover some order in the seemingly random events of daily life. Economic theory is abstract, but not in the sense that its models lack concreteness. On the contrary, good models are laid out with great precision. Economic theories are simplified models abstracted from the complexity of the real world. Economists deliberately concentrate on just a few outstanding features of a problem in an effort to discover the laws that govern the relationships among them. Generally, a theory is a set of abstractions about the real world in which we work. An economic theory is a simplified explanation of how the economy or part of the economy functions or would function under specific conditions.
Quite often the economist must also make unproved assumptions, called simplifying assumptions, about the parts of the economy under study. For example, in examining the effects of price and availability on the amount of food sold, the economist might assume that people eat only oranges and bananas in the model society in question. Such a simplifying assumption is permissible in constructing a model, for two reasons. First, it makes the discussion more manageable. Second, it does not alter the problem under study or destroy its relevance to the real world.
As following chapters will reveal, economic theorizing is largely deductive—that is, the analysis proceeds from very general propositions (such as “more is preferred to less”) to much more precise statements or predictions (for example, “the quantity purchased will rise when the price falls”).4 Economic theories sometimes vary in their premises and conclusions, but all develop through the following three steps.
First, a few very general premises or propositions are stated. “More is preferred to less” or “People will seek to maximize their welfare” are examples of such propositions. The premises tend to be so general that they are beyond dispute, at least to the economists developing the theory.
Second, logical deductions, which are tentative predictions about behavior, are drawn from the premises. From the premise “People will seek to maximize their welfare” we can deduce how people will tend to allocate their incomes at certain prices. We can then conclude that they will purchase more of a good when its price falls. Mathematics and graphic analysis are often very useful in deducing the consequences of premises. Although a theory is not a complete and realistic description of the real world, a good theory should incorporate enough data to simulate real life. That is, it should provide some explanation for past experiences and permit reasonably accurate predictions of the future. When you evaluate a new theory, ask yourself: Does this theory explain what has been observed? Does it provide a better basis for prediction than other theories?
Positive and Normative Economics
Economic thinking is often divided into two categories—positive and normative. Positive economics is that branch of economic inquiry that is concerned with the world as it is rather than as it should be. It deals only with the consequences of changes in economic conditions or policies. A positive economist suspends questions of values when dealing with issues suck as crime or minimum wage laws. The object is to predict the effect of changes in the criminal code or the minimum wage rate—not to evaluate the fairness of such changes. Normative economics is that branch of economic inquiry that deals with value judgments—with what prices, production levels, incomes, and government policies ought to be. A normative economist does not shrink from the question of what the minimum wage rate ought to be. To arrive at an answer, the economist weighs the results of various minimum wage rates on the groups affected by them—the unemployed, employers, taxpayers, and so on. Then, on the basis of value judgments of the relative need or merit of each group, the normative economist recommends a specific minimum wage rate. Of course, values differ from one person to the next. In the analytical jump from recognizing the alternatives to prescribing a solution, scientific thinking gives way to ethical judgment.
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