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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