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Introduction to Economics Chapter 6 The Meaning of Coordination in Market Interaction J. Patrick Gunning February 12, 2007.

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1 Introduction to Economics Chapter 6 The Meaning of Coordination in Market Interaction J. Patrick Gunning February 12, 2007

2 Purpose of the Next Three Chapters To show in greater detail how entrepreneurship coordinates the separate actions of different human capital producers. This chapter tells what coordination means.

3 Three Parts to the Chapter 1. The idea of a completely coordinated economy. 2. How economists represent the completely coordinated economy. 2. The case of monopoly.

4 New Topic: Part 1 The Problem of Articulating Coordination

5 Introduction to Economics Chapter 6 The Meaning of Coordination in Market Interaction J. Patrick Gunning February 12, 2007

6 Introduction (1): Example of Hierarchical Coordination 1. Rowers. 2. Factory work directed by a foreman.

7 Introduction (2): First Example of Market Coordination Kuwaitian oil accountant cooperates with The owner of a Taiwan fishing trawler.

8 Introduction (3): Second Example Of Market Coordination A Colombian coffee plantation worker cooperates with: An advertising executive in the UK who may advertise coffee or tea.

9 What Happens in Market Coordination? A change in the plans, decisions and action of one person gives incentives to others to change their actions. Communication is necessary before the others can decide to change their plans.

10 The Problem of Articulating Coordination We know that coordination in a market economy occurs because we can predict that actors in one part of the economy will react to changes in another part. But it is difficult to say how it occurs in a general way. Suppose that a change occurs. Then two kinds of action must occur before the economy becomes more coordinated after the change. 1. Signaling: actors must receive signals that a change is appropriate. 2. Adjustment: actors must actually adjust to the change.

11 Coordination Is Performed By Two Entrepreneur Roles 1. The intermediary entrepreneur role communicates offers to buy and sell and it arranges exchanges. It signals. Specialists in intermediation: real estate agents, employment agencies, stock brokers, banks. 2. The producing entrepreneur role causes adjustments to occur in the use of resources to produce goods. It adjusts production.

12 Intermediary Entrepreneurship Everyone who participates in market interaction acts in the role of the intermediary entrepreneur. Examples: 1. A consumer who agrees to buy a product at the price offered by a retailer. 2. A retailer who advertises her prices. 3. An employer who announces job opportunities. 4. A producer who stands ready to sell to a retailer at a give price or set of prices.

13 Two Classes Of Coordination 1. Hierarchical coordination. Example: men cooperating in the same factory under a single manager. 2. Market coordination. Example: independent business entrepreneurs located at different positions (joints) in a structure of production. Along the same supply chain. Producing different largely unrelated goods or resources.

14 Hierarchical Coordination (1) Hierarchical coordination: the actions performed by two or more different individuals are coordinated by a single individual – the employer. No intermediary entrepreneur role is involved.

15 Hierarchical Coordination (2) The firm: a hierarchical relationship between an employer and employees in which the employer gives directions to employees, within limits. The intermediary entrepreneur role is involved when the firm is formed. After the firm is formed, it is not. The employer is coordinator in hierarchical coordination. He communicates the desire to change and the employees respond.

16 Market Coordination Market coordination: separate actions performed by different individuals (independent contractors) are coordinated by each actor independently in an effort to gain from exchange. The intermediary entrepreneur role is necessary. Communication by means of markets and prices: communication through the announcements and acceptance of offers to buy and sell specific goods and resources at particular prices. The intermediary entrepreneur role signals the profitability of change and independent contractors adjust.

17 Coordination And The Need to Make Judgments To say that an action leads to greater coordination requires the economist to make a judgment about the benefits and harm due to an action. Coordination in the simple case of the exchange and specialization of two farmers. In market interaction, practically every action – including practically every choice to specialize – yields benefits to some people but also harm to others. We cannot discuss coordination in market interaction without comparing the benefits of some with the harm to others.

18 The Problem (1) It is relatively easy to define the coordination of specialized actions for a two-person case. We only need to put ourselves in the shoes of the two producers of human capital. The example of the two farmers. We define an action or event as coordinating if we believe that it makes them better off. Their actions would be completely coordinated if we could not imagine how they both could benefit from changing their actions.

19 How Economics Organize Their Judgments About Coordination In saying that a change from situation 1 to situation 2 leads to greater coordination, economists refer to individuals in the role of the consumer. If consumers are willing to pay a higher amount of money for the consumer goods that exist after the change than before, economists say that there is greater coordination.

20 How Economists Make Judgments About Whether An Action is Coordinating A formal definition of greater coordination: the actions of individuals are more coordinated if the money gains resulting from the event that causes the coordination are greater than the money losses to individuals in their role as consumers. A consumer is better off in situation A than in situation B if he believes that the satisfaction he receives from the goods he can consume in A is greater than the satisfaction he can receive from the goods he can consume in B. Remember: we must focus on individuals in their role as consumers.

21 Consumers Are The Judges And Entrepreneurs Are The Coordinators Two parts to the procedure for describing a shift from a less coordinated to a more coordinated situation. 1. Describe the coordination by referring to the entrepreneurship that caused it. 2. Evaluate the change by referring to the total gains to individuals in their role as consumers.

22 How We Represent Coordination In a World Of Real Market Interaction Four simplifying assumptions are needed to build an image of coordination in real market interaction. 1. Producing entrepreneurs are employers of human resources (employees). 2. Each producing entrepreneur is an employer of resources, including specialized and non-specific human resources. The producing entrepreneur manages a firm. 3. Each entrepreneur is assigned to a consumer good industry. Industry: a group of producers who produce the same product. The industry is composed of firms. 4. Each producing entrepreneur produces a specific consumer good from start to finish. There is no supply chain.

23 Coordination Along A Supply Chain Two Dimensions of Coordination 1. Coordination in the allocation of resources to produce different goods. 2. Coordination along a supply chain. Supply chain for a resource: the links that connect (1) the discovery or initial production of a raw material used to help make a consumer good to (2) the sale of the consumer good that is made with the resource at the retail level.

24 An Example Of Coordination Along A Supply Chain

25 New Topic: Part 2 The Idea of a Completely Coordinated Economy

26 The Method Of Demonstrating How Coordination Occurs We begin with an image of the completely coordinated economy. 1. Next we compare it with an image of an economy that is not completely coordinated. 2. Then we try to show how the actions of a entrepreneur, or group of entrepreneurs, could lead in the direction of a completely coordinated economy. 3. This chapter tries to complete the first task.

27 A Completely Coordinated Economy A completely coordinated economy: an economy in which there are no opportunities for people to gain in net from changing their actions in any way. To fully understand what this means, we need the concepts of diminishing marginal utility and marginal cost.

28 Diminishing Marginal Utility Assumption of diminishing marginal utility: as a consumer receives a larger quantity, the additional satisfaction he receives from the marginal, or last, unit (marginal utility) falls. Diminishing marginal utility is the reason for the water-diamond paradox of chapter 2.

29 Graph of Diminishing Marginal Utility

30 The Demand Curve (1) Demand: a consumers willingness and ability to buy a good that she wants. Because of diminishing utility, a consumer is willing to pay less for the next unit of a good than she is willing to pay for the previous unit. As a result, a seller must offer a lower price to induce consumers to buy a larger quantity.

31 The Demand Curve (2) Individual demand curve: It represents the quantity of a good that would demanded at each price that might be charged for the good. It is a line that shows the inverse relationship between the price and quantity demanded of a good by a particular consumer. Market demand curve: shows the inverse relationship between the price and quantity demanded of a good by all consumers. In this chapter, we are only interested in the market demand curve.

32 A Market Demand Curve (3): Figure 6-1

33 Explanation of Figure 6-1 The quantity demanded at $5 is 1535 is greater than the quantity demanded at the higher price $10 (590). Diminishing marginal utility explains why the demand curve slopes downward to the right.

34 The Demand Curve (4) The market demand curve is an aggregate. It represents the sum of the individual demand curves of the separate consumers. It is the quantity that all of the consumers together would buy at each price.

35 The Demand Curve (5) Figure 6-2 Each point represents at least one consumers willingness to buy a unit. If the price is slightly lower (p- g ), a consumer will buy one additional unit.

36 The Marginal Consumer Marginal consumer: the consumer who would be unwilling to purchase unless the price was as low as it currently is. Alternatively, it is the consumer of the marginal unit at some quantity demanded. At any given quantity on the demand curve (q i ), there is a corresponding price (pi) that shows the marginal utility of the q i th unit to the marginal consumer. This utility is expressed in terms of money.

37 Rising Marginal Cost Meaning: the additional cost of producing the n+1th unit is greater than the additional cost of producing the nth unit. Why do economists assume this? Because taking away resources from the production of other goods pushes up their prices. This makes producers of the other goods less willing to give them up unless they receive higher prices for them.

38 An Example of Rising Marginal Cost An example: the common labor used for either producing rice or for gardening. If rice entrepreneurs only want to produce a small amount of rice, they must pay only a low price for the additional labor needed to produce one more kilo. If they want to produce a large amount of rice, they must pay higher and higher prices for one more kilo. Why? Partly because they must bid the labor away from the entrepreneurs who want to produce gardening services.

39 Figure 6-3 Shows This

40 Explanation Of Figure 6-3 Suppose that suppliers decide to produce 1,000 units. Then the additional cost that the marginal producer must pay to produce the 1,000 th unit is $7.40. Assume that 999 units are already being produced. For the marginal producer to be willing to produce the 100th unit, he must expect to receive at least $7.40 additional revenue from selling it. Similarly, if 1999 units are already being produced, the marginal producer must expect to receive at least $13 additional revenue.

41 Why Does Marginal Cost Rise? The marginal cost of supplying a particular good increases as more units of the good are produced because of the diminishing marginal utility of consuming the other goods that the resources could be used to produce. To understand, refer to figure 6-4.

42 Figure 6-4

43 Explanation of Figure 6-4 (1) Figure 6-4 shows a demand curve that represents a hypothetical composite of the other goods from which resources must be taken away if an entrepreneur wants to increase the amount of the good in question. Entrepreneurs who produce the composite good must be paid a higher price to allow additional resources to be shifted from other goods industry. Why? Because as more and more resources are shifted, the value of the marginal unit of the composite good (i.e., of the marginal units of other goods) rises.

44 Explanation of Figure 6-4 (2) In figure 6-4, suppose that 995 units of the composite good are now being produced. Assume that in order to produce another kilo of rice, one unit of the composite good must be given up. Then the producer of the rice must be willing to pay $8.70 to obtain the resources to produce it. Now suppose that a larger amount of rice is being produced. As a result of the greater use of resources in the rice industry, only 490 units of the composite good are being produced. The marginal producer of rice must be willing to pay $11.80 for the resources he needs in order to produce another kilo of rice.

45 Exceptions to Rising Marginal Cost? Obviously, the marginal cost of producing the second automobile is lower than the marginal cost of producing the first because of high startup costs, such as the high costs of producing the initial human capital to produce the good, or because of high overhead costs (costs of producing one unit that can be spread over a number of units). Thus, when we assume rising marginal costs, we are referring to a pattern that must exist in market interaction. This pattern is due to that fact that the willingness to satisfy each want is limited by consumers desire to satisfy other wants.

46 Marginal Utility and Marginal Cost in a Fully Coordinated Economy Definition (repeated from above): A completely coordinated economy is one in which there are no opportunities for people to gain from changing their actions in any way, including further specialization. In a completely coordinated economy the price of each product is equal to the entrepreneurs judgment of marginal cost.

47 Two Characteristics Of A Completely Coordinated Economy Two necessary characteristics of a completely coordinated economy: 1. No reallocation of resources can raise net consumer utility in terms of money. 2. There are no opportunities for people to gain from changing their actions in any way. Completely coordinated industry: an industry in a completely coordinated economy.

48 A Model of a Completely Coordinated Industry (Figure 6-5)

49 Completely Coordinated Industry (2) The hat industry is completely coordinated at point ($8, 50), where the 50 hats are produced. The marginal utility of the 50 th hat to the consumer who buys it, in terms of money, equals the marginal cost of $8. If 60 hats are produced, MC > MU; if 40 hats are produced MC < MU. In both cases there is dis- coordination.

50 A Dis-coordinated Industry (Figure 6-6)

51 Explanation of Figure 6-6 Explanation of Figure 6-6 Too many hats are produced – 282. Greater efficiency in the allocation of resources can be achieved if resources are shifted away from hats to other goods until only 226 hats are produced. Consumers in general would be better off if resources were shifted to other industries.

52 A Dis-coordinated Industry (Figure 6-7)

53 Explanation Of Figure 6-7 Too few shoes are produced Greater efficiency in the allocation of resources can be achieved if resources are shifted away from other goods to shoes until 113 pairs of shoes are produced. Consumers in general would be better off if resources were shifted from other industries to shoes.

54 Two Views Of Coordination There are two views of coordination: 1. The efficient use of resources view. We show how a characteristics of the fully coordinated market is that resources are efficient. 2. The entrepreneur view. We show the incentives of entrepreneurs to shift resources until the outcome is a fully coordinated market.

55 The Entrepreneur View Up to now we have been presenting the efficient use of resources view. We can illustrate the entrepreneur view by assuming that entrepreneurs have made the mistake of shifting resources away from shoe production and into hat production. In figure 6-6, they produce 282 hats.

56 Figure 6-6: Because Too Many Hats Are Produced, There Is Dis-coordination

57 Notes on Figure 6-6 At 282 hats, the marginal cost is greater than the marginal utility in terms of money. The entrepreneur who produced the last hat (the marginal entrepreneur) must have incurred a loss. He has an incentive to produce fewer hats in the future. So do other entrepreneurs. The incentive would exist so long as the quantity produced is greater than 226.

58 Figure 6-7: Because Too Few Shoes Are Produced, There Is Dis-coordination

59 Notes on Figure 6-7 At 87 pairs of shoes, the marginal utility in terms of money is greater than the marginal cost. The marginal entrepreneur would find it profitable to produce another pair of shoes. He would have an incentive to produce more pairs of shoes. The incentive would exist so long as the quantity produced is less than 113 pairs.

60 A Two-Good Model Of Hats And Shoes Suppose that hats and shoes were the only two goods. Then figures 6-6 and 6-7 could represent the economy. Dis-coordination would imply too many hats and too few shoes were being produced. Entrepreneurs would shift away from producing hats and toward producing shoes until both industries were completely coordinated.

61 From A Coordinated Economy to a Dis- coordinated Economy and Back 1. Entrepreneurs mistakenly shift away from shoes to producing hats. 2. The price of shoes would rise; the price of hats would fall. 3. Consumers of shoes would lose, consumers of hats would gain. 4. The marginal cost of producing shoes would fall below the price of shoes. The marginal cost of producing hats would rise above price.

62 Continued 5. Entrepreneurs would find it profitable to produce fewer hats and more shoes. 6. The shift would lead to greater coordination. Although hat consumers would lose, shoe consumers would gain more. The effects on producers and owners of specialized resources: some would lose but their losses would be offset by those who gain.

63 A Technological Advance The invention of fortified rice disturbs a completely coordinated economy. At the point when the new technology is invented, the market economy would no longer be completely coordinated. Referring to figure 6-9, the quantity of fortified rice produced is zero. At that quantity, the price would greatly exceed marginal cost. The economy would remain dis-coordinated until entrepreneurs shifted sufficient resources from other uses into the production of the new rice.

64 Figure 6-9: If Quantity is Zero, Price Is Greater Than Marginal Cost For The First Unit

65 Explanation 1. Technological advance in the presence of a completely coordinated economy leads to dis- coordination. 2. The dis-coordination presents profit opportunities to entrepreneurs who respond by shifting resources until coordination is restored. 3. In the process, individuals in the consumer role gain from the technological advance.

66 Effects on the Owners of Resources Who loses? The people who have acquired specialized skills that are suited only to producing the goods that consumers decide not to buy because they shift to fortified ovens. For example, suppliers of work that is specialized in the non-fortified rice industry and that cannot be easily shifted into the fortified rice industry. The losses to these resource owners are offset by the gains to the suppliers of work who are specialized in producing the fortified rice. There is no reason to believe that the losses to these losing resource suppliers would be greater than the gains to the gaining resource suppliers.

67 Effects on the Consumers In the new completely coordinated economy after the technological advance, we know that consumers are likely to be better off because the marginal cost of fortified rice is initially lower than the money value of additional rice to the marginal consumer. This implies that consumers value more fortified rice higher in terms of money than more of other goods. The existence of the new demand curve for fortified rice shows this. This gap between the money value of the marginal unit of fortified rice and the money value of other goods would exist so long as the amount of the new rice is less than the completely coordinated amount.

68 Entrepreneurial Coordination Whose entrepreneurship was responsible for the change due to the technological advance? 1. The entrepreneurship of the fortified rice producers who bid for the resources to produce the rice. 2. The entrepreneurship of the owners of the resources that shifted into rice production. 3. The entrepreneurship of the producers of other goods who allowed the resources to be shifted up to a point.

69 Entrepreneurial Coordination : Giving Signals And Receiving Them The producers acting as intermediary entrepreneurs in each industry give signals on the basis of their profit expectations. Resource suppliers, consumers, and the producing entrepreneurs receive the signals and respond to them. Resource suppliers and consumers are ordinarily regarded as passive responders to signals.

70 Errors By Producing Entrepreneurs: Why Entrepreneurs Make Errors (1) Buyers often conceal their true preferences. Buyers may not know what they prefer until they try it. The producing entrepreneur is unlikely to be aware of the identities of all the buyers.

71 Errors By Producing Entrepreneurs: Why Entrepreneurs Make Errors (2) Owners of resources often conceal the prices they must be paid and, therefore, the costs to the producing entrepreneurs. A producing entrepreneur cannot know the identities of all of the resource suppliers. A producing entrepreneur may not know the true costs until she begins production.

72 Conclusions About Errors Complete coordination is impossible because entrepreneurs make errors. However, it would be against our experience to assume that entrepreneurial actions are more likely to lead to dis- coordination. The images of a completely coordinated economy and of errorless entrepreneurs are tools that we use to help us illustrate the assumption that the actions of individuals in the entrepreneur role are more likely to lead to greater than to lesser coordination.

73 Dis-Coordination in Distribution Dis-coordination in distribution: goods are not distributed to consumers who are willing to pay the highest prices for them. Owners and intermediaries have incentives to take actions that achieve greater coordination in distribution.

74 New Topic: The Case of Monopoly Monopoly: a situation in which there is a single seller of a good or resource. Example: the owner of the only water well in a village.

75 Three Ways To Achieve A Monopoly Position 1. Luck. 2. Deliberate production, particularly of a specialized ability or skill. 3. Causing the transfer or consolidation of the rights associated with a monopoly position held by others: A. Buying a monopoly right from someone who already has a monopoly position. B. Joining with individuals who would otherwise be competitors. This is called a collusive monopoly. C. Buying out competitors. With help from the government (but not in a the pure market economy). Examples: a patent monopoly and special privileges to a favored taxi company.

76 Price Taker And Price Maker A seller who does not have a monopoly must sell at a price that is not much higher than that of her competitors. Such a seller is sometimes called a price taker. A seller who has a monopoly faces no effective competition and, therefore, can choose her price. She is a price maker.

77 Marginal Revenue For the monopolist, the question of whether to raise or lower price depends on marginal revenue. Marginal revenue: the additional revenue from selling one more unit.

78 Example of Marginal Revenue Price Quantity Total Revenue Marginal Revenue $5 100 $ $ Assuming that the monopolist cannot price discriminate, he must reduce prices to all buyers at once. Price discrimination: charging different prices for different units or to different individuals.

79 What Price Should a Monopolist Charge If He Has No Costs? (1): Figure 6-10

80 What Price Should a Monopolist Charge If He Has No Costs? (2) In the graph, show that he should charge the price 20. If he charges a higher price, he can gain by reducing his price. If he charges a lower price, he can gain by raising his price. Show this by calculating the total revenue at a variety of prices.

81 Price Elasticity of Demand (1) Price elasticity of demand: is a measure of the responsiveness of quantity demanded to price changes. Demand is price elastic when an increase (decrease) in price leads to a fall (rise) in total revenue. Demand is price inelastic when an increase (decrease) in price leads to a rise (fall ) in total revenue. A profit-seeking monopolist would never produce a quantity for which demand is price inelastic.

82 Price Elasticity of Demand (2) Examples using figure 6-10.

83 Price Elasticity of Demand (1) Do some examples using the following formula:

84 Monopoly Price Monopoly price: a price charged by a monopolist that is higher than marginal cost. The monopolist charges this price in order to maximize profit. To illustrate the monopoly price with a graph, we first study the relationship between demand and marginal revenue.

85 Relationship Between Demand and Marginal Revenue (1): Figure 6-11

86 Relationship Between Demand and Marginal Revenue (2) Marginal revenue: the additional revenue that a seller could gain if he sold one more unit. Marginal revenue is always less than price for the downward-sloping demand curve. When marginal revenue is positive (to the left of 20 in the graph), the entrepreneur can increase revenue by reducing price and increasing quantity sold.

87 Profit Maximization For Monopoly In Distribution Monopoly in distribution: a monopoly in which there are no costs of production. The situation faced by a monopoly in distribution is represented in figure The monopolist maximizes profit by maximizing revenue, by charging a price of $20. When marginal revenue is zero (at 20 units), the monopolist can no longer increase revenue by reducing price. When marginal revenue is negative (to the right of 20 units in the graph), the entrepreneur can increase revenue by raising price and reducing quantity sold. If the monopolist produced one more unit, say 21, he would lose revenue.

88 The Graph of a Monopoly Producer The graph of a monopoly producer is different from the graph of a monopolist who does not produce because it contains costs. The monopolist maximizes profit by choosing the quantity at which marginal revenue equals marginal cost. Thus he chooses quantity q in the figure If he chose a smaller quantity, he could raise his profit by producing one more unit. If he chose a larger quantity, he could raise his profit by producing one less unit. He charges the highest price at which he can sell this profit- maximizing quantity. This is price p in the graph.

89 A Monopoly Producer With Rising Marginal Costs (Figure 6-12)

90 Monopoly Dis-coordination (1) The examples in figures 6-11 and 6-12 show that a monopolists normal actions of charging a monopoly price results in dis-coordination because price is higher than marginal cost. Charging a monopoly price is an exception to the rule that market interaction under the conditions of the pure market economy tends to be completely coordinated.

91 Monopoly Dis-coordination (2) An entrepreneur could not be a monopolist in distribution unless he possessed monopoly control over a consumer good. resource. Example: the owner of a bridge with no maintenance cost. Dis-coordination is due to the monopolists decision to not sell additional amounts of the bridge service even though the marginal utility and price that someone is willing to pay for an additional unit is greater than zero. The monopolist does not want to reduce his price to those consumers who otherwise would pay a higher price.

92 Monopoly Dis-coordination (3) An entrepreneur could not be a monopolist producer unless he possessed monopoly control over a resource. Example: a monopoly candle producer may own all of wax or all of the superior candle-making skill. Dis-coordination is due to the monopolists decision to not use additional amounts of the monopolized resource even though the marginal cost of producing one more unit is less than the price. The monopolist in production does not want to reduce his price to those consumers who otherwise would pay a higher price.

93 Dis-coordinating Entrepreneurship Entrepreneurship with respect to monopoly and external effects due to the absence of complete private property rights are exceptions to the notion that entrepreneurship is always coordinating. If the goal was to judge the merits of government intervention, we could not disregard these. Since our goal in this book is to explore the coordinating function of entrepreneurship, we disregard monopoly and external effects.


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