1. Managerial Economics and Organizational Architecture, 5e Chapter 3: Markets, Organizations, and the Role of Knowledge
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
McGraw-Hill/Irwin

2. The Goals of an Economic System
To satisfy human needs and wants
What to produce
How to produce it
Who gets it
The answer depends on the allocation mechanisms
Free markets
Central planning
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3. Comparing Effectiveness of Economic Systems
Resource allocation is Pareto efficient if no alternative helps at least one person without harming anyone else
In free markets, economic decisions are decentralized to individuals
In centrally planned economies, government officials make economic decisions
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4. Markets, Property Rights and Exchange
A property right is a legally enforced right to select use of an economic good
Private rights are assigned to a specific entity
private rights are alienable in that they can be transferred to another individual, within limits
individuals have use rights within limits
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5. Gains From Trade
Individuals trade something they value less for something they value more
Trade creates value
Sources of trade gains
differences in preferences
comparative advantage
specialization
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6. Specialization
Individuals specialize in producing goods for which they have a comparative advantage
Comparative advantage occurs when an individual has a lower opportunity cost of producing a good
Specialization and trade make both parties better off
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7. Basics of Supply and Demand
Demand curve—shows the quantity of a good that consumers are willing to buy at various prices
Supply curve—shows the quantity of a good sellers are willing to offer at various prices
Interaction of supply and demand yields a market-clearing price
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8. Supply and Demand in the PC Industry$
When prices are high, the quantity supplied is greater than quantity demanded and a surplus exists.
When prices are low, the quantity demanded is greater than quantity supplied and a shortage exists.
Only the market-clearing price avoids surpluses or shortages.
Supply
Surplus
PHI
Price (in dollars) P*
PLO
Shortage
Demand Q Q*
Quantity of PCs
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9. An Increase in Demand – shift rightP S0 P1 P0 D1 D0 Q0 Q1
Q of PCs
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10. A Decrease in Demand – shift leftP S0 P0 P1 D0 D1 Q1 Q0
Q of PCs
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11. An Increase in Supply – shift rightD0 Q0 Q1
Q of PCs
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12. An Decrease in Supply – shift leftQ1 Q0
Q of PCs
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13. The Nature and Function of Prices
Coordinate consumption and production decisions
prices give suppliers incentives to shift production to high priced products
prices give consumers incentives to reduce quantity of high price products
goods are rationed to those willing to pay
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14. Gains From Trade
Consumer surplus - the difference between what consumers are willing to pay and what they actually pay
measured as the area below the demand curve and above the price
Producer surplus - the difference between the price received and willingness to produce
measured as the area above the supply curve and below the price
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15. Consumer and Producer Surplus
$20
Consumer surplus
(Triangle A)
Supply A
Producer surplus
(Triangle B)
$10 B
Incremental production
Costs (Triangle C) C
Demand Q 10
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16. Government Intervention
Consumer and producer surplus can be used to examine the effects of government intervention on gains from trade
Price caps limit the maximum price that can be charged
Price floors are a legally set minimum price at which goods can be traded
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17. Government Price Cap on Gasoline
$/Gallon
Supply
Lost gains
from trade A
$3.00
Excess demand
(shortage) for gasoline B
$2.00
$2.00 price cap
Demand Q
3-17 QS QD

18. Minimum Wage Laws A B QS Q* QD Unemployment (excess supply of labor)
Labor Supply
$5.15
Minimum Wage A
$4.00
Lost gains from
trade B
Labor Demand QS Q* QD
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Quantity of labor

19. Externalities and the Coase Theorem
Externalities occur when the actions of one party impose a benefit or cost on another party outside the exchange
Pollution, noise, graffiti
Markets may not be efficient
Coase argued market exchange will be efficient if:
Property rights can be traded
Transactions costs are sufficiently low
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20. Free Markets versus Central Planning
General knowledge is freely transferable
Specific knowledge is expensive to transfer
Centrally planned economies fail because specific knowledge is not used in the planning process
Prices convey general knowledge
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21. Specific Knowledge Examples
idiosyncratic knowledge of particular circumstances
scientific knowledge
assembled knowledge
Free markets make superior use of specific knowledge dispersed among many participants
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22. Why do Firms Exist? The role of transaction costs
Types of transaction costs
search and information costs
bargaining and decision costs
policing and enforcement costs
opportunity cost of inefficient resource allocation
Optimal economic organization minimizes transaction costs
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23. Firms Can Reduce Transaction Costs
Advantages of firms over markets
fewer transactions
information specialization
reputational concerns
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24. Appendix
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25. Benefits of Assuming Shareholder Wealth Maximization
Identifies what managers should do to meet fiduciary responsibilities
Describes what good managers actually do, given appropriate incentives
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26. Present Value of Risk-Free Investment
Where
CFt is the cash flow in period t
r is the discount rate
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27. Current Value of Share of Stock
Where each Dt is the expected dividend at time t, k is the risk-adjusted discount rate, and g is a constant growth rate
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28. Determination of Stock Value
Not just current dividend
but
Expected future dividends
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29. Stock Market Efficiency
Share prices respond quickly and rationally to new information
Prices reflect present values of expected future net cash flows to shareholders
Investors should not expect to “beat the market” on a systematic basis
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30. Efficient Financial Markets Management Implications
No ambiguity about firm’s objective function
Management decisions that do not affect current or future cash flows are wasted effort
New securities issued at market prices do not threaten current shareholders
Security returns are meaningful measures of firm performance
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