Business and Industrial Economics

Business & Industrialeconomics

Prof. Luca Grilli A.A. 2016/2017

Efficiency, coordination and economic organizations

Transactions happen inter and intra two categories: individuals and economic organizations. Economic organizations are artificially created to satisfy certain objectives (economic value creation) while individuals are rational human beings dealing with scarcity of resources.

Economic organizations (Milgrom and Roberts 1992)

Economic organizations are created-entities within and through which people interact to reach their goals. We can define different levers: the economic system is made of many markets and within each market have many firms and other entities. The fourth lever is made by individuals.

The highest-level organization is the Economy as a whole. “Markets” (and the way transactions are governed, managed and carried out) are lower-level economic organizations. “Firms” and other formal entities (e.g. labor unions, government/regulatory agencies, associations, etc.) are economic organizations that are formed and interact with individuals in markets.

Inputs, production, outputs, and consumption form the circular flow of economic life (Samuelson and Nordhaus, 2001). All these markets are connected and the behavior of each entity impacts other entities. We are considering both B2B and B2C markets. Each economic system has an infinite set of possible allocation of resources… which is the best of these possibilities?

Pareto efficiency

Pareto efficiency criteria can be applied to compare different possibilities for the market. An allocation of resources A is said to be Pareto efficient (or Pareto optimal) if there is no other available allocation B that everyone concerned likes at least as A and that one person strictly prefers. In such a case, A is inefficient if it is Pareto dominated by B (B is Pareto superior to A) and it is clearly wasteful from a society's point of view.

Notice that to give all resources to a single insatiable and completely selfish individual would be efficient (ethics is not contemplated). Moreover, there are typically many efficient allocations for a given collection of resources. Thus, the efficiency criterion may be weak on ethical grounds and as a predictor of outcomes. But its predictive power is not totally absent: the efficiency principle.

The efficiency principle: If people are able to bargain together effectively and can effectively implement and enforce their decisions, then the outcomes of economic activity will tend to be efficient (at least for the parties to the bargain). Indeed, since efficient choices and allocations are less vulnerable, we should expect inefficient arrangements being supplanted over time, while efficient ones survive.

If there is a Pareto dominated outcome there is a scenario with someone who would stay better and no one worse, the system will automatically migrate to that option.

The Edgeworth box and the gains from trade

Two consumers, A and B. Their endowments of goods 1 and 2 are: (ω1_A, ω2_A) and (ω1_B, ω2_B). For example: ω_A = (6, 4) and ω_B = (2, 2).

The total quantities available are:

• Units of good 1: ω1_A + ω1_B = 6 + 2 = 8
• Units of good 2: ω2_A + ω2_B = 4 + 2 = 6

Recap of indifference wave: U(x₁; x₂) negative scope, monotonic and convex. If I have less x₁, I will want to have more of x₂ in order to maintain the same level of utility. U_a is better than U_b: given the same amount of x_a or x_b, I have more of x_a or x_b.

A mix of x_a and x_b is referred to only having one of them (convexity). The box includes all the feasible allocations of the goods between the two customers. Of course, including the before-trade allocation. The endowment allocation:

• (x_1A, x_2A) denotes an allocation to consumer A
• (x_1B, x_2B) denotes an allocation to consumer B

An allocation is feasible if and only if:

• x_1A + x_1B ≤ ω1_A + ω1_B
• x_2A + x_2B ≤ ω2_A + ω2_B

• Which allocations will be blocked by one or both consumers?
• Which allocations make both consumers better off?

Adding preferences to the box: For consumer A. For consumer B 180°.

Endowment allocation:

Pareto-improvements: An allocation that improves the welfare of a consumer without reducing the welfare of another is a Pareto-improving allocation. Trade improves both A’s and B’s welfares. This is a Pareto-improvement over the endowment allocation. E.g. A reduces consumption of good 2 and sells it to B, who in exchange reduces consumption of good 1 and sells it to A. Further trade cannot improve both A and B’s welfares. It will stop when the two curves are tangent to each other.

Pareto-optimality: The allocation is Pareto-optimal since the only way one consumer’s welfare can be increased is to decrease the welfare of the other consumer. There are many Pareto-optimal possibilities included in the so-called contact curve. The contact curve is the set of all Pareto-optimal allocations.

Theories about equilibrium

• Pareto equilibrium
• Competitive equilibrium

The core

Given an initial allocation (the green dot), the core is defined as the reachable allocations in the contact curve. If there are two individuals specialized in two different goods, they can either trade or not trade. Rearranging activities among individuals makes it possible to increase the overall production capacity of the system. It is feasible until they know it is better to trade with each other. The concept of opportunity cost is related to this situation.

The main message is basically that trade is useful for welfare. We are transforming our society into a market society: we are organizing human activities based on markets. But trade is also important because it leads to more goods and services in the economy (to be traded).

Trading enables specialization, which is useful because it enlarges the possibilities of people to consume goods and services (more of them are available). With the Edgeworth box, we are dealing with two hypothetical goods; this instrument works well also considering “goods” like money and children or time and money (technically it applies, and it is possible to create a market with them, but is it ethically right? Sandel made reflections about the issue in his book).

Coordination

In a market economy, everyone should find his/her talent, specialize in that field in order to improve the overall economic conditions: that’s Smith’s idea. Adam Smith.

Productivity/specialization coordination

Since Adam Smith’s pin factory example, we know that specialization increases productivity. But specialization requires coordination: time and efforts of specialists are wasted unless:

• They can be sure about the fact that other specialists are doing their part;
• They will be able to buy on the market what is necessary for their needs.

How to coordinate? (The need for information)

All this coordination requires information, which is difficult to be gathered. One option is centralized planning (one central person organizes all the production having a broad perspective); another option is autonomous decentralized decisions (the option provided by the market). Basically, a higher price means the request for that good is increasing; it's only true for perfectly competitive markets.

Coordination information

How to gather all this relevant information?

• Centralized planning
• Autonomous decentralized decisions

Markets are costless mechanisms to achieve efficient allocations because PRICE acts as an “informative vehicle” by signaling scarcity. But this is 100% valid only if MARKETS ARE PERFECTLY COMPETITIVE: only in this case prices signal the true benefits and costs for the use of resources by the economic system.

The best general equilibrium possible of all markets is the circular flow of the economic system: perfect condition is the composition of the economy made by only perfectly competitive markets (all of them). Coordination by markets and prices but not only (e.g. the market is the leading device + hierarchical structure).

A thorough use of the market is actually the solution to the problem of coordinating economic activity. At the extreme, all transactions could be between separate individuals on an arm’s-length basis.

• The opposite extreme would be the complete elimination of the price system, under a regime of explicit central planning within a single organization.

Market economies feature firms that interact through markets but within which activities are explicitly coordinated by plans and hierarchical structures. And they appear a remarkably effective mechanism for achieving coordination. We will dig into the reasons why this “hybrid solution” is the prevalent one when we dig into the theory of the firm.

Competitive markets are the ultimate goal

The perfect competition is like a lighthouse that illuminates in the dark. Where there is not the lighthouse and companies are in the dark, three main “market imperfections” are generated:

• Market power
• Externalities
• Asymmetric information

Perfect competition is the best situation which could be achieved is the perfect situation but 3 main market imperfections make this reach impossible:

• Market power makes it structurally impossible;
• Externalities happen when someone makes an action to improve his utility while decreasing the utility of someone else (e.g. environmental externalities like pollution or network externalities, typical of ICT);
• The presence of asymmetric information happens when within a transaction one part knows more than the other.

Another imperfection is the presence of transaction costs.

Production and cost function, short-run/long-run curves, economies of scale and scope [optional]

Production functions and short-run/long-run curves

In economics, resources are limited, thus companies (and generally speaking, economic agents) have to face a trade-off between:

• What they aspire to do – profit maximization
• What they can do – technology constraints

The technology is the process that receives some inputs (a vector X of N inputs) and returns some output (a vector Y of M outputs).

The production set

Production set: set of the input and output combinations achievable with a certain technology (i.e. technically achievable, given the technology). Technology constraints: not all the input/output combination are feasible; given a certain input, it is possible to attain only certain output levels.

The production function

Production function (f(x)): maximum output vector that can be attained given a certain input vector.

{ }f : R^N → R^N MAX Y = f (X)

Thus:

• It represents the efficiency frontier of the production set
• Given x input units, the technology produces y output units’ maximum
• In case of one single input x and one single output y=f(x), also the production function can be represented on the Cartesian plane x0y (see the figure)

(x, y) belongs to the production set:

Given x input units, the technology allows producing y output units (see the figure). Simplifying hypothesis: the company uses 2 inputs (Labour and Capital) in order to produce 1 output.

• Inputs or factors of production: Labour (L) and Capital (K)
• Output: y
• Production function: y=f (L, K)

The marginal productivity

Labour/capital marginal productivity: output variation given a variation of one labour unit (maintaining the same amount of capital/labour)

MP_K = (f (L, K+ΔK) – f (L, K)) / ΔK

MP_L = (f (L+ΔL, K) – f (L, K)) / ΔL

Given infinitesimal variations of the labour/capital:

MP_K = lim_ΔK→0 (f (L, K+ΔK) – f (L, K)) / ΔK = ∂f / ∂K

MP_L = lim_ΔL→0 (f (L+ΔL, K) – f (L, K)) / ΔL = ∂f / ∂L

Deriving the product function for L/K it is possible to attain the labour/capital marginal productivity. The marginal product of an input is the rate at which output changes as the firm changes the quantity of one of its inputs, holding the quantities of all other inputs constant.

1. Changes in quantity of output due to changes in labour.
2. Changes in quantity of output due to changes in capital.

Returns to scale

Returns to scale: percentage by which output will increase due to an increase of all inputs at a certain percentage.

• Increasing returns to scale: the output changes more than proportionally with the inputs.
• Constant returns to scale: the output changes proportionally with the inputs.
• Decreasing returns to scale: the output changes less than proportionally with the inputs.

Law of diminishing returns: keeping constant all the others production factors, beyond a certain production level, additional units of an input cause a decreasing marginal productivity (e.g. too many people working on the same task).

Over the short run some factors of production are fixed, while others can change.

Short-run

• On the left, example of production function in the short run: it is possible to change the quantity of one input only (L) (e.g. recruitment of new employees), keeping the capital constant (the production increases but at a lower rate)

Long-run

• It is possible to change the quantities of both the inputs (L and K) (e.g. construction of new production plants)

The cost taxonomy

Cost function: minimum cost of production to produce the outcome y; it shows the cost of inputs the firm needs to pay to produce output y.

C(y) = f(y)

There are several types of cost:

• Opportunity cost: value of the best alternative forgone, in a situation of limited resources. They should be taken into account when making economic decisions; e.g. the opportunity cost of going to college is the money you would have earned if you worked instead.
• Fixed, variable and total cost:
  • Fixed Costs (FC) - do not vary with the output (A); relevant over the long-run; e.g. rents, plant…
  • Variable Costs (VC) - vary depending on the output (B); they are relevant over the short-run; e.g. raw materials, energy…
  • Quasi-fixed costs - do not depend on the output, but the company faces them in case it produces a certain threshold (e.g. recruitment costs)
  • Total Costs (TC) are given by the sum of fixed and variable costs (TC=FC+VC)

Average cost and economies of scale:

• The Average Cost (AC, or unitary cost) is the cost for every unit produced: C(y) = VC(y) + FC / y = VC(y) / y + FC / y
• The Average Fixed Cost (AFC) is given by: AFC(y) = FC / y; If y → ∞, AFC(y) → 0
• The Average Variable Cost (AVC) is given by: AVC(y) = VC(y) / y; AC=AFC+AVC; AVC=AC-AFC; AVC<AC, the average variable cost is lower than the average cost (by construction). The AVC curve is below the AC curve. The distance between the AVC and the AC reduces as y increases: AC(y) = AVC(y) + AFC(y) and AFC(y) → 0 if y=∞

Avoidable and not avoidable cost: difference between avoidable and not avoidable costs is based on the decision taken (e.g. increasing or decreasing the production, make-or-buy choices…). Not avoidable costs are incurred anyway, regardless of the decision taken (e.g. going on holiday by car) costs:

• Avoidable costs: motorway, oil, tire wear…
• Not avoidable costs: the car, insurance, road tax…

Note: avoidable and variable costs are not the same concept, even though the two measures sometimes coincide (e.g. the labor is sometimes considered a variable cost (greater input implies greater output), but it is a not-avoidable cost (except for seasonal contracts)).

Sunk cost (one-time expense): the input cannot be used for alternative productions; it is also called a “specific asset”. It is a barrier to exit and thus the opportunity cost is null.

• Examples:
  • Plant that cannot be sold because of the lack of second-hand markets;
  • Advertisement costs for a good that is not produced anymore;
  • Employees’ training for a software that is not used anymore…

Marginal cost: total cost change due to the production of one additional unit; i.e. the total cost of producing y+1 units minus the total cost of producing y units of output. In other words, the cost of producing one more unit of a good. It is given by the first derivative of the Total Cost or of the Variable Cost:

MC(y) = ΔC(y) / Δy = C(y+Δy) – C(y) / Δy

MC(y) = lim_Δy→0 (C(y+Δy) – C(y)) / Δy = ∂C(y) / ∂y

MC(y) = ∂C(y) / ∂y = ∂VC(y) / ∂y = D[VC(y) + FC] / dy

Relationship between Average Variable Cost (AVC) and Marginal Cost (MC). We compute the derivative of the AVC:

∂AVC(y) / ∂y = [VC(y) / y] = VC(y) / y² - VC'(y) / y² = [MC(y) - AVC(y)] / y

∂AVC(y) / ∂y > 0 if MC(y) > AVC(y)