Key Issues faced by Modern Firms

Notes Chapter 3 - Warglien Market Efficiency

The Wealth of Nations, Adam Smith in his well-known work, gives precious insight on the great gains in efficiency of specialization of labor, leaving the workers to specialize in a single task to improve their performance. It is best known for his observations concerning the efficiencies of the competitive market. In fact, he describes the "invisible hand" of the market, through which individuals pursue their own interests but their behavior is guided by prices. In other words, the market is described as a good solution to the coordination and motivation problem. In well-functioning markets, the interdependences among people are completely internalized and each person is led to take into account the aggregate benefit and costs, no matter to whom they accrue.

Perfect competitive markets are efficient economic systems because they create the largest possible net social benefit to be distributed among society's members, maximizing aggregate surplus. Moreover, if an economic output maximizes aggregate surplus, it is said to be efficient in the sense that any alternative outcome that makes someone in the society better off must make some others worse off. In this way, we have defined the Pareto optimal.

For this reason, markets are considered efficient methods to overcome coordination and motivation problems. Moreover, well-functioning markets are characterized by product homogeneity, large numbers of competitors, and, as a consequence, the absence of transaction costs. Every person dealing in the market has all the information possible about sellers and prices. Therefore, bargaining becomes costless. People's interests are translated into the demand, and prices will, then, simultaneously reflect the benefit for an extra unit bought by customers and its cost to sellers (P = MB = MR = MC). In essence, the market prices signal what needs to be done, by whom, where, how, and when. Any change occurred in one of these factors will diminish the aggregate surplus and make someone worse off in the process.

However, perfect competitive markets do not exist, but the direct bargaining among interdependent parties can produce the same efficient outcomes, again without conscious control and planning, with each pursuing only their own interests.

Coase Theorem

As we know, externalities are created by actions if these affect someone with whom the decision maker is not engaged in a related market transaction. They can be negative if they affect someone (pollution) or positive if they benefit someone else (public good). Externalities might be a source of negotiation, and the property rights enforce the bargaining position of who owns them, giving the latter possibilities to emerge with a more favorable deal. However, property rights do not affect externalities, and again each entity acts only on its own behalf. Nevertheless, if there are no transaction costs, hence the bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements...