Consider market mechanism and its failures

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Introduction. Markets and national welfare

Esh Trushin and Kevin Hinde

Business Economics part

 

The Nature of Planning and Controlling…, but often forgetting about the economy

Management

Process

 

of

Planning

 

Increase

 

Corrections and revisions plans and actions

 

 

 

Profitability

 

 

 

 

 

 

 

 

 

Control

 

 

 

– Actions

 

 

 

 

– Evaluations

 

 

 

 

 

 

Accounting System

Budgets,

Special

Reports

Accounting

System

Performance

Reports

Other information

systems

Customer surveys

Competitor analysis

Advertising impact

 New items report

Managers can be effective without economics, but a business leader improves firm competitive advantage and needs economic perspectives

 

Strategic management needs economics

Competitive advantage of a firm is based on:

Supply – through cost advantages, often due toknow-how protected by secrecy/patents and

Barriers to entry for rivals

Demand – access to market via key distribution channels, customer captivity through habit formation, high costs of switching/searching or experiencing alternative products

Economies of scale or specialisation – costs decline with more and focused production

3

 

Which economic theory we study in this module?

Out of 9 (or more) economic schools (Classical, Neoclassical, Marxist, development, Austrian, Schumpeterian, Keynesian, Institutional, Behaviourist), we focus on Neoclassical economics with own political, ethical, modelling assumptions and values

Major assumptions of neoclassical economics are free markets, selfish rational individual choices with a focus on exchange, consumption and incentives through prices

We consider some concepts and applications of economics to managerial economics in this module.

Also watch a good introduction in microeconomics at

https://www.youtube.com/watch?v=g9uUIUqhrSQ&list=PL-uRhZ_p-BM4XnKSe3BJa23-XKJs_k4KY

• Watch an entertaining presentation on economics by Prof. Chang at

https://www.youtube.com/watch?v=NdbbcO35arw

4

 

Your learning objectives

After this session, you should be able to:

Consider market mechanism and its failures

Assess minimum market size for a given cost structure

Apply demand and supply analysis and critically examine their national welfare implications

Examine situations where governments might need to intervene because markets don’t work effectively

5

 

The Market Economy

market is any arrangement that enables buyers and sellers to exchange goods and services for a price.

Markets for homogeneous products (e.g. gold, grain) tend to have one price. Markets for differentiated products (cars, toothpaste) tend to have a wider spread of prices

Markets can involve simple or complex transactions, requiring institutions (rules, monitoring and prosecution) to ensure transactions. Out of 200+ market economies, only economies with proper institutions can prosper

 

“One-handed” economist? What do economists

agree/disagree on?

Percentage agreeing

 

 

Proposition

USA

Switzerland

Germany

 

 

 

 

 

 

 

Tariffs reduce economic welfare

95

87

94

 

Flexible exchange rates are

94

91

92

 

effective for international

 

 

 

 

 

transactions

96

79

94

 

Rent controls reduce the quality

 

 

 

 

 

of housing

 

 

 

 

 

 

 

 

 

 

 

68

51

55

 

Government should redistribute

 

 

income

 

51

52

35

 

Government should hire the

 

 

 

 

 

 

 

jobless

 

 

 

 

 

 

 

 

 

 

‘If all economists were laid end to end,

they would never reach a conclusion.’ George Bernard Shaw

7

 

What is economics about?

• We seem to ‘want, want, want’. INSATIABLE WANTS?

Far beyond need?

We cannot satisfy all these wants because SCARCITY exists

To address the distribution and production problems, free MARKETS can maximize National Welfare though PRICE mechanism

Scarcity represents CONSTRAINTS on the DEMANDand SUPPLY side. For example are choices are restricted by

Financial constraints (Budget)

Limits on our Productive Time

The current state of technology

Physical and human capital shortages

Limited information and uncertainty about the environment.

Economics assumes agents (consumers, firms) maximize their utility or profit/value given technological, information, and price constraints.

 

Choice involves a cost

A choice represents a tradeoff (substitutability) — we give up something to get something else — andthe highest valued alternative we give up is the opportunity cost of the activity chosen.

Alternative cost is one of the key concepts – is a cost of the second best available alternative

Example 1: your opportunity cost this year is income lost from employment while studying;

Your opportunity cost of studying for life is different!

Example 2: If you live in a house with a spare room, the opportunity cost is net rent you lose

suphakit73 / FreeDigitalPhotos.net

Image:

 

And a benefit

Remember we want or require products and services and derive benefit from their consumption. Economists refer to this as UTILITY

Utility – is assumed increasing function in consumption which follows from axioms of choice

(preferences), higher utility is preferred

The optimal choice we make is where the benefit from consuming an additional (marginal) unit equals the cost of consuming that unit

Formally, Marginal Benefit = Marginal Cost

10

 

Demand

Customers make choices by maximising their utility of consumption given their budget constraints

Quantity demanded Qd is a function of price Px for a good or service, and preferences, substitutes and complementary goods available

Important assumption - Ceteris paribus – “other things being equal” (may not work)

Under axioms of consumer choice, Demand typically has the property that as Price falls Q rises and vice versa

Demand curve is the maximum price at which a representative consumer wishes to buy amount of

goods Q

11

 

 

Supply reflects marginal costs

Supply (Qs) reflects costs as a function of price Px and underlying technology: Qs = f(Px)

Under typical conditions as price of production Px rises, the output Qs increases and vice versa

Costs of producing one additional unit of goods/services is called marginal costs

Suppliers are motivated by profit, which is the difference between price of a good /service and marginal costs of supply

Producer supplies additional good/service if price is higher or equals marginal costs

Supply curve represents the marginal costs of production an amount of goods Q

12

 

Shifts in demand and supply curves

with prices of different goods Py,Pz, own price Px, Technology T, Preferences U,Z

Movements along the demand curve

Qd = f(Px, Py…Pz, Y, T, U)

Shifts in the demand curve Movements along the supply curve

Qs = g (Px, Pa, Pi, Te, Z)

Shifts in the supply curve

Change in demand – a shift of the entire demand curve caused by a change in a non- price factor that affects demand

Change in supply – a shift of the entire supply curve caused by a change in a non- price factor that affects supply

 

The “market” “equilibrium” scheme

Price

 

Surplus

 

 

P1

 

 

 

Supply

 

 

 

 

P

 

 

 

 

 

 

 

 

Demand

0

Qd

Q

Qs

Quantity per

 

time period

 

 

 

 

At prices above the equilibrium there is a surplus, supply exceeds demand. Suppliers will sell excess stocks at lower prices.

Consumers will lower their offer prices

 

The market scheme (continued)

Price

Supply

P

 

 

 

 

 

 

P1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shortage

 

Demand

0

 

 

 

 

 

 

Qs

Q Qd

 

Quantity per

 

 

time period

At prices below the equilibrium there is a shortage, demand exceeds supply. Consumers (with higher incomes?) will offer higher prices. Suppliers will make more in search of higher returns from the shortage.

 

P

Consumers are willing to pay more than they have to because of the operation of the market

National welfare analysis

Supply = sum of

 

 

the marginal cost

 

Consumer surplus

curves for all

 

firms

 

 

 

 

The difference between what

 

 

the producer receives and the

 

P

marginal cost of supplying

 

 

that unit

 

 

surplus/profit

 

 

demand

 

0

Q

 

Q

 

16

 

The coffee market – what you may infer from this graph? (not much)

Source: http://dev.ico.org/

 

What drives market prices – supply or demand?

Source: http://dev.ico.org/

 

Slopes of demand and supply matter, i.e. ratio of “rise over run”, dP/dQ

Price

D

97

D05

S97

 

Why coffee

 

 

 

 

 

 

S05

 

 

 

 

 

 

 

 

 

 

prices fell – the

P97

 

 

 

 

 

case of parallel

 

 

 

 

 

shifts in 1997

 

 

 

 

 

 

 

 

 

 

 

 

(97) vs 2005 (05)

P05

0

Q97

Q05

Quantity per

 

time period

 

Markets work…don’t they?

Well, usually imperfectly

When they don’t operate perfectly we need

Incentives to ensure markets work

Self-imposed rules – self-regulation, usually within an industry to prevent government regulation “overdose”

Government intervention

Court and enforcement systems, norms, procedures, often referred as government institutions

One of the key question for a start-up or new product:

There is a gap in the market, but is there a market in the gap? How to balance costs and revenues?

20

 

Fixed and variable costs when costing mechanism is complicated…

 

Activity

Cost

 

 

 

cost pools

driver rates

 

 

 

Buying raw

£/purchase

 No. of

 

 

materials

order

orders

 

Overhead

Controlling

£/inspection

 No. of

Product

 

quality

 

inspections

 

expenses

 

 

 

costs

 

Operating

£/machine

 No. of

 

 

machinery

hour

machine hrs

 

 

etc.

etc.

etc.

 

Economists simply separate Costs into FIXED (FC), which do not depend on output (Q) level, and VARIABLE (VC), that change with output level. Total Costs (TC) = Fixed (FC) + Variable (VC) Costs

 

Market (niche) size does matter!

Especially with high R&D and marketing costs of new goods

The break-even point (analysis) is a minimum market size (sales/output Q) at which total costs equal total revenue

Opportunity costs of production are paid, but zero profit

Recall that in economics marginal costs and revenue matter – how many thing you need to sell to cover total Variable Costs (VC) = Unit Variable Costs (UVC)*Q ?

Total Revenue = P*Q = Total Costs = FC + UVC*Q

P*Q – UVC*Q = FC, hence, (P - UVC)*Q = FC

Break-even output Q = BEP =

 

 

 

More details from accounting perspectives will follow in the

 

accounting part of the module

22

Break-even point (BEP) – minimum output

Margin of safety is difference between number of current units sold and BEP

In output units: Margin of safety = Sales - BEP

 

In-class exercise on minimum market for soda

Costs are in p – pence per one can of soda drink

(direct) Materials cost: Electricity – (1p),

-Aluminum cover - (2p), cover paint – (1p),

-Cola concentrate (3p), purified water – (1p)

“Secret” ingredient (2p) – reflects a differentiation strategy or unique selling point

Production overhead:

-Managerial – (£1000.00), renting equipment – (£2000.00) Other overheads:

Marketing – (£2500.00), Administrative (£500.00)

-Separate costs and find Variable(VC) and Fixed(FC) costs

If wholesale price of one can of soda is 20p, find minimum market size (BEP) for this soda company

24

 

When markets may not work (effectively)?

If transactions costs of using markets are much higher than that of other institutional arrangements

Example – within firms - why in a firm often there is no clear market for every job/responsibility allocation?

Demand is too small to cover the marginal cost of supply; for example, development of drugs for neglected diseases

information is NOT perfect, i.e. somebody has better access to important information (Adverse selectionMoral hazard)

Price may be influenced by a seller/buyer (market power)

Externalities – the third party, which has not participated in market transactions, is essentially affected, e.g. “too big to fail” when public is affected by bankruptcy of a large bank

Public goods (non-rival and non-excludable in consumption)

Markets do not automatically reduce income inequality…

25

 

Demand is insufficient to cover the marginal cost of supply – no supply

Price

S

28 MPG -

38 MPG

 

D

0

 

Quantity per

 

 

 

 

 

time period

26

 

Markets do not address normative (ethical?) income distribution (not quite a market failure)

 

Explaining Consumer Complaints

Most markets work well

Particularly where there are frequent and very low cost transactions

Question: Why is it easier to find a high quality supplier of fruit and vegetables than it is to find a high quality firm to carry out domestic building/reparment work correctly?

(see the case of rogue traders on duo)

 

Adverse Selection (market for “lemons”)

double glazing example

75 % chance of high quality units and service

25% chance of poor quality units and service

High quality units, fitting and installation costs £1200

Low quality units, fitting and installation costs £600

Consumer expected willingness to pay

(0.75 x £1200) + (0.25 x £600) = £1050

Thus, market has a problem. High quality suppliers will not be able to operate and ‘rational’ consumers will note that only low quality suppliers will operate in the market for a surplus/profit of £1050 - £600 = £450.

As a result we might have MARKET FAILURE.

Market double glazing may disappear as nobody would purchase local units and services…

 

Adverse Selection

Defined as a process by which an undesirable population of buyers or sellers with an imperfect information participate in voluntary exchange

In this instance the ‘undesirable population’ are sellers (‘cowboys’)

In contract theory this is one of Principal

(employer) - Agent (employee) problems

The Principal (uninformed party) does not knowcharacteristics of the agent (informed party – service provider) and the uninformed party moves first by contracting the informed party

 

Moral Hazard

An action taken not in the interests of Principal by the informed party after a contract is signed

An ex post contractual opportunism

Example – after a contract is signed, a CEO plays golf all days instead of increasing firm value

Customer chooses a supplier, pays over a deposit, but once ‘locked in’ to the transaction, the supplier may ‘act with guile’

Behaviour of Mr Simpson (in the cartoon

“Simpsons”) with and without life insurance

 

Externalities

Market prices do not always incorporate all impacts of activities of either producer or consumer

Consumption or production has indirect effect on other parties; the national welfare not reflected in market prices/transactions

Externalities could be positive, e.g. a smart student asking questions in class that benefit other students

Or negative, e.g. pollution from cars or factories

In modern knowledge-based economy externalities are rather systemic

 

External Costs – plant dumping waste;

S – Social, M - private

The efficient output level is q* where Marginal Social Costs (MSC) =Marginal Social Benefits.

<td class

Price

 

MSC

Price

 

 

 

 

MC

 

 

MSCI

 

 

 

 

 

 

 

 

 

 

S = MCI

 

 

 

P*

 

 

P1

 

 

P1

 

 

 

 

Price: £79

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