Organization Economics Past Paper (Fall 2024) - PDF

Organization Economics (MEEE and ME) TOPIC 1.1. FIRMS VS MARKETS TOPIC 1.2. BOUNDARIES OF FIRMS FALL 2024 | PEDRO LUÍS SILVA WEEK 1 2 Outline for Lecture 1 What is Organisational Architecture and Why does it matter? Review of The Efficiency of M...

Organization Economics (MEEE and ME) TOPIC 1.1. FIRMS VS MARKETS TOPIC 1.2. BOUNDARIES OF FIRMS FALL 2024 | PEDRO LUÍS SILVA WEEK 1 2 Outline for Lecture 1 What is Organisational Architecture and Why does it matter? Review of The Efficiency of Markets: The Price Mechanism. If Markets are so Efficient, Why do Firms Exist? “Costs” of using the Market Mechanism. What is Organisational Architecture? How does it link to Innovation? 3 Review of the Efficiency of Markets: The Price Mechanism Suppose you can manufacture bottles of water for 50p... 4 Suppose the Demand for Bottled Water Increases due to a Health Scare.We know from the Supply and Demand model: Excess demand at the current market price (Demand Curve has shifted right). Buyers bid up the price to a new equilibrium in Bottled Water market. The Market Equilibrium Outcome is Efficient. The price mechanism rations demand: Only consumers willing to pay the most obtain it. => Efficiency on the Demand Side. 5 The Price Mechanism and Efficiency The price mechanism directs resources to their most valuable use within the bottled water industry: Quantity Supplied increases as resources redirected from other uses; e.g. plastic originally assigned for other uses. Investment in bottled water increases. = > Efficiency on the Supply Side. The price mechanism directs resources to their most valuable use in other industries: The price of “raw plastic” (inputs) increases = > Plastic used in food wrapping, replaced with paper bags... = > Plastic used in manufacturing replaced with metal... 6 Applications of Microeconomics The case of Uber/Bolt. Is Uber cheaper than a taxi? Hotel Upgrade Auctions Airline Seats 7 Applications of Microeconomics The case of Uber 8 Applications of Microeconomics Hotel Upgrade Auctions 9 Applications of Microeconomics Airline Seats What would you do? 10 Applications of Microeconomics Airline Seats Economist’s solution: Create a Market for it! Ask the ‘recliner’ what they would need to be paid to Not recline. Ask the ‘reclinee’ what they are willing to pay to avoid the person reclining. Providing the person behind is willing to pay more than the person in front wants, they can trade. Both are better off!  Front person: Given money worth more to him than reclining the seat.  Back person: Pays less than he was willing to, to avoid the reclining seat. 11 Applications of Microeconomics Airline Seats Link: https://www.independent.co.uk/travel/news-and-advice/obese-passenger-charged-seat-flight-reddit-a8806636.html 12 The Concept of Efficiency (of outcomes) Definition: The Efficiency Principle (Milgrom & Roberts, p. 24). If people are able to bargain effectively and can effectively implement and enforce their decisions, then the outcomes of an economic activity will tend to be efficient (at least for the parties involved in the bargaining). Efficient: We cannot make any party better off, without making another party worse off. There can be many efficient outcomes: “Many prices generating efficient allocation of resources” in airline example. Intuition: If it were not efficient, one party can propose an alternative that benefits some, with no downside for anyone. 13 Microeconomics and the Theory of the Firm Firms transform inputs into outputs. Production Functions: A recipe for how to transform inputs into outputs. Operate efficiently: Where Marginal Revenue = Marginal Cost. 14 Economics of Organisation Purpose: To overcome the static “black box” view of a firm developed in Microeconomics. Why do Firms Exist? How are they Organised? Beyond one central manager, acting to maximise firm profit. Firms allocate resources through managers, not prices. “Organisational Architecture:” Who makes the decisions? How are employees rewarded? How is employee performance measured? 15 If markets prices are so efficient, Why do firms exist? Sir Arthur Salter (1933): How do economists typically define a firm? “The normal economic system works itself... it is under no central control... Supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive.”  16 Ronald Coase (1910 – 2013) https://www.nobelprize.org/prizes/economic- sciences/1991/coase/facts/ 17 Coase: The Nature of Firm, 1937, p 387 “An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.” “Sir Arthur Salter’s description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. ” “...in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. Yet in the real world, we find that there are many areas where this does not apply.” 18 Coase: The Nature of Firm, 1937, p 387 “If a workman moves from department A to B, he does not go because of a change in relative prices, but because he is ordered to do so.” “This paper bridges what appears to be a gap in economic theory between the assumption that resources are allocated by means of the price mechanism (for some purposes) and the assumption that this allocation (for other purposes) is dependent on the entrepreneur-co- ordinator.” “We have to explain the basis on which, in practice, this choice between alternatives is effected.” Put simply: Why are some activities directed by the price mechanism, whilst others are organised by firms? 19 Coase: The Nature of Firm, 1937, p 387 “Outside the firm, price movements direct production... co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated... the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator who directs production” “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.” (p.390) 20 Why do firms exist? Transaction costs as one reason Main Idea: Transactions will occur in the market when most efficient, and within a firm/organisation when most efficient. Coase was not explicit regarding the origins/nature of these ‘Transaction Costs’ Much research in ‘Economics of Organisation’ is devoted to this. Two Main Types of Transaction Costs: 1. Co-ordination costs. 2. Motivation/Incentive costs: - Incomplete/Asymmetric Information. - Imperfect Commitment. 21 Why do firms exist? Transaction costs as one reason Coase’s task: to discover why a firm emerges at all in a specialised exchange economy. Coase’s answer: the main reason to establish a firm is that there is a cost of using the market mechanism. This answers introduces the concept of transaction costs and opens a line of inquiry on the make- or-buy decision and the nature of firms. Transaction costs are the costs of using markets – any costs the buyer may incur in excess of the price paid to the supplier of the product (input); these include: Search costs; Costs of negotiating the price and other relevant contractual arrangements; Other costs required to facilitate the exchange; Many transaction costs are ‘hidden’ costs. 22 Co-ordination costs Milgrom & Roberts (p. 28). Co-ordination Costs arise from the need to: 1. Determine prices and other details of the transaction: Costs of negotiating, writing and enforcing a contract. 2. To make potential buyers and sellers known to each other. 3. To bring buyers and sellers together to transact. Example: Financial Services: Transactions take place at finance exchanges. Transaction costs for buyers too: If imperfect match between the product produced and product consumers desire. 23 Motivation/Incentive Costs Two Main Types of Motivation/Incentive Costs: 1. Costs associated with Incomplete and Asymmetric Information: If you contract an external salesperson for your product, do you know how hard they are working? Uncertainty regarding the future: Suppliers unwilling to sign a 25 year contract, preventing investment: o Incomplete Contracts: Cannot specify a contract for every future contingency. Mutually advantageous trade may fail to occur, because one party fears being victimised, or due to cost of protecting against opportunistic behavior of others. 2. Imperfect Commitment: The inability of parties to bind themselves to follow through on threats/promises, which they would like to make, then subsequently renege upon. A manufacturer may want a supplier to invest in machinery to meet the unique needs of a manufacturer. But, the supplier knows that once the investment is sunk, the manufacturer will squeeze the supplier (e.g. on price). Threats and promises lack credibility. If the supplier could be certain that the manufacturer wouldn’t behave opportunistically, both parties could benefit from the supplier’s investment 24 Transaction costs: a reflection Many of these problems also affect non-market organisations: o A salesperson may still not exert effort within a company. Key Insight: Their nature and impact will differ ‘between organisational forms.’ Therefore, one form may be better adapted than another for a specific transaction. o How can we decide which form is best? Definition: Economic Organisation (Milgrom & Roberts, p. 19). Economic Organisations are created entities within and through which people interact to reach individual and collective economic goals. 25 Boundaries of the Firm: Dimensions of Transactions What determines what type of market/organisation is best? 1. Specificity of investments required for the transaction: Bread from a baker vs Wings for a Boeing 787. 2. Frequency of similar transactions and Duration. Buying a house vs regular manager/worker relationship. 3. Complexity of transaction and Uncertainty about what performance will be required. Standardised wheat production vs a Research facility. 4. Difficulty of measuring performance in a transaction. Is low output due to effort, luck or poor machinery? Drawing pin manufacturer vs Divorce lawyer. 5. Connectedness of the transaction to other transactions involving other people. Drawing pin manufacturer vs Computer manufacturer. 26 Limitations to the Transaction Costs approach The idea that economic activity and organisations are arranged to minimise transaction costs, is problematic: 1. Excessively simplistic to suppose: Total Economic Cost = Production Cost + Transaction Cost Production and Transaction costs both depend on the organisation and the available technology. Cannot separate the two components. 2. Why would firms seek to minimise Transaction Costs? Coase’s argument: Firms minimise employment contracts. Why would firms design their employment, salary, promotions to minimise total Transaction Costs? Some are borne by employees/consumers... 27 The Fundamental Problem of Organisational Design Primary goal of any economic organisation is to produce output consumers want, at the lowest cost. Information is incomplete/asymmetric and costly to obtain (The Information Problem). Individuals may have incompatible objectives and incentives with those of owner (The Incentive Problem). The principle challenge in designing firms (and entire economic systems) is to maximize the likelihood that decision-makers: 1. Have all relevant information. 2. Are incentivised to use information productively. Note: Note: We will usually assume that the goal of a firm (i.e. the owners) is profit maximisation. 28 Three components of Organisational Architecture 29 Balancing the Stool: an example Suppose you decide that to improve staff morale, efficiency and loyalty, you will award staff bonuses. Win-Win for all. But we have Opportunistic Behaviour. o How should the bonus be structured? Timescale? o What should the performance be based on? How do you measure performance? Should it be relative performance amongst peers? o Output? Quality? Collegiality? o Who makes the decision for evaluating performance of an individual? 30 High Powered Incentives: Dieselgate in 2015 Devices fitted to VW vehicles enabled them to under-report emissions. By April 2019, it had cost £24bn. 31 High Powered Incentives: The case of Boing 32 High Powered Incentives: The case of Boing Senior managers’ objective: Increase the share price. Short-sighted. Seen as ‘too big to fail’ (Economist, April 7th, ‘why Boeing...’) 33 Aligning incentives: John Lewis Partnership Instead of a Public Company, John Lewis is a Partnership: Employees have a stake in the business. Partners receive annual bonuses, as a percentage of salary, connected to company performance. 34 Themes within Organisational Architecture (OA) Markets are not always the most efficient method for organizing economic activity. There is no automatic system for assigning decision rights or motivating individuals within firms. OA must be created. The internal organisation of firms often attempts to mimic market forces. Decision-rights, rewards/incentives and performance evaluation are inextricably linked. Imbalances can cause company failure. Changes in the external business environment can motivate OA change. o Innovate in OA, as with a new product line. 35 OA: Determinants Feedback effects between OA and Strategy. e.g. A decision system may lend itself to entering new industries. Companies operating in the same industry follow similar OA. 36 Review of Topic 1 Review of the Efficiency of Markets and Prices. o The Efficiency Principle. Why do Firms Exist? What determines whether a transaction occurs within or outside of a firm? What are Transaction Costs? Why do they matter? Introduced the concept of OA: 3 Key Ingredients. The principle challenge in designing firms (and entire economic systems) is to maximize the likelihood that decision-makers: 1. Have all relevant information. 2. Are incentivised to use information productively. 37 Associated Reading Coase (1937) The Nature of the Firm, Economica. – Required Journal Article Milgrom & Roberts: Chapter 1 - Highly recommended for background. Milgrom & Roberts: Chapter 2 - Transaction Cost Analysis: p. 28-35 only. Brickley et al: Chapter 11: Organisational Architecture. – Required Chapter The Economist: o Send in the Clouds (July 2019)One of the Giants (Sept, 2013), Why do firms exist? (September 2017)