EBE – YEAR 1 – ECONOMICS OF MARKETS AND ORGANISATIONS
CHAPTER 1 – ORGANIZATIONS AND EFFICIENCY
- INTRODUCTION
o Market – a place where buyers and sellers can trade goods and services
usually in exchange for money
▪ Sometimes follow strict rules
▪ Usually organized less formally
o 2 fields of economics
▪ Organizational economics
• Focuses on the interval organization of firms
o Firm’s motivation of its personnel, hiring/firing policy,
make/buy decisions
• Transactions within the firm
▪ Industrial organization
• Interaction of firms in markets
• Decisions with respect to price, quality, product positioning
and advertising
• External transactions
▪ They are complements
- 1.1 EFFICIENCY
o We judge functioning of organizations and markets by their efficiency
o We try to create efficient transactions
o We call an allocation of goods and services efficient (or Pareto efficient) if no
reallocation of goods and services exists that makes somebody better off
without making someone worse off
o Value maximization principle
▪ An allocation of goods and services is efficient (only) if it maximizes
the total value among the affected agents
- Example:
o Alfa Benz sells a car for a price of 20
o 4 buyers
▪ A – value of 30
▪ B – value of 26
▪ C – value of 22
▪ D – value of 18
o Value → welfare = consumer + producer surplus
▪ Consumer surplus → net value gained by consumers
• Sum of surpluses
• 𝐶𝑆 = (𝑣𝐴 − 𝑝) + (𝑣𝐵 − 𝑝) + (𝑣𝑐 − 𝑝) = 10 + 6 + 2 = 18
▪ Producer surplus – the sum of the profits of the firms that are active in
the market
• 𝑃𝑆 = 𝜋 = 𝑄(𝑝 − 𝑐) = 3 × (20 − 16) = 12
▪ Welfare is the sum of producer and consumer surpluses
, • W = CS + PS = 18 + 12 = 30
▪ Is the welfare maximized?
• No → welfare is maximized when price equals marginal cost
• p = MC
o transaction between seller and buyer enhances welfare if the buyer’s
additional utility from the transaction is higher that the production costs for
the seller
▪ a buyer buys additional unit only if the marginal utility from this unit
exceeds the price
▪ a seller sells additional unit only if the marginal costs of producing it
are lower than the price
o Welfare is maximized at the marginal cost price
- 1.2 THE NEOCLASSICAL GENERAL EQUILIBRIUM MODEL
o Allocation of goods and services that depends on information → individual
preferences, technological possibilities and resource availability
o Two extreme possibilities
▪ 1. Individuals communicate their information to a central planner who
makes all relevant decisions
▪ 2. Individuals make independent decisions on the basis of prices of
goods and services
o We use a mix of them
o Arrow and Debreu assume that each produces maximizes his own profits and
each consumer maximizes his utility at the prevailing price
o The fundamental theorem of welfare economics
▪ An efficient allocation of goods emerges at a competitive equilibrium
o Two reasons
▪ 1. Producers and consumers only need to know the prices of goods
and services to reach efficient allocation
• No central coordination is required
▪ 2. Producers’ and consumers’ behaviour is in line with the interests og
the entire economy (despite pursuing their own interests – A. Smith)
- 1.3 PERFECT COMPETITION
o Assumptions
▪ 1. Many buyers and sellers – none of them have big influence over the
market
▪ 2. Homogenous product (no product differentiation)
▪ 3. No entry barriers (free entry/exit)
▪ 4. Perfect information
o Market is in equilibrium when the price equals average and marginal costs
▪ p = AC = MC
o If the market price exceeds the firm’s average costs → profits attract more
firms → back to the point when no one makes profit
o Perfect equilibrium model is efficient
o Role of invisible hand
, ▪ 1. The price informs consumers about the quantity they should
purchase to maximize their utilities
▪ 2. The price informs the firms about the quantities they should
produce to maximize profits
▪ 3. The price indicates whether firms should enter/stay/exit
▪ 4. The price can guide consumers and firms to an efficient market
outcome
- 1.4 MARKET FAILURES
o Markets can produce efficient outcome – 3 ways
▪ 1. The market outcome is allocatively efficient
▪ 2. Goods and services are produced at the lowest possible cost
▪ 3. Markets are dynamically efficient → efficient balance between
production and consumption over time
o Why do we see governments intervene? Why do transactions take place
within firms?
▪ Market failures
o 1. Market power
▪ Some producers have power to influence the market price
o 2. Information asymmetry
▪ One party has more or better information than the other
o 3. Externalities
▪ Negative (pollution) – too much of that good is traded
▪ Positive – too few is traded (team production)
o 4. Transaction costs
▪ 4.1 coordination costs
• Costs to complete the transaction
• Advertising/searching – cost to learn about each other’ s
existence
▪ 4.2. information asymmetry
• Moral hazard – investing in monitoring other party to prevent
opportunistic actions
▪ 4.3. imperfect commitment
• If parties cannot bind themselves fully to promises they would
like to make before the transaction
o Coase → transaction costs are the reason why firms exist
▪ Transaction costs are lower within a firm
- 1.5 CASE STUDY: APPLE
o Second largest publicly traded company
o 1985 – Steve Jobs left → 70% decline of its market share
o 1997 – return of Steve Jobs → new era
o Some say that Apple has peaked – not proven
CHAPTER 4 – GAME THEORY
, - Game theory is a powerful tool to study strategic interaction among two or more
decision makers
- 4.1 THE PRISONER’S DILEMMA
o Example:
▪ Two robbery suspects
Prisoner 2
Deny Confess
Prisoner 1 Deny 4,4 2,5
Confess 5,2 3,3
o Simultaneous-move game
▪ All players move simultaneously
▪ 4 elements
• Set of players
• For all players, the actions they take
• For all players, the information they possess when they decide
which action to take
• For all players, the utility they obtain goven their own actions
and the actions of other players
- 4.2. NASH EGUILIBRIUM
o John F. Nash – Nobel prize
o Players’ strategies constitute Nash equilibrium if none of the players has a
reason to chose another strategy given the other players’ strategy
o Prisoners’ dilemma → both confess – only Nash equilibrium
▪ If each player plays a best response against the strategies of the other
players
- Example:
o Two students A and B, see 3 girls (1 blonde – prettiest, 2 brunettes)
Brad
Blonde Brunette
Antonio Blonde 0,0 3,2
Brunette 2,3 2,2
o Two Nash equilibria
- 4.3 THE HOTELLING GAME
o Players can chose from more than 2 actions → infinitively many actions at
their disposal
o Nash equilibria can still be found by looking for combinations of strategies
that are best responses for each player
- Example:
o One beach, two seller of the same ice cream for the same price
o People would buy the ice cream at the nearest seller
o Best response is to locate both stores in the middle of the beach
- Real world applications
o Similar stores locations
CHAPTER 1 – ORGANIZATIONS AND EFFICIENCY
- INTRODUCTION
o Market – a place where buyers and sellers can trade goods and services
usually in exchange for money
▪ Sometimes follow strict rules
▪ Usually organized less formally
o 2 fields of economics
▪ Organizational economics
• Focuses on the interval organization of firms
o Firm’s motivation of its personnel, hiring/firing policy,
make/buy decisions
• Transactions within the firm
▪ Industrial organization
• Interaction of firms in markets
• Decisions with respect to price, quality, product positioning
and advertising
• External transactions
▪ They are complements
- 1.1 EFFICIENCY
o We judge functioning of organizations and markets by their efficiency
o We try to create efficient transactions
o We call an allocation of goods and services efficient (or Pareto efficient) if no
reallocation of goods and services exists that makes somebody better off
without making someone worse off
o Value maximization principle
▪ An allocation of goods and services is efficient (only) if it maximizes
the total value among the affected agents
- Example:
o Alfa Benz sells a car for a price of 20
o 4 buyers
▪ A – value of 30
▪ B – value of 26
▪ C – value of 22
▪ D – value of 18
o Value → welfare = consumer + producer surplus
▪ Consumer surplus → net value gained by consumers
• Sum of surpluses
• 𝐶𝑆 = (𝑣𝐴 − 𝑝) + (𝑣𝐵 − 𝑝) + (𝑣𝑐 − 𝑝) = 10 + 6 + 2 = 18
▪ Producer surplus – the sum of the profits of the firms that are active in
the market
• 𝑃𝑆 = 𝜋 = 𝑄(𝑝 − 𝑐) = 3 × (20 − 16) = 12
▪ Welfare is the sum of producer and consumer surpluses
, • W = CS + PS = 18 + 12 = 30
▪ Is the welfare maximized?
• No → welfare is maximized when price equals marginal cost
• p = MC
o transaction between seller and buyer enhances welfare if the buyer’s
additional utility from the transaction is higher that the production costs for
the seller
▪ a buyer buys additional unit only if the marginal utility from this unit
exceeds the price
▪ a seller sells additional unit only if the marginal costs of producing it
are lower than the price
o Welfare is maximized at the marginal cost price
- 1.2 THE NEOCLASSICAL GENERAL EQUILIBRIUM MODEL
o Allocation of goods and services that depends on information → individual
preferences, technological possibilities and resource availability
o Two extreme possibilities
▪ 1. Individuals communicate their information to a central planner who
makes all relevant decisions
▪ 2. Individuals make independent decisions on the basis of prices of
goods and services
o We use a mix of them
o Arrow and Debreu assume that each produces maximizes his own profits and
each consumer maximizes his utility at the prevailing price
o The fundamental theorem of welfare economics
▪ An efficient allocation of goods emerges at a competitive equilibrium
o Two reasons
▪ 1. Producers and consumers only need to know the prices of goods
and services to reach efficient allocation
• No central coordination is required
▪ 2. Producers’ and consumers’ behaviour is in line with the interests og
the entire economy (despite pursuing their own interests – A. Smith)
- 1.3 PERFECT COMPETITION
o Assumptions
▪ 1. Many buyers and sellers – none of them have big influence over the
market
▪ 2. Homogenous product (no product differentiation)
▪ 3. No entry barriers (free entry/exit)
▪ 4. Perfect information
o Market is in equilibrium when the price equals average and marginal costs
▪ p = AC = MC
o If the market price exceeds the firm’s average costs → profits attract more
firms → back to the point when no one makes profit
o Perfect equilibrium model is efficient
o Role of invisible hand
, ▪ 1. The price informs consumers about the quantity they should
purchase to maximize their utilities
▪ 2. The price informs the firms about the quantities they should
produce to maximize profits
▪ 3. The price indicates whether firms should enter/stay/exit
▪ 4. The price can guide consumers and firms to an efficient market
outcome
- 1.4 MARKET FAILURES
o Markets can produce efficient outcome – 3 ways
▪ 1. The market outcome is allocatively efficient
▪ 2. Goods and services are produced at the lowest possible cost
▪ 3. Markets are dynamically efficient → efficient balance between
production and consumption over time
o Why do we see governments intervene? Why do transactions take place
within firms?
▪ Market failures
o 1. Market power
▪ Some producers have power to influence the market price
o 2. Information asymmetry
▪ One party has more or better information than the other
o 3. Externalities
▪ Negative (pollution) – too much of that good is traded
▪ Positive – too few is traded (team production)
o 4. Transaction costs
▪ 4.1 coordination costs
• Costs to complete the transaction
• Advertising/searching – cost to learn about each other’ s
existence
▪ 4.2. information asymmetry
• Moral hazard – investing in monitoring other party to prevent
opportunistic actions
▪ 4.3. imperfect commitment
• If parties cannot bind themselves fully to promises they would
like to make before the transaction
o Coase → transaction costs are the reason why firms exist
▪ Transaction costs are lower within a firm
- 1.5 CASE STUDY: APPLE
o Second largest publicly traded company
o 1985 – Steve Jobs left → 70% decline of its market share
o 1997 – return of Steve Jobs → new era
o Some say that Apple has peaked – not proven
CHAPTER 4 – GAME THEORY
, - Game theory is a powerful tool to study strategic interaction among two or more
decision makers
- 4.1 THE PRISONER’S DILEMMA
o Example:
▪ Two robbery suspects
Prisoner 2
Deny Confess
Prisoner 1 Deny 4,4 2,5
Confess 5,2 3,3
o Simultaneous-move game
▪ All players move simultaneously
▪ 4 elements
• Set of players
• For all players, the actions they take
• For all players, the information they possess when they decide
which action to take
• For all players, the utility they obtain goven their own actions
and the actions of other players
- 4.2. NASH EGUILIBRIUM
o John F. Nash – Nobel prize
o Players’ strategies constitute Nash equilibrium if none of the players has a
reason to chose another strategy given the other players’ strategy
o Prisoners’ dilemma → both confess – only Nash equilibrium
▪ If each player plays a best response against the strategies of the other
players
- Example:
o Two students A and B, see 3 girls (1 blonde – prettiest, 2 brunettes)
Brad
Blonde Brunette
Antonio Blonde 0,0 3,2
Brunette 2,3 2,2
o Two Nash equilibria
- 4.3 THE HOTELLING GAME
o Players can chose from more than 2 actions → infinitively many actions at
their disposal
o Nash equilibria can still be found by looking for combinations of strategies
that are best responses for each player
- Example:
o One beach, two seller of the same ice cream for the same price
o People would buy the ice cream at the nearest seller
o Best response is to locate both stores in the middle of the beach
- Real world applications
o Similar stores locations
