Sander Onderstal – Economics of Organizations and Markets
Part I
Introduction
Organizations are entities in which people interact to reach economic goals.
A market is an place (in the broadest sense of the word) where buyers and sellers can
trade goods and services, usually in exchange for money.
Organization economics focuses on the internal organization of firms, which includes a
firm’s motivation of its personnel, its hiring and firing policy, and make or buy decisions.
Industrial organization considers the interaction of firms in markets, including their
decisions with respect to price, quantity, quality, product positioning, and advertising
Chapter 1 Organizations and efficiency
1.1 Efficiency
We call an allocation of goods and services efficient (or Pareto optimal) if no reallocation
of goods and services exists that makes somebody better off without making someone
else worse off. An alternative way of evaluating organizations and markets is by
measuring the total value they create. In fact, the concepts of value and efficiency are
closely linked as the value maximization principle shows: an allocation of goods and
services is efficient (only) if it maximizes the total value among the affected agents.
In economics, the usual term for value is welfare, which is the sum of consumer
surplus and producer surplus. The consumer surplus is the net value gained by
consumers. Producer surplus generated in a market equals the sum of the profits of
the firms that are active in the market. Welfare is maximized when price equals marginal
costs : p = MC.
1.2 The neoclassical general equilibrium model
The neoclassical general equilibrium model formalizes the idea that a system of prices
can achieve an efficient allocation. The model analyzes an economy with many producers
and consumers who may trade a great number of goods and services between them.
There is the assumption that each producer maximizes his own profits while each
consumer maximizes his utility at the prevailing prices of all goods and services in the
economy
The key result from the neoclassical general equilibrium model is the
fundamental theorem of welfare economics: an efficient allocation of goods emerges
at a competitive equilibrium.
1.3 Perfect competition
The model of perfect competition focuses on a single market and relies on the
following assumptions:
1. There are ‘many’ small buyers and sellers in the market: none of them can
influence the market price.
2. A homogenous product is traded on the market: there is no product
differentiation.
3. No entry barriers: firms can freely enter and exit the market.
4. Perfect information: all buyers and sellers have perfect knowledge of the prices of
all sellers and every firm has access to the same production technology
The market has a long-run equilibrium where the price equals both average costs and
marginal costs: p = AC = MC.
1.4 market failures
In the ideal world of the neoclassical general equilibrium model, markets can produce an
efficient outcome. In particular, markets can be efficient in three important ways:
1. The market outcome is allocatively efficient
2. The market is productively efficient.
3. Markets are dynamically efficient in that they establish an efficient balance
between production and consumption over time.
, Sources of market failures:
Market power: the extent to which a firm is able to sell its products at a price
above marginal costs.
Information asymmetry: situation in which one party engaged in a transaction
had more or better information than another.
Externalities: cost or benefit which results from an activity which affects an
otherwise uninvolved party who did not choose to incur that cost or benefit.
Transaction costs: costs incurred in making an economic transaction
There may be three sources of transaction costs:
1. Coordination costs: costs parties incur to complete a transaction. These
include the costs trading partners incur to learn about each other’s existence,
to determine the price and the other terms of the transaction, and to come
together to complete the transaction.
2. Information asymmetry
3. Imperfect commitment: situation in which trading partners cannot bind
themselves to fulfil promises they would like to make before a transaction
takes place
1.5 Case study: Apple inc.
Apple computer company was the first company to foresee the potential of a market for
personal computers, and the opportunity that it presented.
Economic theory tells us that patents play an important but delicate role, especially in
markets where innovation is crucial.
Chapter 2 Organizational Economics
2.1 Hiring decisions
2.2 The principal-agent problem
Principal-agent problem: problem arising in motivating one party (the agent) to act in
the interest of another (the principal) rather than in his or her own interests. Principal-
agent relationships are often plagued by moral hazard problems, i.e., behavior by the
agent that is inefficient arising from conflicts of interest between the parties, and the
principal not being able to observe the agent’s actions.
The principal can encourage the agent to exert effort indirectly by offering him an
incentive contract that specifies that the agent’s wage is increasing with his output. In
practice, incentive contracts come in many shapes and sizes. We will mainly focus on
linear contracts, i.e., contracts that specify a base wage w plus a bonus β for each unit of
output. Examples of a non-linear contract:
One that pays the agent a bonus if his output hits some pre-set target.
Managers obtaining a set of stock options in their company
Both contracts may give the agent perverse incentives.
Under the first contract, the agent will stop working as soon as he has reached the
target that guarantees him the bonus.
In the case of stock options, managers have a strong incentive to undertake
overly risky projects if the underlying stock price is below the strike price to
maximize the probability that the stock price exceeds the strike price.
Linear contracts are immune to such perverse incentives.
The optimal bonus is given by : β=p
This result is striking for at least three reasons.
1. The principal can use a simple, linear contract to implement an efficient outcome.
2. The optimal bonus does not depend on the agent’s effort costs. This makes the
efficient contract robust to particularities of the environment.
3. The bonus in the efficient contract is equal to the price per unit of output.
It can be shown that it is efficient if the principal sells ‘the firm’ to the agent.
Part I
Introduction
Organizations are entities in which people interact to reach economic goals.
A market is an place (in the broadest sense of the word) where buyers and sellers can
trade goods and services, usually in exchange for money.
Organization economics focuses on the internal organization of firms, which includes a
firm’s motivation of its personnel, its hiring and firing policy, and make or buy decisions.
Industrial organization considers the interaction of firms in markets, including their
decisions with respect to price, quantity, quality, product positioning, and advertising
Chapter 1 Organizations and efficiency
1.1 Efficiency
We call an allocation of goods and services efficient (or Pareto optimal) if no reallocation
of goods and services exists that makes somebody better off without making someone
else worse off. An alternative way of evaluating organizations and markets is by
measuring the total value they create. In fact, the concepts of value and efficiency are
closely linked as the value maximization principle shows: an allocation of goods and
services is efficient (only) if it maximizes the total value among the affected agents.
In economics, the usual term for value is welfare, which is the sum of consumer
surplus and producer surplus. The consumer surplus is the net value gained by
consumers. Producer surplus generated in a market equals the sum of the profits of
the firms that are active in the market. Welfare is maximized when price equals marginal
costs : p = MC.
1.2 The neoclassical general equilibrium model
The neoclassical general equilibrium model formalizes the idea that a system of prices
can achieve an efficient allocation. The model analyzes an economy with many producers
and consumers who may trade a great number of goods and services between them.
There is the assumption that each producer maximizes his own profits while each
consumer maximizes his utility at the prevailing prices of all goods and services in the
economy
The key result from the neoclassical general equilibrium model is the
fundamental theorem of welfare economics: an efficient allocation of goods emerges
at a competitive equilibrium.
1.3 Perfect competition
The model of perfect competition focuses on a single market and relies on the
following assumptions:
1. There are ‘many’ small buyers and sellers in the market: none of them can
influence the market price.
2. A homogenous product is traded on the market: there is no product
differentiation.
3. No entry barriers: firms can freely enter and exit the market.
4. Perfect information: all buyers and sellers have perfect knowledge of the prices of
all sellers and every firm has access to the same production technology
The market has a long-run equilibrium where the price equals both average costs and
marginal costs: p = AC = MC.
1.4 market failures
In the ideal world of the neoclassical general equilibrium model, markets can produce an
efficient outcome. In particular, markets can be efficient in three important ways:
1. The market outcome is allocatively efficient
2. The market is productively efficient.
3. Markets are dynamically efficient in that they establish an efficient balance
between production and consumption over time.
, Sources of market failures:
Market power: the extent to which a firm is able to sell its products at a price
above marginal costs.
Information asymmetry: situation in which one party engaged in a transaction
had more or better information than another.
Externalities: cost or benefit which results from an activity which affects an
otherwise uninvolved party who did not choose to incur that cost or benefit.
Transaction costs: costs incurred in making an economic transaction
There may be three sources of transaction costs:
1. Coordination costs: costs parties incur to complete a transaction. These
include the costs trading partners incur to learn about each other’s existence,
to determine the price and the other terms of the transaction, and to come
together to complete the transaction.
2. Information asymmetry
3. Imperfect commitment: situation in which trading partners cannot bind
themselves to fulfil promises they would like to make before a transaction
takes place
1.5 Case study: Apple inc.
Apple computer company was the first company to foresee the potential of a market for
personal computers, and the opportunity that it presented.
Economic theory tells us that patents play an important but delicate role, especially in
markets where innovation is crucial.
Chapter 2 Organizational Economics
2.1 Hiring decisions
2.2 The principal-agent problem
Principal-agent problem: problem arising in motivating one party (the agent) to act in
the interest of another (the principal) rather than in his or her own interests. Principal-
agent relationships are often plagued by moral hazard problems, i.e., behavior by the
agent that is inefficient arising from conflicts of interest between the parties, and the
principal not being able to observe the agent’s actions.
The principal can encourage the agent to exert effort indirectly by offering him an
incentive contract that specifies that the agent’s wage is increasing with his output. In
practice, incentive contracts come in many shapes and sizes. We will mainly focus on
linear contracts, i.e., contracts that specify a base wage w plus a bonus β for each unit of
output. Examples of a non-linear contract:
One that pays the agent a bonus if his output hits some pre-set target.
Managers obtaining a set of stock options in their company
Both contracts may give the agent perverse incentives.
Under the first contract, the agent will stop working as soon as he has reached the
target that guarantees him the bonus.
In the case of stock options, managers have a strong incentive to undertake
overly risky projects if the underlying stock price is below the strike price to
maximize the probability that the stock price exceeds the strike price.
Linear contracts are immune to such perverse incentives.
The optimal bonus is given by : β=p
This result is striking for at least three reasons.
1. The principal can use a simple, linear contract to implement an efficient outcome.
2. The optimal bonus does not depend on the agent’s effort costs. This makes the
efficient contract robust to particularities of the environment.
3. The bonus in the efficient contract is equal to the price per unit of output.
It can be shown that it is efficient if the principal sells ‘the firm’ to the agent.
