Chapter 1,2,3 – Markets and organizations
SET = standard economic theory
- Roots in Adam Smith’s work (wealth of nations, 1776)
o Need for economic exchange
o Division of labor and specialization as optimal way of
production
o Economic transactions; need for coordination between buyers
and sellers
- Markets allow sellers and buyers to sell and buy products
- There exist markets for nearly all goods and services; raw materials,
vegetables, finished products, secondhand markets, labor markets,
housing markets, financial markets
- On markets, economic exchanges (transactions) between a seller
and a buyer are coordinated by prices
o Agents (both buyers and sellers) are ‘price takers’ = they
use an externally fixed price; demand = supply
o Price is a ‘sufficient statistic’ = it contains all the necessary
information for the decision to engage into economic
transaction; information about quality, after sale, delivery
conditions
- Market is the ideal mechanism for economic exchange (= perfect
competition model)
o Market transactions use externally fixed market price
o Market prices are by nature fair for all buyers and sellers
o Counterparts always behave as agreed in the exchange
contract
o No need to control contract, no cheating
o Contracts are enforced by law (anti-trust laws, patent laws)
and regulation agencies (governments, international
institutions)
- Market is ideal under certain assumptions;
o Atomicity = many small buyers and sellers no one can
influence the price
o Free entry and exit of firms = anyone can enter/exit the
market without cost (costless)
o Perfect information = everyone in the market has the full
information relevant to the decision on how much to produce
and how much to consume
o Product homogeneity = standardized products (perfect
substitutes)
- Market participants are ‘homo economicus’
o Sellers and buyers are rational
They have complete information about market
conditions, technical limitations, quality, reliability,
customer tastes, weather conditions
They are self-interested (act independently of each
other; no cooperation, just competition; cost on society,
ethics)
, o Sellers and buyers have a unique goal; wealth maximization
They seek to attain specific and predetermined goals to
the greatest extent at the lowest possible cost
Sellers maximize profits
Buyers maximize utility
Decision-making on markets
- Seller
o Proposed price > market price no sales (eventually exit)
o Proposed price < market price irrational behavior
- Buyer
o Proposed price > market price irrational behavior
o Proposed price < market price no purchase (eventually
exit)
- Given a market price each buyer can only decide how much to buy
and each seller can only decide how much to produce and sell
On markets, decisions by economic agents are very limited, related only
to quantities
Ideal market firms
- Firm = producer
o Black boxes = single unified entity, no people inside the firm
o Can be of any size; small firms, large MNCs
- Firm has a single goal; profit maximization
- No strategy; either firms adapt to the environment or they
disappear
- Firms are efficient mechanisms to transform inputs into outputs
o Firms’ actions are determined by the prices of the
inputs/outputs and not by managers or employees
o Firms cannot make any profit in the long run; paradox of
profits
Paradox of profits = abnormal profits entries from new firms
increased competition lower market prices lower profits normal
profits
Management within SET
- Firms cannot change
o No need for strategic reasoning; they do no have to make any
uncertain decisions
o Either firms are adapted to the environment or they disappear
- No room for differentiation = isomorphism
o Same input and output price = same costs, same profits for all
o Same optimal behavior and decision = same structure
o Same scope of activities = same products, presence on the
same markets and countries
- No room for competitive advantage
o Innovations, key people, … are available to all firms via
market transactions
, o Everything has a price and may be bought
Is SET useful for explaining firms’ behavior?
SET does not explain;
- Firms’ profits in the long run
- The diversity of strategies / organizational behaviors
- The diversity of firms’ structures
- The non-profit maximization behaviors
- If there exists an efficient market for everything, why isn’t every
transaction conducted in the market?
Are SET assumptions realistic?
- Fully rational behavior?
o In reality people are not fully rational, do not enjoy full
information, so cannot optimize
o Bounded rationality, satisficing behavior
- What is the market transactions are not costless?
o To make and execute a contract cost money; information
collection costs money
o Asset specificity and opportunism
- Information is not complete and perfectly distributed
o Uncertainty, information asymmetries
Why do firms exist?
- Firms provide additional cost economies, which cannot be reached
though market transactions
o Scale-based economies due to increased size
Employee specialization & division of labor more
efficient workers
Variable costs can be reduced via increased bargaining
power on buyers and/or sellers
Fixed costs are spread on greater volumes
o Experience-based economies
Organization learning; enhanced efficiency of production
process
Can those be achieved through market transaction?
- This is not enough to explain why firm exist, we need a different
view on a firm
o Different conceptualization of a firm
What is an organization (firm)?
How is firm different form a market? (Coase)
- An organization can be seen as an exchange place where resources
are exchanged
- Coordination is not done by prices but using authority
- Examples of organization; FIRMS, governments, trade, unions,
church, family
2 types of ideal coordination; market and organization
, Six organizational mechanisms
- Direct supervision
o An owner gives orders or instructions to several others
o Owner directs production and allocation of recourses
o Inefficient as organization grows
o Entrepreneurial organization; any small firm with
entrepreneur (CEO)
- Standardization of work processes
o Specify work processes of people carrying out interrelated
tasks
o Production routines leading to standard inputs (packaging)
o Machine organization (Mc Donald’s)
- Standardization of outputs
o Specifies the results, but not the way they should be achieved
o Output expectations for division, but autonomy in how to
attain these goals
o Diversified organization (Unilever)
- Standardization of skills (or knowledge)
o Work is coordinated by virtue or related training (impossible to
standardize work process, as it requires creativity)
o Well-trained individuals
o Professional organization; lawyers, accounting firms,
hospitals, school systems
- Standardization of norms
o Norms and the same set of beliefs shared across
organizational member
o Standardization of norms. Strong values and culture
o Missionary organization; church
- Mutual adjustment
o Informal communication, flexible structure, encourages
creativity and innovation
o Trust-based organization
o Innovative organizations; Google
Collusion = conspiracies by the few suppliers in oligopolistic markets to
set prices higher than would result under free market interaction cartel
Tacit collusion = prime example of mutual adjustment as it involves the
informal development of rules regulating market behavior
To sum up
- SET assumptions are too strong to match the reality
o Postulates that markets are efficient mechanisms for
economic transactions. Why do we see firms then?
o Is not very useful in explaining firms’ existence/decision
making/strategies/structures
- To understand what firm is and how it functions we need to;
o Define a firm and understand how it is different from a market
SET = standard economic theory
- Roots in Adam Smith’s work (wealth of nations, 1776)
o Need for economic exchange
o Division of labor and specialization as optimal way of
production
o Economic transactions; need for coordination between buyers
and sellers
- Markets allow sellers and buyers to sell and buy products
- There exist markets for nearly all goods and services; raw materials,
vegetables, finished products, secondhand markets, labor markets,
housing markets, financial markets
- On markets, economic exchanges (transactions) between a seller
and a buyer are coordinated by prices
o Agents (both buyers and sellers) are ‘price takers’ = they
use an externally fixed price; demand = supply
o Price is a ‘sufficient statistic’ = it contains all the necessary
information for the decision to engage into economic
transaction; information about quality, after sale, delivery
conditions
- Market is the ideal mechanism for economic exchange (= perfect
competition model)
o Market transactions use externally fixed market price
o Market prices are by nature fair for all buyers and sellers
o Counterparts always behave as agreed in the exchange
contract
o No need to control contract, no cheating
o Contracts are enforced by law (anti-trust laws, patent laws)
and regulation agencies (governments, international
institutions)
- Market is ideal under certain assumptions;
o Atomicity = many small buyers and sellers no one can
influence the price
o Free entry and exit of firms = anyone can enter/exit the
market without cost (costless)
o Perfect information = everyone in the market has the full
information relevant to the decision on how much to produce
and how much to consume
o Product homogeneity = standardized products (perfect
substitutes)
- Market participants are ‘homo economicus’
o Sellers and buyers are rational
They have complete information about market
conditions, technical limitations, quality, reliability,
customer tastes, weather conditions
They are self-interested (act independently of each
other; no cooperation, just competition; cost on society,
ethics)
, o Sellers and buyers have a unique goal; wealth maximization
They seek to attain specific and predetermined goals to
the greatest extent at the lowest possible cost
Sellers maximize profits
Buyers maximize utility
Decision-making on markets
- Seller
o Proposed price > market price no sales (eventually exit)
o Proposed price < market price irrational behavior
- Buyer
o Proposed price > market price irrational behavior
o Proposed price < market price no purchase (eventually
exit)
- Given a market price each buyer can only decide how much to buy
and each seller can only decide how much to produce and sell
On markets, decisions by economic agents are very limited, related only
to quantities
Ideal market firms
- Firm = producer
o Black boxes = single unified entity, no people inside the firm
o Can be of any size; small firms, large MNCs
- Firm has a single goal; profit maximization
- No strategy; either firms adapt to the environment or they
disappear
- Firms are efficient mechanisms to transform inputs into outputs
o Firms’ actions are determined by the prices of the
inputs/outputs and not by managers or employees
o Firms cannot make any profit in the long run; paradox of
profits
Paradox of profits = abnormal profits entries from new firms
increased competition lower market prices lower profits normal
profits
Management within SET
- Firms cannot change
o No need for strategic reasoning; they do no have to make any
uncertain decisions
o Either firms are adapted to the environment or they disappear
- No room for differentiation = isomorphism
o Same input and output price = same costs, same profits for all
o Same optimal behavior and decision = same structure
o Same scope of activities = same products, presence on the
same markets and countries
- No room for competitive advantage
o Innovations, key people, … are available to all firms via
market transactions
, o Everything has a price and may be bought
Is SET useful for explaining firms’ behavior?
SET does not explain;
- Firms’ profits in the long run
- The diversity of strategies / organizational behaviors
- The diversity of firms’ structures
- The non-profit maximization behaviors
- If there exists an efficient market for everything, why isn’t every
transaction conducted in the market?
Are SET assumptions realistic?
- Fully rational behavior?
o In reality people are not fully rational, do not enjoy full
information, so cannot optimize
o Bounded rationality, satisficing behavior
- What is the market transactions are not costless?
o To make and execute a contract cost money; information
collection costs money
o Asset specificity and opportunism
- Information is not complete and perfectly distributed
o Uncertainty, information asymmetries
Why do firms exist?
- Firms provide additional cost economies, which cannot be reached
though market transactions
o Scale-based economies due to increased size
Employee specialization & division of labor more
efficient workers
Variable costs can be reduced via increased bargaining
power on buyers and/or sellers
Fixed costs are spread on greater volumes
o Experience-based economies
Organization learning; enhanced efficiency of production
process
Can those be achieved through market transaction?
- This is not enough to explain why firm exist, we need a different
view on a firm
o Different conceptualization of a firm
What is an organization (firm)?
How is firm different form a market? (Coase)
- An organization can be seen as an exchange place where resources
are exchanged
- Coordination is not done by prices but using authority
- Examples of organization; FIRMS, governments, trade, unions,
church, family
2 types of ideal coordination; market and organization
, Six organizational mechanisms
- Direct supervision
o An owner gives orders or instructions to several others
o Owner directs production and allocation of recourses
o Inefficient as organization grows
o Entrepreneurial organization; any small firm with
entrepreneur (CEO)
- Standardization of work processes
o Specify work processes of people carrying out interrelated
tasks
o Production routines leading to standard inputs (packaging)
o Machine organization (Mc Donald’s)
- Standardization of outputs
o Specifies the results, but not the way they should be achieved
o Output expectations for division, but autonomy in how to
attain these goals
o Diversified organization (Unilever)
- Standardization of skills (or knowledge)
o Work is coordinated by virtue or related training (impossible to
standardize work process, as it requires creativity)
o Well-trained individuals
o Professional organization; lawyers, accounting firms,
hospitals, school systems
- Standardization of norms
o Norms and the same set of beliefs shared across
organizational member
o Standardization of norms. Strong values and culture
o Missionary organization; church
- Mutual adjustment
o Informal communication, flexible structure, encourages
creativity and innovation
o Trust-based organization
o Innovative organizations; Google
Collusion = conspiracies by the few suppliers in oligopolistic markets to
set prices higher than would result under free market interaction cartel
Tacit collusion = prime example of mutual adjustment as it involves the
informal development of rules regulating market behavior
To sum up
- SET assumptions are too strong to match the reality
o Postulates that markets are efficient mechanisms for
economic transactions. Why do we see firms then?
o Is not very useful in explaining firms’ existence/decision
making/strategies/structures
- To understand what firm is and how it functions we need to;
o Define a firm and understand how it is different from a market
