ECOS3003 Lecture 1 1
Markets, organisations and the role of the market
The market:
What? How? For whom?
Market mechanism determines much economic activity – but activity
within the firm largely centrally planned.
Questions:
- how do market systems work?
- what are the relative advantages of market systems cf centrally planning?
- why do we observe so much eco. activity conducted within firms in a
market economy
Note: decision to centralise at country level similar to decision at the firm level (costs
and benefits of central planning over market).
ECOS3003 Lecture 1 2
Pareto efficiency – a distribution of resources is P.E. if there is no alternative
allocation that keeps all individuals at least as well off but makes at least one person
better off
- in theory central planner can order a P.E. outcome in terms of
production & distribution; that is, any allocation of resources that could
be achieved by the market can be achieved by a central planner?
Do you think this will happen?
(Now – discuss market outcome; how it is PE; then argue why large economy
outcome of market better than centralised planning)
ECOS3003 Lecture 1 3
Property rights and exchange market economy
Property rights – legally enforced right to select uses of an economic good
- private property right when it is assigned to a specific person
- private property rights alienable as it can be transferred (sold) to another
person
(cf centrally planned – govt owns property)
2 aspects to ownership
- use rights (ie renting)
- alienable rights (landlord can sell apartment but can use it while leased)
ECOS3003 Lecture 1 4
Trade – participants in market trade when it benefits them
- because eash aprty can opt out all trades will be mutually beneficial
(at least weakly)
- provided gains, trade will occur
- all trades increase overall surplus
- trade ceases when no longer mutually beneficial to buy & sell
- ie when Pareto efficient, trade ceases; hence market
outcome is P.E.
(Note gains from trade from exchange and specialisation)
Market mechanism: coordinates trade through prices; outcome P.E. (minimises
costs of product, those who benefit the most get the goods)
ECOS3003 Lecture 1 5
Externalities – externality exists when the action of one party affects the well being
or production possibilities of another party outside the exchange
- as market prices reflect costs, externalities prevent markets from
being efficient (to max social surplus need SMB = SMC)
Can the market deal with externalities?
Coase theorem – the ultimate resource allocation will be efficient, regardless of
the initial assignment of property rights, as long as contracting costs are sufficiently
low and property rights are clearly assigned, are well enforced and can be
exchanged readily
- ie polluting factory and laundry
- distribution of rights have no effect on final outcome (will
affect distn of income)
- driving factor – gains from trade
ECOS3003 Lecture 1 6
What about contracting costs?
- search, information costs, bargaining and decision costs, enforcement
costs
These costs can prevent efficient outcome from occurring
- benefits of bargaining smaller with greater number of parties
- how can you deal with new parties before they arrive?
Alternative to Coase theorem:
- merge; merged entity takes into account ‘externality’, so as to
maximise surplus
ECOS3003 Lecture 1 7
Market versus central planning
Market advantage over central planning stems from:
(a) price system motivates better use of knowledge and information and
economic decision
(b) it provides stronger incentives for individual to make productive
decisions
ECOS3003 Lecture 1 8
General versus specific knowledge
General knowledge – free to transfer
Specific knowledge – expensive to transfer
- cost of communications: knowledge might be idiosyncratic, scientific
or assembled
Specific knowledge important to ensure allocation of resources most effectively
- economic opportunities are short lived
- system needs to promote its use
ECOS3003 Lecture 1 9
Centrally planned economies – difficult to incorporate specific knowledge in
decision making
- difficult to aggregate specific knowledge
- costly to transfer
In market economy
- decisions are decentralised to individuals who are likely to have
the relevant specific knowledge
ECOS3003 Lecture 1 10
Incentives in markets
- private property rights give holders/owners incentive to act on their
specific knowledge because they get the benefits
- central planners limited incentives to make productive use of
information since they do not own the resource under their control
ECOS3003 Lecture 1 11
Contracting costs & existence of firms
- why do firms exist if the market is so good?
Coase (1937) – economic transactions involve contracting costs, including
search and information bargaining and decision costs, policing
enforcement
- also an opportunity costs if the transaction results in an inefficient
resource allocation
- optimal method of organising a giving economic transaction is the one
minimises contracting costs
ECOS3003 Lecture 1 12
Contracting costs in markets
- in a market exchange need to discover and negotiate prices
If N customers, M factors of production
- a firm hires M factors, then sells to N customers
- total transactions N+M
If N customers each contract with every factor get N.M transactions
- large information requirement for everyone
ECOS3003 Lecture 1 13
Contracting costs within firms
- as a firm gets larger, organising economic activity within a firm
increases
- managers harder to make timely/effective decisions (lack of
specific knowledge), monitor workers
ECOS3003 Lecture 1 14
Game theory (review)
Nash equilibrium – each player is maximising their payoff, given the strategies
of all the other players
Prisoners’ dilemma
Cheat
Cheat
Cooperate
Cooperate
1,1 4,0
0,4 3,3
1
2
ECOS3003 Lecture 1 15
Dominant strategy to cheat for both players
- unique NE of (Cheat, Cheat)
- surplus is not maximised (not Pareto efficient)
These are the components of a prisoners’ dilemma
Ways out of a prisoners’ dilemma
1. government regulations/third party rules (restricts choice)
2. repeated game
- allows for credible punishment for cheating
- reduces the benefit of cheating
3. Credible commitments (pre-game)
ECOS3003 Lecture 1 16
B
B
N
N
30,30 0,0
0,0 30,30
1
2
Coordination game
ECOS3003 Lecture 1 17
want to coordinate actions
NE – (B,B) and (N,N)
What about a mixed strategy?
- want to make other player indifferent between going one way or
the other
Player 1 plays B with prob q so that
30q + (1 – q) .0 = q.0 +(1-q).30
30q = 30 – q.30
60q = 30
q = ½
ECOS3003 Lecture 1 18
Also for p
p* = ½
Mixed strategy equilibrium:
(Play B with prob ½; play B with prob ½)
What institutions established to get around coordination problem?
1. cheat talk
2. custom/tradition
3. govt rules/regulations or standards
4. Repetition
ECOS3003 Lecture 1 19
Other coordination games
- asymmetric interests
B
B
N
N
30,20 0,0
0,0 20,30
1
2
- would like to be the first mover
ECOS3003 Lecture 1 20
B
B
N
N
0,0 20,50
50,20 0,0
1
2
Australian battle of the sexes
ECOS3003 Lecture 1 21
Matching pennies
H
H
T
T
1,-1 -1,1
-1,1 1,-1
1
2
ECOS3003 Lecture 1 22
No pure strategy NE exists (mixed strategy exists)
- want to delay making choice (if can)
- if can observe other player’s choice can adopt best
response
Second-mover advantage
- investment free riding
- group assignments
- advertising new products
ECOS3003 Lecture 1 23
Extensive-form games
Entrant
NE E
(0,20) Incumbent
Cooperate Punish
(10,10) (-5,5)
ECOS3003 Lecture 1 24
The normal form of this game
NE
C
E
P
0,20 0,20
10,10 -5,5
E
2
ECOS3003 Lecture 1 25
NE – (NE,P) and (E,Cooperate)
Subgame perfect equilibrium (SPE) – each player’s strategy must be a NE
in every subgame
- threats must be credible (ie strategy would be adopted if need)
- solve backwards
SPE - (E, Cooperate)
ECOS3003 Lecture 1 26
Key managerial insights from game theory
1. Understand your business setting
- understand rivals, actions and consequences
2. Place yourself behind rival’s desk
3. With a first-mover advantage, move first
4. With a second-mover advantage, avoid moving first
5. Repetition can facilitate cooperation