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Resource allocation problem
Allocate 3000 man hrs among fixed set of competing uses
Choice of 6 alternative production plans
lives saved per 1,000 man hrs.?
Q= lives saved, L = man hrs.
1. L=800, Q=2 -> (2/800)x1000=2.52. L=1,300, Q=2 ->
(2/1300)x1000=1.543. L=700, Q =1 -> (1/700)x1000=1.434. L=900, Q= 3 -> (3/900)x1000= 3.335. L=800, Q= 4 -> (4/800)x1000=5.006. L=500, Q= 1 -> (1/500)x1000=2.00
ranking
Apply 3,000 man hrs to highest valued uses. Economic efficiency => Accept #5, #4, #1, #6 Reject #2, #3 P=MC= 2 lives per 1,000 man hrs Illustrates how price is expressed in
virtually any units, provided all costs-benefits are expressed in the same units.
Role of pricing
A well-functioning price system directs privately owned resources towards most efficient uses. Prices motivate and coordinate
“discipline agents in economic life to provide their goods and services skillfully and cheaply” ~ Stigler
Price-taker?
Single seller faces an infinitely elastic demand curve
Single buyer faces an infinitely elastic supply curve At the other extreme, agents possess
some degree of market power monopoly seller Monopsony buyer
Market competition
Large number of well-informed market participants disciplines agents, diffusing the market power of any one buyer or seller.
Market power? barriers to entry, or increasing returns
to scale can confer monopoly market power.
Theory of the natural monopoly: technological possibilities result in
significant economies-of-scale Unit costs of activity fall continuously over
the relevant range of market demand
example
P=$16 X < 100; P=0 X > 100
Fixed cost = $1,000, Variable cost = $5X
If x= 1, AC = 1,005; If x = 100 AC = 15
Value-max solution: R-C =$100 Note P> MC
External costs/benefits?
Negative or positive effects from an agent’s economic behavior not reflected in market prices. Here again, P ≠ MC Decision maker doesn’t take full
account of the benefits-costs associated with their choices.
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Revisiting Coase
If agent’s property rights are well-defined, and there are zero transaction costs then agents can bargain with one another to reach p=MV=MC.
Arrow: incomplete or missing markets
Agents cannot define property rights Agents cannot arrange transactions Agents lack information, knowledge
In these cases markets fail to assign meaningful prices, precluding transactions.
Search, matching and coordination problems
Akerloff ~ “markets for lemons” Assume buyers cannot observe
quality
MCH = $1.00 for high quality milk MCL = $0.60 for low quality milk WTPH = $1.20 for high quality milk WTPL = $0.80 for low quality milk
Transaction prices?
If quality was observed, transactions would take place between $0.60 and $0.80 for low quality $1.00 and $1.20 for high quality
What happens when quality cannot be observed?
Cont. With quality unobservable the goods
would sell at the same price.
Suppose buyers believe 60% of the producers water down their milk. How much would they be WTP on average?
Cont.
.60($0.80)+.40($1.20) = $.96 on avg
But since it costs $1.00 to mfg the high quality product, Gresham’s law applies: “low quality goods drive out high quality goods from the market.”
Stigler and search cost “Price dispersion (non-uniformity of
price) for a homogenous good is an indication of ignorance in the market.”
In a well informed market, the price at one location will differ from the price at another by the transportation costs between the two.
Search and the market price
N $200 $300 Expected min price
1 1-(1-p)1 =.5 (1-p)1=.5 $250
2 1-(1-p)2= .75 (1-p)2=.25 $225
3 1-(1-p)3= .875 (1-p)3=.125 $212.50
∞ 1 0 $200
Optimum search?
Up to the point where MC = MB, and MC varies by agent.
Search cost (MC) is proportional to the number of sellers canvassed
Savings (MB) will be greater the more frequent and larger the amount of expenditures on the commodity
summary Agents rely on markets to satisfy myriad
economic needs.
Yet, agents also use non-market organizational forms, e.g. a mfg setting up an IT department instead of outsourcing these services to a vendor.
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Price system within business organization? Multidivisional firm: divisions
assume responsibility for a given product, market region or technology.
The more decentralized the org structure, the greater autonomy given to divisions over R&D, design, engineering, procurement, personnel, mfg, marketing and sales.
Defining divisions
Defense product divisions ( customer-defined)
Biotech division (technology-defined)
International division (geographically-defined)
Other divisions may be product-based
Transfer prices Pricing goods and services that are
transferred within organizations, e.g. “integrated petroleum company”
Production -> transportation -> refining
Two transfer prices Transfer prices determine cost-revenue
performance of divisions
Transfer pricing … if the product or service is
equivalent to one sold in the market then the division should set a market-based transfer price
…if the product or service is specialized then the division should set a cost-based transfer price