Transcript Chapter 6

Introduction to Economics
Chapter 6
The Meaning of Coordination
in Market Interaction
J. Patrick Gunning
February 12, 2007
Purpose of the Next Three Chapters
 To
show in greater detail how entrepreneurship
coordinates the separate actions of different human
capital producers.
 This chapter tells what coordination means.
Three Parts to the Chapter
 1.
The idea of a completely coordinated economy.
 2.
How economists represent the completely
coordinated economy.
 2.
The case of monopoly.
New Topic: Part 1
The Problem of Articulating
Coordination
Introduction to Economics
Chapter 6
The Meaning of Coordination
in Market Interaction
J. Patrick Gunning
February 12, 2007
Introduction (1): Example of
Hierarchical Coordination
 1.
 2.
Rowers.
Factory work directed
by a foreman.
Introduction (2): First Example of Market
Coordination

Kuwaitian oil accountant
cooperates with

The owner of a Taiwan
fishing trawler.
Introduction (3): Second Example Of Market
Coordination

A Colombian coffee plantation
worker cooperates with:

An advertising executive in the
UK who may advertise coffee
or tea.
What Happens in Market Coordination?
 A change
in the plans, decisions and action of one
person gives incentives to others to change their
actions.
 Communication is necessary before the others can
decide to change their plans.
The Problem of Articulating Coordination
We know that coordination in a market economy occurs
because we can predict that actors in one part of the
economy will react to changes in another part. But it is
difficult to say how it occurs in a general way.
 Suppose that a change occurs. Then two kinds of action
must occur before the “economy becomes more
coordinated” after the change.

1. Signaling: actors must receive signals that a change is
appropriate.
 2. Adjustment: actors must actually adjust to the change.

Coordination Is Performed By Two
Entrepreneur Roles
 1.
The intermediary entrepreneur role
communicates offers to buy and sell and it
arranges exchanges. It signals.
 Specialists
in intermediation: real estate agents,
employment agencies, stock brokers, banks.
 2.
The producing entrepreneur role causes
adjustments to occur in the use of resources to
produce goods. It adjusts production.
Intermediary Entrepreneurship
Everyone who participates in market interaction acts in the
role of the intermediary entrepreneur.
 Examples:

1. A consumer who agrees to buy a product at the price offered
by a retailer.
 2. A retailer who advertises her prices.
 3. An employer who announces job opportunities.
 4. A producer who stands ready to sell to a retailer at a give price
or set of prices.

Two Classes Of Coordination
 1.
Hierarchical coordination.
 Example:
men cooperating in the same factory under a
single manager.
 2.
Market coordination.
 Example:
independent business entrepreneurs located at
different positions (joints) in a structure of production.
 Along
the same supply chain.
 Producing different largely unrelated goods or resources.
Hierarchical Coordination (1)

Hierarchical coordination:
the actions performed by
two or more different
individuals are
coordinated by a single
individual – the employer.
No intermediary
entrepreneur role is
involved.
Hierarchical Coordination (2)


The firm: a hierarchical relationship between an
employer and employees in which the employer
gives directions to employees, within limits.
The intermediary entrepreneur role is involved
when the firm is formed. After the firm is
formed, it is not.
The employer is coordinator in hierarchical
coordination. He communicates the desire to
change and the employees respond.
Market Coordination
Market coordination: separate actions performed by
different individuals (independent contractors) are
coordinated by each actor independently in an effort to
gain from exchange. The intermediary entrepreneur role is
necessary.
 Communication by means of markets and prices:
communication through the announcements and
acceptance of offers to buy and sell specific goods and
resources at particular prices.
 The intermediary entrepreneur role signals the profitability
of change and independent contractors adjust.

Coordination And The Need
to Make Judgments
To say that an action leads to greater coordination requires
the economist to make a judgment about the benefits and
harm due to an action.
 Coordination in the simple case of the exchange and
specialization of two farmers.
 In market interaction, practically every action – including
practically every choice to specialize – yields benefits to
some people but also harm to others.
 We cannot discuss coordination in market interaction
without comparing the benefits of some with the harm to
others.

The Problem (1)
It is relatively easy to define the coordination of
specialized actions for a two-person case.
 We only need to put ourselves in the shoes of the two
producers of human capital.
 The example of the two farmers.
 We define an action or event as coordinating if we believe
that it makes them better off.
 Their actions would be completely coordinated if we
could not imagine how they both could benefit from
changing their actions.

How Economics Organize Their
Judgments About Coordination
 In
saying that a change from situation 1 to situation
2 leads to greater coordination, economists refer to
individuals in the role of the consumer.
 If consumers are willing to pay a higher amount of
money for the consumer goods that exist after the
change than before, economists say that there is
greater coordination.
How Economists Make Judgments About
Whether An Action is Coordinating
A formal definition of greater coordination: the actions of
individuals are more coordinated if the money gains
resulting from the event that causes the coordination are
greater than the money losses to individuals in their role as
consumers.
 A consumer is better off in situation A than in situation B
if he believes that the satisfaction he receives from the
goods he can consume in A is greater than the satisfaction
he can receive from the goods he can consume in B.
 Remember: we must focus on individuals in their role as
consumers.

Consumers Are The Judges And
Entrepreneurs Are The Coordinators
 Two
parts to the procedure for describing a shift
from a less coordinated to a more coordinated
situation.
 1.
Describe the coordination by referring to the
entrepreneurship that caused it.
 2. Evaluate the change by referring to the total
gains to individuals in their role as consumers.
How We Represent Coordination In a
World Of Real Market Interaction




Four simplifying assumptions are needed to build an image of
coordination in real market interaction.
1. Producing entrepreneurs are employers of human resources
(employees).
2. Each producing entrepreneur is an employer of resources,
including specialized and non-specific human resources. The
producing entrepreneur manages a firm.
3. Each entrepreneur is assigned to a consumer good industry.


Industry: a group of producers who produce the same product. The industry is
composed of firms.
4. Each producing entrepreneur produces a specific consumer good
from start to finish. There is no supply chain.
Coordination Along A Supply Chain
 Two
Dimensions of Coordination
 1. Coordination in the allocation of resources to
produce different goods.
 2. Coordination along a supply chain.
 Supply
chain for a resource: the links that connect (1)
the discovery or initial production of a raw material
used to help make a consumer good to (2) the sale of
the consumer good that is made with the resource at the
retail level.
An Example Of Coordination
Along A Supply Chain
New Topic: Part 2
The Idea of a Completely
Coordinated Economy
The Method Of Demonstrating How
Coordination Occurs
We begin with an image of the completely coordinated
economy.
 1. Next we compare it with an image of an economy that
is not completely coordinated.
 2. Then we try to show how the actions of a entrepreneur,
or group of entrepreneurs, could lead in the direction of a
completely coordinated economy.
 3. This chapter tries to complete the first task.

A Completely Coordinated Economy
 A completely
coordinated economy: an economy
in which there are no opportunities for people to
gain in net from changing their actions in any way.
 To
fully understand what this means, we need the
concepts of diminishing marginal utility and
marginal cost.
Diminishing Marginal Utility
 Assumption
of diminishing marginal utility: as a
consumer receives a larger quantity, the additional
satisfaction he receives from the marginal, or last,
unit (marginal utility) falls.
 Diminishing marginal utility is the reason for the
water-diamond paradox of chapter 2.
Graph of Diminishing Marginal Utility
The Demand Curve (1)
a consumer’s willingness and ability to
buy a good that she wants.
 Because of diminishing utility, a consumer is
willing to pay less for the next unit of a good than
she is willing to pay for the previous unit.
 As a result, a seller must offer a lower price to
induce consumers to buy a larger quantity.
 Demand:
The Demand Curve (2)
Individual demand curve: It represents the quantity of a
good that would demanded at each price that might be
charged for the good. It is a line that shows the inverse
relationship between the price and quantity demanded of a
good by a particular consumer.
 Market demand curve: shows the inverse relationship
between the price and quantity demanded of a good by all
consumers.
 In this chapter, we are only interested in the market
demand curve.

A Market Demand Curve (3):
Figure 6-1
Explanation of Figure 6-1
 The
quantity demanded at $5 is 1535 is greater
than the quantity demanded at the higher price $10
(590).
 Diminishing marginal utility explains why the
demand curve slopes downward to the right.
The Demand Curve (4)
 The
market demand curve is an aggregate. It
represents the sum of the individual demand curves
of the separate consumers.
 It is the quantity that all of the consumers together
would buy at each price.
The Demand Curve (5)
Figure 6-2

Each point represents at least one consumer’s willingness to buy a unit. If the price is
slightly lower (p-g), a consumer will buy one additional unit.
The Marginal Consumer
 Marginal
consumer: the consumer who would be
unwilling to purchase unless the price was as low
as it currently is. Alternatively, it is the consumer
of the marginal unit at some quantity demanded.
 At any given quantity on the demand curve (qi),
there is a corresponding price (pi) that shows the
marginal utility of the qith unit to the marginal
consumer. This utility is expressed in terms of
money.
Rising Marginal Cost
 Meaning:
the additional cost of producing the
n+1th unit is greater than the additional cost of
producing the nth unit.
 Why do economists assume this? Because taking
away resources from the production of other goods
pushes up their prices. This makes producers of the
other goods less willing to give them up unless
they receive higher prices for them.
An Example of Rising Marginal Cost

An example: the common labor used for either producing
rice or for gardening. If rice entrepreneurs only want to
produce a small amount of rice, they must pay only a low
price for the additional labor needed to produce one more
kilo. If they want to produce a large amount of rice, they
must pay higher and higher prices for one more kilo.
Why? Partly because they must bid the labor away from
the entrepreneurs who want to produce gardening services.
Figure 6-3 Shows This
Explanation Of Figure 6-3
Suppose that suppliers decide to produce 1,000 units.
Then the additional cost that the marginal producer must
pay to produce the 1,000th unit is $7.40. Assume that 999
units are already being produced. For the marginal
producer to be willing to produce the 100th unit, he must
expect to receive at least $7.40 additional revenue from
selling it.
 Similarly, if 1999 units are already being produced, the
marginal producer must expect to receive at least $13
additional revenue.

Why Does Marginal Cost Rise?
 The
marginal cost of supplying a particular good
increases as more units of the good are produced
because of the diminishing marginal utility of
consuming the other goods that the resources could
be used to produce.
 To understand, refer to figure 6-4.
Figure 6-4
Explanation of Figure 6-4 (1)
Figure 6-4 shows a demand curve that represents a
hypothetical composite of the other goods from which
resources must be taken away if an entrepreneur wants to
increase the amount of the good in question.
 Entrepreneurs who produce the composite good must be
paid a higher price to allow additional resources to be
shifted from other goods’ industry.
 Why? Because as more and more resources are shifted, the
value of the marginal unit of the composite good (i.e., of
the marginal units of other goods) rises.

Explanation of Figure 6-4 (2)


In figure 6-4, suppose that 995 units of the composite good are
now being produced. Assume that in order to produce another
kilo of rice, one unit of the composite good must be given up.
Then the producer of the rice must be willing to pay $8.70 to
obtain the resources to produce it.
Now suppose that a larger amount of rice is being produced.
As a result of the greater use of resources in the rice industry,
only 490 units of the composite good are being produced. The
marginal producer of rice must be willing to pay $11.80 for the
resources he needs in order to produce another kilo of rice.
Exceptions to Rising Marginal Cost?


Obviously, the marginal cost of producing the second automobile is
lower than the marginal cost of producing the first because of high
startup costs, such as the high costs of producing the initial human
capital to produce the good, or because of high overhead costs
(costs of producing one unit that can be spread over a number of
units).
Thus, when we assume rising marginal costs, we are referring to a
pattern that must exist in market interaction. This pattern is due to
that fact that the willingness to satisfy each want is limited by
consumers’ desire to satisfy other wants.
Marginal Utility and Marginal Cost in a
Fully Coordinated Economy
 Definition
(repeated from above): A completely
coordinated economy is one in which there are no
opportunities for people to gain from changing
their actions in any way, including further
specialization.
 In a completely coordinated economy the price of
each product is equal to the entrepreneurs’
judgment of marginal cost.
Two Characteristics Of A Completely
Coordinated Economy
 Two
necessary characteristics of a completely
coordinated economy:
 1.
No reallocation of resources can raise net consumer
utility in terms of money.
 2. There are no opportunities for people to gain from
changing their actions in any way.
 Completely
coordinated industry: an industry in a
completely coordinated economy.
A Model of a Completely Coordinated
Industry (Figure 6-5)
Completely Coordinated Industry (2)
 The
hat industry is completely coordinated at point
($8, 50), where the 50 hats are produced.
 The marginal utility of the 50th hat to the consumer
who buys it, in terms of money, equals the
marginal cost of $8.
 If 60 hats are produced, MC > MU; if 40 hats are
produced MC < MU. In both cases there is discoordination.
A Dis-coordinated Industry (Figure 6-6)
Explanation of Figure 6-6
many hats are produced – 282.
 Greater efficiency in the allocation of resources
can be achieved if resources are shifted away from
hats to other goods until only 226 hats are
produced.
 Consumers in general would be better off if
resources were shifted to other industries.
 Too
A Dis-coordinated Industry (Figure 6-7)
Explanation Of Figure 6-7
 Too
few shoes are produced -- 87.
 Greater efficiency in the allocation of resources
can be achieved if resources are shifted away from
other goods to shoes until 113 pairs of shoes are
produced.
 Consumers in general would be better off if
resources were shifted from other industries to
shoes.
Two Views Of Coordination
 There
are two views of coordination:
 1. The efficient use of resources view. We show
how a characteristics of the fully coordinated
market is that resources are efficient.
 2. The entrepreneur view. We show the incentives
of entrepreneurs to shift resources until the
outcome is a fully coordinated market.
The Entrepreneur View
 Up
to now we have been presenting the efficient
use of resources view.
 We can illustrate the entrepreneur view by
assuming that entrepreneurs have made the
mistake of shifting resources away from shoe
production and into hat production.
 In figure 6-6, they produce 282 hats.
Figure 6-6: Because Too Many Hats Are
Produced, There Is Dis-coordination
Notes on Figure 6-6
At 282 hats, the marginal cost is greater than the marginal
utility in terms of money.
 The entrepreneur who produced the last hat (the marginal
entrepreneur) must have incurred a loss.
 He has an incentive to produce fewer hats in the future.
 So do other entrepreneurs.
 The incentive would exist so long as the quantity
produced is greater than 226.

Figure 6-7: Because Too Few Shoes Are
Produced, There Is Dis-coordination
Notes on Figure 6-7
 At
87 pairs of shoes, the marginal utility in terms
of money is greater than the marginal cost.
 The marginal entrepreneur would find it profitable
to produce another pair of shoes.
 He would have an incentive to produce more pairs
of shoes.
 The incentive would exist so long as the quantity
produced is less than 113 pairs.
A Two-Good Model Of Hats And Shoes
Suppose that hats and shoes were the only two goods.
 Then figures 6-6 and 6-7 could represent the economy.
 Dis-coordination would imply too many hats and too few
shoes were being produced.
 Entrepreneurs would shift away from producing hats and
toward producing shoes until both industries were
completely coordinated.

From A Coordinated Economy to a Discoordinated Economy and Back
1. Entrepreneurs mistakenly shift away from shoes to
producing hats.
 2. The price of shoes would rise; the price of hats would
fall.
 3. Consumers of shoes would lose, consumers of hats
would gain.
 4. The marginal cost of producing shoes would fall below
the price of shoes. The marginal cost of producing hats
would rise above price.

Continued
 5.
Entrepreneurs would find it profitable to
produce fewer hats and more shoes.
 6. The shift would lead to greater coordination.
Although hat consumers would lose, shoe
consumers would gain more.
 The effects on producers and owners of specialized
resources: some would lose but their losses would
be offset by those who gain.
A Technological Advance
The invention of fortified rice disturbs a completely
coordinated economy.
 At the point when the new technology is invented, the
market economy would no longer be completely
coordinated. Referring to figure 6-9, the quantity of
fortified rice produced is zero. At that quantity, the price
would greatly exceed marginal cost.
 The economy would remain dis-coordinated until
entrepreneurs shifted sufficient resources from other uses
into the production of the new rice.

Figure 6-9: If Quantity is Zero, Price Is Greater
Than Marginal Cost For The First Unit
Explanation
 1.
Technological advance in the presence of a
completely coordinated economy leads to discoordination.
 2. The dis-coordination presents profit
opportunities to entrepreneurs who respond by
shifting resources until coordination is restored.
 3. In the process, individuals in the consumer role
gain from the technological advance.
Effects on the Owners of Resources



Who loses? The people who have acquired specialized skills that are
suited only to producing the goods that consumers decide not to buy
because they shift to fortified ovens. For example, suppliers of work
that is specialized in the non-fortified rice industry and that cannot
be easily shifted into the fortified rice industry.
The losses to these resource owners are offset by the gains to the
suppliers of work who are specialized in producing the fortified rice.
There is no reason to believe that the losses to these losing resource
suppliers would be greater than the gains to the gaining resource
suppliers.
Effects on the Consumers


In the new completely coordinated economy after the technological
advance, we know that consumers are likely to be better off because
the marginal cost of fortified rice is initially lower than the money
value of additional rice to the marginal consumer. This implies that
consumers value more fortified rice higher in terms of money than
more of other goods. The existence of the new demand curve for
fortified rice shows this.
This gap between the money value of the marginal unit of fortified
rice and the money value of other goods would exist so long as the
amount of the new rice is less than the completely coordinated
amount.
Entrepreneurial Coordination
Whose entrepreneurship was responsible for the change
due to the technological advance?
 1. The entrepreneurship of the fortified rice producers who
bid for the resources to produce the rice.
 2. The entrepreneurship of the owners of the resources that
shifted into rice production.
 3. The entrepreneurship of the producers of other goods
who allowed the resources to be shifted up to a point.

Entrepreneurial Coordination :
Giving Signals And Receiving Them
 The
producers acting as intermediary entrepreneurs
in each industry give signals on the basis of their
profit expectations.
 Resource suppliers, consumers, and the producing
entrepreneurs receive the signals and respond to
them.
 Resource suppliers and consumers are ordinarily
regarded as passive responders to signals.
Errors By Producing Entrepreneurs: Why
Entrepreneurs Make Errors (1)
 Buyers
often conceal their true preferences.
 Buyers may not know what they prefer until they
try it.
 The producing entrepreneur is unlikely to be aware
of the identities of all the buyers.
Errors By Producing Entrepreneurs: Why
Entrepreneurs Make Errors (2)
 Owners
of resources often conceal the prices they
must be paid and, therefore, the costs to the
producing entrepreneurs.
 A producing entrepreneur cannot know the
identities of all of the resource suppliers.
 A producing entrepreneur may not know the true
costs until she begins production.
Conclusions About Errors
Complete coordination is impossible because
entrepreneurs make errors.
 However, it would be against our experience to assume
that entrepreneurial actions are more likely to lead to discoordination.
 The images of a completely coordinated economy and of
errorless entrepreneurs are tools that we use to help us
illustrate the assumption that the actions of individuals in
the entrepreneur role are more likely to lead to greater
than to lesser coordination.

Dis-Coordination in Distribution
 Dis-coordination
in distribution: goods are not
distributed to consumers who are willing to pay the
highest prices for them.
 Owners and intermediaries have incentives to take
actions that achieve greater coordination in
distribution.
New Topic: The Case of Monopoly
 Monopoly:
a situation in which there is a single
seller of a good or resource.
 Example: the owner of the only water well in a
village.
Three Ways To Achieve
A Monopoly Position



1. Luck.
2. Deliberate production, particularly of a specialized ability or skill.
3. Causing the transfer or consolidation of the rights associated with
a monopoly position held by others:




A. Buying a monopoly right from someone who already has a monopoly
position.
B. Joining with individuals who would otherwise be competitors. This is
called a collusive monopoly.
C. Buying out competitors.
With help from the government (but not in a the pure market
economy). Examples: a patent monopoly and special privileges to a
favored taxi company.
Price Taker And Price Maker
 A seller
who does not have a monopoly must sell
at a price that is not much higher than that of her
competitors. Such a seller is sometimes called a
price taker.
 A seller who has a monopoly faces no effective
competition and, therefore, can choose her price.
She is a price maker.
Marginal Revenue
 For
the monopolist, the question of whether to
raise or lower price depends on marginal revenue.
 Marginal revenue: the additional revenue from
selling one more unit.
Example of Marginal Revenue
Price Quantity Total Revenue Marginal Revenue
$5
100
$500
4.95
101
$499.95
-.05
Assuming that the monopolist cannot price discriminate, he
must reduce prices to all buyers at once.
Price discrimination: charging different prices for different
units or to different individuals.
What Price Should a Monopolist Charge
If He Has No Costs? (1): Figure 6-10
What Price Should a Monopolist Charge
If He Has No Costs? (2)
 In
the graph, show that he should charge the price
20.
 If he charges a higher price, he can gain by
reducing his price.
 If he charges a lower price, he can gain by raising
his price.
 Show this by calculating the total revenue at a
variety of prices.
Price Elasticity of Demand (1)
Price elasticity of demand: is a measure of the
responsiveness of quantity demanded to price changes.
 Demand is price elastic when an increase (decrease) in
price leads to a fall (rise) in total revenue.
 Demand is price inelastic when an increase (decrease) in
price leads to a rise (fall ) in total revenue.
 A profit-seeking monopolist would never produce a
quantity for which demand is price inelastic.

Price Elasticity of Demand (2)

Examples using figure 6-10.
Price Elasticity of Demand (1)

Do some examples using the following formula:
Monopoly Price
 Monopoly
price: a price charged by a monopolist
that is higher than marginal cost.
 The monopolist charges this price in order to
maximize profit.
 To illustrate the monopoly price with a graph, we
first study the relationship between demand and
marginal revenue.
Relationship Between Demand and
Marginal Revenue (1): Figure 6-11
Relationship Between Demand and
Marginal Revenue (2)
 Marginal
revenue: the additional revenue that a
seller could gain if he sold one more unit.
 Marginal revenue is always less than price for the
downward-sloping demand curve.
 When marginal revenue is positive (to the left of
20 in the graph), the entrepreneur can increase
revenue by reducing price and increasing quantity
sold.
Profit Maximization For
Monopoly In Distribution





Monopoly in distribution: a monopoly in which there are no costs of
production.
The situation faced by a monopoly in distribution is represented in
figure 6-11. The monopolist maximizes profit by maximizing
revenue, by charging a price of $20.
When marginal revenue is zero (at 20 units), the monopolist can no
longer increase revenue by reducing price.
When marginal revenue is negative (to the right of 20 units in the
graph), the entrepreneur can increase revenue by raising price and
reducing quantity sold.
If the monopolist produced one more unit, say 21, he would lose
revenue.
The Graph of a Monopoly Producer





The graph of a monopoly producer is different from the graph of a
monopolist who does not produce because it contains costs.
The monopolist maximizes profit by choosing the quantity at which
marginal revenue equals marginal cost. Thus he chooses quantity q
in the figure 6-12.
If he chose a smaller quantity, he could raise his profit by producing
one more unit.
If he chose a larger quantity, he could raise his profit by producing
one less unit.
He charges the highest price at which he can sell this profitmaximizing quantity. This is price p in the graph.
A Monopoly Producer With Rising
Marginal Costs (Figure 6-12)
Monopoly Dis-coordination (1)
 The
examples in figures 6-11 and 6-12 show that a
monopolist’s normal actions of charging a
monopoly price results in dis-coordination because
price is higher than marginal cost.
 Charging a monopoly price is an exception to the
rule that market interaction under the conditions of
the pure market economy tends to be completely
coordinated.
Monopoly Dis-coordination (2)

An entrepreneur could not be a monopolist in distribution
unless he possessed monopoly control over a consumer
good. resource.

Example: the owner of a bridge with no maintenance cost.
Dis-coordination is due to the monopolist’s decision to not
sell additional amounts of the bridge service even though
the marginal utility and price that someone is willing to
pay for an additional unit is greater than zero.
 The monopolist does not want to reduce his price to those
consumers who otherwise would pay a higher price.

Monopoly Dis-coordination (3)

An entrepreneur could not be a monopolist producer
unless he possessed monopoly control over a resource.

Example: a monopoly candle producer may own all of wax or all
of the superior candle-making skill.
Dis-coordination is due to the monopolist’s decision to not
use additional amounts of the monopolized resource even
though the marginal cost of producing one more unit is
less than the price.
 The monopolist in production does not want to reduce his
price to those consumers who otherwise would pay a
higher price.

Dis-coordinating Entrepreneurship
Entrepreneurship with respect to monopoly and external
effects due to the absence of complete private property
rights are exceptions to the notion that entrepreneurship is
always coordinating.
 If the goal was to judge the merits of government
intervention, we could not disregard these.
 Since our goal in this book is to explore the coordinating
function of entrepreneurship, we disregard monopoly and
external effects.
