Prof. Phillip J. BrysonMarriott School

Brigham Young University

What are markets?

Market in Istanbul, Turkey

Markets are institutions of buying and selling on the basis of voluntary exchange.

Can you draw one?

Market in Istanbul, Turkey

0

20

40

60

80

100

120

Quantity

Price

S

D

P*

Q*

What does the S curve show?What does the D curve show?Is freedom shown in these curves?What role does the government play in this?

0

20

40

60

80

100

120

Quantity

Price

S

D

P*

Q*

Supply shows what sellers wish to do, Demand shows what buyers wish to do, and both express the freedom of economic agents to pursue their own interests.

What are Hierarchies?

(Bureaucratic) Institutions or Organizations

Why are they bureaucratic?

Because they are designed to allocate resources without the use of markets.

They use strict lines of authority

Transactions and Efficiency

What is the fundamental unit of analysis in economics?

The fundamental unit of analysis is the transaction.

What are transactions costs?Where parties must bargain

particular terms, for example, higher transactions costs are incurred.

Transactions and Efficiency

In either markets or hierarchies, should production processes be performed efficiently? Is that an important criterion of success?

Why?What is the goal of markets and

hierarchies?The greatest possible happiness

of the people. (To maximize society’s “utility” or satisfaction.)

Why Is Efficiency Important?

Consider the economic notion of efficiency. For a given set of available resources, can more than one allocation be efficient?

Numerous allocations will be possible and efficiency doesn’t require a unique outcome.

Why Is Efficiency Important?Alternative distributions of

resources offer diverse outcomes. What is “Pareto optimality”?

It is an allocation of resources achieved in the social situation where, given some distribution of incomes or resources…

…no individual can be made better off without making someone else worse off.

Economic SystemsWhat is an economic system?A set of institutions (practices

and organizations) that will allocate scarce resources among competing uses.

Economic SystemsGive me an example or two of

economic systems.Capitalist or Socialist

systems, which allocate scarce resourcesthrough markets or through a central planning agency.

 

Who was the spiritual father of this hostility and the theorist of “scientific” socialism?

Karl Marx. Who was the

great, real-world builder of the Marxian system?

Vladimir Ilyich Lenin, of course.

He said “” What does that mean?

So what is “Who whom?” supposed to mean

Contrast to bargaining mentality or to a western sales mentality. Who gains in the normal transaction? Do both gain, or is one party always the sucker, the exploited participant?

The Socialist Dilemma

What is the efficiency dilemma for socialism

To achieve efficient allocation without markets.

All goods need to be produced at the lowest possible cost,

The right mix of outputs must be forthcoming for the benefit of consumers, and

the right levels of savings and investment must be provided. Generally,…

The Socialist Dilemma

There must be no way to increase consumer satisfaction by any reallocation of society’s resources.

The Socialist Dilemma

Could supercomputing generate an efficient allocation of resources for a complex, modern economy?

In my view, computing an efficient allocation for a complex modern economy is not feasible.

The Socialist DilemmaWhy might it be impossible to achieve

this?

By the time all preferences and production possibilities were determined, recorded and digitized, they would already have changed.

Even with only two people, it may be impossible to determine how to arrange their activities to help one without hurting the other.

The fundamental planning problem:

The objective is to destroy markets so the property and power (to set prices, etc.) is taken away from the capitalists.

But planners are removed from the production process and don’t have the information available to producers.

How can planners get sufficient information to deal with the tremendous complexity of the economy?

Only from managers of the enterprises.

This disparity in the need for and availability of information gives rise to:

Principle/agent problems. Incentive compatibility problems.The solution(?) to the problem?Establish quotas: gross output targets

for producers.This provides the enterprises with the

objective securing soft target.)

The Gross Output Target

The primary objective: “bury” the capitalists.

Who said they would bury us?

What did Khruschev mean with this threat?

They would shame capitalist systems by superior production!

The Gross Output TargetSo the Soviet Union

sought above all else rapid economic growth.

Frenetic pursuit of growth results in:

No quality dimension,

No innovation,Environmental

degradation.

The Information Problem in Central Planning

Material Balances, the committee approach to allocation.

Half the committee works on sources, the other half on distribution.

Send letters to suppliers and buyers for quantities.

Make plan and inform enterprises. Hear their problems and revise.

7-13 iterations should do.

The Information Solution

Input-Output Analysis would solve the information problem. Who came up with Input-Output analysis?

Wassily Leontief, from St. Petersburg. He won the Nobel in 1973

The Information Solution

In a matrix of inputs (columns) and outputs (rows) all industries are listed.

Invert the matrix to solve for precise planning quantities.

But Leontief was promoting bourgeois doctrine. Why?

The Information Solution

By the time he had published his results, he was a bourgeois economist at a bourgeois university: Harvard.

They had to wait for Kontorovich to develop linear programming.

Planning’s failure to achieve consistency and productive results led to private efforts to meet needs.

Extensive growth was possible, especially early on, but intensive growth was not. Productivity stagnation was the nightmare of Brezhnev.

Private efforts to manage resources began with the enterprises sending out their Tolkach (expediter, “pusher”) to find the resources the plan had misdirected.

From this the second economy developed, and it was huge.

How Would You Organize?

Let us assume that 2,000 Saints moved to a newly discovered and unpopulated island in the Puget Sound region to start a new life and establish Ytopia?

How Would You Organize?Could this be done even without

a government to pass laws? Who would tell the people what

to do, what to produce? Without a government and economic plan, why would anyone want to produce anything?

How Would You Organize?

If whole economies can’t be organized efficiently, can individual economic organizations function efficiently?

Some corporations are also extremely large with multiple divisions and widely diverse activities. Like those corporations, an economic community would face the tasks of coordination and motivation.

How Would You Organize?

Specialization is the key to societal material wealth.

Adam Smith told how complex were the processes and from what distances the materials and parts were gathered to produce pins.

Milton Friedman told a similar story about producing the “simple” pencils a couple centuries later.

How Would You Organize?

To coordinate effectively, widely dispersed information must be available for planning. A manager could either collect it from lower hierarchical

levels of the organization or let those individuals who have it

use it with decentralized decision powers to produce and buy, sell and consume.

How Would You Organize?

Prices summarize all market knowledge and information between firms and consumers.

What incentives are available to motivate people to act on their information?

How Would You Organize?

Adam Smith’s form of regulation of the market system was the “invisible hand.” What was that?

The forces of market competition.

Transactions CostsA creative new

approach to economic analysis suggests that economic activity and organizations are arranged so as to minimize transactions costs.

Who developed this idea?

I thought you’d recognize Ronald Coase.

Transactions CostsWhy are some

transactions conducted through markets while others are not.

Ronald Coase (Nobel, 1991) pointed out that transactions costs depend on the way a transaction is carried out.

Transactions Costs

Coase taught that transactions agents will tend to adopt institutional arrangements that minimize transactions costs. Generally, they are the costs of running the system, of coordinating and motivating.

Transactions Costs

Coordination costs. It is necessary to determine prices and other details of transactions, to locate and negotiate with potential buyers and sellers. Producers must research buyers’ tastes and determine market demands. Buyers must search for the best prices and characteristics of goods.

Transactions Costs

Transactions costs also include the benefits lost when buyer and seller matching is non-optimal or when worthwhile transactions don’t come about.

Transactions CostsMotivation Costs. First, informational incompleteness

and asymmetries can cause transactions costs.

Second, imperfect commitment

causes them when parties are unable to commit themselves to follow and implement the contract.

Transactions Costs

When agents must decide whether to follow through on threats and promises they would like to make, but which, having made, they would later like to renounce, transactions costs must be incurred.

Attributes of Transactions

The specificity of required investments. High specificity means the investment can’t be used in other transactions.

The frequency with which transactions occur and their duration.

Thuan Phuoc Fish Market

Attributes of Transactions

The complexity and the uncertainty (about the transaction’s required performance).

The difficulty of measuring performance

The connectedness of the transaction to other transactions

Thuan Phuoc Fish Market

Viability of the Theory

The theory that economic activity and organizations are designed to minimize transactions costs is helpful conceptually, problematic in two ways.

Viability of the Theory

First, Production costs = f (technology, inputs)

Transactions costs = f(organization of transactions).

But both depend on organization and technology; separating and measuring the two is difficult.

Viability of the TheorySecond, the notion that firms

will organize so as to minimize transactions costs (as Coase suggests) is problematic.

Why should employers minimize total transactions costs rather than those costs which they themselves must bear?

Viability of the TheoryThe standard answer is that

employees costs will be taken account of where competition forces employers to do so. But that greatly reduces the range of application of the theory. Competitive forces are not always sufficiently strong.