Your lecturer today and tomorrow:
Dr Alfred Kleinknecht
CV:
1972-77: Study of Economics in Berlin
1977-84: Junior researcher, Wissenschaftszentrum Berlin and
Free University of Amsterdam
1984-88: Lecturer in economics at Univ. of Maastricht
1988-94: Researcher at Univ. of Amsterdam
1994-97: Professor of Economics, Free Univ. of Amsterdam
Since 1997: Professor, Economics of Innovation, TU Delft
2006: Visiting Professor, Università la Sapienza, Rome
2009: Visiting Professor, Université Panthéon Sorbonne, Paris I
Structure of lectures:
• Introduction to some basic micro-economic
principles
• Application of micro-economic principles to
management decisions
• From micro-economics to innovation theory
• Measuring innovation
• Labour relations and innovation
• Macro-economic aspects of innovation
What is economics (1)?
General Economics:
• Micro-economics (choices made by individual
firms, households or persons)
• Macro-economics (aggregate economy)
• International economics (including
development economics)
• Economics of the public sector (Efficient
taxing and public spending)
• Evolutionary and institutional economics:
innovation
What is economics (2)?
Management economics:
• Accounting (balance sheets, cost estimates,
etc.)
• Finance and investment
• Organisation and strategic management
• Marketing and market research
• Human Resource Management
• Innovation management
Values and political preferences
Positive economics:
• Factual or predictive statements
• (e. g.: "During a hot day, we sell more ice cream")
Normative economics:
• Value judgments (e. g.: "Income distribution should be more
equal")
Is economics a "value-free" science?
• Not in the selection of topics for research (a scarce resource!)
• Political/ideological views can play an (often hidden) role
• Economists involved in policy advice may be too closely
engaged with the subject of their research and with vested
interests
A key difference between economics and natural
sciences:
Economists can not do physical experiments!
Alternative: Economic models
Economic models:
• Concentrate on features considered essential for
understanding reality (ignoring details; using simplifying
assumptions)
• Outcomes from models can be confronted with observed
statistical data → A good 'fit' gives confidence on the model's
suitability for predictions (typical research path: interaction
between data analysis and model building)
• There can be competing models! The choice between models
should not depend (but often it does) on ideological
preferences of the economist
Micro-economics as a theory of choices:
Typical questions:
• How can I spend my money in a way that I get
maximum satisfaction/utility from it?
• How can I distribute my time between work (=
utility of money) and free time (= utility of
leisure)?
• How can I best spend my study time: Reading
a book in a library or attending this lecture?
• How can I distribute my income between
immediate consumption and future
consumption (savings)?
• Etc.
Basic question: How to maximise my utility,
using scarce resources efficiently?
Some standard assumptions:
• Wants are unlimited but resources are
limited
• Self-interested behaviour: I maximise my
individual utility (or my company's profits)
• Personal/individual preferences
• Rational behaviour
• Responsive to incentives (e.g. price change)
• Simplified models with ceteris paribus
assumption ('everything else unchanged')
• Decision in the margin: important is the
decision about the "last unit" (produced /
bought / invested) → "marginal utility versus
marginal costs …"
Opportunity costs: Utility foregone …
Choosing between alternatives:
• A certain quantity of energy can be used for warming
your house or for driving your car → the opportunity
cost of using it for driving is that you can not warm
your house
• This principle applies to every factor of production
• This also applies to allocating your scarce time
• This also applies to the choice between current
consumption and future consumption (consume now
or save?)
• Your choice will be influenced by (changes in)
relative prices, taxes etc.
Price
Demand and supply for apples:
S
Equilibrium Price:
the market can
"clear"
D
Quantity
Equilibrium (market clearing) quantity:
all apples are sold; no unsatisfied
demand
Demand and supply for apples
The demand curve (D) stands for peoples' "willingness to
pay" which depends on personal preferences. People on the
dark green part of the curve have a high preference for
apples and are willing the pay the equilibrium price (they
would have paid even more!)
S
Equilibrium Price:
the market can
"clear"
Suppliers on this
part of the curve are
willing to supply:
their marginal costs
of production are
below the
equilibrium price
D
Equilibrium (market clearing) quantity:
all apples are sold; no unsatisfied
demand
Producers on the
green part of the
supply curve (S) are
not willing to supply
as their marginal
costs of production
are higher than
marginal revenues
(= the market
equilibrium price)
People on this red
part of the curve are
not willing to pay the
equilibrium price as
they have a lower
preference for
apples
Price
C
Consumer Surplus: surface
PeBC. People on part C - B
of the demand curve are
lucky as the market price is
lower than what they would
have been willing to pay!
Supply
Producer
surplus:
surface PeAB.
Firms on part
A-B of the
supply curve
are lucky as
they could have
supplied at
prices below
the market
price!
B
Pe
Demand
A
Qe
Quantity
Two types of efficiency:
1.
Productive efficiency: production at lowest
possible costs
2.
Allocative (Pareto) efficiency: Not more and not
less than the amount of goods or services desired
by consumers is produced: the market is fairly
democratic!
How is allocative efficiency achieved?
Allocative efficiency: firms produce what
consumers want
Assume the market for pea nuts is in equilibrium at q e and P e.
Suddenly, sales rise strongly, as newspapers report that pea nuts are
good for your hart.
And what happens if newspapers report that pea nuts cause cancer?
As prices rise,
producers move
along their supply
curve from A to B
B
p*
Extra demand
makes prices rise
D*
pe
A
If pea
nuts
cause
cancer …
Supply of pea nuts
qe
"Pea nuts are good
for your hart" →
demand curve
shifts from D to D *
D = Original demand
For pea nuts
q*
Demand & Supply: Movement along versus shift of the
curves
.
A shift from S to S* can be due to a lower numbers of sellers or higher prices of
production factors, or some exogenous shock (e. g. a bad harvest).
Price
S*
S
D
D*
A shift from D to D* can be due to lower
income, changing preferences or price
reduction of substitute goods
Quantity
A producer's
willingness to supply
increases with price
A buyer's
willingness to pay
declines due to
income and
substitution effects
Demand & Supply:
The market disturbed by government
→What happens if government imposes minimum or
maximum prices?
Examples:
• Minimum prices for agricultural goods in the
European Union to protect peasants
• A maximum milk price to protect poor children
• A minimum wage against excessive exploitation of
labour?
If government imposes maximum prices:
People have to queue up!
S
Equilibrium
Price
Maximum
Price
D
q S*
qe
q D*
Chronic shortage of goods as supply
shrinks and demand expands
If government imposes minimum prices:
Chronic over-production!
Minimum
Price
S
Equilibrium
Price
D
q D*
qe
q S*
Overproduction as supply expands and demand shrinks
The perfect competition model:
An ideal market
Assumptions behind the model:
• A very large number of buyers and sellers: Nobody
has a notable influence on supply, demand or price
• Homogeneous products: All produce the same thing
in the same quality
• Free entry to and exit from markets (resources are
mobile)
• Everybody has adequate knowledge of prices and
technology
• Technology is given exogenously
The perfect competition model: implications
• Nobody has market power
• Everybody is a 'price taker' (accepting the market
price, you can sell as much as you want)
• Demand curves are horizontal (to individuals)
• Everybody tends to earn a 'normal' profit (abovenormal profits lead to entry of new firms; below
normal profits lead to exit)
Question:
Are there markets that fulfil these assumptions?
Summarizing:
• Allocation of scarce resources will be more efficient
to the degree that the assumptions behind the model
of perfect competition are fulfilled
• If the assumptions are fulfilled, markets will always
tend towards equilibrium (no clients queuing up; no
unsold goods: "market clearing")
• If an equilibrium is disturbed (e.g. by a bad harvest),
the market will "from alone" move towards a new
equilibrium → markets are "stable" (=always striving
towards equilibrium)
• Note: Markets not only "clear"; the way this happens
is also efficient (= welfare maximizing!)
• → How?
An example of efficient market clearing: A bad harvest drastically
reduces the supply of apples (Supply curve S shifts to S *)
Efficient solution:
thanks to a higher
price, the "right"
people will stop
buying apples!
These are the true apple
lovers! They derive so
much utility from apples
that they are willing to
pay Price P *
These people derive enough
utility from apples to buy at
the equilibrium price, but not
enough utility to pay price P *
S*
P * = New
equilibrium
price
S
These people derive
so little utility from
apples that they are
not willing to pay the
equilibrium price!
P e = Initial
equilibrium
price
D
q*
qe
Efficient (welfare maximizing) solution: Scarce apples
go to those that derive the highest utility from them!
Imagine, the harvest was abundant; the market is
flooded by apples! How will the market solve this?
The abundant harvest shifts supply from S to S *.
Prices decline from P e to P *.
At price P *, people on the green part of the Demand curve become
willing buying apples, hence the extra supply (Q e - Q *) can be sold
S
Pe
S*
P*
Qe
Q*
Extra apples from
marvellous harvest
People deriving
lower utility from
apples start
buying, thanks to
the lower price
Another example: the market for savings and credit. The market is
in equilibrium (at i e and q e), but suddenly people become scared
about the future and start saving excessively → the supply curve
shifts to the right (from S to S *)
These people
have a high
preference for
credit: They are
willing to pay
interest rate ie
These people have a moderate preference for credit.
As the interest rate declines, they start taking credit
and absorb the extra savings
Initial supply of savings
Initial
interest
rate i e
New
interest
rate i *
New supply of savings
Low preference for
credit: they are not
even willing to pay
the new interest
rate
S
Demand for credit
S*
qe
q*
Quantity
An opposite example: there is suddenly a great
demand for credit (shift from D to D *)
Due to rising interest rates,
banks supply more credit
D*
New interest
rate i *
Banks'
supply of
credit
D
New demand
for credit
Initial
interest rate
ie
Initial demand
for credit
qe
q*
Quantity
Another example: The labour market for professors
in full employment equilibrium
Professors'
Wages
Equilibrium
wage W e
As professors become
cheaper, universities
buy more of them (as
with apples!)
Question: How could we
get long-lasting (mass)
unemployment among
professors?
S = Supply of professors
As wages rise, more people
exchange the utility of free
time against the utility of
earning a professor's salary
D= Demand for professors
Quantity of professors
to be traded
Market clearing equilibrium quantity: Every professor who is
willing to work at wage We can be employed; every university
ready to pay We can find professors
?
Professors get unemployed as their wages are too high!
Overcoming unemployment?
Follow the green arrows!
Professors'
wages
determined by
aggressive trade
unions
S = Supply of
professors
Market
clearing
wage for
professors
Due to high wages,
universities demand
fewer professors
D = Demand for
professors
qe
Unemployed
professors
Q
Due to too high wages, supply of
professors is too high
Summarizing (continued)
• We think of an economy as a large number of markets (socalled 'partial' markets)
• There are markets for (almost) everything: steel and potatoes,
savings and credit; labour; shares and bonds, land, houses,
art, services, marriages, etc.
• Micro-economics tends to analyse these markets in isolation
from each other (interaction between markets → macroeconomics)
• Under perfect competition, all markets tend towards
equilibrium → general equilibrium
• Problem: How to explain major crises (business cycles;
depressions; financial crises)?
Discussion:
More revenues through lower prices?
The London city council discusses about how to reduce
the public transport company's losses by raising
more revenues:
→The Tories argue that ticket prices should be
increased in order to raise more revenues
→The Labour Party suggests the opposite: Attract more
people to public transport with cheaper tickets!
How to decide who is right or wrong?
Price Elasticity of Demand (PED): Percentage
change in quantity demanded divided by
percentage change in price
Inelastic demand (or low elasticity of demand):
• Weak reaction of quantity sold to price change
Highly elastic demand:
• Strong reaction of quantity to price change
Note:
→As a rise in prices usually leads to a decline in
demand, PED has a negative sign)
Effects of price changes on Total Revenues (TR = P x
Q) depend on Price Elasticity of Demand (PED)!
TR gained through
price increase
TR lost through
lower price
P
P
P*
S
S
Po
P0
P*
D
D
Q
TR lost through
price increase
Highly inelastic demand:
The Tories are right!
Q
TR gained through
lower price
Highly elastic demand:
Labour is right!
What influences price elasticities of demand?
• Availability of (close) substitutes
• Time needed by consumer to adjust to price change
(long-run PED is higher than short-run PED)
• Costs incurred for switching to a substitute product
(lock-in through standards? Earlier investments that
may be lost?)
• Relative importance of a good (as a percentage of
your total budget)
Income elasticity of demand
→Percentage change in goods demanded divided by
percentage change in income
→Note that income growth will lead to more demand.
Other than the price elasticity of demand, income
elasticity for typical goods has an upward slope
→Law on diminishing marginal utility: increasing
consumption of a good will lead to lower utility from
the last unit consumed
→You arrange your consumption such that the last
Euro spent on each good gives you the same utility
as the last Euro spent on any other good (this
explains why the demand curve slopes down: with
falling prices you rearrange your choices)
Cross (price) elasticity of demand
→Demand of a good not only depends on its 'own'
(positive) income elasticity of demand and it's 'own'
(negative) price elasticity of demand, but also on
prices of other (substitute or complementary) goods
Example:
• Rising prices for potatoes will lead to more demand
for rice and pasta (cross elasticity is positive)
Definition:
• Percentage change in demand for potatoes, divided
by percentage change in price of (substitute) good
(rice or pasta).
The opposite holds for complementary goods:
• Complementary goods: e.g. automobiles and
motorways
→If the price of one good increases (e.g. higher road
tolls), the complementary good will also be less in
demand (higher road tolls lead to lower car sales)
→The cross price elasticity of complementary goods is
negative
→The cross price elasticity of substitute goods is
positive
Choices in using scarce resources – e. g.
allocating scarce health services
→Suppose you are a doctor in a jungle hospital, and
you have medicines for treating 5 people, but 10
heavily sick people reached your hospital: How to
decide which of the 5 people you treat and which
you let die?
• On a first-come, first-served basis? ('bureaucratic
solution')
• Auctioning to the highest bidder? ('market solution')
• Other criteria? (e.g. discrimination by age, sex or
education?)
Reasons for market failure
Market failure due to externalities:
→Positive external effects: somebody else takes
advantage from your effort without paying for it (e.g.
costless imitation of your invention)
→Negative external effects: somebody else has a
disadvantage from your activities without being
compensated for it (e.g. you pollute the environment
for free)
An example of positive external effects: vaccination
Crucial assumption: vaccines are traded on a free market; in your
decision to pay for vaccination, you only think of your own individual
utility derived from being vaccinated (you do not take into account that
your vaccination also protects others!)
.
Under-investment in
vaccination
D * = Desired
demand curve for
vaccinations from
society's viewpoint
(taking account of
individual and social
benefits)
P
S
D*
D
Q
Amount of vaccinations
individuals would choose
D = Willingness to
pay for vaccination,
based on individual
benefits
Welfare maximizing amount of
vaccinations
An example of a negative external effect: Pollution
N.B.: In your individual decision to pollute, you do not take into account that
your pollution has a negative utility for others!
Overproduction if
pollution is for free
Price
when
pollution
is
charged
to firm
Price
when
pollution
is for
free
Quantity of production if
costs of pollution are
charged to the firm
Optimum supply curve
for society if costs of
pollution are charged
to the firm
S*
S
Supply curve of firms
that can pollute for
free
D
Quantity of production if
pollution is for free
Economic effects of externalities:
• Positive external effects lead to under-production (or underinvestment)
• Negative external effects lead to over-production (or overinvestment)
"Under-production" from society's
viewpoint – for the individual firm
it's the right amount as it receives
no compensation for externality
"Over-production" from society's
viewpoint – for the individual firm
it's the right amount as pollution is
for free
Cures?
• Regulation by governments (emission standards, fees, tradable
emission rights)
• Pigouvian subsidies or taxes
• Negotiation (only among small groups; Coase)
Another source of market failure:
"Asymmetric information" (= one party in a market
knows much more than the other)
Examples:
• Doctors know more about treatments and health than
patients → as suppliers they can largely determine
demand for their services!
• Insurance companies can be easily cheated by their
clients (e.g. with travel insurances)
• Lawyers know more than their clients know and they
want to maximize their declarations …
• Second hand cars: the seller knows about hidden
deficiencies of the car - but will he tell the buyer?
• Noisy flats: the seller knows it but for the buyer it's
hard to know
Market failure through asymmetric information:
Consequences and cures
• Markets for automobiles and flats can become
"lemon" markets! (Cure: Guarantee rules)
• As clients cheat, there will be overproduction of
insurance services (Cure …?)
• Profit maximizing doctors may "over-treat" their
patients; the same holds for lawyers (unnecessary
law suits). (Cures …?)
Adverse selection:
The problem of "good" and "bad" risks
• Mainly people with high risks (e.g. chronically sick
people) buy insurances; healthy people may choose
to carry risks themselves → insurances may become
too expensive for those who really need them.
• 'Bad' goods drive out 'good' ones: mainly noisy flats,
or Monday-morning cars are offered for sale ('lemon
markets')
Cures?
• Everybody is obliged to take an insurance and
insurance companies have to accept everybody
• Guarantees for cars
Moral hazard
• There may be over-supply of insurance services (e.g.
for theft insurances) since people (once insured)
become less careful against theft
• Patients will not complain against over-treatment by
doctors, as their insurance will pay for it
• People with an insurance for lawyers' costs will
more easily sue somebody
Types of costs
Fixed costs (FC):
• FC do not vary with output (e. g. start-up costs,
costs of fire insurance or lease contracts)
Variable costs (VC):
• FC vary with output (e. g. raw materials, energy
costs)
Total costs (TC): FC + VC
Note: Variable costs (VC) change according to the "law
of increasing costs": given a certain level of fixed
costs (FC) incurred, adding more and more VC will (in
the short-run) result in diminishing returns to VC (VC
will grow more quickly than production)
Illustration:
• Assume, there is one machine (FC), and the
management can choose how many workers to add
to the machine → There will be diminishing returns
to adding more and more workers; each worker
added may still increase production, but at a
diminishing rate (see illustration in Heather p. 100)
Average costs:
Average Fixed Costs (AFC) = FC / Q
(Q = quantity produced)
Average Variable Costs (AVC) = VC / Q
Average Total Costs (ATC)
= TC / Q = AFC + AVC
Marginal Costs (MC) and Marginal Revenues
(MR)
Marginal Cost (MC):
Extra costs per additional unit of output, i.e.:
MC = change in Total Costs / change in Q
Marginal Revenue (MR):
Extra revenue per additional unit of output, i.e.:
MR = Change in Total Revenue / change in Q
Short-run costs of a hypothetical firm. Hint: Study this
table carefully and try to draft the figures in a plot
TVC
MC
(=∆TVC)
AVC
(TVC/q)
TFC
0
0
--
--
1.000
TC
(TVC+
TFC)
1.000
1
10
10
10
1.000
2
18
8
9
3
24
6
4
32
5
AFC= ATC (TC/q)
(TFC/q)
--
--
1.010
1.000
1.010
1.000
1.018
500
509
8
1.000
1.024
333
341
8
8
1.000
1.032
250
258
42
10
8.4
1.000
1.042
200
208.4
…
…
…
…
…
…
…
…
500
8000
20
16
1.000
9.000
2
18
Choosing the profit maximizing output: The relevance of one more
unit of product ('decision in the margin').
Marginal Costs;
Marginal Revenues
A firm's
marginal cost
curve (= costs of
one extra unit of
product)
Stop expanding
production!
A firm's marginal
revenue curve =
revenues from
one extra unit of
product =
(market price
under perfect
competition)
Output
Profit-maximizing output (marginal costs = marginal
revenues): the costs of producing one more unit are
equal to the revenues of that unit
Broader applications of the MR = MC rule:
• Protecting the environment: The marginal revenues ( =
marginal utility) derived from the last Euro spent on abatement
of pollution should at least equal one Euro (= marginal costs)
• Training & education: The marginal costs of an extra
investment (e.g. hiring one extra teacher) should at least be
equal to the marginal revenue (= marginal utility) of the extra
education & training
Question for discussion: Why is it, from an
economic viewpoint, not desirable that
criminality is reduced to zero?
From short-run to long-run costs
Costs per unit
N.B.: In the long run, labour and capital can be changed (shortrun: only labour can be changed, capital is fixed)
Short-run average total cost curves
Long-run
average
cost curve
(combining
the sort-run
curves)
Firm enjoys
economies of
scale!
Firm suffers from
diseconomies of
scale!
Units of output
Economies of scale:
• Constant costs: An expansion of output does not
lead to changes in costs
• Economies of scale: An expansion of output leads to
lower costs
• Diseconomies of scale: An expansion of output
leads to higher costs
Note that in the previous figure, the firm first enjoys
economies and then diseconomies of scale
Reasons for economies of scale:
In larger plants (or a chain of plants):
• Specialization and division of labour
• Indivisibilities: certain investments require a minimum
scale (e.g. combine harvester in agriculture; R&D)
• The container principle: the larger, the cheaper per
unit
• Greater efficiency of large machines
• By-products: With large-scale production there may be
sufficient waste products to make by-products
• Market power (discounts) when buying inputs
• Economies of scope: A 'family' of related products
allows to spread costs of R&D, marketing etc. over
more products
Reasons for diseconomies of scale:
• Managerial diseconomies: Coordination problems
increase as the organization becomes larger and
more complex and lines of communication get
longer
• Personnel may feel 'alienated' as they become an
invisibly small part of a large organization→
Motivation? Shirking?
• Complex interdependencies in a mass-production
system can lead to great disruptions through holdups in any part
Minimum efficient scale (MES)
½ MES = Smaller scale of
production at higher costs
LRAC
MES = Minimum Efficient
Scale: The point where
further extension of
production gives hardly
any further cost savings
Long-run
average
total costs
(LRAC)
Output
An illustration: MES in Great Britain.
Note that MES has an impact on market structure!
MES as % of
production in
UK:
MES as % of
production in
EU:
% additional
costs at ½
MES:
Cellulose fibres
125
16
3
Rolled aluminium semi-manufactures
114
15
15
Refrigerators
85
11
4
Steel
72
10
6
Electric motors
60
6
15
TV sets
40
9
9
Cigarettes
24
6
1.4
Ball bearings
20
2
6
Beer
12
3
7
Nylon
4
1
12
Bricks
1
0.2
25
Tufted carpets
0.3
0.04
10
Shoes
0.3
0.03
1
Product:
Source: C.F. Pratten: 'A survey of the economies of scale' in: Research on the 'Costs of nonEurope', Vol. 2 (Office for Official Publications of the European Community, 1988).
Another application of the "marginal cost
versus marginal benefit" principle: Sunk costs
Remember we had two types of costs:
• Variable costs (total, average, marginal): they
vary as your production varies
• Fixed costs (total, average, marginal): they
are independent of what you produce →
these fixed costs can still be split into two
types
Fixed costs can be sunk
(= specific, irreversible)
Two types of
Fixed Costs
Costs that are fixed
but not sunk: they can
be recovered if the
project fails (or if the
business relationship
is terminated) e.g. a
factory building
Fixed costs that are sunk are
irreversible as they are specific to
a project (e.g advertising): They
can only be recovered it the project
succeeds or if the business
relationship is maintained (e.g.
sunk costs by a subcontractor)
Sunk costs have implications for decision-making,
applying again the "decision in the margin" principle
→Imagine that you and your partner are planning a
holiday in Spain or Greece. In a spontaneous
impulse, you book an arrangement for two persons
in Greece for 500 euro, all-in. In the evening, your
partner tells you that he also booked something
similar in Spain (for 800 euro) – unfortunately in the
same week! The booking cannot be cancelled and
you cannot sell it to somebody else, as the airplane
tickets are on your names. You both feel that Greece,
although cheaper, is probably nicer, as the hotel
seems to look better.
Let bygones be
bygones!
You are free to choose: Greece or Spain?
Another example of decision-making with the
sunk cost principle:
→As a subcontractor, you bought a special machine to
produce front windows for the new Volkswagen Golf.
You estimate that, at a price of 400 euro per window,
you can regain your full (fixed and variable) costs,
and earn a satisfactory profit. Your variable costs
(raw materials, energy, wages, etc.) are 200 euro per
window. In a tough price negotiation, Volkswagen
offers you 220 euro per window ('take it or leave it!').
• You take it or leave it?
Let bygones be
bygones!
Yet another example of decision-making with
the sunk costs principle:
→You are responsible for a Research & Development
project with a budget of 2 million euro. The sales
expectations of the new product to be developed
would justify a maximum of 2.5 million spending on
R&D. In the meanwhile, half of the budget is
consumed and it turns out that, due to unforeseen
difficulties, the project is more expensive than
expected. A reliable estimate says that, above the
one million that is already consumed, you need
another two million euro to finalise the project.
• Make a 'stop or go' decision!
Let bygones be
bygones!
General conclusion:
Let bygones be bygones! (accept your loss!)
• Sunk investments from the past should play no role
in your decision about the future! Just ignore them!
• The only rational consideration is: What are the
costs and revenues from now on?
• In fact, this is a version of decision-making "in the
margin": What counts is the decision about the next
units.
Transaction costs can make market
transactions inefficient
Definitions:
External transaction costs:
• All costs of transactions via the (external) market.
These include all costs of collecting relevant market
information, negotiating and preparing contracts,
monitoring whether partners fulfil contracts, and the
taking of sanctions if they do not.
Internal transaction costs:
• Costs of coordination and management of
transactions within hierarchical organisations
The problem behind transaction costs:
→In principle, every activity of a firm could be
contracted out
Question:
→Which activities should be contracted out (market
transaction) or done internally (hierarchical
transaction?) →The famous 'make-or-buy?' problem
Questions:
• Why not contracting out everything?
• Why do (large) organizations exist at all?
• Why does not everybody have her own company?
A simple criterion for handling the 'make-orbuy' problem:
• If costs of internal, hierarchical transaction are
higher than external (market) transaction costs, then
contract out ('buy')
• In the opposite case: 'make'
But this requires some refinements …
Factors favouring 'make' (instead of 'buy'):
•
The existence of uncertainty (e.g. in judging the
quality of a good or service) creates strong
possibilities of opportunistic behaviour which
increase costs and risks of market transactions
•
Asset specificity: Assets can have higher economic
value inside than outside a particular transactional
relationship, e. g. sunk costs by a subcontractor; or
dependence on a specialised supplier who achieves
some monopoly power. Opposite case: if there are
many suppliers of standardized goods, market
transactions are to be preferred.
Factors favouring 'make' (instead of 'buy'):
• Frequency of transaction: Frequency influences the
relative costs of market versus hierarchical
governance. Repeated market transactions among a
small number of participants offer wide possibilities
of opportunistic behaviour
• Turbulence in an environment may require frequent
changes of contracts for market transactions and
struggle about how to interpret incomplete contracts
• Incentives: Where other contract parties have
incentives to act against the interests of the
contracting firm, costs of contracting, control and
sanctions can multiply (e.g. contracting out R&D)
Summarizing:
Is there an imperfect market?
… In other words, is there:
• Information asymmetry? (quality of product)
• Turbulence? (incompletely specified contracts)
• Has the other party some market power?
• … or possibilities for opportunistic behaviour?
• Are you vulnerable as you made sunk costs?
• Has the other party a motive to act against your
interests? (e.g. leaking of knowledge to your
competitor?)
→ If yes, do not contract out!
… and when should you choose for
contracting out?
Ideal situation:
• The other party operates in a market with
transparent quality
• There are many suppliers
• They deliver standardized products
• They are fiercely competing (e.g. cleaning or
catering)
An important motive for "buy" instead of "make":
If you choose for "make", you often experience the
principal-versus-agent problem!
A typical example: Supporting services in large conglomerates:
 Heads of supporting services tend towards budget
maximization → they want to have large "Royal Courts" of
personnel!
Painstaking problems for you:
 Are they indeed doing their best? (How can we curb overhead
costs?)
 Heads of departments benefit from information asymmetry!
(they know more about their work than you can know)
Benchmarking through contracting out can help!
Forms of collaboration
Type of
collaboration:
Typical
duration
Advantages (rationale)
Disadvantages
(transaction costs)
Subcontracting
Short
term
Cost and risk reduction,
reduced lead time
Search costs;
quality?
Licensing
Fixed
term
Technology acquisition
Contract costs and
constraints
Consortia
Medium Expertise, standards, share Knowledge leakage
term
funding
Strategic
alliance
Flexible Low commitment; market
access
Joint
Venture
Long
term
Complementary know-how; Strategic drift;
dedicated management
cultural mismatch
Network
Long
term
Dynamic learning potential
Potential lock-in;
knowledge leakage
Static inefficiencies