Market Coordination vs. Firm Coordination

Economic activity can be coordinated by markets or by individual firms.

Market coordination
Assemble a final products by outsourcing, i.e. purchasing vaious components from firms specializing in product them.

Firm coordination
A firm organizes input production factors to produce and market goods. Firms can coordinate activity more efficiently than market due to:

· Economies of scope
· Economies of scale
· Team production (lower production costs)
· Transaction costs

Concentration ratio indicates the relative size of firms in relation to their industry as a whole.

Four-firm concentration ratio
It consists of the market share (in percentage) of the four largest firms in an industry.

• Competitive market: below 40%
• Oligopoly: above 60%
• Monopoly: 100%
  

Herfindahl-Hirschman Index (HHI)
It is calculted by suming up the square of the market share of each firm in a market. HHI can range from close to zero to 10,000.

HHI = S1² + S2² + S3² + ... + Sn²
Where:
Si is the market share of the ith firm)

The closer a market is to being a monopoly, the higher the market's concentration (and the lower its competition). In general, the market is not competitive if HHI is above 1,800 and is a monopoly if HHI is 10,000 (=100²).

Limitation of concentration measures

• Do not take account of the barriers to entry
• Do not take account of geographical scope, e.g. local or global economy
• Definition of product, e.g. men’s shoes, female’s shoes or children’s shoes

Four market types, price takers, price searchers

Market types
Perfect competition

• Identical products
• Perfect knowledge about product quality, price and cost
• Large no.of independent firms (small size each relative to market)
• No single buyer or seller is influential to the market price
• No barriers to entry or exit
• Perfectly elastic (horizontal) demand

Monopolistic competition

• Slightly differentiated products
• Large no. of competitors
• Downward sloping demand
  

Oligopoly

• Similar or differentiated products
• Small no of competitors
• Interdependence among competitors
• Significant barriers to entry (e.g. large economies of scale)

Monopoly

• Single seller
• Well-defined product with no good substitutes
• High barriers to entry
  

Price takers:

• Small output compared to the whole market.
• Can sell entire output at market price but nothing at a higher price.
• Face a perfectly elastic (horizontal) demand curve.
  

Price searchers:

• Have some price setting power.
• Can choose to charge higher prices but will sell less. Face a downward sloping demand curve.

Types of organization

Business Type	Features	Advantages	Disadvantages
Proprietorship	single owner unlimited liability personal income	easy to set up simple decision making profit taxed once only	owners’ wealth is exposed to risk difficult to raise fund firm may die with owner decision made by the owner only
Partnership	two or more people as co-owners unlimited liability income allocated to partners	easy to set up profit taxed once only	difficult to achieve consensus decision partner’s wealth exposed to risk potential capital shortfall if a partner leaves or die
Corporation	owned by stockholders limited liability firm pays corporate tax	limited liability inexpensive capital available management expertise unlimited life able to enter long term labour contract	Complex management structure Double taxation of income paid out as dividend

Principle-agent problem

Different objectives between principle and agent, e.g. it occurs when:

• Workers: incentive to shirk
• Manager: incentive to maximize their own income
• Owner: incentive to maximize the profit of the firm

Ways to solve the principal-agent problem:

• Provide ownership interests to employees eg options
• Pay incentives based on performance
• Arrange longer contract period with managers

Command System and Incentive System

Command system

• Commands flow down from top of the orginization, eg armies.
• It works best if employee's performance is easily monitored
  

Incentive system

• Provide incentives to each layer of the organization, eg sales
• It works best if employee's activities are difficult or costly to monitored.

Technological efficiency vs. Economic effeciency

Technological efficiency
Refer to the quantities of inputs vs the quantity of output.

A firm is said to be technologically efficient if it produces the output with the least amount of inputs.

Economic efficiency
Refer to dollar value of inputs vs the dollar value of output

A firm is said to be economically efficient if it produces the output with the lowest cost of inputs.

Notes:

• If a firm is not technologically efficient, it cannot be economically efficient. But if it is technologically efficient, it may be not economically efficeint.

Firms' constraints to profit maximization

Information
Costly to get complete market information

Technology
Costly to adopt new technology

Market
Prices consumers willing to pay, prices that other firms offer, availability of resources.

Economic profit vs. Accounting profit

Economic profit
Total revenue minus both explicit costs and implicit costs

Accounting profit
Total revenue minus explicit cost, ignores implicit costs and thus is greater than economic profit

Types of opportunity cost

Explicit cost
measurable (cash flow) operating expense, usually reflected in accounting statements.

Implicit cost
intangible costs that are not easily accounted for, such as the opportunity costs of equity captial

Total cost = Explicit cost + Implicit cost