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B200 Understanding Business Behavior Dr. Fatimata LY Source: Mohammad Nader This presentation will not replace the book at any rate. Understanding Business Markets The Evolution Of The Modern World Economy Economic Agents How Markets Work Market Failure The Global Market Markets: Good Servants, Bad Masters 2 The Evolution Of The Modern World Economy The global economy, AD 1400-1800: comparisons and relations The British Industrial Revolution 3 The global economy AD 1400-1800: Comparisons and Relations Asian not Europe was the center of world industry throughout early modern times Japan was the world leading exporter in silver and copper, China in porcelain and India in silk Asians were preponderant in the world economy and system in population, production & productivity, competitiveness and trade till the end of 1800AD. 4 Europe did not emerge as a Newly Industrializing Economy (NIE) challenging Asia until the late eighteenth century. Europeans did not create the world economic system itself nor develop world capitalism. Data on global production and income are hard to come by for this period (it is difficult to find or construct data, few people interested). Data on world and regional population growth before the nineteenth century are speculative. 5 So estimates for the 17th and 18th centuries by Carr Saunders (1936) , Walter Willcox (1931), M.K. Bennett (1954) and Colin Clark (1977). According to M.K. Bennett: population grew by about 20% in the 15th century and 10% in the 16th century Between 1650-1750 the growth rate was near 45% in production in the world supply and distribution of money. World 6 According to Bennett and Clark: During the period 1400 -1800 population grew faster in Asia than in Europe Standard of living, the years of expectancy of life. During 1750-1800 Asian production was much greater than Europe & America, For example, 2/3 of people in Asia produced 4/5 of total world output. Asians were more productive than Europeans. 7 The global economy, AD 1400-1800: Comparisons and Relations Asia was the leader in exporting esp. China and India Asia earn money Asia was more industrious and more productive than the rest of the world. Europe was not a major center in terms of exports to the rest of the world economy. Intermediation place in trade because it controlled a huge supply of billion at that time. 1500-1800 the commodity that Europe was able to produce and export was money. 8 Economic Agents Households More on Consumer Demand Organizations 9 Economic Agents In market economy there are 3 important kinds of decision makers: Households, Firms and Governments The households supply factors of production to firms on a factor or input market. link the economic activities such the consumption, production and distribution Firms Private producing units of goods and services sell them to households and government. 10 Firm is an organization aim to make a profit. But family has non economic purpose. Micro-Economy: the study of individual economic unites. Focus on households and firm. Macro-Economy: the study of economic aggregates and an overview of the economy like inflation, national income, monetary and fiscal policies. 11 Households Households make decisions about paid and unpaid work, the future workforce, What to purchase. Households have different structures: single, family (made of two or more), friends. social characteristics: class, race, gender or generation economic characteristics: poor, rich, work, retired. Consumption and the purchasing power of people depends on the level of income. 12 Factors of production: Capital, land, natural resources Income: Money received by Households from selling labor services or property: wages, salaries and rent All the exchanges are done in terms of: Quantity: hours worked/used, month, etc. Prices: wages, interests, profits, etc. The choices made by Households are transmitted to business by prices and quantities (levels, and changes). 13 Households Consumption Expenditure Factors of production households firms Consumption goods and services Income Household circular flow of income 14 Consumption Expenditure Food ,drinks, tobacco and housing make the largest part This amount varied from one country to another based on the wealth of the country (Germany and Spain) Income is unequally distributed between households in all countries and in the same country Hierarchy of patterns of consumption between rich and poor. This unequal distribution of purchasing power will affect the markets for individual products (national Income) 15 The household income is used in 3 ways: Consumer expenditure (day to day activities), Saving in order to provide security for the family in the future and for housing, Taxes used by the governments to pay social consumption (education, roads, etc.) and to redistribute purchasing power between household. 16 In summary The personal sector concerns with households dividing their income between expenditures and savings (budgeting). The households characteristics, the technology, the purchasing power, preferences etc. influence our life and consumption. Demand: what buyers are willing and able to purchase. Price is the most important variables considered by economists: a transaction is done for a quantity at a given price. What link Price to Quantity? 17 What link Price to Quantity? Is there a relationship between PriceQuantity? Yes, “The law of Demand”. Does the price affect the demand Yes, price does affect the demand Yes, The Elasticity 18 The Law of demand The quantity demanded is inversely related to the price, Ceteris Paribus. Represented by the demand curve (downward slope) Ceteris Paribus: other things constant (Income, Substitutes, complement, Taste, Future expectation regarding income and preference). Special Goods Veblen Goods: when prices goes demand (e.g. luxury goods) Giffen Goods: when prices goes demand goes (e.g. inferior goods) in poor countries. 19 Households P Q: Quantity Demanded P: Price P1 P2 D1 D 0 Q1 Q2 Q Demand curve and Demand Curve shift 20 ELASTICITY Anyone who sells a product or service is concerned with how a change in price affects demand. Price elasticity of demand, ED It is very important to know the ED for the economists and sellers in order to set their prices. And the same thing for Chancellor of the Exchequer in order to set taxes. 21 The sensitivity of demand to price changes varies with different items: For some products ( drinks, peppers, light bulbs, etc.) relatively small percentage changes in price will not change the demand for the item much more; For other items (cars, home loans, furniture & computer equipment, etc.) small % changes in price have significant effects on demand. Price elasticity of demand is one way to measure the sensitivity of demand to changes in price. 22 If Q= the quantity demanded and P=the price, Q = the change in Q a percent change in demand = Q /Q P = the change in P a percent change in price = P/P ELASTICITY could be calculated by the ratio of %change in demand to %change in price. This ratio can be written as: E = - (P/Q) × (Q /P) 23 How to interpret Elasticity When E=1: the relative changes in demand and in price are relatively equal, and the demand is said to have unit elasticity. If E<1: the relative change in demand is less than the relative change in price, the demand is called inelastic; If E>1: the relative change in demand is greater than the relative change in price, the demand is called elastic. 24 Elasticity of demand measures the instantaneous responsiveness (sensitivity) of demand to price: E=0.2 for medical service E=1.2 for stereo equipment The demand of medical service is much less responsive to price change than is the demand for non essential commodities, such as stereo equipment; the demand of medical service is inelastic; the demand of stereo equipment is elastic. 25 Elasticity Formula Price elasticity of demand ED ED = % ED / % PD ED = (Q1-Q2)/(Q1+Q2)/2 / (P1-P2)/(P1+P2)/2 ED = - (P/Q) × (Q /P) 26 Factors influencing ED : availability of substitutes (more elastic), if the products is a necessity or a luxury, proportion of a person’s income (more elastic) and time the longer the more elastic. Revenue (R) = Quantity (Q) × Price (P) When demand is elastic, an increase in the price will a fall in the firm’s revenue. Question: What if the demand inelastic? 27 More on Consumer Demand ED > 1 ED < 1 P P P1 P1 D P2 P2 D Q 0 Q1 Q2 Elastic Demand 0 Q1 Q2 Q Inelastic Demand 28 More on Consumer Demand P D P ED=0 D Q 0 Q 0 Zero Elasticity Perfectly Inelastic Infinite Elasticity Perfectly Elastic 29 Price Elasticity of Demand ~ Revenue Demand is elastic: Price Firm Revenue Price Firm Revenue Demand is inelastic: Price Firm Revenue Price Firm Revenue D unit elastic: Price no in the Firm Revenue 30 Price Elasticity P Revenue at higher prices P1 Sales Revenue at lower prices D Revenue 0 P Q Q1 P P1 P1 D P2 P2 D Q 0 Q1 Q2 0 Q1 Q2 31 Q Income Elasticity of Demand To witch extent demand changes as income changes? Depends on the nature of the product. Demand could be: income elastic, income inelastic etc. EI > 1 Demand is income elastic The percentage increase in demand is greater(>) than the percentage increase in income; E.g. luxuries. 32 EI < 1 : low income elastic, e.g. necessities EI < 0 : Income elasticity of demand is negative, ex: Inferior products Consumption when Income Inverse relationship between income and demand Public transport (substituted by private car). 33 Analyze the predictions about changes in spending A rise in high IED products eating out, leisure, foreign holidays etc. A slight rise in low IED products necessities, bread, soap A fall in negative IED products public transport. 34 Cross Elasticity Elasticity between 2 products: X , Y Could a price change in product Y influence the demand for product X ? The % change in demand for product X divided by the % change in price of product y. If the value of the Cross Elasticity EXY > 0 (X,Y) are substitutes EXY < 0 (X,Y) are complements. 35 Cross Elasticity of demand Formula = % Dx / % Py = (D1-D2)/(D1+D2)/2 / (P1-P2)/(P1+P2)/2 36 Chap 5: Organizations The relationships within a firm are rarely market relations but rather relations of command and co-operation. Organizations existed to make profit but there are non profit organizations: Mosques, Churches, Universities, PTA, Pension funds, and Hospitals. Economists consider the importance of the firm structure in order to understand how the firm set its objectives and why firm is complex. 37 Organizations One of the most important function for the company is Finance. In order to perform well the company needs to keep record of its day to day transactions by the accounting system. 38 Joint Stock Company Joint Stock Companies can raise fund by selling shares to public or borrowing through the sale of bonds. E.g. in England in order to provide financial resources for railways The Main feature of a joint stock company: separate firm-entity from the individual who own it. Limited liability the owner’s responsibility is limited to the amount of money he had invested (shares). the owner will not be liable on his personal assets to meet the liabilities of the company 39 Organizations Fund raised through the sale of shares are usually referred to as Equity. Equity holder receives dividends The bond holder purchases bonds; he is a creditor and receives interest. There is a separation of ownership from control. The Technostructure: the skilled managers and professionals who work for the company and are knowledgeable about its markets and other aspects of its environment Impossibly for many groups to influence the management team to satisfy the stakeholders (owner). 40 In order to function efficiently any organization must maintain adequate records. That will benefit the stakeholders (Governments, Creditors, Employees, Tax Department, and Managers) The Annual Report prepared at the end of each year contains : The Balance Sheet, The Income / Profit Statement, The Cash Flow Statement 41 The Balance Sheet Asset = Value, physical, not physical right to do or to use something The Balance Sheet Assets Liabilities Net Worth Liability = Obligation Assets = Liabilities + Net Worth 42 The Balance Sheet Assets Current Assets Cash Inventory Liabilities Liabilities Fixed Assets Equipment Building Total SR 55,000 Account Payable Notes Payable Long Term Liabilities Net Worth Stockholder’s Equity Total Common Stock SR 55,000 43 The Cash Flow Statement The cash flow is the net amount of money actually received during the period. The Cash Flow Statement presents and measures during one year the cash inflows and cash outflows. 44 The Income Statement Statement of Profit and Loss Measures during a given period Income Cy. and expenses passing through the The Income Statement total Revenue – Expenses = Profit or Loss. 45 The Income Statement Revenues: Net Sales x - Expenses: Cost of goods sold - Wages Rent Advertising Other expenses = Income before Taxes - Taxes paid = Net Income (Profit after Taxes) X X X X = Gross profit X X (Loss after Taxes) 46 The Function of Production Objectives of the production process: how to produce efficiently / at the lowest cost The max level of output for a given quantity of input How to maximize economic profits The production function summarize the relationship between inputs and outputs { Q= f ( F1,F2, …..,Fn) } The maximum output that can be produced with a given quantity of inputs, a mix of the production factors for a given state (of engineering and technology). 47 Efficient Production Efficient Production requires to optimize the use of inputs like labor. Division of labor means dividing up a work process into specialized activities undertaken by different workers in order to increase the quantity of output available from given inputs. Efficient Production Requires Time In production and cost analysis 2 time periods are distinguished: The The Short Run Long Run 48 Time in Production The Short Run is The period of time in which only some inputs, the variable inputs, can be adjusted. In the short run, fixed factors, such as plant and equipment, cannot be fully modified or adjusted. The Long Run is the period in which all factors employed by the firm, including capital, can be changed. But in the long run all factors of production are variables. 49 Production Costs Total Cost: TC = FC + VC ATC = AFC + AVC On Average, ATC = TC/Q AFC = FC/Q AVC = VC/Q TC: Total Cost FC: Fixed Cost VC: Variable Cost Q : Quantity A : Average 50 Economies of Scale Economies of scale: When there is a increase in the output level, the cost per unit falls due this mass production, when all inputs are changeable the total costs are rising (TC ) and the average costs are falling (AC ). Diseconomies of scale in production when the per-unit cost of all inputs increases as a result of an increase in output. 51 Long Run Average Cost LRAC curve shows the lowest unit costs that can be obtained at all levels of output. The relationship between output and cost per unit in the long run. Average cost falling until Minimum efficient scale is reached. This curve takes L shape. It is a representation of the factors of production. 52 Cost per unit Long Run Average Cost Minimum efficient scale Cost per unit increasing Diseconomies of scale Cost per unit falling: Economies of scale Cost per unit Constant 0 Quantity Output When quantity of output , average cost falling until Minimum efficient scale is reached. This curve takes L shape. LRAC curve shows the lowest unit costs that can be obtained at all levels of output. 53 SRAC: Short Run Average Cost Cost SRAC Costs per unit rise as maximum capacity level is approached Costs per unit fall as machinery is more fully utilized 0 Quantity 54 LRAC ~ SRAC Cost SRAC1 LRAC Hello SRAC2 Long Run Average Cost SRAC3 Quantity 0 Diminishing returns: are short run phenomenon. As more of the variable factors (labor) is added to the fixed factors (capital &land), the increase in the output for every extra increment of the variable factors gets smaller. 55 Cost Upward shift of the Long Run Average Cost LRAC2 LRAC1 0 Quantity If factor prices , then total costs . The average cost curve would shift upwards at any given output level to reflect a general increase in costs. 56 Cost The relationship between MC & AC MC AC MC: Marginal Cost AC: Average Cost Quantity 0 Level of Output No. of units (Q) Total Cost (TC) $ Average Cost (AC) $ Marginal Cost (MC) $ 1 100 100 100 2 180 90 80 3 240 80 60 4 300 75 60 57 Organizations Economies of Scale are the reduction in costs associated with expansion in output in the long run. Internal economies of Scale are arise within the firm, through such things as the division of labor. External economies of Scale which the firm gains as a result of the expansion of the industry. MC, Marginal Cost, The cost of additional unit produced. Knowing the MC enable the firm to maximize its profit. The firm remain profitable as R = AC 58 Organizations: Culture & Goals The Human resources planning process should be clearly tied to the organization strategic goals. Beside the mechanical issues there are other important features: the workers employed : personal goals and qualities, the power systems, information processing limitation, etc. Non- cultural features are vital such as the objective conditions faced by the organization, the knowledge and understanding of organization members, etc. 59 Organizations Many objectives: The objective will change as the environment changes. making profit, minimizing costs, sales volume, loyal customers, profit maximizing and growth, controlling the environment. E.g. changes in competitor behavior or new opportunities If the environment become tough, the main goal of any firm is to survive. All decisions and changes may be done under the Profit Constraint: a minimum level of profit that is acceptable to the owners (satisfying level). Considering the culture of the organization and the 60 determining variables. Organizational Form of a Firm The main distinction in industrial economies has been between the U form and the M form. The U, unitary hierarchical structure in which different divisions report to Chief Executive Officer (CEO) or managing director. The M, multi divisional is larger and has a central office to which several operating divisions report (each division has a structure like the U form so have its own CEO). 61 Firm Evolution Firms begin their lives as entrepreneurial organizations (simple & small). Then organization became bureaucracy jobs are specialized and standardized. elaborating administrative structure controlled by Technostructure of experts. The bureaucracy has essentially the U form. When environment become complex Professional org. existed which are made of individuals who are highly skilled (hospitals, universities, etc) 62 How Markets Work Competition And Power In Markets How Efficiency and Productivity are ensured Market Strengths and Weaknesses What are the Different Aspects of the Market Process Different Schools 63 How Markets Work Capitalistic Economic Environment Theory Competitive Markets, Innovation, Schumpeter Equilibrium, Neoclassical Model Signaling, Hayek Conflict of Interests, Sen 64 Key Words Competition, Competitive Markets, Perfect competition, Pure competition, Monopolistic competition. Price Equilibrium, Creative Destruction Process, Signal, Price Taker, Free Market, Asymmetric Information, Conflict of Interests. 65 Competition And Power In Markets Competition promotes choice, quality and lower prices. Monopoly: producers become insufficient. No choice, no quality and high prices. Market: efficient coordinator of the activities of free individuals where interplay of demand and supply in a competitive market is the key to prosperity for everyone. determines the Wealth of the nation 66 Competition And Power In Markets Corner Shop has monopoly over his neighborhood but has competition from hypermarkets. As long there is freedom of entry, even local monopolies in short period will have to face competition from innovative units. Natural monopoly where large scale of economies can’t be supported by more than one supplier as this single firm can undercut all of its rivals. (Network industry such as telephone service or railway) 67 Competitive Markets by Innovation Schumpeter The process of creative destruction Joseph Schumpeter set up a model of competitive markets characterized by competition over new products and new process of production. Schumpeter stated that firms are forced to innovate in order to stay in the race. And this view of competitive markets as a dynamic process of continuous change. The key to this processes is the introduction of innovations, new products and new process like motor car. In the process of competition over innovation, firms innovate or go bust. 68 Competitive Markets by Innovation Schumpeter Innovation often depends on advances in technological knowledge and permit costs reductions: 2 sources Dynamic efficiency Process Costs are reduced because of advances in technological knowledge that enables new production process to be used large firms have the fund and R&D. Economies of scale, which relate to the scale of operations of the firm that enable to produce cheap by spreading the fixed costs over a large scale of output. 69 Schumpeter Mkt Structure: Dynamic market competition over the L-T may be consistent with elements of monopoly in ST 70 Competitive Market and Equilibrium Neoclassical Model Competition: absence of such corporate power in the market Neoclassical model of competitive equilibrium or perfect competition in determining prices by the Balancing of Demand & Supply. 71 Competitive Market and Equilibrium Neoclassical Model Neoclassical model of competitive equilibrium examines the influence on the price of commodity in 2 ways: 1) On the Supply side Influences on the production of a commodity: Availability of right, kind of labor, raw materials, machinery, power and technology 2) On Demand side Influences affect customers demand for commodity such as income, lifestyle, age and customer tastes. 72 Neoclassical Model Disequilibrium equilibrium If D is less than S: P will fall for D and S to be in equilibrium If D is more than S : P will increases D and S to be in equilibrium At the Equilibrium price: D and S are equal and everything is at rest. The strength of the neoclassical model: shows the equilibrium properties of a competitive markets. 73 Neoclassical Model Does Competition efficiency? The model set clearly the link between competition and efficiency: firms are price taker, they can’t influence the market price. Firms have to reduce its costs as possible to make profit Productively efficient: costs are at the minimum possible level for any given stake of technology. Automatic equilibrium: in order to balance If D > S : equilibrium price have to go up If S > D : equilibrium price have to go down 74 Neoclassical Model Assumptions: A large number of firms Each firm supplies a small share of a homogeneous product No firm has an impact on the product’ s price Perfect competition model: Demonstration: the forces of demand and supply leads to the determination of an equilibrium price. the interests of consumers and producers are harmonized no conflict. 75 Limitations: More static than Schumpeter's model Weak in explaining the process of price formation on market competition. Alternative model how mkts work Competition is a process of mkt adjustment. 76 Competitive Markets and Information Asymmetric Information Signals F.A Hayek said that individuals never have complete information when responding to economies changes Hayek sees changing competitive prices as signal mechanism for transmitting information between individuals in the market. By responding to these changes prices, producers and consumers are led to respond in an appropriate way to economic changes Price as Signal 77 Competitive Markets and Information Hayek Hayek emphasizes The importance of the process of competition rather than the end result of equilibrium; Information about changes in consumers tastes or in the conditions of production, is transmitted by changes in prices; The importance of price system as a decentralized mechanism for transmitting information prices as information signals; 78 Competitive Markets and Information Hayek Hayek and individual freedom Free market is the best may of guaranteeing individual freedom Through a decentralized market system. Market outcomes are seen as natural outcomes because they are the result of human actions but not human design. Market outcomes are not just the results of individuals luck and judgment. 79 Competitive Markets and Information Hayek Limitations: Prices ~ Information Prices can’t always be relied upon to provide the necessary signals and incentives to allocate resources to their best uses. E.g. market prices may not transmit all the relevant information because they include only the costs borne by the individual producer and exclude the wider effects on society. 80 Competitive Markets and Information Hayek Limitations of Hayek Model Prices reflect only the individual consumer’s satisfaction and exclude the wider benefits to society as a whole. Sometimes prices don’t transmit the correct information externalities are present when prices don’t convey all the social costs and social benefits arising from an economic activity. E.g. Environment pollution and greenhouse effect are externalities: social costs arising from an economic activity, but are not reflected in market prices. 81 Competitive Markets and Conflicts Sen’s approach Sen argues that conflicts of interest are inherent to the market transactions. In contrast of the neoclassical assumption. There is any automatic harmonization of interest through the mkt mechanism Most market situations are accompanied by large imbalances in power 82 Competitive Markets and Conflicts Sen’s approach The market transactions ensure the distribution of profit Depends upon the relative economic power of each party Market works as a “power balance” to sold the conflicts of interest. Interpretation of freedom as positive freedom where material powers underlying the capability to make choices are also significant. 83 Competitive Markets and Conflicts Sen’s approach Imbalance of market power means that income is distributed unequally across the population E. g. This inequality of income is reduced somewhat by the operation of welfare system in UK. Between 1979 and 1986 inequality in UK increased and this remains after the equalizing tendency of tax and benefit system is taken into account. 84 Competition And Power In Markets Model of competition Source of efficiency organizations freedom Schumpeter's model Neoclassical model Hayek's model Sen's model Dynamic competition forward-looking competition over innovations in products and processes Perfect competition/ competitive equilibrium, Prices set @ Competition as a process of adjustment to change; Prices are signals transmitting information Competition as a power struggle markets characterized by conflict rather than by harmony of interests Dynamic efficiencyinnovations arising from technological advances and economies of scale result in lower prices and costs Large corporations with their entrepreneurial managers Productive efficiencyprices and costs at the minimum level given existing technology The decentralized price mechanism transmits information about changing preferences and conditions of production Firms respond to price signals in an environment where they cannot have all the information Emphasis here not on efficiency whose gains may occur to all , but on the unequal nature of the gains and losses - - Price system guarantees individual freedom ; market outcomes are neither just nor unjust ;freedom as negative freedom Emphasis on freedom as enabling powers and capabilities (positive freedom), but markets do not ensure this for all equilibrium where demand=supply Firms are price-takers Economic organizations are part of the struggle for economic power 85 Market Failure When Markets Fail 86 When Markets Fail Market Failure: This term describes the failure of the market economy to achieve an efficient allocation of resources. Basic Functions of Government: Adjust market failure Governments are as old as organized economic Activity. Governments from Adam Smith’s vision: the first duty for sovereign is that protecting the society from violence, second protecting every member of the society from the injustice. 87 When Markets Fail There are several important circumstances under which markets fail to allocate resources with reasonable efficiencies: 1) If there are resources that can be used by everyone but belong to no one- common property resources. 2) If there are goods whose consumption cannot be restricted to those who are willing to pay for them. Public goods. 88 3) If people not party to some market bargain are none the less significantly affected by it – externalities. 4) If one party to a market transaction has fuller knowledge of its consequences than is available to other party – asymmetric information. 5) Where needed markets do not exist 6) Where substantial monopoly power exist. 89 When Markets Fail Non rivalries and non excludable goods: Rivalries: if no 2 persons can consume the same unit. Apple Excludable: if people can be prevented from obtaining it. Owner of a good give it to who pay for it. 1) Rivalrous – Excludable: normal goods: apple, PC’s (most goods) 2) Rivalrous – Non Excludable: common property” wildlife, common land 3) Non-rivalrous – excludable: Museums, Roads 4) Non-rivalrous – Non excludable: Public goods: defense, police - Non rivalrous: when the amount that one person consumes does not affect the amount that other people can consume. - Non excludable: when once produced there is no way to stop anyone from consuming them. 90 When Markets Fail Excludability depends on the specific circumstances and the state of technology Excludable goods: private agents who produce goods and services for sale on the free market must be able to prohibit consumption of their output by those who will not pay for the privilege. (otherwise, the producers can’t gain the Revenue to cover their Cost). Exp. Ordinary goods: excludable and rivalrous. Non excludable goods: Provides 2 sources on our list of Major Market failure (common property resources and public goods) Common property: non-excludable but rivalrous. Common property resource: is one that is rivalrous but non excludable. Like fish in oceans 91 When Markets Fail No one has an exclusive property right to it, and it can be used by anyone. No on owns ocean’s fish until they are caught. The tragedy of commons: the tendency for commonly held property to be overexploited, often to the extend of destruction. So the solution is to agree on optimal level of use (fishing quota) and hunting licenses Another method is to create property rights that make the resources excludable. Public goods: non- excludable and non rivalrious or can be called collective consumption goods (national defense). police force/ public goods are non excludable private firms will not provide them. So governments provide them and they took taxes. 92 When Markets Fail Externalities: (beneficial or harmful): Externalities are costs or benefits of a transaction that are incurred or received by other members of the society but not taken into account by the parties to the transaction. (third party effects or neighborhood effects) other parties, other than customers and producers participated in the transaction. When it occurs? When a factory generate pollution, social cost, profit maximizing (harmful) Beneficial – paint your house. Private costs: these costs that are incurred by the parties directly involved in some economic activities. Firms. Social costs: costs incurred by the whole society (private costs borne by third party). Private benefits: benefits received by those involved in the activity. utilities obtained by buyers. 93 Social benefits: benefits to the whale society. (Private + 3rd party) When Markets Fail The control of pollution: steel, farms, house holds. How government react to this? 1) Pollution control though direct regulations: Direct controls are common method of environmental regulation. ex. Car emission test and laws that prohibit burnings stuff. 2) Control through emissions taxes: Pollution taxes internalize the externality: increasing the firms private cost by the amount of external cost. Asymmetric information: markets work when everyone is well informed people can’t make decision without full information. - State intervenes to impose standards and testing requirements in the consumers own best interests. - Standards are also set in workplace. 94 When Markets Fail Missing Markets: One important set of missing markets is risk. Insure your house against burning. If you are a farmer you can’t insure your corps against bad weather. You insure your house against fire from ordinary purpose not war. - Future events another set. You can buy oil or corn in future market. But not for cars and TVs because no one knows the models. Public policy towards Monopoly and Competition: The law and other instruments that are used to encourage competition and discourage monopoly practices make up competition policy and are used to influence both the market structure and the behavior of individual firms. Government encourages competition and employ economic regulation which prescribe rules under which firms can do business. 95 When Markets Fail The government can control the prices. 1) Direct Control of natural monopolies: One firm operate at the minimum efficient scale. Natural monopolist restrict output, raise prices, reap monopoly profit Solution: government assumes ownership of the single firm, setting it up as a nationalized industry. Also, regulation. By privatization (telecommunication, Gas, water) after the Second World War. - The very long un concept means one firm operate professionally, technology make them disappear. 2) Direct control of oligopolies: Government should intervene to enforce type of price and entry behavior. Airlines, railways, steel. Deregulation and privatization in order to reduce government control. 3) Intervention to keep firms competing: Policies to create competitive market structure and prevent firms from reducing competition by engaging in certain form of cooperative behavior. Globalization: internationalization of competition (free trade) 96 When Markets Fail -UK competition policies: Who is responsible is the secretary of state for trade and Industry: elements of monitoring and enforcement delegated to: restrictive practices court (RPC) the office of Fair Trading (OFT) the Monopolies and Mergers Commission (MMO) by 1998 merge with OFT The future of completion policy: Government has an important rule as a rule maker and referee of market economy. 97 When Markets Fail Government objectives: 1) Protect life and property by exercising a monopoly of violence 2) Improve economic efficiency by addressing various cases of market failures 3) Achieve some accepted standard of equity. 4) Protect individuals from others and from themselves 5) Influence rate of economic growth 6) Stabilize economy against income and price level fluctuation. 98 When Markets Fail -The distribution of income: - Important characteristics of the markets -People whose skills are scare relative to supply earn large income -Differentials in earnings serve important fraction of motivating people to adopt. 2 kind of equity; horizontal and vertical: -Horizontal equity: persons in similar circumstances should be treated similarly. -Vertical Equity: different treatment of people in different economic situations in order to reduce inequalities between them. (taxes on income) -The distribution of wealth: in order to reduce inequalities: 1) To levy taxes on wealth at the time is wealth transferred from one owner to another. (gift, bequest) 2) Annual tax on the value of each persons wealth 99 When Markets Fail Policies to protect individuals: 1) Protection from others: child labor laws from selfish parents, standards of work 2) Protection from oneself: Prohibiting use of heroin, cocaine, drugs, and seat belts in cars are methods called paternalism. Merit goods: goods that society operating through governments deems to be especially important or that those in power feel individuals should be encouraged to consume. (housing, education, health care). The cost of government Intervention: 1) Internal cost: When government uses resources it costs money when government inspectors visit a plant to (compliance with standards, industry safety) judges salaries and clerks. 2) Direct External costs: cost that government imposes on others. Direct external costs fall on agents with whom the governments is directly interacting. Increase in production costs (inspections) Costs of compliance (CPAs, occupational safety and environmental control) Losses in productivity: experiments and innovation. 3) Indirect external cost: Costs of government action spread beyond those immediately affected by it. Externalities (Safety 100 and new drugs) When Markets Fail -Government Failure: When government don’t succeed in achieving potential benefits that exceed the full direct and indirect cost -Rigidities: Rules and Regulations, tax rates. Exp. Policies are hard to change market conditions changeable. governments slow to admit mistakes even when they become aware of them -Decision Makers Objectives: Most important cause of government failure arise from the nature of the government own objectives. Governments need to know when to intervene 101 When Markets Fail - Public choice theory by James Buchanan: deals with 3 maximizing groups: 1) Elected officials: seek to maximize their votes 2) Civil servants: seek to maximize their salaries (position in hierarchy) 3) Voters: seek to maximize their own utility. So voters want the government to provide them with goods and services and income transfers that raise their personal utility. - Government intervention today: little, much respond to failure. - The role of analysis: Economy eliminates misconception. - The role of ideology: Measure cost of intervention and classify this intervention whether it is successful or not. 102 The Global Markets International Trade Protectionism And Industrialization: A Historical Perspective Multinational Corporations Globalization In The Age Of Empire 103 International Trade Economic growth will be achieved when an economy buy goods from abroad and export other goods to generate revenue International trade: exchanges of goods and services that take place across international boundaries. Open economy: An economy that is engaged in international trade. Closed is the one that did not do so. Autarky: a situation in which a country does no foreign trade. Gaines from trade: the advantages realized as a result of trade Trade will benefit individuals, groups, regions, and countries. Without trade every person has to be self sufficient , so he/she has to produce everything food, cloths, shelter, etc. which is impossible. Trade among individuals allows people to specialize in such activities (doctors, carpenters, etc) so with trade everyone can specialize in what he/she does well and satisfy other needs by trading. The same principles apply for regions. Each region can specialize in producing goods and services for which it has some natural or acquired advantage (hot, cold, mountains, forests, sandy, sunshine etc) The same principle will apply for nations. Trade allows each individual, region, and nation to concentrate on producing those goods and services that it produces 104 efficiently and to obtain those goods and services that it doesn’t produce well. International Trade Two sources of the gains from trade: 1-differences among regions of the world in climate and resource endowment that lead to advantages in producing certain goods and disadvantages in producing others. 2-reduction in each country’s costs of production that comes from the greater production that specialization encourage. The country has an absolute advantage over another one in the production of X when an equal quantity of resources can produce more X in the country. So the total production can be increased if each country specializes in producing the product for which it has an absolute advantage. David Ricardo English Economist (1772-1823) has come with the theory of comparative advantage. The gains from specialization and trade depend on the pattern of comparative. The opportunity cost tells us how much of one good we have to give up in order to produce one or more unit of the other. So a country has a comparative advantage over another country when the opportunity cost of production in the country is lower. If the opportunity cost is the same in all countries, there is no comparative 105 advantage and there is no gains from specialization. International Trade Production costs measured in terms of recourses used, often fall as the scale of output increase. Smaller countries like Switzerland and Belgium could whose domestic markets are not large enough to exploit economies of scale would find it expensive to become self sufficient. Trade allows smaller countries to specialize and produce a few products at high enough levels of output to reap the available economies of scale. Learning by doing: a country gain experience in producing a good over time so it will become efficient in producing it. Terms of trade: measure the quantity of imported goods that can be obtained per unit of goods exported. Terms of trade = Index of export prices * 100 Index of import A rise in the index referred to as a favorable change in the prices country’s terms of trade. A favorable change means that more can be imported per unit of goods exported than previously. The unfavorable change means that the country can import less in return for any given amount of export. For instance, a rise in oil prices in 1970s led to large unfavorable in the term of trade oil importing countries like USA and a favorable for oil countries like KSA Commercial policy: government policy towards international trade 106 International Trade Free Trade: freedom from any interference with trade Protectionism: giving protection to domestic industries from foreign competition Tariffs: taxes designed to raise the price of foreign goods Non-Tariff barriers: devices other than tariffs that are designed to reduce the flow of imports such as quotas and customs Free trade allows countries to specialize in producing products in which they have a comparative advantage which enhance the maximization of world production and this will allow consumers to consume more goods and services. Also, Free trade will improve everyone’s living standards. 107 International Trade The case for protectionism: there are 2 kinds. 1) The national objectives other than total income. a) Non-economic advantages of diversification: Due to comparative advantages this will lead government to narrow their range of products in order to specialize. Government social advantages in encouraging more diverse (Living Standards) b) Risk of specialization For small countries there is a risk in specializing in the production of few products (technological advances may render its major product obsolete). Government protect weak industries by the tariff to encourage diversification. c) National Defense UK need experienced merchant navy in case of war. It should be fostered by protection. d) Protection of Specific Group. Free trade will maximize per casita GDP over the whole economy. Some groups have higher income under protectionism protect such an industry. 108 International Trade Tariffs tend to raise the relative income of a group of people who are in short supply domestically and to lower the relative income of a group of people who are plentiful supply domestically (free trade does the apposite). 109 International Trade 2) Increase one countries National Income (NI) NI: total income earned by all people in a country. a) To alter the terms of trade: Trade restrictions can be used to turn the terms of trade in favor of countries that produce and export a large fraction of the world’s supply of some product. When OPEC countries restricted their output of oil in 1970’s they where able to drive up the prices of oil relative to prices of other traded goods. The apposite in 1980’s b) To protect against unfair actions by foreign firms and government. Tariffs may be used to prevent foreign industries from gaining an advantage over domestic industries. Dumping: selling a good in a foreign country at a lower price than in the country where it is produced. c) To protect infant industries: if an industry has large economies of scale. Cost will be high when the industry is small. d) To encourage learning by doing: Country develops a comparative advantage as the learning process lowers their costs. protecting a domestic industry from foreign competition may give its management a time to learn to be efficient and develop comparative advantages.And labor to acquire necessary skills. e) To create or to exploit a strategic trade advantages: Important argument for tariffs is to create a strategic advantage in producing or marketing 110 some new product that is expected to generate profits.Small firms competing large ones (with economies of scale) government should adopt strategic trade policies more broadly. International Trade Methods of protection: how government protect (tools): There are 2 main types of protection policies. Both cause the price of the imported goods to raise and its quantity to fall. 1) Policies that directly raise prices: Raise prices of imported products by a Tariff (import duty) => affect foreign and domestic product and customers. 2) Policies that directly lower quantities: Restricts imported products: a.Non-tariff Barrier: an implicit or explicit restriction on trade that does not involve a tariff (quality standard, customs complications). b.Import quota: importing county sets a maximum on the quantity of some product. c.Voluntary Export Restriction (VER): an agreement by an exporting country to limit the amount of goods that it sells to the importing country. 111 International Trade Global commercial policy: Before 1947 any country was free to impose any tariffs on its imports. In 1930s great depression has world protectionism in order to raise its employment then change GATT & WTO 1. Achievement of the post war was creation of GATT (General Agreement of Tariff & Trade). The principle of GATT is that each member country agrees not to make unilateral tariff increases. 2. There have been 8 rounds of global trade talks since 1948. 3. The Uruguay round created a new body, world trade organization (WTO) that superseded the GATT in 1995 to liberalize trade. Type of Regional Agreement : Regional Agreement seeks to liberalize trade over a smaller set of countries than the WTO membership. 3 standard forms of Regional trade Agreement: Free Trade Areas (FTA), Customs Unions and Common Markets. -Customs Union: free trade area plus an agreement to establish common barriers to trade with the rest of the world. - Common Market: is a customs union that also has free movement of labor and capital 112 among its members. International Trade 1. 2. 3. - EFTA, NAFTA: European Free Trade Association (EFTA)(1960) by countries unwilling to join EU. They joined EU in 1995. NAFTA 1993: Please refer to my last summary for extra information on it. Common Markets: The EU (European Union) In 1945 after Second World War to avoid future military conflict E.U created economic integration to face USA & Japan. 1952 European coal and steal community. 1957 Treaty of Rome European Economic community EEC. 1993 EU. And in 1973 UK joined. In first 2 decades the main Economic Achievement of EEC is the elimination of internal tariff barriers & establishment of common external tariff (customs unions) and common agricultural policy. The single market Program: Signed in 1986 in order to remove all barriers to create fully integrated single market by 1992. The Maastricht Treaty signed in 1992 to push the integration of EU further 113 (common currency) in 1999 and to harmonize the policies. Protectionism and Industrialization (historical perspective) Part of the developed world, protectionism was the dominant commercial policy .The United States, the mother country and bastion of modern protectionism. The future Third World (and especially those countries that were colonized), liberalism prevailed, but it was not by choice; it was enforced liberal commercial policy. THE UNITED STATES: MOTHER COUNTRY AND BASTION OF MODERN PROTECTIONISM (1791-1860) : One should not forget that modern protectionism was born in the United States. Alexander Hamilton, the First Secretary of the Treasury. The major contribution of Hamilton is the emphasis he put on the idea that industrialization is not possible without tariff protection. He was apparently the first to have introduced the term “infant industries”. 1) We divide the nineteenth century American commercial history into 3 relatively distinct periods. 1- 1816 – 1846 protectionist avg. 40% tariff (nature of it) 2- 1846 – 1861 Liberal Somehow (modest protectionism) return of democratic party. 114 3- 1861 – End of World War II strict protectionism. Protectionism and Industrialization (historical perspective) THE UNITED STATES: FROM “INFANT INDUSTRIES” ARGUMENTS TO THE PROTECTION OF AMERICAN WAGES (1861-1914): The 1861 tariff was the beginning of a policy that was to be followed in the United States until the end of World War II. Import duties were increased again during the American Civil War, and victory by the North brought further protectionism. 1866 to 1883 imported duties avg. 45% 1913 Underwood tariffs decrease on tariffs 25% avg. 115 Protectionism and Industrialization (historical perspective) - British Dominions: Tariff independence brings protectionism. In the 19th century the trade policies in (Canada, Australia and New Zealand) sent through 2 main phases: 1) Depend on the country 1867 – 88 liberal policies / exported opportunities for agricultural products favored with early 1850’s. 2) (1867/88 and 1913) they encourage their industrial sectors through protectionist tariff polices. The geographical location as important influence for this isolation and far. In the future third world: Liberalism enforced. The future of the third world will be toward liberalism. It was compulsory economic liberalism of two types: 1) Real colonies: the general rule consisted of free access to all the products of the mother country. (They charge low duties for fiscal reasons) British colonies. 2)Independent or not real colonies: in 19th century Western countries imposed treaties on Latin American, China, and Thailand that entailed a more or less total elimination of customs duties on imports. Pressure from UK between 1810-1850. 116 Multinational Corporations Foreign direct investment (FDI) is increasing in importance in the world economy They have always attracted a good deal of attention and given rise to heated controversy. The main distinction between direct and portfolio investments is that in the former the investor retains control over the invested capital. Direct investments and management go together. With portfolio investments, no such control is exercised. Here the investor lends the capital in order to get a return on it, but has no control over the use of that capital. There were 3 major elements in international capital flows in the 80s: increase in FDI in USA, Japan become a major source of FDI and portfolio lending to LDC cause high level crisis 117 Multinational Corporations DIRECT INVESTMENTS AND MULTINATIONAL ENTRPRISES. Most FDI is undertaken by enterprises, and the larger part of that by multinational enterprises (MNEs). Multinational enterprises are essentially those that own or control production facilities in more than one country. Their importance nowadays is as major providers of FDI, often using capital which has been raised in the capital markets of the country in which they are investing rather than capital market of their home country. Direct investment is typically industry-specific. Industryspecific investments take two important forms: horizontal and vertical integration. Large corporations wish to integrate horizontally by opening new subsidiaries in various parts of the world. This is often done in a predatory way: one or several existing, competing firms in the host country are simply bought up by a large international rival. In the process, competition is often reduced. Vertical integration is also a strong motive for direct investment. For instance, there are only a few companies that refine and fabricate copper. It is not surprising that they have sought control over copper mines by vertically integrating backwards in the production process. One obvious reason for vertical integration is a desire to reduce risk 118 Multinational Corporations THE THEORY OF DIRECT INVESTEMENTS Venron said that a firm tends to become multinational at a certain stage in its growth. In the early stages of the product cycle, initial expansion into overseas markets is by means of exports. Prior to the standardization of the production process, the firm requires close contacts with both its product market and its suppliers. The firm may decide to look overseas for the lower-cost locations and new markets. Market imperfections and FDI Advantages which some firms enjoy and on which they may be able to obtain rents in foreign markets. Such advantages include access to panted and generally unavailable technology, team-specific management skills, plant economies of scale, special marketing skills, possession of a brand name, and so on. The potential gains from these advantages must of course outweigh the disadvantages of establishing and operating in a foreign country, such as communication difficulties and ignorance of institutions, customs and tastes, before the firm will invest abroad. Lack of direct control of MNE will increase the likelihood of the leaking of the technology to competitors. These markets are imperfect because they are difficult to organize and involve considerable uncertainty. Barriers to trade and FDI Transport costs offer one explanation of FDI. If transport costs are sufficiently high then they may make the expansion of production in domestic plants and the export of that increased production less profitable than production within the putative importing country. Import barriers. First, they raise the price of the good within the protected market. Second, import barriers reduce the exports of firms in other countries. 119 Multinational Corporations Dunning`s “eclectic theory” Dunning has suggested an eclectic theory of FDI, often referred to as the OLI paradigm. The O, L and I in the paradigm refer to three groups of conditions that determine whether a firm, industry or company will be a source or a host of FDI(or neither, of course). These groups are Ownership advantage, Locational considerations, and Internalization gains. Ownership advantages are advantages which are specific to the firm. That expansion in the domestic market may be an alternative strategy. For example, advantages in technology and in management and organisational skills. Others often cited are size and diversification, access to or control over raw materials, the ability to call on the political support of their government. Locational considerations encompass such things as transport costs facing both finished products and raw material, import restrictions, the ease with which the firm can operate in another country. Internalization gains concern those factors which make it more profitable to carry out transactions within the firm than to rely on external markets. Such gains arise from avoiding market imperfections (uncertainty , economies of scale, problems of control, the undesirability of providing full information to a prospective purchaser, and soon). The essential element in the eclectic theory is that all three types of condition must be met before there will be foreign direct investment. 120 Multinational Corporations Taxation and the transfer pricing problem: - Taxation policies in host countries will affect the flow of FDI and differences between policies in countries encourage MNE to maximize their post tax profit on global. - Other things begin equal, high rates of tax on profits will encourage firms to look outside their home country to pay low taxes. - Transfer price: price which products are sold by MNE in low tax countries to that in high tax countries. E.x. car engine. - The consequences of MNE activities: 1) Control: · To host country this means parts of its industry will be controlled by foreigners. Some countries didn’t accept that. · One of obvious aspect of control that MNE want subsidiaries to operate their policies. (Restrictions on exports, R&D, money transfer) 121 Multinational Corporations 2) External benefits of FDI to host a country: MNE offer benefits on the host country (training the local labor, if it’s free and use equipment and technology. If workers pay whether by money or law wages then external benefits reduced also, expenditure on the R&D. - Policy response in host countries: To FDI are far from uniform. Same of them with restriction and control on FDI on the operation of MNE like Canada. Same of them with it like UK. Export processing Zones (EPZs): - Are designated area within the host country intended to attract investment largely from foreign firms by offering favored treatment (absence of import controls). So tariffs are not levied on imported goods. (exemption from domestic taxation and industrial regulations) . - It required public investment from host country. - Objectives increase foreign exchange earnings, increase employments, and encourage transfer of technology and management skills. 122 Globalization in Age of Empire 1875 – 1914 called the age of empires. It develops a new kind of imperialism - Globalization: coming together of cultures. There are two forces of globalizations: 1) Coercive: impose it self on others. linked to imperialism 2) Cooperative: live side by side, interacting and evolving together. (cultural coexistence) - Empires: provision of public goods and military strength where able to force globalization onto a multitude of cultures. So they foster globalization. 1) Empires built reliable infrastructure and imposed common language leading to increase in commerce and migration. (Roman) 2) Empires imposed common religious practices (Spain in South America) 3) Empires installed a common political culture (British) - Culture coming together intend of coercion - Amsterdam opened its doors to scientist, philosophers, and escaping ethical persecution. So they contribute to the city development. 1870-1939 Paris for 123 writers and painters. Markets: Good servants, Bad Masters The Diversity Of Capitalism Capitalism And Global Free Markets Why Did East Asia Grow So Fast Not included in our Midterm exam 124