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Summary Book Economic Approaches
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Summary bookEconomic Approaches
Contents
Chapter 1 – Markets and organizations ........................................................................................... 2
Chapter 2 – Markets ......................................................................................................................... 2
Chapter 3 – Organizations ............................................................................................................... 3
Chapter 4 – Information.................................................................................................................... 4
Chapter 5 – Game theory ................................................................................................................. 5
Chapter 6 – Econs and humans ....................................................................................................... 7
Chapter 7 – Behavioural theory of the firm ...................................................................................... 8
Chapter 8 – Agency theory............................................................................................................... 9
Chapter 16 – Corporate governance.............................................................................................. 13
Chapter 9 – Transaction cost economics ....................................................................................... 14
Chapter 15 – Hybrid organizations................................................................................................. 16
Chapter 10 – Economic contributions to business / competitive strategy ..................................... 19
Chapter 11 – Economic contributions to corporate strategy .......................................................... 21
Chapter 12 – Evolutionary approaches to organizations ............................................................... 23
Chapter 14 – Economic approaches to mergers and acquisitions ................................................ 26
Article – Corporate social responsibility: a theory of the firm perspective ..................................... 29
Chapter 13 – All in the family ......................................................................................................... 31
1
,Chapter 1 – Markets and organizations
There is an economic problem if needs are not met as a result of
scarcity resources. We try to use the resources with efficiency and in
the optimal allocation. Economic approaches to organizations are
fruitful whenever the problem to be studied has an economic aspect.
1. Division of labour. Productivity increases if the labour is divided.
2. Specialization. Specialized production is more efficient than unspecialized production. You can select a
task that suits your needs and capabilities. For an individual, specialization results in higher performance
but also in restricted choice; the range of activities shouldn’t become too narrow.
3. Coordination. Exchange has to take place and is beneficial to both parties. Exchange results in a
transaction, which can take place either across markets or within organizations. Coordination is needed.
4. Markets and organizations. In an ideal market (e.g. stock market), the price system is the coordinating
device that takes care of allocation, no personal contact is needed. The price contains all the information you
need to base your transaction on: it is a sufficient statistic. However, usually, there is a cost to find out the
relevant prices and a contract is drawn up, which results in transaction costs economics. Ideal organizations
are all forms of coordination of transactions that do not use prices to communicate information between the
transacting parties.
5. Information. The price does not always include all information, as a result, organizations arise as solutions
to information problems. Information and communication costs determine the relative effectiveness of
markets and organizations.
6. Environment and institutions. The environment is the context in which trade-offs are made. The
environment provides conditions for organization/markets to be created, shapes all organizations/markets by
economic, social and political pressures and is the ultimate selection mechanism for determining which
organizations/markets can be successful and survive. Markets are influenced by the government (important
actor in the environment). Institutions are the rules of the game in a society; the humanly devised
constraints that shape human interaction. The government often regulates markets, e.g. the legal system.
Until recently, economists mostly studied coordination between or within organizations.
Chapter 2 – Markets
There is demand and supply for goods or services and a market can match demand
and supply at a certain price. How much companies are going to produce and how
much consumers are going to consume, results in the process of market interaction,
which determines the price. The law of demand assumes that total demand goes
down if the price goes up. The law of supply assumes that supply goes up as the
price goes up. Market equilibrium occurs if the two curves intersect. If there is an
increase in demand, the curve will shift upwards and the price will increase.
The preference rankings for products are assumed to
be transitive (if you prefer A over B and B over C,
you also prefer A over C). Preferences can be
presented with indifferences curves. Offer 120 for 120
is preferred because the green curve is further away
from the origin than the black curve. The satisfaction
consumers derive from having a good is called
utility. The budget line (blue line) shows the quantity
that can be bought with a certain budget. If you want
to maximize your utility, you should choose the offer
with the red dot, which is tangential to curve 1.
The promotion function describes the relationship between any combination of inputs (Capital (K) and Labour
(L) and the quantity of output that the firm can produce with those inputs: Quantity (Q) = Q(K, L). A company
calculates the optimal values to maximize their profits.
A firm can earn no economic profit in the long run in a competitive market (many sellers/buyers and free
entry/exit), because if there is economic profits, entry occurs, supply increase, price goes down and economic
profits vanish. A Pareto-optimal allocation of resources is that no one can be better off by changing the
allocation of resources without anyone becoming worse off.
2
,The perfect competition also has some assumptions: a large number of small buyers and sellers (their decisions
do not influence the market price), free entry and exit of firms, and standardized products (doesn’t matter if you
buy from A or B).
All models of standard microeconomics are examined as if they function in isolation (not true because there are
environmental contexts) and are based on four assumptions: firms are holistic entities, have a single objective
(e.g. maximizing profits), there is perfect information (everyone knows everything) and behaviour of producers
and consumers is described as maximizing behaviour (either profit or utility). This are simplifying assumptions.
Chapter 3 – Organizations
Organizational configurations shows several types of coordination mechanisms:
1. Mutual adjustment achieves coordination by the simple process of informal communication (between two
employees). This configuration is called innovative organizations.
2. Direct supervision achieves coordination by having one person issue orders or instructions to several
others whose work interrelates (boss tells people what to do). This configuration is called entrepreneurial
organization: the entrepreneur controls the activities of the organization, in a flexible, informal and not
elaborated structure, often in a simple and dynamic environment.
3. Standardization of work process achieves coordination by specifying the work processes of people
carrying out interrelated tasks. The standards are developed in the technostructure and the work
processes are carried out in the operating core. This configuration is called machine organization.
4. Standardization of outputs achieves coordination by specifying the results of different work. This
configuration is called diversified organization.
5. Standardization of skills and knowledge achieves coordination by virtue of the related training the
workers have received. This configuration is called professional organizations (e.g. hospitals).
6. Standardization of norms achieves coordination by the norms which determine the work that is
controlled, so that everyone functions according to beliefs. This configuration is called missionary
organizations.
This shows that there are several ways to coordinate an
organization and authority is just an option. Bigger organizations
will combine a variety of these coordination mechanisms. An
organization often starts with
direct supervision and later moves
towards another form.
Some companies with several divisions have an internal market for goods, especially if one division needs the
product made by another division, based on a transfer price. Some other companies have an internal capital
market, if corporate management allocates its funds to the divisions on the basis of those divisional plans that fit
best with corporate policy and generate the highest returns. An internal labour market exists where divisions
compete for the best human resources and may also bid up their potential salaries. You can apply internally for
better positions. But, the external markets will always remain linked, because it is still possible that people from
the outside enter the organization. Thus, within organizations, several types of market may operate.
A pure market coordination, e.g. a stock market, is run by the price mechanism. However, two organizational
coordination mechanisms operate as well: the market is regulated by the government and stock exchange
boards, and has direct supervision. Also, mutual adjustment achieves coordination through informal
communications, but markets also have informal communication (called (tactic) collusion). Lastly, markets are
influenced by culture. To conclude, combining market and organizational coordination happens a lot.
3
, The Internet of Things (IoT) is the network of physical objects which are embedded with electronics, which
enables these objects to collect and exchange data. E-commerce is upcoming and the management is often
using enterprise resource planning (ERP). There is a digitization of organizations. There are three
characteristics of digital platforms as coordination mechanisms:
1. Digital platforms make use of digital technology and human intervention is not necessary.
2. Coordination is usually achieved by an algorithm (set of rules to solve a problem).
3. Digital platforms can be easily expanded if already developed and running.
An organization that predominantly uses a digital platform as coordination mechanism is a platform
organization, e.g. Uber or Google. It has several characteristics:
Digital platforms can easily be expended or replicated in other geographical areas (scalability). Also, if they
attract more users, they become more valuable to potential new users (direct network effects) but also for
suppliers (indirect network effects).
Positive feedback loops: lower costs leading to more customers, attracting more sellers and the volume
growth enabling further lowering of the cost base and prices. This results in exponential growth.
New and successful digital platforms give their platform organization a first mover advantage. Often, it is a
winner-takes-all market: one company or one technology dominates.
Successful platform organization achieve high market valuations, because of their exponential growth and
operating at low costs.
Chapter 4 – Information
Coordination and information
If a market has perfect competition, everyone is necessarily a price-taker: it has to accept the prevailing market
price and cannot hope to influence the price level. In such markets, you can only choose how much to sell or how
much to buy. The goods are homogeneous, which means that it only comes in one standardized form. There are
no quality differences, thus is doesn’t matter from who you sell or buy. We can only rely on this price mechanism
if all necessary information can be absorbed in the price. For example, with soup, brand names are supposed to
reflect the quality, and sugar is a more standardized product than fruit. Fruit is uncertain in quality (due to weather
etc.) and therefore a contingent claims contract can guarantee quality and price levels. However, often there is an
incomplete contract which does not cover the uncertainty completely. In some situations, information is unevenly
distributed, called information asymmetry. The value of information can only be realized by revealing it to the
other party, but this destroys its value, which is called fundamental paradox of information. Information
asymmetry can give problems because information is crucial to have transactions.
Hidden information
With insurances, there is an adverse selection: you will get a set of clients in which the high-risk part of the
population is overrepresented, because for them the offer of an insurance is very attractive. As a result, you must
raise your prices, and this offer is unattractive for the average-risk group. Adverse selection is a problem of
hidden information: one party has private information that exists before both parties agree on a transaction, e.g.
you are better informed about your health than the insurance company. You have private information that is
unobservable for the other party. Observability could be increase by e.g. a medical examination, inspection of a
car. Also, some signals will give information (e.g. went to business school) or screening can be used as a
strategy to tempt owners of private information to self-select and thereby reveal the value of their private
information. Other options are to pool the risks, redistribute the risks involved (providing a warranty), or to
segment risks.
Hidden action
Hidden actions or moral hazard refers to unobservable actions that parties in a transaction take after they have
agreed to execute the transaction. An example is insurance for the damage of a cigarette on your cloths: the
insurance company cannot observe if it happened as accident or due to sloppiness. Another example is going on
business trip but having disappointing results: due to having other interest when abroad? Solutions can be to
increase observability or to consider risk-sharing arrangements (e.g. salary based on your sales). Sometimes we
cannot even determine whether or not actions are correct, even if you observe them. For example, the relation
between a physician and a patient.
4
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