ECON 696: Managerial Economics and Strategy Lecture Notes 1: The Evolution of the Modern Firm This chapter

in the text discussed the formation of a number of institutions between 1840 and the present day, which have resulted in the business world as we now recognize it. This discussion serves several purposes. First, it demonstrates several conditions necessary for markets to function with relative efficiency. This has its roots in the theory of perfect competition, which analyzes markets under the somewhat unrealistic assumptions of : Many small firms and consumers Perfect information Free entry and exit Identical products Under these assumptions (which, admittedly, are infrequently satisfied) markets are very efficient in the sense that the marginal cost of production is equal to consumers' marginal value. The lack of a good transport infrastructure meant that it was difficult for sellers from one region to enter the market for their good in another region. Further, the extreme difficulty of moving goods from one place to another could only perpetuate local monopolies and their accompanying inefficiencies. The lack of good flows of information meant that goods could not move from regions of the country where they were relatively plentiful (as indicated by low prices) to regions where they were relatively plentiful (as indicated by high prices). This not only restricted profitable opportunities for entrepreneurs, it also kept markets from fulfilling their important task of redistributing goods from where they are most common to where they are most critical. Second, analysis of situations in which different elements critical to the smooth functioning of markets are absent demonstrates quite effectively how markets function when these elements are missing. The lack of current information about prices in different places and the great amounts of time required to transport goods meant that middlemen took great risks in buying goods and moving them to other areas. The high level of risk meant that price differences had to be huge to provide sufficient incentives for interregional commerce.

The lack of good financial systems (due in part to the lack of good information about people who were trying to borrow) limited entrepreneurs' and firms' ability to borrow the capital necessary to expand existing businesses or start new ones, even if those businesses stood a good chance of being profitable. The lack of good capital markets and the difficulties of interregional trade worked together to keep firms small, because larger firms couldn't access sufficiently large areas over which to distribute their goods and, in harmony with this idea, they couldn't get the capital necessary to become large anyway. Relatively small regional markets reduced opportunities for lower costs through economies of scale and also limited the variety of goods which might have been available had businesses appealing to a smaller segment of the population been able to sell nationwide. The end result was small local or regional markets for a relatively small variety of goods. This can be illustrated by some relatively simple diagrams. Imagine that there are two technologies which may be used to make a product, a small scale technology and a large scale technology, and that their average cost curves are represented as follows:

If the area to which a firm can ship is very limited, they may only be able to sell a small quantity of their output and the small-scale technology may offer a lower average cost. The ability to distribute more widely would allow use of the large-scale technology and

lower their average cost, but only if they could borrow the capital necessary to purchase the equipment for the large scale technology. The lack of capital markets and a good transport infrastructure perpetuated the existence of many small firms, offering most consumers a relatively narrow selection of goods which were produced at higher than necessary costs. This also reduced demand for the development of more efficient, larger scale technologies. As the institutions that are important to modern business came into being, business became more like what is seen today. Over time (in the book, this means from about 1860 to 1910 and beyond) advances in transportation infrastructure, communication infrastructure and financial markets made larger firms possible. A large factory, taking advantage of economies of scale and lower average costs, could produce goods and ship them over a wide area. This had the advantage of using fewer scarce resources than would have been used by many small producers. More interestingly, with firms getting larger, the owners of the firms could not be involved in the daily operations of every aspect of the business and had to hire managers to run operations and make decisions. The problem with hiring managers, however, is that they don't usually own the business and are likely to make decisions that maximize their own welfare rather than the long run profits of the company. Further, with larger, more complicated firms, decisions had to be made about what a firm would do, what it would buy, what it would make and how it would handle distribution and sales. The fundamental problem in organization is that there are many people who are not the firm's owners supplying goods and services to it and making decisions for it. How can managers, employees, suppliers, distributors and other agents of the firm be trusted or encouraged to act in the firm's best interest when they are not entitled to the firm's profits?

Effects of Missing Institutions Take a moment and consider what the modern economy and business world might look like in the absence of some of the critical modern institutions mentioned in this chapter. This is not merely a historical question. There are places around the world where one or more of the important institutions are non-existent, and business practices there reflect the lack of these institutions. How would business be different if:

The legal environment (or lack thereof) prohibited the existence of good financial markets An area lacked a transportation infrastructure or had legal barriers against trade or the transport of goods A poor communications infrastructure meant that information about prices and wages in other regions was unavailable

Effects of Poor Financial Markets Good financial markets allow people with some savings to invest those savings in a large number of projects that are typically screened by an intermediary such as a bank or a mutual fund. The investors should be well protected against abuse by both the intermediary and the borrower and the process should be as transparent as possible. When good financial markets do not exist (as in the case of some transitioning economies in eastern Europe and in parts of southeast Asia) there are two problems. First, people with some savings must turn elsewhere to invest their money, leading perhaps to capital flight from a country without good financial markets to those with them. Second, firms seeking to start or expand operations must find single, large investors who have extralegal means of protecting their investment and extracting their returns, a role often filled by organized crime. Effects of Barriers to Trade Free trade allows prices to be equated across regions and countries and allow low cost producers to supply goods at low prices to areas in which production is more costly. Legal or structural barriers to trade allow wide variations in production costs and prices between different areas, meaning that a much greater quantity of scarce resources may be used in production of a good than is absolutely necessary. Further, small local monopolists protected from more distant competition may charge inefficiently high prices for a product in their area. We are particularly lucky to have very few barriers to trade within the United States, but consider what might happen if this were not the case. It is not practical to grow oranges in Minnesota, but with enough energy to produce heat and light in greenhouses, it might be technologically possible. If an association of Minnesota orange growers was able to prevent orange imports from Florida and California (where growers clearly have unfair cost advantages) there could be very, very high prices for oranges in Minnesota with huge amounts of resources being consumed in their production while, at the same time, orange prices would be much lower just a few hundred miles south or just acros the border in North Dakota. This would not only hurt consumers in Minnesota, but would also lead to very inefficient use of resources.

Effects of Poor Communication When information about prices and wages in different regions and for different jobs is freely available, people can use this information to make decisions which are not only profit maximizing, but which also allocate resources to where they are most scarce. Higher prices for a good or a particular type of labor in an area indicate that these are more scarce there than they are elsewhere. People acting in their own self-interest offer their goods or services in these markets and simultaneously allocate goods and services to where they are most scarce. Internet auction sites allow people to exchange information about what is available and what people are willing to pay for it. A person seeking to sell an item can easily find a group of people who wish to purchase it, determine who values it most highly and negotiate (through auction) a mutually agreeable price. Such free availability of information makes mutually beneficial trades possible and allows all participants to benefit. Lacking such information, there may be many trades that would be mutually beneficial but are never executed. Summary Modern transportation and communication infrastructure not only makes conducting business easier, it fundamentally changes how business operates. Firms can become much larger due to good transport opportunities and access to large amounts of capital in properly functioning credit markets. New advances in transport and information have the capability of further altering the way business is done and generating greater levels of efficiency. Situations in which particular components of modern business are missing exist in many places in the world today. It is important to be able to predict the effect of these missing components and to have the ability to see what problems and opportunities they present.