The Economics of Business

The Economics of Business Class 1 Notes Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

Part I: Introducing Economics • Economics, the Delightful Science (our framework) • The beneficial power of self-interest • The division of labor (specialization) is source of society’s wealth • The importance offreedom to trade • An autonomous, self-directed system • A Very Brief History of Trade and Business • Business and Government • Positive vs. Normative Economics Notes are incomplete without oral presentation

Economics: The Delightful Science • Adam Smith; foundations laid down in Wealth of Nations • The beneficial power of self-interest • The division of labor, or specialization, as a primary basis of a nation’s wealth • The importance of freedom to trade, among people, businesses, and nations • The market as a self-directed, autonomous system Notes are incomplete without oral presentation

The beneficial power of self-interest Butcher, brewer, and baker p14 Self-interest ≠ greed, avarice, etc. Interests among people may conflict –> incentive systems Pursuit of self-interest requires some degree of rationality Perfect rationality vs. bounded rationality Experimental and behavioral economics explore human decision making Smith’s Theory of Moral Sentiments anticipates some behavioral economics Notes are incomplete without oral presentation

The beneficial power of self-interest… • Utility; an introspective measure of self-interest • Initially only a consumer attribute • Utility extended to production through managers’ behavior and decision-making Notes are incomplete without oral presentation

The beneficial power of self-interest… • Pursuit of self-interest involves some degree of rationality to justify consumer choice and sovereignty • Early utility theory reflected hedonistic philosophy/psychology • Cardinal utility, Bentham, et al measurable degrees of utility; pleasure and pain (Edgeworth’s hedonimeter) • Ordinal utility, doubts about measurement, eventual realization it was unnecessary • Marginal utility credited to Jevons, Marshall expanded • Slutsky, 1915, effort to disengage entirely from hedonistic psychology (not completely successful) • Samuelson, 1938, advances “purely behavioral” revealed preference (later recants on degree of separation) Notes are incomplete without oral presentation

The beneficial power of self-interest… • Now, neoclassical utility is as Armen Alchian said: “…For analytical convenience it is customary to postulate that an individual seeks to maximize something subject to some constraints. The thing -or numerical measure of the "thing"- which he seeks to maximize is called "utility". Whether or not utility is of some kind glow or warmth, or happiness, is here irrelevant; …” Notes are incomplete without oral presentation

The division of labor or specialization: primary source of society’s wealth • Smith’s most fundamental and powerful insight • Observation of extraordinary productivity of pin-makers • Specialization calls for trade – “can’t eat pins” • Societies can be measured in terms of division of labor • Anthropologists use to evaluate civilizations • Neanderthals were probably generalists • Greeks recognized value of occupational specialty Notes are incomplete without oral presentation

The division of labor or specialization: primary source of society’s wealth… • The division of labor is limited by the extent of the market • The more extensive the opportunities for trade, the more intensive will be the division of labor among people • Some industries go through a life cycle of generalist-specialist-generalist Notes are incomplete without oral presentation

The division of labor or specialization: primary source of society’s wealth… • Specialization gives rise to complexity and then need for organization • At some point, the option of organizing production through firms instead of the market emerges • Using the market involves costs • Hierarchy may be more efficient • Productivity is largely a function of specialization and the quality of organization supporting the specialists • Capital and investment in physical assets such as tools stimulates specialization Notes are incomplete without oral presentation

The division of labor or specialization: primary source of society’s wealth… Extensive/intensive relationship holds within firms; ceteris paribus, larger firms comprise more specialists Specialization is seen in products as well, segmentation, customization, multi-attribute goods Words you’ll see that are variants on specialization; idiosyncrasy, asset-specific, transaction-specific… Notes are incomplete without oral presentation

The division of labor or specialization: primary source of society’s wealth… • Some see specialization as evil • Industrialization fostered by specialization • Knight’s list of gains from organized activity: • Utilization of natural aptitudes; especially leaders and followers • Development and utilization of acquired skill and knowledge • Changing the piece of work is cheaper, within limits, than changing the activity performed on the work • Natural advantages in the case of “natural” resources • Artificial specialization of material agents (tools and machines) • Minor technical gains • Easy to overlook the tremendous strides in science, technology, medicine etc through specialization Notes are incomplete without oral presentation

The division of labor or specialization: primary source of society’s wealth… • Second industrial revolution of late 1800s stimulated development of management science • Substantially larger, more complex organizations • Need to better coordinate resources • Frederick Taylor and “scientific management” sought optimal degree of specialization • Modern process reengineering descended from Taylor via Michael Hammer to focus on process and application of information technology Notes are incomplete without oral presentation

The Importance of Freedom to Trade Benefits of specialization are realized through trade Trade is the voluntary exchange of goods for mutual benefit Smith believed that propensity to trade was innate Trade has to be protected from rent-seeking Trade benefits from and stimulates development of financial institutions and systems Currency benefits trade but is vulnerable to manipulation Notes are incomplete without oral presentation

The Importance of Freedom to Trade • Trade promotes wealth by directing resources to most efficient uses • Trade helps liberate people to do what they do best or enjoy • Trade expands markets and thus extends opportunities for wealth creation • Trade involves risks and stimulates the development of financial instruments • Insurance, risk management arrangements • Investment and lending against future prospects • Equity arrangements Notes are incomplete without oral presentation

The Importance of Freedom to Trade • Laissez faire – “let it be” or “leave alone” • Not used by Smith, nor equivalent to the Invisible Hand • Initially a form of economic liberalism • Now used derogatorily by many • Originated in context of oppressive state meddling and mercantile policies • Established in English thought during debate on Corn Laws • Embraced by libertarians Notes are incomplete without oral presentation

An Autonomous, Self-Directed System • In most cases, market directs scarce resources efficiently • “Invisible Hand” • Markets are not perfect • Rules, laws, customs may distort operation • Market power may be abused • Asymmetric information may undermine market transactions • Social costs may not equal private • Initial conditions may be inequitable and difficult to correct Notes are incomplete without oral presentation

An Autonomous, Self-Directed System • Power of the evolutionary, self-organizing system • Influenced Darwin, other disciplines • Significance of selection pressures versus behavior; adoption versus adaption • Uncertainty and random events versus intentions and motives • Evolutionary dynamic expressed in product and industry life cycles Notes are incomplete without oral presentation

A Very Brief History of Trade and Business Hunter gatherers, mostly generalists Emergence of agricultural economy in temperate belt from 8000BC to 2000BC Trade in durables established by the latter part of the period, e.g. pottery in 3000BC Mesoamerica Societas publicanorem in Roman Republic (509BC – 30 BC) first significant “firms” with tradable equity, corporate life separate from founders Seventeenth century joint stock companies, Dutch East India Company (1602), English East India Company (1660) Notes are incomplete without oral presentation

A Very Brief History of Trade and Business… Industrial Revolution various dating; mid/late 18th century to mid 19th century, driven by the application of steam to ships, trains, plants Business historian Chandler saw another late 19th century revolution driven by the “network” technologies, rail and telegraph enabling larger more coordinated firms Some think information and communication technology, especially Internet, are stimulating another industrial/commercial revolution Notes are incomplete without oral presentation

The Supreme Myths of the Industrial Revolution Hayek deplored, “… the legend of the deterioration of the position of the working classes in consequence of the rise of ‘capitalism’ ….” Clapham’s extensive study of statistics and accounts revealed steady progress and improvement Durkheim credited the IR with expanding and enhancing culture Different story was told by Dickens, Marx, Engels, Hobsbawm, and K. Polanyi Romanticism, Rousseau-ism, etc. still attractive to many Notes are incomplete without oral presentation

The Supreme Myths of the Industrial Revolution • Cultural, political, social reaction to industrial revolution • Popular vision of satanic mills, child labor and abuse • Destruction of semi-mythical pastoral life • Stimulated Marxism and socialism • Fostered class divisions in Great Britain Notes are incomplete without oral presentation

Second Industrial Revolution • Alfred Chandler saw late 1800s as a second IR • Brought about by network technologies e.g. telegraph, telephone, railroad • Enlarged markets, supported scale, fostered specialization • Called for more systematic approach to management • Birth of scientific management, e.g. Frederick Taylor • Modern business firm evolved • Economists’ classic view of the firm no longer adequate Notes are incomplete without oral presentation

Business and Government • Current mixed economy • Government affects business on three levels • Rules and legal environment – very important • Government firms, e.g. USPS and government backed firms e.g. Fannie Mae, compete with private firms • Regulation and taxation • Private and social costs may diverge • Licensing often barrier to entry • Unintended and inadvertent consequences common in government action Notes are incomplete without oral presentation

Positive Versus Normative Economics Positive economics: objective science looking at the way the real economy works, seeks to develop models and make predictions Normative economics, policy advice and advocacy, perhaps based on positive economics Positive economics always looks at real opportunity costs Notes are incomplete without oral presentation

Positive Versus Normative Economics… Economics takes broad social field for its domain Economics itself is subject to division of labor or specialization Homo economicus is a simplification to make basic analysis tractable Recent work in behavioral economics, hybrid of psychology and economics, providing insights Notes are incomplete without oral presentation

Part II. The Firm • Where do firms come from? • Before Coase, neoclassical firm • comprised set of production cost functions, • operated by entrepreneur with hyper-rational skill • Some noticed anomaly; Sir Dennis Robertson: • “… islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.” Notes are incomplete without oral presentation

The Emergence of Firms • Coase’s fundamental insight; there are costs to using the market • Determining prices • Contracting and re-contracting • Variety of transactions costs • Coase proclaimed the distinguishing characteristic of the firm to be suppression of the price mechanism and substitution of hierarchy • In Coase’s world, the fundamental question facing a firm is “make or buy” – the issue of vertical integration Notes are incomplete without oral presentation

Coase’s Firm and Its Limits • Firm; an entity that conducts transactions internally through hierarchy more efficiently than can be achieved externally through market • Coase didn’t address issue of ongoing comparative efficiency • Hirshleifer (1956) worked out relationship between transfer pricing and market price Notes are incomplete without oral presentation

Coase’s Firm and Its Limits • Limits to firm scale and scope set by diminishing returns to management • Point where cost of additional activity plus transaction costs just equals cost of working through market or another firm • “Other things being equal, therefore, a firm will tend to be larger: • the less the costs of organizing and the slower these costs rise with an increase in the transactions organized. • the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized. • the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size” Notes are incomplete without oral presentation

Coase’s Firm and Its Limits • Coase acknowledges but does not develop possibility that small firms might have some advantages • Technology often, but not always, favors larger firms (recall Chandler) • Technologies that reduce the: • cost of spatial separation favor large • cost of management (metering) favor large • Some technologies favor market over internal transactions Notes are incomplete without oral presentation

Next Week Develop the notion of the firm more fully, particularly the role of management Look at a production cost based explanation of vertical integration Notes are incomplete without oral presentation

The Economics of Business