MDC_Institutional EconomicsCukmades.pptx

Regarding institutional economics this is a ppt

1. Baumol’s theory of sales revenue maximisation Prof. Baumol, an American economist, in his book Business Behaviour , Value and Growth (1967) has presented a managerial theory of the firm based on sales maximization. He discusses two models of sales maximisation : a static model and a dynamic model. Baumol’s contention is that, in a public limited company, the management aims at maximising the sales revenue subject to attaining some minimum profit to satisfy the shareholders Why is the management interested in maximising the sales revenue and not the profit?. Profit maximisation would only increase the dividends to the shareholders and in no way help the management.

2. Assumptions This model is based on the following assumptions There is a single period time horizon of the firm. The firm aims at maximising its total sales revenue in the long run subject to a profit constraint. The firm’s minimum profit constraint is set competitively in terms of the current market value of its shares. The firm is oligopolistic whose cost curves are U-shaped and the demand curve is downward sloping. Its total cost and revenue curves are also of the conventional type.

3. The model Baumol’s findings of oligopoly firms in America reveal that they follow the sales maximisation objective. According to Baumol, with the separation of ownership and control in modern corporations, managers seek prestige and higher salaries by trying to expand company sales even at the expense of profits. Being a consultant to a number of firms, Baumol observes that revenue or sales maximisation rather than profit maximisation is consistent with the actual behaviour of firms. Baumol cites evidence to suggest that short-run revenue maximisation may be consistent with long-run profit maximisation . But sales maximisation is regarded as the short-run and long-run goal of the management

4. Reasons for his arguments He gives a number of arguments in support of his theory A firm attaches great importance to the magnitude of sales and is much concerned about declining. If the sales of a firm are declining, banks, creditors and the capital market are not prepared to provide finance to it L arge sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders. Its own distributors and dealers might stop taking interest in it. Consumers might not buy its product because of its unpopularity. Firm reduces its managerial and other staff with fall in sales. But if firm’s sales are large, there are economies of scale and the firm expands and earns large profits. Salaries of workers and management also depend to a large extent on more sales and the firm gives them bonus and other facilities.

5. By sales maximisation , Baumol means maximisation of total revenue. It does not imply the sale of large quantities of output, but refers to the increase in money sales (in rupee, dollar, etc.). Sales can increase up to the point of profit maximization where the marginal cost equals marginal revenue.

6. Baumol’s model is illustrated in the following figure (without advertising)

7. TR and TC curves represents total revenue and total cost, respectively. Profit is the difference b/w TR and TC. Curve P is inverted ‘U’ and represents that profit increases until production reaches Q1 and declines thereafter. A profit maximising firm would produce at Q1. Whereas, if the manager of the firm wants to maximise sales revenue, then the output would be Q3, at which the TR is maximum This substantially reduce the profit level so, let us assume that the shareholders fix the minimum profit to be earned as N. Accordingly, the sales maximising output would be Q2.

8. Baumol’s model with advertising We have shown above how price and output are determined in a static single period model without advertising In an oligopolistic market structure, however, price and output are subject to non-price competition Baumol considers in his model with advertising as the typical form of non-price competition and suggests that the various forms of non-price competition may be analysed on similar lines. In his analysis of advertising, Baumol makes the following assumptions

9. Firm’s objective is to maximize sales, subject to a minimum profit constraint. Advertising causes a shift in the demand curve and hence the total sales revenue rises with an increase in advertisement expenditure Price remains constant — a simplifying assumption. Production costs are independent of advertising. This is rather an unrealistic assumption since increase in sales may put output at a different cost structure

10. Baumol views on Dynamic Model: Baumol’s also gives a dynamic model. The major criticism of the static model is that profit is exogenously determined by the shareholders. In the dynamic model the profit is endogenously determined. The assumption of the dynamic model are 1. The firm attempts to maximise the rate of growth of sales over its lifetime. 2. Profit supplies the finances to attain higher sales volume, so profit endogenously determined. 3. Sales growth may be financed through external sources, such as market borrowing, but profit is the surest way to do it, so profit is endogenously determined. Conclusion: Through this dynamic model, Baumol shows that the sales volume increases as profit increases. This satisfies both the manager and shareholder.

11. Criticisms Although Baumol’s sales maximization model is found to be theoretically sound and empirically practicable, economists have pointed out the following shortcomings in his model. It has been argued that in the long-run, Baumol’s sales maximization hypothesis and the conventional hypothesis would yield identical results, because the minimum required level of profits would coincide with the normal level of profits. Baumol’s theory does not distinguish between firm’s equilibrium and industry equilibrium. Nor does it establish industry’s equilibrium when all the firms are sales maximizers. it does not clearly bring out the implications of interdependence of the firm’s price and output decisions. Thus, Baumol’s theory ignores not only actual competition between the firms but also the threat of potential competition in an oligopolistic market. Baumol’s claim that his solution is preferable to the solutions offered by the conventional theory, from a social welfare point of view, is not necessarily valid

12. Tragedy of commons A common resource or "commons" is any resource, such as water or land, that provides users with tangible benefits but which nobody has an exclusive claim. Areas like rivers, forests, village ponds, water bodies, parking lots and train compartments are referred to as Common Property Resources (CPR) or Common Pool Resources in academic and governance domain . How are they situated in our social domain? How are they defined, governed and what are problems arising around them? This was the concern of many social and environmental scientists including anthropologists in the 60’s and 70’s decade Resources are classified by their physical nature, ownership and use pattern. A property right is a claim of benefit that is legally and socially recognized and respected by the communities and state. There are four forms of properties prevalent in society, they are private, public or state, common property and open access. A distinction is made between property rights and tenure. Property right brings some kind of management status to the ownership of property, but tenure refers to acts of pure ownership with no references to management

13. The public good or property resources are not owned by any individual or firm, and people in general are not excluded from using or enjoying them. They allow collective use and consumption, often indivisible. Examples of public property is natural and environmental resources, national parks, rivers, waterways, oceans, marine fisheries in exclusive economic zones (EEZ) etc. Other examples are state owned minerals units, municipal corporations, and national highway authority owning public roads. Therefore, public goods are also considered as state property, as it is the exclusive owner of the resources or properties.

14. Common property The most commonly talked commons are grazing lands, village ponds, Non Timber Forest produces and forests, etc. Common represents all natural resources used for human welfare, which are not necessarily owned by an individual or a group of individuals. A definition of Common Property Resources quite acceptable to thinkers of Economics is: ‘A property on which well defined collective claims by an exclusive group are established, the use of the resources is subtractive, having the characteristic of a public good such as indivisibility, shall be termed as Common Property Resources ( Kadekodi , 2004).

15. Tragedy of commons The discussion on Commons started way back in years of 1950s after seeing the rapidly degrading and depleting condition of Common all around. Basically most of countries had adopted capitalistic model of development, which emphasized privatization and rapid exploitation of natural resources. But initially it did not get much attention, many thinker were looking at it as problem of economics and technology. But a seminr paper in 1968, by G Hardin in Science journal brought the Common to centre stage of discussion in welfare economic and other social science disciplines.

16. Tragedy of Commons’ paper by Hardin (1968) in Science journal about the management of CPRs, predicted overexploitation and ultimate degrading of common resources due to the users’ rational incentive to maximize utility. The tragedy of commons   is an economic problem where the individual consumes a resource at the expense of society. The tragedy of the commons is an economic theory claiming that individuals tend to exploit shared  resources   so that demand outweighs supply, and it becomes unavailable for the whole He suggested that either privatization or state can provide solution to this so-called ‘commons dilemma’

17. Hardin used an example of grazing pasture to explain his view point. He said if a pasture is open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Historically, such an arrangement would have worked reasonably satisfactorily for centuries But in present period, that is, when social stability has becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy. As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?” This utility has one negative and one positive component The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly + 1. The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision making herdsman is only a fraction of – 1 Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd

18. And another... But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit - in a world that is limited. Ruin is the destination towards which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all

19. Theory of collective action Collective action is considered to be the solution to manage private, public, or common property resources for effective decision making and implementation. The basic social philosophy of collective action is participatory development as against individual development Various disciplines explain the collective action from their perspective, like economic theory takes the course of minimizing transactions costs, externalities as a parameter management of CPR. Two approaches are followed in economics; first is to opt for a strategy to minimize economic costs i.e. minimize transactions or information costs in efficient management of resources. The second argument is reducing the cost of economics of scale in CPR management

20. Practices such as crop rotation, seasonal grazing, and enforceable sanctions against overuse and abuse of the resource meant collective action arrangements readily overcame the tragedy of the commons. collective action requires the involvement of a group of people, a shared interest within the group and some kinds of common action which works in pursuit of that shared interes

21. Asymmetric information In a perfect competitive market structure, one of the key assumptions defining the market is that of complete and symmetric information among the parties involved in the transaction. That is, we assumed no seller knows more about a product’s characteristics than a buyer, and no buyer knows more about the product’s costs than a seller Such an assumption is unrealistic due to the fact that in real life, one party to a transaction often has more information than another about the characteristics of the good or service to be traded. This condition is referred to as that of asymmetric information For instance, the seller of a product usually knows more about the quality of the good than the buyer; workers usually know more about their abilities than the potential employers; in the market for second-hand cars, sellers have more information regarding the true status of the car than the buyer;

22. “Asymmetric information is a situation in which economic agents involved in transaction have different information, as when a private motor cycle seller has more detailed information about the its quality than the prospective purchaser, or an employee will know more about their ability than their employer”. The concept of asymmetric information was first analysed by George Akerlof in his 1970 paper titled “The market for lemons: quality uncertainty and the market mechanism” He considered an example of automobile market. Asymmetric information exists, when amongst different parties in the trade, unequal information set persists. That is, if we assume there are buyers and sellers in the market, then under asymmetric information, one agent will have greater (or lesser) information than the other

23. Market for lemons Let us consider a market where buyers and sellers have different information regarding the quality of the product offered for sale in the market for second-hand cars, also called the market for lemons, sellers of the second-hand cars have more information about the real value of the car than the buyer. Consider a market where there are 100 sellers and 100 buyers for used cars. Everyone knows that all the used cars are not of same quality and there is 50 per cent chance of getting a car in good condition (‘Plums’) and 50 per cent chance of getting a car in bad condition (‘lemons’). However, the owner of the cars know the actual quality of the car, but the buyers have no clue about which one is plum and which one is lemon. Moreover it is not easy to verify the quality of car from the market

24. Let the owners of the lemon want to sell it at Rs. 1,00,000 and the owners of the plums want to sell at Rs. 2,00,000. Let the buyer of the car is ready to pay Rs. 2,40,000 if the car is a plum but Rs. 1,20,000 if the car is a lemon. If there is no problem in verifying the quality of car from the market, then the lemons will be sold at some price between Rs. 1,00,000 to Rs. 1,20,000 and the plums will be sold at some price in between Rs. 2,00,000 to Rs. 2,40,000 Since buyers cannot observe the quality of car to be purchased, they will have to guess about the quality of an average car. Given that there is only 50 per cent chance of getting a plum (i.e., a car is equally likely to be a plum or a lemon), the expected value of the car for a typical buyer is: E(B)= ½*240000+ ½*120000= 180000

25. However, at that price the owner of the lemons will be only willing to sell the car (Because E(B)=180000> E(S lemon)=100000)but not the owner of the plums (because(B)=180000< 200000) The price that the buyers are willing to pay for an average car is less than the price that the sellers of plum expect from the transaction So at a price of Rs. 180000, only lemons would be offered for sale Even though the price at which buyers are willing to buy plums exceeds the price at which sellers are willing to sell them, no such transaction for plums will take place This is the problem of market failure. There is an externality problem between the sellers of plums and lemons, which result in the market failure. When an individual is trying to sell lemons he affects the buyers’ perception on the quality of average car in the market. This lowers the price that the buyers are willing to pay for an average car in the market. This further discourages the sellers of plums. This is an externality problem. Thus in the presence of information asymmetry, if too many low quality items are offered for sale, it changes the buyers’ perception (and dampens the willingness to pay) on the average product, and thus making difficult for the sellers of high quality items to offer their products in the market

26. Principal agent problem We often study a simplified model with only one agent on either side of the market to understand asymmetric information problems. The party who proposes the contract is called the principal and the party who either accepts or rejects the contract is called the agent. Agents are the individuals employed by the principal to achieve principal’s objective In the presence of information asymmetries, often preferences of the principal and agents are not aligned and agents tend to pursue their own goals rather than the goals of the principals. For instance, the employee (or the agent) on duty has incentive to shirk effort, which his employer (or the principal) fails to observe.

27. Common examples of a principal-agent relationship include corporate management (agent) and shareholders (principal), politicians (agent) and voters (principal), or brokers (agent) and markets— buyers and sellers (principals). The principal-agent problem is a conflict in priorities between the owner of an asset and the person to whom control of the asset has been delegated. Agents who pursue their own goals often take decisions which are contrary to the goal of the principals Arises when one party (principal) delegates an action to another party (the agent), and there exists information asymmetries between them

28. In Principal-Agent relationship, the agent is likely to have more information than the principal because ( i ) he will have more information about his own actions, preferences and abilities, and (ii) it will cost him less to acquire information about the particulars affecting the individual tasks assigned to him by the principal Hence information is distributed asymmetrically between the two It is costly for the principal to measure the characteristics and performance of agents. So agents could engage in shirking and opportunistic behaviour Agent may have informational advantages in the form of “hidden actions” and “hidden information”

29. Hidden actions cannot be accurately observed or inferred by others, such as is the case, for example, with workers’ (agent’s) effort which cannot be costlessly measured by employers (principal) The problem of hidden information arises when the principal is not in a position to determine whether the agents’ actions, even if these could be costlessly observed, are in his interest or not. Situation where agent has more knowledge about the decision that they have taken on behalf of principal.

30. Adverse selection Asymmetric information makes inefficiencies. One reason behind why presence of asymmetric information leads to market failure is due to adverse selection Adverse selection refers to a situation when parties gaining from the presence of asymmetric information are more likely to enter into a trade than the parties suffering from information asymmetries. Adverse selection refers to the situation where one side of the market cannot observe the type or quality of the goods of the other side of the market In our examples mentioned in the previous section, if buyers of the secondhand cars cannot distinguish good cars from bad ones, sellers may be inclined to sell only lemons (bad-quality cars). If insurance companies have difficulty in evaluating applicants’ health status, they may end up serving high-health risk policyholders and may not be able to harness the cross subsidies from the low health risk policyholders and thus may not be able to breakeven due to high insurance claims from the high risk clients If the potential employers have trouble assessing the abilities of workers, they may end up employing poorly qualified workers

31. In each of these examples, the informed parties, viz. second-hand car sellers, insurance buyers, workers, are more willing to trade when trading is less advantageous to the uninformed parties, viz. second-hand car buyers, insurance companies, and potential employers, respectively. This phenomenon is known as adverse selection When the affected uninformed parties realise that they face adverse selection, they may become reluctant to even come forward for trade, causing a market failure Gresham’s Law “Bad money drives out good money”. In the model we just examined the low-quality items crowded out the high-quality items because of the high cost of acquiring information. Adverse selection leads to completely destroy the market.

32. Moral hazard Moral hazard is also a result of asymmetric information where asymmetry arises due to hidden action by agents such that the action of one party is not observed by the other party in trade, which in turn affects the benefits of the latter. For example, in the case of the insurance market, an insured individual’s risk of death or disability may increase in the post insured stage because of his unhealthy lifestyle including smoking, excessive drinking, or a lack of exercise. However, the insurance company is likely to have difficulty in monitoring his behaviour and adjusting its premiums accordingly.

33. A simple illustration explaining moral hazard associated with asymmetric information problem and how it leads to increase in the costs is as follows. Consider a case of night security guard in a company. Since the duty is for the night, nobody observes the actions of the security guard. This in turn is incentive enough for the guard to shirk, that is, not guarding properly. Suppose he frequently sleeps during his duty hours as he knows his actions are not observed. As a result of this, one night the company suffers a breaking, leading to huge costs to the company. This is due to the presence of moral hazard in the guard’s hidden behaviour which the firm is unable to observe. Thus the presence of asymmetric information leads to market failure.

34. Consider the bike theft insurance market again and suppose for simplicity that all of the consumers live in areas with identical probabilities of theft, so there is no problem of adverse selection. On the other hand, the probability of theft may be affected by the actions taken by the bike-owners. The bike owners don’t bother to lock their bikes or use only a flimsy lock. Because they are having insurance for a bike. If don’t have insurance for bike they can use secure lock rather than flimsy lock. In general, moral hazard occurs when a party to a transaction takes hidden actions that remain unobserved by its trading partner and that affect the benefits or payoff of the latter

35. Signalling solution to asymmetric information The existence of asymmetric information often leads to the problem of adverse selection and this leads to market failure. Now what to do when asymmetric information is prevalent? One way in which the buyer and seller can deal with this problem is through market signalling . Signaling is a solution to the problem of asymmetric information in which the knowledgeable party alerts the other party to an unobservable characteristic of the good. Often, economic actors will attempt to communicate their quality via a signal. The concept of market signalling is where the buyer or the seller signals the other uninformed party, to increase their information about the product in trade. To see how market signalling works, let us consider the case of asymmetric information in the labour market.

36. In the labour market where high- and low ability workers are present and are not easy distinguishable, employing somebody can be very costly to the potential employer If an employer hires a low-ability worker for a job requiring high-ability, he will be in severe loss. The high-ability worker can signal the employer about his abilities, which stand out amongst all the other low-ability candidates. Signals could be in the form of better resume, being highly qualified, education level, showing good etiquettes, speaking in decent language, etc. These mechanisms are often used by the high-ability worker to signal the potential employer about his (her) potential and makes sure the employer credit him (her) with a high quality tag

37. Attitude towards Risk Risk is generally perceived as the possibility of facing a misfortune or a loss. In other words, it is the potential that a choice or a decision made will bring an undesirable outcome That is here, risk is involved with uncertainty of happening or not happening of an event. Such uncertain situations are often connected to some associated probabilities of occurrence or non-occurrence of an event. Now the question arises, “How do people react to events involving risk compared to those that are risk-free?” There exists heterogeneity in people’s preference toward risk

38. Risk aversion consider an individual who has an aversion to risk, i.e. one who strongly dislikes risk. Risk averter: not ready to take risk. The consumer having a wealth of $10. and he is contemplating a gamble that give him 50% of winning $5 extra and 50% probability of losing $5 His actual wealth is $10 and he may end up with either $5 or $15 Expected value of his wealth= ½(5)+1/2(15)=$10 Expected utility will be= 1/2u(5)+1/2u(15)

39. Mm

40. U(½(15) + ½(5)) = U(10) 1/2U(15)+ ½(U(5)= Expected utility of his wealth Diminishing marginal utility of wealth as he has more of money Expected value of wealth= ½(5) + ½(15)= 10 Utility for $5= 10 Utility for $10= 20 Utility for $15 = 25 Expected utility of wealth= ½u(5)+ ½u(15) =½(10)+½(25) = 17.5 The expected utility of expected wealth is less than the utility of actual wealth. So rism averse

41. The utility function representing a risk-averse individual is not a straight line but rather is concave Concavity of the function implies that its slope is decreasing, which in turn implies that this individual exhibits diminishing marginal utility for additional units of payoff In other words, the risk-averse consumer is not willing to incur additional risk for the possibility of a higher valued payoff.

42. Risk lover There are some individuals who actually prefer risky activities to risk-free ones. These individuals are called risk lovers possessing a risk preferring attitude.

43. Consumer He is having $10 wealth He is contemplating a gamble 50% probability of winning $5 extra 50% probability of losing $5 There is 50% probability of ending up with $15 and there is 50% probability of ending up with $5 Now the expected value of his wealth = .5(5)+.5(15)= 10$ The expected utility = .5u($5)+ .5u($15)

44. Utility for $5= 10 Utility of $10= 20 Utility for $15 =40 Expected utility of his expected wealth $ 15=40 Expected Utility of his expected wealth $5= 10 Expected utility of his expected wealth= ½(10)+½(40) =25 Since the expected utility of expected wealth {0.5u($5)+0.5u($10)} is greater than the utility of the actual wealth u($10), this individual prefers to enter into the gamble

45. Hence, a risk-preferring agent has increasing marginal utility for additional units of payoff represented by convex utility function. This simply means that the risk preferring individual is quite willing to take on additional risk for the possibility of a higher valued payoff

46. Risk neutral Mu remains constant with extra unit of money People are indifferent towards risk The expected utility of wealth is the utility of its expected value A risk neutral person shows no preference between a certain income, and an uncertain income, given they both have equal expected value. In other words, he will be indifferent between a risky and a risk-free choice, if both result in same expected value to him