Business Economics I

Problem Set 3

‘Markets and Organizations’ and ‘Coordination through Contracts’

Question 1. The organization of production

1a.

These two forms of organization of production are different and therefore don't have the same costs.
In the first place, in the market solution we find that for each piece of the 5 that makes up the product,
the consumers have to pay € 3 of the piece plus € 2 of transaction, in addition to € 5 of the assembly
cost. That is, the cost per unit of product in this case would be (3 + 2) * 5 + 5, which gives us a cost of
€ 30 per product. On the other hand, in the organizational solution, you pay the same price for each
piece, but the transaction cost does not depend on the amount exchanged, but includes a transaction
cost of selling a finished product to each consumer of € 2. Therefore the cost of the product in this
form of organization would be 3 * 5 + 4 + 5 of the assembly, which would be € 24. Observing the
results, it is clearly seen that in the organizational solution the cost per unit of product is lower, due to
the principle fact that the transaction cost is not per piece.

1b.

If the assembly doesn't entail any cost for the consumers, but rather a benefit b> 0, for Anna's business
to be inefficient, it is necessary to calculate how large 'b' must be as a minimum. That is, instead of
adding the cost, we have to subtract the profit and we would have 3 * 5 + 4 - b = 0, which would give
us that from b = 19 Anna's business would be ineffective.

1c.

Fewer transactions take place in the organizational solution than in the market solution, and this is for
the following reason. Businesses exist primarily because they allow to reduce exchange costs. This
cost reduction is possible because, given that all workers have an interest in the company doing well,
their interests are partially aligned and it is easier to resolve possible conflicts of interest that workers
may have, which are known as motivation costs. In addition, it is less expensive to resolve these
conflicts through hierarchies than in the market, so that’s why the coordination costs are also reduced,
given the fact that communication is greater and there are fewer problems related to the adequacy of
supply and demand, and those that do arise can be fixed more quickly.

1d.

As a business grows, it benefits from a number of efficiencies. In the first place, the fact of having
hired more workers makes the transformation costs lower, since now the company will have the
capacity to produce more products, and therefore at a lower production cost, because its costs
decrease due to less duplication of initial investments in workers and machinery. On the other hand, as
companies begin to grow, transaction costs increase, because obviously there will be more production
when there are more workers and demand, and therefore more transfers of the good have to be made.
Furthermore, more transaction problems related to coordination and motivation may arise and also
there is the possibility of making a greater amount of errors when the company grows, because many
more aspects are involved.

Question 2. Political solution to the economic problem

2a.

In the first place, I do not agree with this statement, since for an investment to be justified, high-speed
trains should not generate negative externalities, on the contrary, it would be a public investment from
which society in general benefits, and therefore be a positive externality. That is, if the impact
generated by the infrastructure has more disadvantages than positive points, the state should not invest
in it, and to decide it, it would have to do an analysis and really assess its impact.

2b.

I quite agree with this statement, since it is true that one of the problems of democracy is the few
incentives for voters to become informed, as a result of the fact that they practically do not assume the
consequences of their decisions. People don't give the importance that should to problems such as
railways, of which there are many in disuse and they continue to invest more in them, when they
could invest in other goods and services of greater need.

Question 3. Specialization, organizations, and markets

3a.

In the system of economic organization described by G. C. Allen, a large number of manufacturers

were involved who specialized in particular processes, a method of organization that entailed the
frequent transport of parts from one workshop to another. Therefore, in the different phases of the
arms creation process, many exchanges were carried out, and for that reason I think it is clear that
many problems arose associated with these transactions, since the more specialization, the higher are
the exchange costs. Since there are so many activities, it is very difficult to coordinate them all, so
there could be the problem that suppliers did not deliver as many pieces as they needed to satisfy the
demand or that they did not comply with the delivery date. Also, a cost of motivation that could arise,
may be that the suppliers behaved opportunistically and did not produce what they were asked or
raised the price for their own interest.

3b.

I believe that this organization was not efficient, especially due to the fact that too many people and
phases were involved in the process, there was too much specialization and exchanges and therefore
many transaction costs, which was not effective. Coordinating so many workers is unfeasible as well
as expensive, but on the other hand, in this way, productivity greatly increased and transformation
costs per unit were greatly reduced.
3c.

Actually the transactions described in this market would be carried out within several large industrial
companies, not the same, since nowadays specialization is very present and each factory would focus
on a specific phase or piece. On the other hand, mass production is the manufacture of large quantities
of standardized products, often using assembly lines or automation technology, and this type of
production can have some drawbacks, such as huge start-up costs, such as those of the factory, the
land and the machinery.

Question 4. Opportunism in developing countries

4a.

In this case, considering that I am a teacher in a developing country, if going to work I have a problem
that prevents me from arriving, I certainly would not worry much about it. The lack of enough
unemployed teachers to replace the bad ones means that they have no incentive to have a good
behavior and attitude, and that's the reason why they are irresponsible and act opportunistically, since
they are sure that they will not be fired. Therefore, in this case, the costs of not attending work would
be being fired, but that is compensated by the fact of the lack of substitutes and prevails for their
decision to go to school or not. Normally we should try to reach our workspace, but in this situation
this would not be the case.

4b.

Given that it is practically impossible to stipulate in a contract what has to be done taking into account
all possible unforeseen events or contingencies, the contracts are incomplete and, therefore, lead to the
appearance of asymmetric information and opportunism, as is the case in this case. Asymmetric
information arises when one of the parties of the contract has more information than the other,
therefore, in this case, the teacher has more information about the situation than surely the school
principal. Thus, since the teacher knows that there is a difficulty in being a substitute and that he will
continue to earn the same salary despite everything, there is a high moral hazard, that has arised due to
the asymmetric information after hiring when one of the parties in this case does not comply with the
conditions of the contract after. Therefore, this problem happens after you have signed a contract.

4c.

Introducing cameras in schools and financial rewards as a solution to low absenteeism has both
advantages and disadvantages. That is, from my point of view the financial rewards are really a
potential solution, insofar as it is an incentive that would clearly work with the teachers and would
greatly reduce absenteeism. A higher salary would motivate them not to miss work, but on the other
hand the school should not give them any kind of economic reward, since it is a higher expense that is
unnecessary, while the duty of teachers is to attend class. On the other hand, I think that the cameras
would not be of great help, since when the teachers do not appear in the center the directors are
already aware of that, and even if there were cameras, it would not change anything, it would not
make irresponsible behavior and the opportunism of the teachers disappear, and for that reason they
would not stop being absent from work. Therefore, cameras would be another unnecessary expense.
4d.

From my point of view, absenteeism could not be the result of information problems before the
contract is drawn up, since this opportunism arises after having been hired and after having seen that
there is asymmetric information that can be taken advantage of. In that way, I don't think the main
source of the problem is adverse selection, it is moral hazard. On the other hand, if the teacher's record
shows absenteeism in other previous jobs, it could be considered to be an adverse selection problem
and the problem of asymmetric information could be mitigated if the uninformed party tries to make
the informed party reveal your information. Therefore, these two cases can be taken into account, but
it is more clear that opportunism arises after having a contract, since the uninformed party does not
know that this problem will arise.