Teaching Note Week 1

The Economic Model.

This course on business strategy is not economics. Economists typically are interested in explaining how markets operate. Economic policy strives to ensure the competitiveness, efficiency, and fairness of markets. In business strategy objectives are to out-perform rivals, "beat the market", find and exploit failures in the market, create and sustain long-term profits, and survive. In business, we use the concepts and theories of economics to objectives quite differently than those of most economists, but a general understanding of economic theory and its concepts is useful and can yield powerful strategies.

In 1860 Alfred Marshall, a British economist, codified economic knowledge in his book Principles of Economics. Marshall, among others, worked out just how Adam Smith's "invisible hand" operates. Simply stated, the value of limited or scarce resources is determined by a market defined by demand and supply:

For there to be an economic market, the things that are desired must be scarce or limited. If resources are ubiquitous, they are freely available, and creating more or consuming more does not benefit or disadvantage anyone. Buyers have choices under scarcity. They make trade-offs in what is consumed. Suppliers also have choices. They make decisions as to what and how much of something they will make.

Choices imply trade-offs, or opportunity costs. Buyers and suppliers make decisions that sacrifice some alternative choices. Getting more of one thing means getting less of another. Producing one thing means producing less of another.

Prices allocate resources. As buyers demand more of a scarce resource, the market price goes up, if the good remains scarce. This is the economist's Law of Demand. Higher prices should induce greater supply. If suppliers produce more of something, then it is less scarce, and the price goes down. Lower prices should induce greater consumption. This is the economist's Law of Supply.

Price is a measure of the value or utility of something. There is an interdependence among buyers and suppliers that is regulated by market price. What a thing is worth is simply the price that sellers and buyers negotiate through the market.

Market prices serve to regulate an economy. An equilibrium exists when neither buyers nor sellers seek to change the price or the amount of goods produced or bought. The market allocates and regulates resources because sellers will produce only what can be sold and only the amount of that good that will be bought at "market" price. The economist states that the "market clears" - meaning that at equilibrium there is no surplus, no shortage of resources. The amount demanded equals the amount supplied.

The student will recall from introductory economics courses that this mechanism can be illustrated as follows:

As Supply increases, the price decreases.	As Demand increases, the price decreases	The market price is set at the equilibrium of Supply and Demand.

Assumptions of the Economic Model.

For an economic theory of the market to work, all buyers and sellers must be motivated by profit maximization or self interest. A producer typically will not sell at prices below costs, but instead will switch to the manufacture of goods in which prices cover costs. A typical buyer will not buy at a price higher than alternative, equally attractive alternative goods. So, the market is simply an auction in which sellers are trying to get the highest price possible, while buyers are trying to get the lowest price possible. In the "haggling" of buyers and sellers trying to maximize self-interest, the "market" price emerges. Market theory also implies:

Information must be freely available to all buyers and sellers. That is, no one has special inside or secret information so that all bidders and sellers have equal chances of getting the "market" price. A seller, for instance, cannot intentionally sell a defective product as a normal product. A buyer should be able to rationally assess and evaluate all alternative product offerings. Advertising in this context is justified by informing prospective buyers of the attributes of a product, perhaps to justify a higher price; but, advertising cannot be deceptive for the market to work properly.

Resources should be freely mobile. That is, no producer should have an advantageous access to raw materials and labor. A worker should be able to go to work for any company at the prevailing wage rate and not be denied the opportunity to work for any producer. All producers should have equal access to raw materials and at comparable costs. Producers and buyers should be able to freely enter or leave the market. Anyone wishing to sell a product should be able to offer the product to prospective buyers. Any one wishing to buy a product should be able to offer a bid. The market will yield the "correct" price, but any one can try to sell at any price; any one can try to buy at any price. In the short term, some buyer and some producers may find advantageous prices, but in the long run the equilibrium price will prevail and decide which producers are viable and at which price buyers will be able to acquire preferred goods.

There should be many buyers and many sellers. If there is only one buyer and one seller, then a price can be negotiated. If there is only one producer and many buyers, the seller has a monopoly and can sell at a price higher than a competitive market would yield. If there is only one buyer and many sellers, then the buyer has power to obtain a favorable price lower than would be yielded by a competitive market. There is no "absolute" number of buyers and sellers needed to create a competitive market. In anti-trust law the conditions for monopoly seem to vary in different historical periods.

Over the long run no producer should be able to sustain higher than normal profits. Because the producer will not usually sell below costs and the buyer will reject paying more than any other buyer, the auction process of the market over the long run drives the price of goods to an equilibrium price for most buyers and sellers. At this price the producer receives a "normal" profit which is near the added costs incurred by a producer for making more goods. We condense this assumption to the statement "You can't beat the market" - indicating that on average no buyer or seller should sustain a "really good deal" and over the long haul no buyer or seller has an advantage over any other buyer or seller.

Products are continuously variable in quantity. This is the economist's concept of divisibility. This assumption is required to ensure that at all times any buyer can acquire some portion of goods, and to ensure that any seller can trade some portion of goods produced (You do not have to buy or sell a "whole" product, you can buy or sell a "partial product". Since every buyer can purchase as much as needed at the prevailing market price, there is no "backlog" of a supply of partial products. The economists say that "markets clear", indicating that the market always finds an equilibrium: everything ought to be bought and sold.

Goods are homogenous - Only similar kinds of products compete against each other, have similar costs, and have similar market prices. Obviously, there is a diversity of products within an economy and wheat used in the making of bread does not directly compete against grapes used in the making of wine. The simple economic model, however, assumes that wheat and grapes are different "markets". They are also commodities - that is, we do not care who grows them and that, roughly, all wheat is similar and all grapes are similar.

Using this last illustration, the function of the market economy is to ensure that the proper amount of wheat and grapes are produced. Since we use both wine and bread for subsistence, the price mechanism of the economy operates to raise prices of one when it is scarce. Higher prices ought to increase future production, and higher production will bring prices down. The price relationship between supply and demand, then, is an allocative mechanism. Scarce products have higher prices, abundant resources have lower prices. Resources in the total economy will be optimally utilized because market prices should provide incentives for growing more wheat when it is scarce or growing more grapes when they are scarce. Competitive markets should be efficient in the allocation of resources to the different types of goods that are in demand.