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.