CHAPTER 18
Internal Markets
CHAPTER SUMMARY AND TEACHING OBJECTIVES
One of the themes of the text is that markets process information. If a market is competitive, the
mechanism for processing this information is efficient. This means that market is the best source for
information relative to all other sources of information. Prediction markets have shown themselves to
be very good at forecasting things like election outcomes as well as other types of events. This chapter
IMPORTANT TERMS
Internal Market markets inside a firm to generate prices to allocate resources inside the firm
Transfer Price price charge between different units of the same firm
Net marginal product this is the transfer price charged a company unit that maximizes the profit of
the entire company
Prediction market independent markets that are used to simply predict the outcome of uncertain
events
TOPICS AND TEACHING SUGGESTIONS
1. The Market as a Collector of Information
The free market produces an efficient allocation of resources. This is a recurring theme of the text.
2. Using Markets to Collect Dispersed Information
ANSWERS TO EXERCISES
1. You have been hired as a consultant to create a market-based economy in a nation that has
never before experienced markets. Explain how you would do that.
2. A large firm has two divisions: an upstream division that is a monopoly supplier of a resource
whose only market is the downstream division that produces the final output. Would the
firm’s profit be maximized by paying upstream and downstream divisional managers a
percentage of their divisional profits? Explain.
3. A large firm has two divisions: an upstream division that produces an output that is used by
the downstream division. The downstream division could obtain that output from external
firms as well as the upstream division. Should the firm allow the downstream division to
purchase the product externally or should it require the firm use only the upstream division’s
product? Explain
4. Define the term “principal-agent problem”. What principal agent problems exist in a market?
What principal agent problems exist in a firm? What are possible solutions to principal-agent
issues within the firm?
5. What is moral hazard? How does the firm deal with moral hazard in its relationships with
suppliers or customers? How does the firm deal with moral hazard internally?
6. Capital markets enable us to spend large sums of money that don’t belong to us? Would it be
necessary to create an internal capital market if a firm was to be led by market based
management? Explain
7. What would the role of the CEO be in a company led by market-based management?
8. If market-based management is more efficient than the command and control of a hierarchy,
why have firms not employed the strategy?
9. How would internal markets adjust for or take into account the cost of capital?
10. Suppose economic profit was used to evaluate each division in a company. Describe how it
would serve to foster the correct incentives inside the firm.
11. The following demand and marginal cost equations represent the demand for some service
inside the firm. What price should the service be sold at? Would it matter whether there was
an external market for this service?
12. A firm has estimated the following demand function for its product:
Q = 8 – 2P + 0.10I + E
Where Q is quantity demanded per month in thousands, P is product price, I is an index of
13. Explain why firms exist. Explain why there is not just one huge firm.
Firms exist because market transactions are costly and that complete contracts cannot be
14. Using markets to gather information is quite different than market-based management.
Explain how they are different.
15. What steps are necessary to create an internal market?
16. BP relies on internal markets to collect information and help make decisions. Would the use
of a predictive market related to oil well blowouts have predicted the 2010 Gulf of Mexico
disaster? Explain your answer.
17. What is the role of headquarters and the CEO in a factory type firm? What is their role in
a market-based firm?
18. A recent book was titled, The End of Management. Suppose the technology evolves in
such a way that a high percentage of employees do not work in the company office. They
telecommute or work offline. What then is the role of management? Is there one or is the
book title correct?