Lecture 1Lecture 1

The Elements of TheoryThe Elements of Theory

■ ■ OverviewOverview

► ► Microeconomic TheoryMicroeconomic Theory

Macroeconomic TheoryMacroeconomic Theory

Economic Principles for Economic Principles for ManagersManagers (what is behind what we will (what is behind what we will study)study)1. The Role of Managers Is to Make Decisions 1. The Role of Managers Is to Make Decisions 2. Decisions Are Always Among Alternatives 2. Decisions Are Always Among Alternatives 3. Decision Alternatives Always Have Costs and Benefits 3. Decision Alternatives Always Have Costs and Benefits 4. The Objective of Management Is to Increase the Firm's 4. The Objective of Management Is to Increase the Firm's

Value Value 5. A Firm's Value Is Measured by Its Expected Profits 5. A Firm's Value Is Measured by Its Expected Profits 6. A Firm's Sales Revenue Depends on Demand for Its 6. A Firm's Sales Revenue Depends on Demand for Its

Product Product 7. A Firm Must Minimize Cost for Each Level of Output 7. A Firm Must Minimize Cost for Each Level of Output 8. A Firm Must Develop a Strategy Consistent with Its 8. A Firm Must Develop a Strategy Consistent with Its

Market Market 9. A Firm's Growth Depends on Rational Investment 9. A Firm's Growth Depends on Rational Investment

Decisions Decisions 10. Successful Firms Deal Rationally with Laws and 10. Successful Firms Deal Rationally with Laws and

Regulations Regulations

TheoriesTheoriesA part of the modern worldA part of the modern world

Why use theories? They enable us toWhy use theories? They enable us to-Simplify-Simplify-Organize-Organize-Speak the same “language”-Speak the same “language”

■ ■ They are simplified representations of the worldThey are simplified representations of the world

■ ■ Everybody uses themEverybody uses them► ► MapsMaps► ► Crossing the streetCrossing the street

■ ■ The essentials of a good theoryThe essentials of a good theory►► GeneralGeneral► ► UsefulUseful

Try navigating without a map – Try navigating without a map – a tool that you follow carefully a tool that you follow carefully and consistently or you get and consistently or you get lost.lost.

More on methodologyMore on methodology

■ ■ Positive vs. NormativePositive vs. Normative ► ► Positive: What Positive: What isis ► ► Normative: What Normative: What should beshould be ► ► We stay with positive analysis as much as We stay with positive analysis as much as

possiblepossible

■ ■ But a theory can be wrong!But a theory can be wrong! ► ► Why complain if it will put a man in space?Why complain if it will put a man in space? ► ► It takes a theory to beat a theory!It takes a theory to beat a theory! ► ► New learning improves theories.New learning improves theories.

Let’s Use Accepted Science Let’s Use Accepted Science Example: OrganicsExample: Organics

What is strychnine?What is strychnine?

A toxic organic chemical.A toxic organic chemical.

Many people believe organic Many people believe organic chemicals are safer than chemicals are safer than inorganic (synthetic) chemicals.inorganic (synthetic) chemicals.

But, in the science of chemistry, But, in the science of chemistry, chemicals are chemicals.chemicals are chemicals.

Believe what you want … but Believe what you want … but try to distinguish science from try to distinguish science from opinionopinion

““Organic advocates operate under the pre-Organic advocates operate under the pre-scientific delusion that substances produced scientific delusion that substances produced by living organisms aren’t really chemicals, by living organisms aren’t really chemicals, but just organic constituents of nature…. No but just organic constituents of nature…. No approved crop pesticide, organic or not, has approved crop pesticide, organic or not, has any detectable effect on the health of any detectable effect on the health of consumers. The premium paid to purchase consumers. The premium paid to purchase organic foods is based on mythology, not organic foods is based on mythology, not fact.”fact.”

Lee Silver, Prof. Molecular Biology, Princeton Lee Silver, Prof. Molecular Biology, Princeton Univ.Univ.

The Essence of The Essence of EconomicsEconomics

■ ■ We live in a world of We live in a world of SCARCITYSCARCITY► ► Limited resourcesLimited resources► ► Unlimited wantsUnlimited wants

■ ■ Scarcity means:Scarcity means:► ► Choices must be madeChoices must be made► ► Something must be given up to obtain Something must be given up to obtain something elsesomething else► ► People, not society, choosePeople, not society, choose

■ ■ Scarcity creates conflictsScarcity creates conflicts► ► Conflict or competition due to scarcity is Conflict or competition due to scarcity is amongamong the demanders and the demanders and amongamong suppliers, not suppliers, not betweenbetween demanders and suppliersdemanders and suppliers

CompetitionCompetitionIs everywhere and alwaysIs everywhere and always

■■ Scarcity means resource allocation must Scarcity means resource allocation must occur: How? Many ways possible:occur: How? Many ways possible:

Lottery; need; contest; force; Lottery; need; contest; force; markets.markets.All produce different results.All produce different results.

■ ■ Competition Competition cannotcannot be avoided be avoided► ► The form depends on the rulesThe form depends on the rules► ► Objections to the rules common Objections to the rules common

- Different rules favor different parties- Different rules favor different parties► ► People respond to the rules People respond to the rules (incentives) they face(incentives) they face

Economic Cost:Economic Cost:Highest valued foregone alternativeHighest valued foregone alternative

■ ■ Every choice means a costEvery choice means a cost► ► Something is given up - sacrificedSomething is given up - sacrificed

■ ■ Opportunity costOpportunity cost ► ► The value of what is sacrificedThe value of what is sacrificed ► ► The cost of The cost of anyany choice choice isis the best the best opportunity opportunity sacrificed. sacrificed. It is the It is the bestbest (highest-valued) (highest-valued) alternative not taken.alternative not taken.

■ ■ We assume people act We assume people act as ifas if they understand they understand the costs of their actions. Decisions are the costs of their actions. Decisions are rational in the mind of the decision-maker.rational in the mind of the decision-maker.

RememberRemember

Opportunity cost is the value of the Opportunity cost is the value of the most valuable alternative that must most valuable alternative that must be forgone to undertake a given act. be forgone to undertake a given act. In decision making, we must look at In decision making, we must look at opportunity cost rather than book opportunity cost rather than book costs. That is, we must look forward costs. That is, we must look forward rather than backward.”rather than backward.”

Charles G. Koch, CEO Koch Industries,Charles G. Koch, CEO Koch Industries,p. 33, “The Science of Success”p. 33, “The Science of Success”

Self-InterestSelf-Interest

Economic theory presumes that people are Economic theory presumes that people are resourceful and maximizing.resourceful and maximizing.

Decisions we observe in markets and Decisions we observe in markets and organizations come from individual actions. organizations come from individual actions. People make decisions in their own best People make decisions in their own best interest, given the constraints they face.interest, given the constraints they face.

People economize—based on what is People economize—based on what is most of most of interestinterest to them. to them.

P.S. This seems to work pretty well as a P.S. This seems to work pretty well as a model in the workplace when dealing with model in the workplace when dealing with others.others.

Most Decisions Are at the Most Decisions Are at the MarginMargin

Much of what we do is concerned Much of what we do is concerned with marginal costs and marginal with marginal costs and marginal benefits.benefits.

We are rarely in a position of a total We are rarely in a position of a total change—most decisions affect change—most decisions affect margins. A little bit more or a little bit margins. A little bit more or a little bit less.less.

Example: Yahoo has learned that a Example: Yahoo has learned that a very small change in the location of very small change in the location of an icon for a search box results in an icon for a search box results in millions more or fewer searches.millions more or fewer searches.

Economic PostulatesEconomic Postulates

We assert these to be trueWe assert these to be true1. Every person desires many goods1. Every person desires many goods

2. For every person, some goods are scarce2. For every person, some goods are scarce

3. Every person must sacrifice some good a to get more of other 3. Every person must sacrifice some good a to get more of other goods (people weigh Marginal Costs and Marginal Benefits)goods (people weigh Marginal Costs and Marginal Benefits)

4. As the consumption of a good rises, the total value rises but at 4. As the consumption of a good rises, the total value rises but at a diminishing rate (diminishing marginal value)a diminishing rate (diminishing marginal value)

5. People have different preferences5. People have different preferences

6. People are innovative but consistent, so we can make some 6. People are innovative but consistent, so we can make some sense of what we observe in the worldsense of what we observe in the world

Questions about the Very Questions about the Very Basics:Basics:

True or False:True or False:

1.1. We cannot care for all humans We cannot care for all humans the same.the same.

2.2. The cost of a week of vacation is The cost of a week of vacation is measured by the price we pay measured by the price we pay for the hotel, food and travel.for the hotel, food and travel.

3.3. Friendship is scarce.Friendship is scarce.