Download Lecture 1 The Basics

Lecture 1
The Elements of Theory
■ Overview
► Microeconomic Theory
Macroeconomic Theory
Economic Principles for Managers
(what is behind what we will study)
1. The Role of Managers Is to Make Decisions
2. Decisions Are Always Among Alternatives
3. Decision Alternatives Always Have Costs and Benefits
4. The Objective of Management Is to Increase the Firm's Value
5. A Firm's Value Is Measured by Its Expected Profits
6. A Firm's Sales Revenue Depends on Demand for Its Product
7. A Firm Must Minimize Cost for Each Level of Output
8. A Firm Must Develop a Strategy Consistent with Its Market
9. A Firm's Growth Depends on Rational Investment Decisions
10. Successful Firms Deal Rationally with Laws and Regulations
Theories
A part of the modern world
Why use theories? They enable us to
-Simplify
-Organize
-Speak the same “language”
■ They are simplified representations of the world
■ Everybody uses them
► Maps
► Crossing the street
■ The essentials of a good theory
► General
► Useful
Try navigating without a map –
a tool that you follow carefully and
consistently or you get lost.
More on methodology
■ Positive vs. Normative
► Positive: What is
► Normative: What should be
► We stay with positive analysis as much as
possible
■ But a theory can be wrong!
► Why complain if it will put a man in space?
► It takes a theory to beat a theory!
► New learning improves theories.
Let’s Use Accepted Science
Example: Organics
What is strychnine?
A toxic organic chemical.
Many people believe organic chemicals
are safer than inorganic (synthetic)
chemicals.
But, in the science of chemistry,
chemicals are chemicals.
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Believe what you want … but try to
distinguish science from opinion
“Organic advocates operate under the pre-scientific
delusion that substances produced by living
organisms aren’t really chemicals, but just
organic constituents of nature…. No approved
crop pesticide, organic or not, has any detectable
effect on the health of consumers. The premium
paid to purchase organic foods is based on
mythology, not fact.”
Lee Silver, Prof. Molecular Biology, Princeton Univ.
The Essence of Economics
■ We live in a world of SCARCITY
► Limited resources
► Unlimited wants
■ Scarcity means:
► Choices must be made
► Something must be given up to obtain something else
► People, not society, choose
■ Scarcity creates conflicts
► Conflict or competition due to scarcity is among the
demanders and among suppliers, not between
demanders and suppliers
Competition
Is everywhere and always
■ Scarcity means resource allocation must occur:
How? Many ways possible:
Lottery; need; contest; force; markets.
All produce different results.
■ Competition cannot be avoided
► The form depends on the rules
► Objections to the rules common
- Different rules favor different parties
► People respond to the rules (incentives) they
face
Economic Cost:
Highest valued foregone alternative
■ Every choice means a cost
► Something is given up - sacrificed
■ Opportunity cost
► The value of what is sacrificed
► The cost of any choice is the best opportunity
sacrificed. It is the best (highest-valued)
alternative not taken.
■ We assume people act as if they understand the
costs of their actions. Decisions are rational in the
mind of the decision-maker.
Remember
Opportunity cost is the value of the most
valuable alternative that must be forgone
to undertake a given act. In decision
making, we must look at opportunity cost
rather than book costs. That is, we must
look forward rather than backward.”
 Charles G. Koch, CEO Koch Industries,
p. 33, “The Science of Success”

Self-Interest
Economic theory presumes that people are
resourceful and maximizing.
Decisions we observe in markets and
organizations come from individual actions.
People make decisions in their own best
interest, given the constraints they face.
People economize—based on what is most of
interest to them.
P.S. This seems to work pretty well as a model
in the workplace when dealing with others.
Most Decisions Are at the Margin

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Much of what we do is concerned with
marginal costs and marginal benefits.
We are rarely in a position of a total
change—most decisions affect margins.
A little bit more or a little bit less.
Example: Yahoo has learned that a very
small change in the location of an icon
for a search box results in millions more
or fewer searches.
Economic Postulates
We assert these to be true
1. Every person desires many goods
2. For every person, some goods are scarce
3. Every person must sacrifice some good a to get more of other
goods (people weigh Marginal Costs and Marginal Benefits)
4. As the consumption of a good rises, the total value rises but at a
diminishing rate (diminishing marginal value)
5. People have different preferences
6. People are innovative but consistent, so we can make some sense
of what we observe in the world
Questions about the Very Basics:
True or False:
1. We cannot care for all humans the
same.
2. The cost of a week of vacation is
measured by the price we pay for the
hotel, food and travel.
3. Friendship is scarce.