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Global Economics for Managers MBA 505 1 Stephen E. Margolis MBA 505 Economics for Managers Economics It’s not about the money 2 MBA 505 Economics for Managers Economics Defined The study of: • Responses of humans to unlimited wants and limited resources. • Scarcity Elaborations: • Exchange (James Buchanan) • Optimization and coordination 3 MBA 505 Economics for Managers So, what are we? • Greedy materialists? MBA 505 Economics for Managers So, what are we? • Greedy materialists? Or • Noble visionaries? MBA 505 Economics for Managers Our concern is with anything that people value. • Yes, it’s all the stuff we buy: food, shelter, clothing, entertainment, education, medical care, automobiles, travel, jewelry, art, gadgets and so on. • It is also everything else we value. Security, health, clean air and water, leisure, privacy, …children… MBA 505 Economics for Managers But isn’t scarcity temporary? • No • We will live in scarcity – in the economists sense of it, so long as we can imagine things we would like to have….more food, better food, better health, safer cars, cleaner air, faster travel, more free time. • So again, is it greed? Imagination? MBA 505 Economics for Managers Adam Smith on self interest: He advocates generosity in The Theory of Moral Sentiments, but in The Wealth of Nations famously offers this: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest” MBA 505 Economics for Managers What Makes Economics Different? • Scarcity: The inevitability of choice. Cost is the value of what is given up— Opportunity Cost • Rationality: People pursue their own interests as they know it. • Competition • Individualism: As a methodology As an ethical foundation 9 MBA 505 Economics for Managers Today’s Lecture • • • • • • • • 10 Definition (done) Course operation Approach to economics Law of demand Supply and demand Prices Costs Comparative Advantage MBA 505 Economics for Managers Course Operation • • • • • 11 Syllabus Groups Evaluation Moodle Paper MBA 505 Economics for Managers About this course • Economics for business • Primarily microeconomics, but with some coverage of macroeconomics and the principles of trade • Introductory—intermediate level • Economics of business decisions • Applied as opposed to theoretical • It can be a first course in economics. MBA 505 Economics for Managers P (Don’t copy this down) Pm MC Q MR 13 D MBA 505 Economics for Managers P (This either) 5675 Pm MC Q 456550 12389 MR 14 D MBA 505 Economics for Managers Objectives • Understand how markets work • Understand the economic logic in business decisions. In other contexts this is expressed as organization and optimization, respectively. MBA 505 Economics for Managers Normative and Positive Economics • Positive • Normative • Prescriptive 16 MBA 505 Economics for Managers Normative and Positive Economics • Positive: What is • Normative: What’s good • Prescriptive: What to do (See Normative) 17 MBA 505 Economics for Managers Managers Are Teachers Stephen E. Margolis Mathematics Algebra 1? y = mx + b p = a - bq 19 MBA 505 Economics for Managers This will become familiar P a P = a - bQ a/b Q/t MBA 505 Economics for Managers This will become familiar P a P = a - bQ -b is the slope, a is the vertical intercept a/b Q/t MBA 505 Economics for Managers More math I will use some calculus. It will always be optional. Some things are easier and more persuasive that way. MBA 505 Economics for Managers Back to Economics Demand, Supply, and Equilibrium A very quick overview. Incentives matter. We pick the low hanging fruit first. The fundamental structure of economics MBA 505 Economics for Managers The fundamental structure of economics Incentives matter. Law of demand We pick the low hanging fruit first. The law of diminishing marginal product Supply behavior MBA 505 Economics for Managers The Law of Demand If the price of some good goes up, all other things equal, the quantity of the good that is consumed will fall. Incentives Matter What would the alternative be? 26 MBA 505 Economics for Managers Suppose Green Peppers Regular Price: $.99 per pound Today Only: $1.49 MBA 505 Economics for Managers Demand as a Diagram Price 0 A flow 28 Q/t MBA 505 Economics for Managers Demand as a Diagram (My coffee consumption) Price 3.00 * 2.00 * 1.00 0 29 * 1 2 3 A flow Q/t MBA 505 Economics for Managers Demand as a Diagram Hillsborough St. Shops Price 3.00 * 2.00 * 1.00 0 30 * 1,000 2,500 5000A flow Q/t MBA 505 Economics for Managers It’s not (just) about the money • Extensions to the law of demand – – – – Seatbelts Meetings Emily’s Band-Aids Insulin – Shaving 31 MBA 505 Economics for Managers P Supply S Q/t 32 MBA 505 Economics for Managers P S and D S Po D Qo 33 Q/t MBA 505 Economics for Managers Price Adjustment P Po D Q/t 34 MBA 505 Economics for Managers More price Adjustment P Po D Q/t 35 MBA 505 Economics for Managers S and D S’ P S P’ Po D Qo 36 Q/t MBA 505 Economics for Managers S and D P S S’ Po P1 D Qo 37 Q1 Q/t MBA 505 Economics for Managers S and D P S Po D1 D Qo 38 Q1 Q/t MBA 505 Economics for Managers S and D (one more time) P S Po P1 D’ Q1 39 Q0 D Q/t MBA 505 Economics for Managers About Prices 40 MBA 505 Economics for Managers About Prices • Chapter 2 material. • What matters is relative price. – How many restaurant meals per month do I give up to make payments on an Cayman S. – How many loaves of bread do I give up to get a bottle of wine? – How many hours of leisure do I give up to get a 60” HDTV 41 MBA 505 Economics for Managers Suppose every price doubles • You wage is a price, that doubles too. • So do all your stocks. • And your bonds too. (Although that one is more of a fantasy) What Happens? MBA 505 Economics for Managers Movie Ticket 1 lb. Coffee 43 2008 2013 6.00 9.00 10.00 12.00 MBA 505 Economics for Managers What Is Pure Inflation? A balanced increase in the prices of all goods, services and non money- denominated assets. 44 MBA 505 Economics for Managers Does that ever happen? 45 MBA 505 Economics for Managers Does that ever happen? Well actually, No. 46 MBA 505 Economics for Managers What about the overall price level? Suppose some prices went up 20% and some prices went up 50%, and you wanted to know what happened to the price level? 47 MBA 505 Economics for Managers Laspeyres Index The cost of the old bundle at the new prices X 100 The cost of the old bundle at the old prices MBA 505 Economics for Managers A price index N L P qi , 0 P qi , 0 i 1 N i 1 49 i ,t i ,0 100 MBA 505 Economics for Managers Even Steven Vegetarians, just make believe for a minute. Suppose the price of beef goes up dramatically, but no other price changes. Suppose further that the cost of the bundle that you consume goes up exactly 5%. And finally, suppose you get a raise of exactly 5%, just to keep things even. Are things even? 50 MBA 505 Economics for Managers Opportunity Cost Again • Again, it is the concept of cost in economics. • If taking an action does not impose any forgone opportunity, it has no cost. • The empty factory floor MBA 505 Economics for Managers Exchange and Production “The division of labour is limited by the extent of the market” Adam Smith Specialization is a fundamental issue in economics, a fundamental characteristic of modern life 52 MBA 505 Economics for Managers Comparative Advantage Motor Paint Paul 40 30 Steve 30 45 53 MBA 505 Economics for Managers Comparative Advantage Motor Paint Paul 40 30 Steve 30 50 54 70 80 MBA 505 Economics for Managers Specialization Paul Steve Motor Paint 40 30 30 50 70 80 Steve does both motors and finishes in 60 hours, Paul does both paint jobs; 60 hours. MBA 505 Economics for 55 Managers Costs Motor Paint Paul 40 30 70 Steve 30 50 80 If Paul paints both cars he takes 60 hours If Steve reworks both motors, he also takes 60 hours. 56 MBA 505 Economics for Managers Costs Motor Paint Paul 40 30 70 Steve 30 50 80 Steve’s cost of a motor is 3/5 of a paint job. Paul’s cost of a motor is 4/3 of a paint job. Steve is the low cost provider of motor work 57 MBA 505 Economics for Managers Costs Motor Paint Paul 40 30 70 Steve 30 50 80 Steve’s cost of a paint job is 5/3 of a motor overhaul. Paul’s cost of a paint job is 3/4 of a motor overhaul. Paul is the low cost provider of painting. 58 MBA 505 Economics for Managers Now, Suppose Steve is worse at both activities. Motor Paint Paul 40 30 70 Steve 45 75 120 CAN THEY TRADE? 59 MBA 505 Economics for Managers Steve’s comparative advantage? Motor Paint Paul 40 30 70 Steve 45 75 120 Steve does both motors, finishes in 90 hours. Paul does both paint jobs, finishes in 60. Notice that Steve’s opportunity costs haven’t changed. 60 MBA 505 Economics for Managers Lesson Your can be better at everything and still be the high cost provider, in terms of opportunity cost, of something. You can be worse at everything and still be the low cost provider, in terms of opportunity cost, in something. You may have an absolute advantage in no activity and still have a comparative advantage in something. 61 MBA 505 Economics for Managers Consumer Theory • • • • Foundations of demand Illustrates choice under uncertainty A tool for conceptualizing certain problems Used in business fields – Finance – Marketing 62 MBA 505 Economics for Managers What we assume about preferences. • More is preferred to less • Consumers are willing to substitute • If A is preferred to B, and P is preferred to C, then A is preferred to C • The more x you have and the less y, the more x you would be willing to give up to get additional units of y. 63 MBA 505 Economics for Managers Introducing… MBA 505 Economics for Managers So, you’re driving to work…. In need of coffee. You pull into the parking lot of an odd shop marked only by the sign: DONUTS There is also something slightly odd about the man behind the counter. There is a display case that might once have displayed prices. MBA 505 Economics for Managers You order your coffee and then you ask, “How much is a donut?” MBA 505 Economics for Managers A march down the demand curve .80 .70 .60 .50 .40 .30 MBA 505 Economics for Managers A march down the demand curve .80 .70 .60 .50 So the donut seller says, $.80. and then, if you want a second, $.70. And if you want a third… .40 .30 MBA 505 Economics for Managers A march down the demand curve $ .80 .80 + .70 + .60 + .50 + .40 + .30 = $3.30 .70 .60 .50 And yet, to sell six donuts with simple pricing, you would have to charge how much per donut? And revenue would be what? .40 .30 Donuts MBA 505 Economics for Managers A march down the demand curve $ .80 .80 + .70 + .60 + .50 + .40 + .30 = $3.30 .70 .60 .50 Conventional pricing would require a price of $.30 to get the buyer to purchase six donuts, yielding revenue of 6*.30 = 1.80 .40 .30 Donuts MBA 505 Economics for Managers OK, swell, what’s the point? • Diminishing marginal valuation • The step function that we see is also the individual’s demand curve. • So, downward sloping demand originates in diminishing marginal evaluation MBA 505 Economics for Managers We will see the donut seller again • Consumer surplus • Price discrimination MBA 505 Economics for Managers The Science of Success. Why this book? • The theme of this course is, what ideas that are accepted principles in economics are readily carried into business management? • And related, to that, how does economics help us to better understand accepted business principles? Market Based Management • Views the firm as a miniature societies. • Uses the principles that permit societies to prosper. • These principles include the principles of markets. MBA 505 Economics for Managers Examples of applied economics • Opportunity cost (p. 33, 109) • Marginal analysis (p. 107) • Comparative advantage (p. 35-6 and elsewhere) MBA 505 Economics for Managers And still more Comparative advantage: Unless two people (nations) are exact multiples of each other in terms of productivity, they will each have a comparative advantage, even if one is absolutely better in each activity. The more productive party will benefit from practicing the activity in which it has the greatest advantage. The less productive party will benefit from practicing the activity in which it is least disadvantaged. Elasticity How we characterize demand and supply functions. Here we will deal with price elasticity of demand. 77 Dreaded Elasticity 78 Scared as a Child? Q1 Q1 P1 P1 79 Q2 Q2 P2 P2 MBA 505 Hear Elasticity… Think Responsiveness 80 P P P’ D Elastic Q P P Q’ Q Inelastic P’ Q 81 Q’ Q P Responsive P P’ D Elastic Q P Q’ Q Not so responsive P Inelastic P’ Q 82 Q’ Q Is it just slope? Suppose price goes up $1 and the number of units sold goes down 100,000 units. Responsive or not? 83 We need to know not just the change in quantity and the change in price, but also the price and quantity. We get 84 Q 100 Q P 100 P %Q % P Q Q P P Rearranging: Q P Q P Q P P Q Or, letting P and Q get small: dQ p dp q 85 Examples • Your sales force reports that if they were to cut price by 10%, units sold would increase by 14%. What is the elasticity of demand? • You are given a study that says that the elasticity of demand for one of your products is –2.5. A price increase of 4% will do what to units sold? 86 A simple numerical example Q=4000-.5P What is the price elasticity of demand when P is 1500? 87 A simple numerical example Q=4000-.5P What is the price elasticity of demand when P is 1500? dQ P dP Q 88 Q=4000-.5P What is the price elasticity of demand when P is 1500? dQ P dP Q .23 1500 .5 3250 .23 89 Now consider the relationship between price changes and revenue. For example, if you raise price, what happens to revenue? Does revenue always go up? 90 For example, if you raise price, what happens to revenue? Does revenue always go up? If you said no, you’re correct. If demand is very responsive, then the decrease in quantity will more than offset the increase in price. 91 Elasticity informs us about the effect of price changes on revenues. For this purpose, its more convenient to talk about the absolute values of elasticity. IF: . 1, Then the proportionate change in quantity is greater than the proportionate change in price. Revenues will increase when price decreases. 92 On the other hand, IF: 1 . Then the proportionate change in quantity is less than the proportionate change in price. Revenues will decrease when price decreases. 93 NC State MBA Program Fall 2002 Elasticity varies along a straight-line demand curve. P P/Q is large P/Q is small D Q 94 NC State MBA Program Fall 2002 Here’s a useful mnemonic; The arrows point in the direction of increased revenues. P Elastic Revenues are maximized where 1 1 Inelastic D Q 95 NC State MBA Program Fall 2002