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Managerial Economics and Organizational Architecture, 5e

Managerial Economics and
Organizational Architecture, 5e

Chapter 2: Economists’
View of Behavior

McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Managerial Economics and Organizational Architecture, 5e

Economic Behavior
• People have unlimited wants
• Resources are limited
• Choices must be made on how to allocate
these scarce resources among the
unlimited wants
2-2

Managerial Economics and Organizational Architecture. subject to constraints of: • limited resources • costly and imperfect information • Individuals learn from their mistakes 2-3 . 5e The Nature of Economic Choice • Individuals choose the preferred option.

Managerial Economics and Organizational Architecture. people think at the margin • Marginal benefits are the additional benefits obtained if the choice is made • Marginal costs are the additional costs incurred if the choice is made • Take an action if marginal benefits are greater than the marginal costs 2-4 . 5e Thinking at the Margin • When choices are made.

what should you do? 2-5 . 5e Sunk Costs • Benefits and costs that have preceded the decision are sunk and therefore irrelevant to the decision • If you drive three hours to the Nelly Furtado concert and realize when you get to the door that you left your tickets at home.Managerial Economics and Organizational Architecture.

5e The Nature of Opportunity Costs • Choices involve trade-offs • play a round of golf or study for an exam? • spend a vacation at the beach or in the mountains? • The value of the foregone option is the opportunity cost of the option selected 2-6 .Managerial Economics and Organizational Architecture.

Managerial Economics and Organizational Architecture. 5e The Nature of Opportunity Costs • Explicit costs are direct dollar expenditures • Implicit costs reflect opportunity costs that are not direct dollar expenditures • using your time to run a business • using a storefront that you own to operate your own business • the implicit cost and opportunity cost is the forgone rent 2-7 .

Managerial Economics and Organizational Architecture. Clothing) subject to a budget constraint • This can be shown graphically with indifference curves and budget constraint 2-8 . 5e The Use of Graphical Tools • Desired goal: Maximize utility Utility = f(Food.

Clothing) • Indifference curves show all combinations of food and clothing that yield the same level of utility • Indifference curves have negative slopes – indicates a tradeoff between food and clothing 2-9 .Managerial Economics and Organizational Architecture. 5e Indifference Curves • For a utility function U=f(Food.

Managerial Economics and Organizational Architecture. 5e Indifference Curves Diagram F Quantity of Food 25 16 U=20 4 U=8 4 16 25 Quantity of Clothing C 2-10 .

(Pc/Pf)C and this can be drawn as … 2-11 . 5e The Budget Constraint I  PfF + PcC which can be rearranged as F  I/Pf .Managerial Economics and Organizational Architecture.

5e The Budget Constraint Diagram F Combinations above the line are unaffordable Quantity of Food I PF  PC PF Combinations below line are affordable Quantity of Clothing I PC C 2-12 .Managerial Economics and Organizational Architecture.

Managerial Economics and Organizational Architecture. 5e The Budget Constraint Diagram I HI PF F I PF Higher Income Original Constraint Quantity of Food I LO PF Lower Income I LO PC Quantity of Clothing I PC I HI PC C 2-13 .

and lower prices produce a flatter line. changes in the price of clothing change the slope of the budget constraint. Increase in the price of clothing Original Constraint Decrease in the price of clothing I PCHI I PC C I PCLO Quantity of Clothing 2-14 .Managerial Economics and Organizational Architecture. 5e Changing a Price F I PF Quantity of Food In this example. Higher prices produce a steeper line.

5e Combining Indifference Curves and the Budget Constraint This individual is best off by choosing point a (F*. C*). Quantity of Food F 3 F* 2 1 C* Quantity of Clothing C 2-15 .Managerial Economics and Organizational Architecture. Points on curve 3 are preferred but infeasible. where the constraint is tangent to curve 2.

Constraint after increase in the price of food F*0 F*1 C* Quantity of Clothing C 2-16 . In this example.Managerial Economics and Organizational Architecture. 5e Changing the Price of Food F Original Constraint Quantity of Food An increase in the price of food changes the optimal choice. while clothing purchases remain unchanged. the amount of food purchased declines.

5e Using Budgets to Motivate Workers • Merrill Lynch paid its analysts bonuses based on the analyst’s contribution to the banking side of their business • If an analyst rated a company as a poor investment. that company may take its business elsewhere • The analyst’s bonus would be smaller • Analyst’s tradeoff is integrity for money 2-17 .Managerial Economics and Organizational Architecture.

given the bonus plan and conditions at Merrill Lynch.Managerial Economics and Organizational Architecture. $min I Ic Quantity of integrity 2-18 . 5e Hypothetical Constraint at Merrill Lynch $ $max Income (in dollars) This constraint shows the maximum amounts of money and integrity that are possible for the analyst.

Income (in dollars) $ $*1 $* 2 Case 2 Case 1 I * 1 I * 2 Quantity of integrity I 2-19 . while the compensation in Case 2 encourages the analyst to choose a higher level of integrity.Managerial Economics and Organizational Architecture. 5e Optimal Analyst Choice Two Different Compensation Plans Case 1 reflects the original compensation plan. Managers can motivate desired actions by establishing appropriate incentives.

Managerial Economics and Organizational Architecture. 5e Alternative Models of Behavior • Happy-is-productive • promote employee satisfaction • Good citizen • communicate. and praise • Product of the environment • hire the right people • Economic model • change relevant costs and benefits • incentives matter 2-20 . facilitate.

we make decisions based on the expected value of the outcome: E (V )   piVi • The amount of risk is measured by the standard deviation of the value of the outcomes: SDV   pi (Vi V ) • People choose a balance between expected value (return) and risk 2-21 . 5e Decision Making Under Uncertainty • Since nothing is guaranteed.Managerial Economics and Organizational Architecture.

650 Standard deviation (in dollars) 2-22 $ .000 80. Expected value (in dollars) $ Increasing utility 3 2 100.000 81.000 1 Risk premium = $20.Managerial Economics and Organizational Architecture. a measure of risk. 5e Risk Versus Return This risk-averse individual prefers higher expected value but lower standard deviation.

Managerial Economics and Organizational Architecture. 5e Appendix Material .

2-24 . the marginal utility of food is 10 (the slope of the utility line). 5e Tom’s Utility as a Function of Food With clothing purchases held constant at 10.Managerial Economics and Organizational Architecture.

5e Slope of Tom’s Indifference Curve Quantity of Food Indifference curve for 100 units of utility 20 A (5. 10): MRS = 1 10 C (20.Managerial Economics and Organizational Architecture. The equation for the curve is F=100/c. The absolute value of the slope is the marginal rate of substitution (MRS). 20): MRS = 4 B (10. . and the slope at any point is –(MUC/MUF).25 5 5 10 20 Quantity of Clothing This indifference curve reflects 100 units of utility. 2-25 which declines continuously along the curve. 5): MRS = .

5e Income and Substitution Effects With budget line B1 and indifference curve I1.517.7 25 Quantity of Clothing C 2-26 . This includes a substitution effect (t1t’) and an income effect (t’t2). Quantity of Food F t’ 70. Tom chooses t1. Tom moves to t2.6 50 t2 t1 B2 B’ B1 12.Managerial Economics and Organizational Architecture. When food becomes more expensive.

000 Total income Ralph Kramden divides 100 hours per week between work and leisure. 60 40 Budget line for wage = $20/hr. 2-27 . he works fewer hours because the income effect is larger than the substitution effect. $600 $1. When his wage rate rises.000 $2. 5e Income Effects in Labor Supply Leisure time (hr) 100 Budget line for wage = $10/hr.Managerial Economics and Organizational Architecture.

Managerial Economics and Organizational Architecture. 5e Good X Perfect Complements Good Y Good Y Good Y Convexity of Indifference Curves Good X Good X Normal Case Perfect Substitutes 2-28 .