Managerial Economics

An Introduction
 Why Study Economics?

• Almost every discipline that is taught at a

modern university can be described as fitting in
one of three categories:
– Art and Humanities
– Technology
– Science
• How to define each area?
Let’s Ask the Two Most Authoritative Sources
Available: Your Instructor and Wikipedia
Art
• Wikipedia: a diverse range
of human activities in
creating visual, auditory or
performing artifacts
expressing the author’s
expressing the author’s
technical skill, intended to
be appreciated for their
beauty or emotional power.

• Davis: an attempt influence

or express values and
emotion.
Technology

• Wikipedia: the collection

of techniques, skills,
methods and processes
used in the production of
goods or services or in
the accomplishment of
objectives.

• Davis: Useful stuff

Science
• Wikipedia: a systematic
enterprise that builds and
organizes knowledge in
the form of testable
explanations and
predictions about the
universe.

• Davis: The attempt to

understand and explain
observable reality
 Claim: Economics is Science
Which Means That
it is Not

• Art: Economics speaks to things that are of value (things like

the alleviation of poverty). But when done right economics
distinguishes
– Positive statements (“if minimum wage is increased some people
get a raise but other people will lose their jobs”)
– Normative statements (“the people who get a raise are more
important than the people who will become unemployed”.
• Technology: Economics isn’t a blueprint for business success.
– Unlike finance, accounting, marketing and the other disciplines
taught in the business school which, if done right, really do teach
you how to build and use valuable tools.
An Economist After Work
 My Favorite Analogy
Meteorology is a Science

Does the Captain Need to Understand Meteorology?

 Maybe Not…
• The captain of the ship can’t control the weather
and so it might be a waste of term to learn about it.
Why not learn
– the technology of sailing ships
– leadership skills necessary to get the crew working
effectively.
• In business you can’t control the economy and so
maybe you should learn
– the technical skills (finance, accounting, etc)
– the leadership skills
Don’t Think that Econ is a Key to Making
Forecasts

Prediction is hard, especially about the future…Neils

Bohr
 Why Are You Here? #1
• The obvious reason is that, many of the tools that are part of
the practical training are based on economic theory. Learning
the theories will help you build better tools
• In fact, our former Dean, who is an economist, is sometimes
fond of reminding his colleagues that economics “is the
mother discipline”.
– For example, in finance you will learn all about the “efficient market
hypothesis” which is an amazingly important tool for investment
analysis that really makes sense only if you understand the law of
demand and supply.
• As an analogy, think about how important it is for a good
engineer to understand certain aspects of physics, or a
physician to understand biology.
 Why You Are Here: #2
• A less obvious reason is that economics relies
on some specific tools--especially
mathematics and statistics--that are used in
other classes. This is a good opportunity to
sharpen your skills.
In other words, econ is to Business School what boot camp is to
the Marine Corp.

In boot camp, you endure sleepless nights of seemingly pointless activity

designed by an arrogant, humorless sociopath. The goal is not to make you
good at doing push ups or shooting targets on the range. The real goal is to
teach you basic skills and of toughen you for the grim years of combat that lie
ahead.
 Why You Are Here: #3
• I think most compelling reason is that
economics examines the world in a very
particular way. And this approach can be
useful to non economists. This is a big claim
and rather than try and express it as an
abstraction, let’s consider the following
exercise
 An Example of How Economists Think: Why Give Grades?

• Grades are expensive and complicated. Large

amounts of resources are devoted to the giving and
getting. An economic analysis is often begun by
asking why resources are used in a particular way.
• This question is way too broad and so the next step
will be to break it down into smaller questions.
• Grades are a relationship, thus an economic
approach to the puzzle begins by asking
– why do professors supply them? and
– why do students demand them?
 Why Do Professors Supply Grades?

• Money: By offering tests and promising grades, the

class becomes more valuable to the student (why?)
and so the student is willing to pay more.
• Non Pecuniary Rewards (Utility): Most Profs enjoy
their subject, think it’s important and want their
students to learn (or at least stay awake during part
of the lecture). Grades motivate the student to learn.
• But think about why most economists would begin
with the pecuniary motive.
– Hint: It’s not because we think people are shallow and
materialistic.
 Why Do Students Demand Grades?

• They Don’t. Employers and grad schools are

the real users of grades, and so the demand
for grades is actually a derived demand--the
student’s demand for grades is actually
derived from the employers demand. (In
much the same way that GM’s demand for
steel is really derived from the demand for
cars.)
 Why do employers and grad schools demand grades?
Two Possible Theories

• Grades are an absolute measure of

knowledge. (Consistent with the HUMAN
CAPITAL theory of education.)
• Grades are a relative measure of knowledge
and other important characteristics.
(Consistent with the SIGNALING/SORTING
theory of education.)
 Does This Constitute a Theory of Grades?

• Sure. The “theory” we have just described has two

important characteristics.
– It is logically consistent and more important
– Give explanations that can, at least in principle, be
refuted.
 Even It Is a Theory, What Good Is It?

• Theories are just good.

– There seems to be something about the human
mind that likes the order and connections that
obtain from a good theory. Most of us could live
long and healthy lives without ever having heard
about the theory of evolution. But most of us also
crave a better understanding of our surroundings
and find a really good theory (one that is both
simple and fits the evidence) very satisfying.
 Even It Is a Theory, What Good Is It?
• Theories can be a good guide to policy.
– There are two basic grading policies: You can be graded on
an absolute scale (e.g.,everybody who scores a 90 or
better gets an A), or on a relative scale (the top 20% of the
class gets an A)
• If I believe that students work harder when in competition against
an absolute scale and that employers are interested in the
absolute level of achievement, I’d use an absolute scale.
• If I believe students work harder when in competition against each
other and that employers are interested in relative rankings, I’d
use a relative scale.
 Take-Aways: What characterizes an
“economic way of thinkings”?
• Economics tends to be a science of the ordinary in that most
economists are attracted to problems and patterns of behavior
that are common to many people.
• In one way or another an economic problem tends to focus on
decisions that affect the allocation of resources, either for
consumption or further production.
• Whenever possible economists like to break up a big
complicated problem into small more manageable problems.
• Economists assume that behavior is purposeful and almost all
economic analysis begins by asking who is making the decision
and what the decision maker is trying to achieve.
• Economists tend to focus on self-interest and pecuniary motives
because we believe that these kinds of things matter to almost
everybody and we want our theories to be as broad as possible.
 A Final Note on How Economists See the World: Macroeconomics
and Microeconomics

• Macroeconomics: The Study of Aggregate behavior and the

flows between producers and consumers
– GDP, Price Levels, Interest Rates
• Microeconomics: The study of individual producers, consumers
and markets.
– Pricing, internal organization of firms, strategic interaction between
firms
• The first part of this class is microeconomics. This are at least
two good reasons for this
– Micro is the foundation for macro (for example, you can’t really
understand how interest rates are set if you don’t understand supply
and demand.
– Micro is where one really learns “the economic view of the world”,
which I believe is a remarkably useful analytical framework.