MBA I602

Economics and Business Statistics

(Fall 2022)
Introduction
• Economics is the study of decision-making in the presence
of scarcity. Managerial economics is the application of
economic analysis to managerial decision-making.

• Managers make economic decisions by allocating the

scarce resources at their disposal.

• They must understand the behavior of consumers,

workers, other managers, and governments to make good
decisions
Marginal Reasoning
• Under scarcity, managers must focus on the trade-offs that
directly or indirectly affect profits/benefits. Evaluating
them involves marginal reasoning - considering the effect of
a small change.

• How to Produce: To produce a given level of output, a firm

must use more of one input if it uses less of another input.

• What Prices to Charge: Consumers buy fewer units of a

product when its price rises given their limited budgets.

• Whether to Innovate: There are short run and long run

profits, the trade-off of which takes place over time.
Managerial Decision Making
• While firms can be motivated by a number of different
objectives, we focus on a simple quantitative metric: profit.
• Profit = Revenue – Costs

• While we focus on profit-seeking enterprises in this course the

same economic reasoning can be applied to any perceived
benefit with the definition of costs similarly expanded.
• If you do so though, be careful with arbitrary pricing (GIGO in effect).

• Maximizing profit requires coordination.

• The production manager minimizes the cost of producing a good or
service, the market manager determines how many units can be sold
at any given price, the finance manager seeks out the most efficient
source of capital, etc. Optimization often involves multiple agents.
Other Decision Makers
• Other decision makers are making choices as well:
• Consumers purchase products subject to their limited budgets
• Workers decide on which jobs to take and how much to work given
their scarce time and limits on their abilities.
• Rivals may introduce new, superior products or cut the prices of
existing products.
• Governments may tax, subsidize, or regulate products.

• To understand how others make economic decisions, most

economic analysis assumes they are “maximizers”: they do
the best they can with their limited resources.
• Behavioral economics attempts to explain why people
usually “fail” to maximize successfully as the result of a
variety of psychological complications to reasoning.
Markets for Factors and Goods
• Most economic interactions take place in markets, an
exchange mechanism which improves buyers and sellers
ability to trade.

• Markets exist for both finished goods and factors (labour,

energy, etc). The primary participants in a market are
firms who buy factors from households and then supply
products to consumers and governments who buy them.

• Government policies such as taxes and regulations play an

important role in the operation of markets.
Economic Models
• While economists use models to explain how economic
agents make choices (and the resulting market outcomes),
managers use them to improve their resource allocation
• What would happen if we raised our prices by 10%?
• Would profit rise if we phased out one of our product lines?

• The complexity of all economic interactions exceeds our

modelling capacity so most are simplifications focusing on
specific (significant) aspects of the whole.
• For example, we might build a model that attempts to explain car
purchasing behavior assuming that only income has an important
effect on the decision. All other factors are ignored.
• If this assumption is reasonable, our analysis of the auto market is
simplified but if we’re wrong, predictions may be inaccurate.
 Economics

Economics of the Firm

The Company You Keep
• Companies are collective associations formed to improve
the allocation of resources.
• They can be profit seeking firms or non-profit civic organizations
(hospitals, charities, etc) with social outcomes as their primary goals.
• http://en.wikipedia.org/wiki/Nonprofit_organization

• They exist to reduce the costs of allocating resources via

market mechanisms (searching, bargaining, contracting).
• With perfect markets, we could replicate everything a company does
via a portfolio of contracts between individual economic actors.
• http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0335.1937.tb00002.x/full
It’s Hard To Organize
• One of the obstacles to efficient and robust coordination is a
set of issues collectively known as “agency costs”
• These are the frictions imposed on value creation by the imperfect
alignment of interests among the coordinating parties
• https://www.sciencedirect.com/science/article/pii/0304405X7690026X

• Put simply, there are costs associated with both getting a

group’s interests to line up and with failing to do so.
• The “best” trade-off is unique to each situation but will involve both
incentives and controls (profits and contracts are popular, but by no
means exclusive).
Management
• A common technique for ensuring that the misalignment of
interests doesn’t severely impede an organization is to
empower a leader to make allocation decisions by fiat
rather than through negotiation.
• In many cases, the cost of establishing prices, contracting, and
oversight is higher than those imposed by organizational rigidity,
power struggles, etc.

• Managerial discretion does not eliminate the coordination

problem – it simply concentrates the issue in fewer people.
• Which can make it easier to resolve (easier to monitor, etc)
What Should Management Do?
• Milton Friedman summarized the manager’s role in the firm in a
1970 interview regarding his book Freedom and Capitalism:
• “In a free-enterprise, private-property system, a corporate executive is an
employee of the owners of the business. He has direct responsibility to his
employers. That responsibility is to conduct the business in accordance with
their desires, which generally will be to make as much money as possible while
conforming to the basic rules of the society, both those embodied in law and
those embodied in ethical custom. Of course, in some cases his employers may
have a different objective. A group of persons might establish a corporation for
an eleemosynary purpose–for example, a hospital or a school. The manager of
such a corporation will not have money profit as his objective but the rendering
of certain services”

• In Friedman’s view, firms should maximize profit and remit them to

the firm’s owners who can decide for themselves how best to
allocate it (social purposes, charities, personal consumption, etc)
• What do YOU think?
Profit Now vs. Profit Later
• Money in the future is worth less than today so a stream of
future profits is assessed using its present value.
Present Value (PV) = FV / (1+i)t
• “i” accounts for inflation and uncertainty (more in your finance course)

Net Present Value (NPV) = ∑PV(revenues) - ∑PV(costs)

• Although profit maximization is often cited as a firm’s

primary objective, it is better framed as the maximization
of long-term, risk-adjusted value (NPV).
• Profit = Revenue – Cost
• Marginal Profit = Marginal Revenue – Marginal Cost
• Marginal NPV = Marginal PV(revenues) – Marginal PV(costs)
How to Maximize Profit
• To maximize profit, produce the quantity of output such
that marginal revenue = marginal cost
• “Keep doing it until we would lose money on the next unit”
• This is equivalent to setting marginal profit, the slope of the
profit curve, to zero. The slope is 0 at its peak.
Economic Profit (full costing)
• Accounting profit refers to the net income of a firm in which
the only costs are those which are explicit.

• Conversely, economic profit includes implicit opportunity

costs – such as the return the firm’s owners could have
otherwise earned by redeploying their assets and efforts to
another use with equal risk.

• Negative externalities (affecting unrelated third parties) are

often ignored but when firms fail to account for them it
leads to a societal failure to efficiently allocate resources
• Admittedly many costs are difficult to measure but others are actively
denied by business owners in an attempt to free-ride society at large.

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Owners’ vs. Managers’
Objectives
• Despite the firm’s generally accepted objective, many
managers use their control of the organization to secure
private benefits rather than optimizing asset use for those
providing them.
• A manager receiving a fixed salary (not tied to performance) and
who values leisure may not work hard to maximize profit.
• Some managers unilaterally grant themselves perks with little or no
tangible advantage to the firm.

• This conflict of interests is a manifestation of the principal-

agent problem. The misalignment of interests between
owners and managers can lead to significant costs to the firm.
What Managers Want
• To consumer perquisites: If manager owns less than 100% of the
firm’s stock, $1 of the company’s money costs him less than $1

• To build empires: Managers usually associate corporate success or

failure with themselves and thus often equate corporate
aggrandizement with their own. Rivalries can be a problem.

• To invest in fun industries: Who doesn’t like interesting work? (or the
fame / press coverage that accompanies such projects?)

• To have discretion: Less oversight, fewer reporting obligations, the

ability to build their own teams, and the freedom to invest in pet
projects they believe in.

• To avoid uncertainty: Low corporate debt, over-investment in areas

they understand, defenses against hostile take-overs, etc
The Carrot and The Stick
• Getting agents to behave “properly” involves offering a mix
of rewards and threatening to impose sanctions.
• Executive compensation is complex and often combines a base
salary, stock options, perquisites, patronage, bonuses, and of
course, discretion.
• Sanctions typically include the threat of dismissal but could involve
the claw-back of bonuses or restrictions on freedom of action in
less serious cases.

• The goal is to structure compensation so that the agent’s

personally motivated actions produce (to the extent
possible) benefits for the principals as well.
Problems Disciplining
Managers
“The supreme irony of business management is that it is far
easier for an inadequate CEO to keep his job than it is for
an inadequate subordinate. One reason is that performance
standards for the job seldom exist. When they do, they are
often fuzzy or may be waived or explained away...”

Warren Buffet,
Berkshire Hathaway Annual Report (1988)
https://www.berkshirehathaway.com/letters/1988.html
Aligning Interests
• To make the owner and manager objectives more closely aligned,
many firms use contingent rewards: higher pay if the firm does well.
• If profit is easily observed and both the owner and manager want to
maximize personal earnings, pay the manager a share of the firm’s profit.
• Similarly, a year-end bonus based on the performance of the firm or a
group of workers within the firm could be paid

• For public firms, it is widely believed that the best way to line up
managerial interests with those of shareholders is to make the agents
shareholders too. But how much of the firm should they control?
• Not enough  shirking; Too much  entrenchment
• (The first casualty is the plan): http://www.forbes.com/2002/03/22/0322enronpay.html
Bad Objectives
• Poorly designed compensation systems can increase
conflicts of interest however.
• Rewarding managers based on revenue can lead to greater
quantities of output than is economically efficient.
Who Watches the Watchmen?
• To ensure management is allocating capital as desired by
those providing it, an oversight layer is frequently added
with the power to reward or dismiss managers as needed
for the organization’s best interests
• Although this structure insulates management from individual
grievances, it also limits their independence.

• Known as boards of directors (or supervisory boards), such

authorities help to balance the competing needs of an
organization’s constituents while ensuring that its mission
is responsibly pursued.
• http://www.nber.org/papers/w14486
Other Governance Tools
• Other mechanisms for promoting the alignment of interests
exist beyond the selection and oversight of fiat allocators.

• Internal mechanisms:
• Articles of incorporation detail the powers and responsibilities of those
operating the firm
• A mission statement helps to align the firm’s short-term objectives with a
long-term strategy that protects the interests of a firm’s stakeholders.

• External mechanisms:
• Independent audits of the firm’s financial position provided to all investors
• Collective bargaining (labour) protects the interests of workers
• Public opinion helps to reinforce the need for defensible allocation choices
• Good laws and swift adjudication can help with contract enforcement
How to Reduce Coordination
Costs
• To benefit from an understanding of coordination problems,
firms must recognize that such difficulties exist at ALL levels.
• How do we properly motivate employees to care about the firm’s
health (and thus about value creation)?

• This is an area where economics crosses over with

organizational behavior and strategy:
• Will our people need more discretion or direction?
• How can we design better teams for better outcomes?
• How can we minimize shirking without excessive monitoring (which
imposes costs of its own)

• Maximizing firm value depends on a lot more than simple

mathematics – you need to understand people and design!
Monitoring
• Employees who are paid a fixed salary have little incentive to
work hard if the employer cannot observe shirking.
• If paid hourly but the employer but cannot observe how many are
actually done, employees may inflate their numbers.

• It pays to prevent shirking by monitoring and disciplining

employees who do not work hard if the cost is low enough.
• Types of surveillance: tallying phone numbers called and recording
the duration of the calls (37%), videotaping employees’ work (16%),
storing and reviewing e-mail (15%), storing and reviewing computer
files (14%), and taping and reviewing phone conversations (10%).
• ~75% of employers monitor and surveillance employees (81% in
finance). 25% of firms that monitor employees do not tell them.
Monitoring
• For some jobs monitoring is counterproductive or not cost
effective as it may lower morale and productivity.
• Northwest Airlines took the doors off bathroom stalls to prevent
workers from staying too long in the stalls. When new management
eliminated this policy, productivity increased.

• As telecommuting increases in the work place, monitoring

workers may become increasingly difficult.
• In a study of firms where senior executives engaged in illegal price-
fixing (exposing the firm to significant liability), these executives
were found to be more inclined to seek the appointment of directors
who were likely to be inattentive monitors of their behavior.
After-the-Fact Monitoring
• It is often easier to detect the effects of shirking or other
undesirable actions after they occur.

• An employer can check the amount that an employee

produces or quality of work after it is completed. If shirking
is detected after the fact, the offending employee may be
fired or disciplined. This discourages shirking in the future.

• If an insurance company determines after the fact that a

claim resulted from behavior rather than chance, the firm
may refuse to pay (reducing opportunistic behavior).
Contracts
• If monitoring is not possible, payoffs may be set contingently
• In a state-contingent contract, one party’s payoff is contingent on
only the state of nature which determines the firm’s profit potential
• Under a profit sharing arrangement, each party earns a fraction of
total profit (not always efficient for risk-averse agents).
• Bonuses work better for workers with low risk aversion.
• Piece rates / Commissions provide an incentive for agents to work
harder but this incentive is not necessarily strong enough to offset the
agent’s cost of extra effort and the agent bears some risk.

• No single structure works best in all situations but a skillfully

designed contract provides strong incentives for the agent to
act so that the outcome is efficient.
Economic Hostages
• When direct monitoring is too costly, firms may use “hostage”
incentives to reduce the necessary amount of monitoring.
• Bonding requires agents to deposit funds guaranteeing good
behavior (couriers, guards, construction contractors, etc)

• Deferred payments hold back some compensation until a record

of reliable performance has been established.
• The firm provides a retirement pension that rewards only workers who stay
with the firm for a sufficiently long period of time.

• Efficiency wages involve paying a wage above the worker’s

opportunity cost. If worker is fired and finds another job, the
amount offered elsewhere is less than the efficiency wage.
The Bottom Line
• Minimizing the organizational burden of coordination
involves a mix of rewards and sanctions.

• The best techniques jointly minimize the costs of monitoring,

bonding, enforcement, and misaligned utility, creating more
value than they cost.

• Be mindful of the costs of monitoring and bonding – these

the gains from them do not come for free.