An Introduction to the Economics of Business Decisions

1. An Introduction to the Economics of Business Decisions

2. Where does Economics fit in a business school? • Almost every discipline that is taught at a modern university can be described as fitting in one of three categories: • Art and Humanities • Science • Technology • Think about where business and economics belong • Hint: Not in the same place

3. Technology and Science Are Different • Ultimately, technology is about building useful tools. • We judge whether a technology is successful is by evaluating the usefulness of the tools—the Chrysler minivan was successful technology, the Yugo was not. • In claiming that business schools and engineering schools are in the technology part of the university, I’m claiming that they are all about the creation of useful tools. • [Notice, by the way that “tools” don’t have to have a physical dimension. An accounting system or a business plan can be good tools but lousy paper weights.] • What this means is that a business school should be judged by the utility of the tools it produces . And by extension business education should be judged by how successfully its students apply those tools.

4. Science is all about formulating and testing Theories • Theories are nothing more than ways of understanding what we observe. • The theory of evolution helps understand the relationship between species and important aspects of the fossil record, the law of gravity helps understand the behavior of the planets and the law of demand helps understand the price of oil.

5. A theory is worthwhile if • It is consistent with what is observed. • We believe the law of gravity because apples really do fall down, not up. We believe that law of demand because when the relative price of oil goes up, people really do buy less oil. • Helps us lead understand a wide range of phenomena. • The law of gravity also explains the position of the planets and, there is a pursuasive argument that the law of demand also explains the choice of marriage partners. • So ultimately the distinction between science and technology is that science is all about building theories, which are tools of understanding what we observe, whereas technology is all about building real practical tools. • Even if the “law” of gravity didn’t help us launch rockets, it would still be a very good theory.

6. Economics is Different • An economic theory is “good” even if it isn’t “practical”. • This is unlike everything else in Business School, where the test is always one of usefulness. • If you complete your basic finance class and don’t know how to figure out whether the net present value of a project is positive or negative, something has gone wrong. • But if you complete this class, and haven’t learned a single thing that will contribute directly to the success of whatever business you’re involved with, that is fine. • Before the entire class storms the Dean’s Office, I should quickly add that I don’t think that will be the case. In fact, there’s lots of good stuff that economics can contribute directly to the bottom line. But that’s just a sidebar. The goal here is to make theory, not money.

7. Why You Are Here: #1 • The obvious reason is that, many of the tools that are part of the practical training are based on economic theory. • In fact, our 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.

8. 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. • Just as in boot camp, you will endure sleepless nights of seemingly pointless activity designed by an arrogant, humorless sociopath, all with the goal of toughening you for the grim years of combat that lie ahead.

10. Why You Are Here: #3 • I think most compelling reason is that economics examines the world in a very particular way. And this appoach 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

11. 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 to 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.

12. 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.

13. 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.)

14. 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. (Consistent with the SIGNALING/SORTING theory of education.)

15. 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.

16. 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.

17. 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.

18. 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 • This class is almost entirely 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.