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Chapter 2: Economist’s View of Behavior

Chapter 2: Economist’s View of Behavior. Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture , 4 th ed. The economist’s view of behavior. What price to charge? How much to produce? Whom to hire? What markets to enter?.

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Chapter 2: Economist’s View of Behavior

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  1. Chapter 2: Economist’s View of Behavior Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.

  2. The economist’s view of behavior • What price to charge? • How much to produce? • Whom to hire? • What markets to enter?

  3. Economics and behaviorlearning objectives Students should be able to • Describe the economic approach to behavior, use simple choice models, and compare to alternative models • Define and apply the concept of opportunity cost

  4. ScarcityThe essential economic problem Wants are unlimited... but …resources are limited! So we all must make choices!

  5. The nature of economic choice • Individuals make the best choices they can, subject to • cognitive limitations • resource scarcity • costly (and imperfect) information • Individuals learn from their mistakes

  6. The nature of economic choiceExample The allocation of a truly scarce resource- your time! How do you allocate your daily 24 hours? • Maintenance of self, family, household • Learning • Working • Other What might change your allocation?

  7. Thinking at the margin Many economic choices involve some change in behavior • take an action if marginal benefits justify marginal costs • benefits and costs that have preceded the decision are sunk and therefore irrelevant to the decision

  8. 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

  9. The nature of opportunity costsExample Suppose you are a full-time student and your favorite professor offers you a research assistantship • What do you gain? • What do you lose? • What are the opportunity costs?

  10. The use of graphical toolssimplified models of reality • Desired goal: utility maximization Utility = f(Food, Clothing) (what assumption is inherent in this expression?) • Indifference curves • Budget constraint

  11. Indifference curves • Given a utility function U=f(X,Y) (can you provide a verbal description?) • Indifference curves portray the marginal tradeoffs between X and Y that maintain a constant U

  12. Indifference curvesdiagram

  13. The budget constraint I  PfF + PcC which can be rearranged as F  I/Pf - (Pc/Pf)C and this can be drawn as …

  14. The budget constraintdiagram

  15. Shifting the budget constraint

  16. Changing a price In this example, changes in the price of clothing change the slope of the budget constraint. Higher prices produce a steeper line, and lower prices produce a flatter line.

  17. Combining indifference curves and the budget constraint This individual is best off by choosing point a (F*, C*), where the constraint is tangent to indifference curve 2. Points on indifference curve 3 are preferred by infeasible.

  18. Changing the price of food An increase in the price of food changes the optimal choice. In this example, the amount of food purchased declines, while clothing purchases remain unchanged.

  19. Hypothetical constraint at Merrill Lynch This constraint pictures the maximum amounts of money and integrity that are possible for the analyst, given the bonus plan and conditions at Merrill Lynch.

  20. Optimal Merrill Lynch analyst choicetwo different compensation plans Case 1 reflects the original compensation plan, while the compensation in Case 2 encourages the analyst to choose a higher level of integrity.

  21. Alternative models of behavior • Happy-is-productive • promote employee satisfaction • Good citizen • communicate, facilitate, and praise • Product of the environment • hire the right people • Economic model • change relevant costs and benefits

  22. Decision making under uncertainty • Since nothing is guaranteed, we make decisions based on the expected value of the outcome: • The amount of risk is measured by the standard deviation of the value of the outcomes: • People choose a balance between expected value (return) and risk

  23. Risk versus return This risk-averse individual prefers higher expected value but lower standard deviation, a measure of risk.

  24. Tom’s utility as a function of food With clothing purchases held constant at 10, the marginal utility of food is 10 (the slope of the utility line).

  25. Slope of Tom’s indifference curve This indifference curve reflects 100 units of utility. The equation for the curve is F=100/c, and the slope at any point is –(MUC/MUF). The absolute value of the slope is the marginal rate of substitution (MRS), which declines continuously along the curve.

  26. Income and substitution effects With budget line B1 and indifference curve I1, Tom chooses t1. When food becomes more expensive, Tom moves to t2, which includes a substitution effect (t1t’) and an income effect (t’t2).

  27. Income effects in labor supply Ralph Kramden divides 100 hours per week between work and leisure. When his wage rate rises, he works fewer hours because the income effect is larger than the substitution effect.

  28. Convexity of indifference curves

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