Instructor: Richard Hannah rlhannah@mtsu.edu Phone: 615-898-2228 (office)
Note...this page is getting a bit dated and may suffer from link rot. But the in-text explanation is still sound. ContentsELECTRONIC LECTURES
The Opportunity Cost Principle Ambiguity in Economics The Profit Maximization Principle What Are Quantity Demanded, Revenue, Cost, Profit, and Profit Maximization? Why Do Economists Speak in Terms of Variables, Functions, Statistics, and Calculus? Why Would the Economist's Way of Analyzing Problems and Opportunities be of Interest to Managers? Supply and Demand Elasticity Regression Analysis and Economics Forecasting Production Costs Cross-Disciplinary Review Mixing Government and Markets Fairness in Pricing Game Theory Risk and Uncertainty Capital: Origin, Project Analysis, and Firm Behavior The Changing 'Scape of American Markets The Proposition of Universal Access The Economics of the Internet
LECTURE #1: THE OPPORTUNITY COST PRINCIPLE One of the most fundamental, and yet most slippery, principles of economics is opportunity cost. Students should not despair when they do not find a single, irrefutable, universally accepted definition of opportunity cost. Like all economic principles, a more useful approach to grasping the significance of opportunity cost is to think of its role in the process of decision making. By analogy, we can try to explain how to learn to ride a bicycle with all the laws of physics--e.g., gravity, resistance, acceleration, etc.--or by helping the novice learn by understanding the common sense process--get on the seat, pedal, keep the handle bars straight, and learn by doing (practice). Well then, learning to use economic principles in the thought process in economic decision making can only be accomplished one way--practice. Practicing with the principle of opportunity cost requires that we ask ourselves, What requires us to make decisions (whether economic or any other kind)? Answer: because life gives us many alternatives. Next question, How do we decide (or choose) among those alternatives? Answer: by somehow assessing their value to us. This value might be utility, or satisfaction, if we are making decisions as a consumer, profit if we are a producer (manager or entrepreneur), or wages vs. leisure if we are workers. Third question, How do we determine value? This is where both economic theory and practice get fuzzy, and fuzzy is a fact of life. Again, the objective of this course is not to argue that there is always one single, precise answer, but to sharpen your reasoning powers. On balance, this should mean that you then make more "good" decisions than if did not learn the economic way of thinking. Back to the third question, How do we determine value? Disciplined thought requires more than just guesswork or defaulting to the rather meaningless presumption that everyone has "his or her own way." Subjective value is admittedly nebulous. Human beings value the same good different ways and at different levels. For example, lima beans don't yield the same utility for everyone. Even objective values, in a crude sense meaning we have some observable basis for assigning numbers (e.g., profit, cost, price, time values, statistics, etc.), are not always straightforward. In the end we must know the value of the alternatives in order to know the opportunity cost (consequences) of our choice. Some common sense rules are in order. Ask yourself, 1) What else could you do with your time or money? 2) What are the costs and benefits of alternative allocations of time and money? 3) Having considered the costs/benefits, what is the largest net gain you can realize? The next largest, the third largest, and so forth? Now you have a rational method of decision making. [Advanced student question: At what point will you stop making choices, or decisions? What other economic principle does this illustrate?] LECTURE #2: AMBIGUITY IN ECONOMICS The theory of perfect competition assumes that all relevant economic information is instantly known by everyone. We will study many departures from this theory, which will mean that you simply don't have all the information and hence the economic situation and possible decisions are ambiguous. This is a phenomenon with which you must become comfortable in this course. A crucial advancement in your intellectual development is the maturing ability to weed out "bad" decisions based on faulty analysis or logic. This proportionally gives you more "good" decisions from which to choose. You narrow the range to the "best" set of options by good analysis, the ability to make use of the relevant information at hand, and experience. Academics can only give you the first two tools, but if you master them, the third should be more fruitful. LECTURE #3: THE PROFIT MAXIMIZATION PRINCIPLE At the core of most economic theory is the idea that if one single motivation could be described for firms, entrepreneurs, business people, etc., the principle would be profit maximization. Firms exist primarily to make a profit, pure and simple. There are numerous variations on this principle--sales growth, satisficing, stakeholder theory--but in essence the "bottom line" is the bottom line. Think of the argument this way, if you had a $1000, would you invest in a firm pursuing profit maximization or one of the other goals? Of course, the term, profit maximization, can be construed different ways. For example, would a firm be maximizing profits if it were sacrificing lower profits today in anticipation of larger profits in the future? Well, that depends, and that's why we study time values, a way of comparing the future profits expected with present profits foregone. The phraseology of the last sentence should sound familiar--opportunity cost ring a bell? Yes, there is a clear linkage between the principles of opportunity cost and profit maximization. Firm managers or owners must decide what kinds of workers to hire, what kinds of equipment to purchase, who their customers are, production locations, marketing approaches, financing arrangements, and so forth. And economic theory argues that the one guiding principle in evaluating these decisions is profit maximization. [Advanced student questions: (1) Demonstrate, by constructing an example of a time value application, the relationship of opportunity cost and profit maximization. (2) Demonstrate the accounting linkage between total revenues, profit, retained earnings, and stock dividends. What is the effect if profits are not being maximized?] Additional Details on the Profit Maximizing Principle, and Some Notes on Why Economics is Important for Good Management Decisions LECTURE #4: WHAT ARE QUANTITY DEMANDED, REVENUE, COST, PROFIT, AND PROFIT MAXIMIZATION? For our purposes quantity demanded means that at some price, some product will be purchased. From a consumer's point of view, s/he will "value" the product enough to part with some money to buy it. So obviously, if you are in business to make a profit, the trick is to figure out just what the consumer wants, and how much the consumer is willing to pay for it. The next step is to learn how much of the product consumers will buy from YOU, which in turn helps you decide how much to produce. Revenues then are defined as the prices consumers pay for the products you produce, or TR=P*Q. Your method of production will determine your cost of production. If the combination of materials, equipment, labor, information, technology, managerial know-how, etc...is inefficient, your costs will be higher than necessary. So now we have the other side of the equation, costs. Or TC=FC+VC. Thus, you can reckon with common sense that profit is TR-TC. The details for everything that has been described so far draws upon your studies in accounting, finance, marketing, and management. Economic analysis intensely stresses another aspect of the revenue and cost relationship, that of MARGINAL cost and MARGINAL revenue. In economic theory THE PROFIT MAXIMIZATION PRINCIPLE requires the condition that marginal cost equal marginal revenue. The DECISION MAKING aspect of this view is that as long as you incur $X in expense (cost) by taking an economic action (business decision), and you will receive more than $X in revenue, you will decide to take that action. [Question: at what point will you not take such action?] Obviously, both theory and practice are a lot more complicated because you have to define and measure all the components of cost and revenue. But that does not detract from the guiding principle of profit maximization. LECTURE #5: WHY DO ECONOMISTS SPEAK IN TERMS OF VARIABLES, FUNCTIONS, STATISTICS, AND CALCULUS? Think of the answer to the above question as sophisticated information mangement. Every day we encounter too much information to consider every piece of it. So we develop ways to cope, ranging from ignoring the information to committing it to memory. In the business world ignoring important information can mean disaster. As long as the information can contribute to profit maximization, it must be considered by a rational decision maker. [Note however that information itself has a cost. What are some examples?] The tools mentioned above help to organize and analyze information in an efficient manner, to decide what is relevant and irrelevant, and to predict the results of decisions. Perhaps none of you will be a professional economist, but success in the business world will require that you have an orderly and disciplined way of thinking. In a world where more and more information is becoming available, economics has a lot to offer in helping improve our mental processing of information. The next section briefly sketches the fundamentals of the economic way of thinking about economic information. LECTURE #6: WHY WOULD THE ECONOMIST'S WAY OF ANALYZING PROBLEMS AND OPPORTUNITIES BE OF INTEREST TO MANAGERS? As we revisit a number of economic principles during this course, you will hopefully more fully appreciate the power of these principles to clarify important relationships. For example, the profit maximizing principle described above requires thinking in terms of MARGINAL ANALYSIS (marginal revenue and marginal cost). Marginal analysis is applied in a number of situations throughout this course (e.g., marginal product, value of the marginal product, marginal revenue product, etc.). As we shall see, calculus is a very convenient method of marginal analysis. A second important contribution of the economic way of thinking to good management decisions is the clarification of relationships among variables. A very basic one is price and quantity demanded of a product. More complicated relationships might include trying to determine the best combination of inputs (labor, machinery, energy supply, production facility size, etc.) to produce a certain type of product. A crucial aspect of the analytic thought process is the determination of the direction of cause and effect. In order to predict what may happen if we undertake an action, we must have some cause and effect framework within which we can work. For example, if we raise the price of our product, will our profits drop? [Question: Under what market conditions might profits go up?] Once a system of cause and effect has been worked out, the next question is, what is the magnitude of the impact? We need ways to measure these impacts, and statistical modeling, especially regression analysis, is a very convenient for this purpose. As a practical matter, managers are not going to let statistical results or probabilities make decisions for them. In this course the distinctions among the following possibilities are of consequence: (1) statistically significant, but of small magnitude; (2) statistically significant, but of large magnitude; (3) statistically insignificant, but of small magnitude, and (4) statistically insignificant, but of large magnitude. We are often concerned not only with the magnitude of impacts (cause and effect) and whether they are statistically significant, but also with the rate of change of these relationships. Are they speeding up, slowing down, or fairly stable? With respect to functional relationships expressed in mathematical form, calculus again offers a very convenient way of measuring these relationships. The process of economic thinking described herein should get the manager closer to making good decisions. In the end, economic analysis can only get you so far because there will still exist in most cases a considerable amount of ambiguity. Experience and synthesis of information from a variety of sources are required of the manager as well. LECTURE #7: SUPPLY AND DEMAND You may recall from your principles courses drawing endless graphs of supply and demand. Though the underlying forces for changes in quantity demanded and supplied, and shifts in demand and supply, were probably discussed at length, you may have been trying so hard to get the graphs right that the details didn't sink in. Now's the time for them to really sink in. Understanding the market system requires some well ordered thought about supply and demand. A previous lecture hammered on the principle of PROFIT MAXIMIZATION and we can link this to market supply. Why does anything in a market economy get to market? Because someone wants to make a buck, and if they behave rationally, they will maximize the bucks they make. On the demand side of the market, why are purchases made from the market? Because people get satisfaction from consuming, and if they are rational, they seek to maximize utility. These objectives evoke the principle of OPTIMIZATION, which means that producers and consumers will take into account the relevant market information and and act in a manner that balances these many variables at the margin for the best solution(s). Some economists refer to this process as the principle of MARGINALISM. Think about optimization the next time you look at a drive-through fast food menu. Say you have 5 dollars for your meal. How do you decide what to buy? Drink, what size? Meat, what kind? Side orders, which ones? Sweets? Well, obviously much depends on your hunger, your health, whether or not you are a meat eater, etc.... Whether you sense it or not, your brain is doing a heck of a lot of optimizing. And you can bet the fast food firm did a heck of a lot of optimizing in figuring out the least costly way to give you what you want. The strength of markets is that they provide an efficient way to allocate scarce resources for unlimited human wants. When you drive up to the pay window in above example, EXCHANGE of your money for the food is an example of how the PRICE SYSTEM enables markets to work. When prices are too high or too low, adjustments are made in quantity supplied or quantity demanded. As we have seen, when other variables in these functions change, the functions shift. [Question: What other variables might shift the supply or demand functions for fast food?] Keep in mind that there are markets other than product markets, such as labor (and other resource) markets, and different market structures, such as monopoly, oligopoly, monopolistic competition, and perfect competition. To really understand the market process, you must put the building blocks of the theory together. This is truly an intellectual test of your capacity to understand cause and effect, to assess the magnitude and significance of changes, and to render some judgement of consistent reasoning. LECTURE #8: ELASTICITIES As we have learned with partial derivatives, the influence of a change in an independent variable (e.g., price) on a dependent variable (e.g., quantity demanded) can be isolated within a more complicated function and then measured. In the most simplistic terms, we are concerned with the change in the numerator (dependent variable) caused by a change in the denominator (independent variable) of the partial derivative expression. However, the partial derivative alone does not give us a relative measure. For example, we might observe that a price decrease results in an increase in quantity demanded, but are the relative price and quantity changes a "lot" or a "little"? This is where the concept of elasticity can sometimes offer a more precise measure of the relationships of the dependent and independent variables. Mathematically, elasticity can be applied to virtually any two variables. However, for our purposes its importance lies in the economic meaning of the application. This gets to the heart of the appropriate application of mathematics to economics. MEASUREMENT OF ELASTICITY Quite simply expressed, elasticity can be expressed as the percentage change of "something" divided by the percentage change of "something else." Our concern is the meaningful economic relationship of the "something" and the "something else"--e.g., quantities, prices, substitutes, complements, income, advertising, etc.... The focus of the notes below is on point elasticity measures. Arc elasticity is fairly simple numeric substitution, but you may want to review it to clarify percentage relationships in your reasoning. Point elasticity measurement extends the concept of the partial derivative. The mathematical proof will not be stated here, but the formulation simply takes the partial derivative, for example partial of Q with respect to P, and multiplies it by the ratio of P/Q. This expresses the percentage change of Q divided by the percentage change of P--i.e., price elasticity. Why is this important? Well, if you knew that the price of your product could be increased one percent and the quantity demanded only decreased .01 percent, what kind of pricing strategy might you follow? What is an example which would lead to an opposite strategy? Point elasticity measures also have considerable application when we interpret the results of regressions. As you might imagine, we would be concerned with the percentage change of our dependent variable as impacted by percentage changes of the different independent variables we have specified in the regression. As a common sense problem, wouldn't knowing whether the quantity demanded of your product would be more or less influenced by proportional increases in advertising or decreases in price be useful? You should be very clear about the categorizations of price elasticity as elastic (greater than 1), inelastic (less than 1), or unit elasticity (equal to 1), and about how marginal revenue fits into this picture. OTHER MEASURES OF ELASTICITY The other commonly referred to measures of elasticity at this level of study are: cross elasticity, income elasticity, and elasticity of supply. The mathematical formulations are not covered here, but the student should commit to understanding their derivations and interpretations. Cross elasticity is of interest because it allows us to determine how two products may be related, as substitutes or complements. If the sign of the relationship is positive, they are considered substitutes; if negative, they are considered complements. The strength of the substitution relationship is clearly an indicator of competition. Interpreting the sign of income elasticity is a bit more complicated. If it is negative, the product is considered inferior. In other words, as income goes up, consumers buy less of it. Income elasticities between 0 and 1 imply normal goods, while a measure greater than one indicates superior goods. Supply elasticity is useful in examining the other side of the market. I.e., what is the percentage change in the quantity supplied relative to a given percentage change in price? Can you think of examples at the elastic and inelastic extremes of this spectrum? IMPORTANCE OF DEMAND & SUPPLY ELASTICITIES IN MARKET STRUCTURES Most of the information conveyed above has implied applications to individual producers. The relative elastic and inelastic nature of demand and supply in a market context is also very important in understanding the degree of competition and pricing behaviors. As an exercise, try drawing different scenarios of elastic and inelastic demand and supply curves and asking yourself what happens if a surplus, shortage, or shift in the functions occurs. LECTURE #9: REGRESSION ANALYSIS AND ECONOMICS In our text, regression analysis is most thoroughly covered with respect to demand estimation. However, the general conceptual framework and technical interpretation is relevant to most areas of applied economics. To gain a proficient understanding of this topic you need to master a third component--THE ECONOMIC MEANING OF THE REGRESSION RESULTS. The terms which should be instantly recognizable and which you should be able to render meaningful interpretation are: Hypothesis testing--particularly the importance of the null statement Intercept Slope--or coefficient of the independent variable(s) Linear vs. Nonlinear functions t value--as derived from standard error and coefficient R squared F value We add to these concepts and tools those which we have already learned, with particular emphasis given to partial derivatives and computation of elasticities. When thinking about the level of proficiency I expect concerning this subject matter, I suggest returning to an earlier point I made--a great deal of the orientation of this course is focused on your "squeezing" the good information out of economic analysis and recognizing, and hence not wasting time, on information that does not add value to what you are doing (in the world of capitalism, this means profit maximizing). Good regression analysis starts with well reasoned and specified economic relationships among variables (cause and effect), and then you can hopefully find some high quality data to measure these relationships. Theory and experience are both useful guides in this respect. From this starting point, we can the logical flow of questions you might consider. (1) How do you isolate the different relationships among the variables in the regression analysis? Partial derivatives. (2) What is the direction of the relationship? Positive or negative? With respect to the dependent and independent variable, the sign of the coefficient answers this question. (3) What is the magnitude of the relationship? Examine the coefficient of the independent variables for an absolute measure. If the independent variable is expressed in a power higher than one, you need to consider the full expression of the partial derivative. Exercise care in how you interpret the units of measurement. (4) What is the relative importance of changes in the dependent variable with respect to changes in different independent variables? Examine the elasticities. (5) Are the independent variables good predictors? Examine the statistical significance, the t value, of each coefficient. (6) Does the equation as a whole have good explanatory power? Examine the R squared term. Remember that this measure should be viewed in the context of time series or cross sectional data, the latter usually being higher because of the natural tendency of events in time to be correlated. (7) Are there statistical problems with the regression? Multicollinearity, heteroskedasticity, or autocorrelation. What corrective measures can be taken? Throwing out variables, specifying a different functional form, including different variables, applying econometric corrections. (8) Could more meaningful functional forms of the equation have been specified? Log-log, semi-log. (9) When all is said and done, have you teased the best information you could from your analysis? If you are confident about this, then you probably recognize that good economic analysis can remove a lot of the uncertainty and potential mistakes from managerial decision making, but as I have said before, economic reasoning only gets you to the doorstep of the decision. The rest requires the seasoning and reasoning of qualitative experience. LECTURE #10: FORECASTING The subject of forecasting is a logical extension from our recent review of regression analysis, because, in fact, regression equations are a forecasting tool. For example, we have been substituting hypothetical values into the demand equation independent variables in order to estimate the quantity demanded. In a sense we can think of this as a forecast under certain "what if" scenarios. But, as we have learned, one must be quite careful about the nature of these "what if" substitutions. Two very important caveats cited are: (1) whether the coefficients have been found to be statistically significant, and (2) whether the data values you are substituting are within the range of the data you have used to estimate the equation. These and other common sense rules boil down to KNOW THE LIMITATIONS OF THE DATA. We must also recognize that regressions are rather rigidly structured and grounded in limiting assumptions--e.g., ceteris paribus. Thus they are generally for short term estimates (forecasts). Sometimes there is wisdom in considering other options under such circumstances. FORECASTING TECHNIQUES OTHER THAN REGRESSION ANALYSIS The text covers most of these quite thoroughly, so only brief comments are offered here. First, the Delphi approach is quite useful in trying to get at consensus forecasts based on the opinions of professionals. Second, opinion polls are sometimes used, particularly in marketing research. For example, questions are carefully crafted to try to determine what consumers would do if faced with a specific set of circumstances and choices. The economist would usually argue that such data is suspect because we can not be sure people would really do what they say they would do. The economist would most generally rely on analyzing consumer purchases, i.e., what they really did. Of course, the marketing research professionals are sometimes trying to get a handle on consumer behavior with respect to a product that may not yet be on the market. This is one example of a fairly clear distinction between the marketing and economic disciplines. Data decomposition is an interesting method, particularly when demand or other economic variables fluctuate for different underlying reasons. For example, the demand for electricity can be broken down into four distinct components: (1) secular--long-term core trend, (2) seasonal--variations with weather, (3) cyclical--variations with general economic condition (the business cycle), and (4) outliers--unpredictable up or down spikes, such as unforeseen loss of major customers. Analysis of data via this process usually relies on a moving average concept, and there are specially developed software packages to accomplish this analysis (such as PROC X-11 in SAS). Data decomposition can be quite interesting because sometimes it's the outliers which we want to study. Can you describe other industries or businesses which might benefit from this kind of analysis? THE ACCURACY OF FORECASTS In evaluating forecasts one must be careful to consider their intended purpose. From a government policy making perspective, for example, a forecast that millions of workers will be unemployed because of international trade agreements, might cause the government to take actions to retrain and even employ workers in public works projects. This in turn means the forecast did not come true. From a technical perspective, the accuracy of forecasts can be tested by applying the model to historical data to examine the variations of what really happened relative to what the model would have predicted. Some analysts refer to this as backcasting. THE LEVEL OF FORECASTS Forecasts can be made at almost any level--business units, or subunits, industry levels, geographic regions, and macro-economic modeling. You should be clear on which level you are discussing, and clear on whether the micro-economic and macro-economic models are consistent. THE VALUE OF FORECASTS Of course, one must weigh the cost of obtaining a forecast against the expected gain. One of the gains to be expected is a reduction of risk, or lowering of the threshold of uncertainty. The obvious implications for the firm are many: not being stuck with inventories, matching resource needs (labor, capital, etc) with output fluctuations, finding those all-important market niches as they unfold, heeding major turns in market conditions, etc.... Most firms, or entrepreneurs, will not be building some elaborate economic forecasting model. But, most will be considering trends, variable interrelationships, etc. The level of analytic sophistication is easily enhanced with software which is very inexpensive in today's market. EXTERNAL ENVIRONMENT vs INTERNAL CONTROL There are many economic factors which the firm might formally or informally forecast, but for which no control can be exercised--e.g., business cycles, international competition, changing quality of the workforce, changing technology, etc.... But the firm can react to these changing factors through its decision making process. For example, having some sense of demand and price fluctuations might allow the firm to reduce the risk and uncertainty of internal resource allocations (workers, equipment, space). With this in mind, the objective is to better match resources with production, which in turn can vary to meet market demand. Theory is clear that these "marginal" adjustments are necessary for profit maximization. Forecasting might also help identify market niches to exploit for economic gain. From marketing classes you might remember this in the context of identifying threats and opportunities. In summary, forecasting can be an intricate tool in the analysis of markets, the economist's perspective, and the identification of market shifts. LECTURE #11: PRODUCTION In the sequence of subject matter covered in econ courses it is convenient to cover production and cost separately. But in fact, the two are different sides of the same coin. To get the full logic of economic analysis we must also include price and then compute value added to know if a decision incorporates good economic reasoning. For example, if you owned a large retail merchandising store, how would you know whether it made sense to hire another employee? You have to estimate what that worker could produce (e.g., number of sales), what that worker cost you (compensation, benefits, training), and the price of what that worker was selling. Quite simply, is the worker adding value to your firm (putting money in your pocket)? You should recognize this as an application of the marginal revenue--marginal cost principle. PRODUCTION THEORY I will quickly review the derivation of isocosts, isoquants, and the different expressions of a production function in class. A quick review of the optimal concept will be given. I will answer any questions on this material in class, but you are responsible for reading the technical details. Understanding the theoretical concept of optimization is crucial, because we must then compare this to reality, and as we will see, reality is a lot more complicated than theory. Still, production theory provides some very useful principles with which you should be familiar because they can at least guide analysis and decisions. The following are the most important: Law of diminishing marginal returns Returns to scale Elasticity of substitution Output elasticity Constrained optimization LECTURE #12: COSTS A great deal of economics can be learned from a basic understanding of accounting. For example, consider the following income statement (from Bingham, FUNDAMENTALS OF FINANCIAL MANAGEMENT, p. 37). All entries are in millions of dollars. Sales 401.0 COGS (excluding depreciation) 280.7 Other operating expenses 79.6 Depreciation 4.9 Total operating costs 365.2 Earnings before interest/taxes 35.8 Interest Expense 12.6 Earnings before taxes 23.2 Taxes (34%) 7.9 Net Income 15.3 Preferred Dividends 0.9 Income available to common stockholders 14.4 Common dividends 6.0 Additions to Retained Earnings 8.4 Net Cash Flow (net inc. + dep.) 19.3 Earnings per share in $ 8.44 Dividends per share in $ 3.52 How do the ideas of market exploitation, cost cutting, productivity, and goals of the firm fit into the above context? If the firm is considering changes--such as entering new markets, new technologies of production, different ways of financing, etc...---what economic principles might be invoked? What are the practical measures and types of analysis which should proceed? What kinds of data might you want to help in this kind of decision making? LECTURE #13: CROSS-DISCIPLINARY REVIEW Part of the objective of this course is to encourage you to think about how much of the Business Curriculum fits together. Though many of our efforts are oriented toward how the economist views the operation of a firm or organization, the contrast of this view with those of other disciplines is quite important. Recall that the economist tends to see much of the world from the perspective resource markets or product markets. Therefore, to date we have dwelled a great deal on demand and supply and the functional characterization and analysis of important market variables. Though we have especially emphasized the role of prices, you have also learned that many other factors can be important. But the distinction has clearly been drawn between analyzing MARKETS and the activity of MARKETING--the latter being the who, what, when, and how underpinning the former's why (e.g., profit maximization). >From the economic perspective we have also drawn together the conceptual pieces which are the components of production theory. In this context we studied such phenomena as productivity (marginal and average), the law of diminishing marginal returns, the division and specialization of labor, and optimization. Again, the distinction is drawn between PRODUCTION THEORY in economics and PRODUCTION MANAGEMENT or OPERATIONS MANAGEMENT as taught elsewhere in the curriculum. The latter encompass the nuts and bolts of the organization and conduct of production. The two views need not be incompatible. The concepts should help you sharpen decisions in practice and the practical material should help you retain concepts. A third area we have examined is time value analysis in decision making. The practical side of this concept is heavily emphasized in finance courses, in which the discount or interest rate assumption is particularly crucial. As we shall explore later, the many other tools, such as internal rates of return, NPV, discounted payback, and others, illustrate the close kinship between economics and finance. More refined distinctions arise when we consider the emphasis on NVP or cash flow in finance compared to the profit maximizing behavior emphasized by economists. The finance field also draws heavily on the conceptual development in economics with respect to risk analysis. More independently, the finance profession has developed numerous financial ratios to analyze the strength of various kinds of firms. With respect to cost, there are some clear conceptual distinctions between accounting and economics. The economist is not only concerned with explicit costs, but also focuses on the relevance of implicit costs (opportunity costs), while emphasizing that sunk costs are of no consequence economic decisions. From a societal perspective the economist is also concerned about externalities. In this context, the usefulness of different accounting costs to the economist vary--such as the relevance of historical vs. replacement cost. Still, the economist is heavily dependent on accounting data for firm-level empirical analysis. Hence, it is important to stress what is being conveyed in accounting information--such as cost accounting vs. managerial accounting, activity based costing, different inventory costing methods, different depreciation methods, etc... Furthermore, the accountant will tend to think in terms of fixed and variable costs, but does not place the emphasis on distinguishing between average and marginal cost, as does the economist. The reason for this is that the economist is thinking in a conceptual world about what ultimately drives the behavior of firms, while the accountant is generating data which generally is developed for internal control purposes and is not amenable to more than average cost calculations. One way to think about this is that we all find it easy and natural to think in terms of averages--what has happened--but take action on the margin--reflecting what we expect to happen. As you have learned, the economist uses a somewhat different set of tools for analysis--elasticity, regressions, statistical analysis, calculus, time values, and different forecasting methods. But it is the process of economic thinking, applying the simple principles, which is really the most powerful tool, especially when practitioners use this in support of traditional applications. Traditional organization structures subdivide responsibilities into functional areas--finance, accounting, marketing, production, etc...--with somewhat rigorous lines of control. Traditional management teaching somewhat reinforced this structure with the plan, organize, monitor, control model. The "modern" approach is to look at your organization, think about what systems are crucial, and structure the organization around these systems. This often requires dissolving traditional functional lines. The current trends toward team production, participative management, TQM, and other philosophies are often in conflict with the traditional management model. Basically, we might think of production models as "lean, team, or mean" in the highly competitive economic environment emerging globally. In very simplistic terms this means survival offers two choices--find and exploit market niches and cut costs. THEORETICAL IMPLICATIONS OF... Relaxing the assumptions of perfect competition. You should be clear about how the different models of market structures are related to the the relaxation of the underlying assumptions of perfect competition--e.g., perfect information, no individual producer can influence price (firms are price takers), easy entry/exit of firms, product homogeneity, and readily available substitutes. We know that all these conditions do not exist in the real world, but the real point of the technical analysis to gain insights on what happens as more or less of these conditions are approximated. For example, what can we surmise if the tendency is for one firm to dominate an industry by somehow putting the other firms out of business? Observed behavior of firms in different market structures. As we examine the movement along the spectrum of market structures from perfect competition to monopoly, not only are the assumptions of perfect competition relaxed, but new behaviors are introduced. For example, note the importance of product differentiation in monopolistic competition and interdependence, and hence the possibility of collusion, in oligopoly models. Measures of the structure of markets. The examination of market structures has very real implications for activities such as business planning and decisions of the government whether to pursue anti-trust litigation. There are numerous measures of industry concentration, such as the "four firm concentration ratio" or the Herfindahl Index. (From a contrarian perspective, it is important to note the theory of contestable markets based on "free" entry and exit.) These measures of market shares might focus on output, sales, or profits. Another very important economic concept in examining market structure is the measure of price elasticity. In theory a high price elasticity would be associated with a competitive market, while a low elasticity would reflect a market with monopoly power. The formation of a cartel. If different firms do collude to form a cartel, a crucial determinant of the stability of the cartel is the different cost configurations of the separate firms, which in turn will mean different profit levels given they all sell at the same price. Therefore, an "equitable" division of the profits can present great difficulties. Some firms will realize they can realize greater profits by going their own way and maximizing profits with the MC=MR rule. Hence, there is considerable incentive to cheat by producing and selling more output than the quota set by the governing body of the cartel. Price discrimination. The simple assumptions which will allow this activity to flourish are an undeveloped resale market and the ability to segment one's customers into different market niches (the necessary condition being different elasticities of demand). Market segmentation is truly the name of the game in the study of marketing. The technical analysis of all three types of price discrimination will covered in class. Non-marginal pricing behavior. In reality deviations from the profit maximization principle of MC=MR obviously occur. The important points to gather from this behavior are (1) understanding the implications of such deviations, and (2) understanding what might appear as short-run deviations could in fact be very close to profit maximization in the long-run. Note that this certainly introduces the notion of time value and a much more complicated view of consumer (or customer) psychology than is possible to cover in this course. The numerous non-marginal pricing behavior include: revenue maximizing, satisficing, stakeholder theory, cost-plus pricing, transfer pricing, price skimming, penetration pricing, predatory pricing, prestige pricing, and psychological pricing. Joint production and cost. Thus far all of our analysis has been simplied by assuming one homogeneous product (or resource). In reality firms are likely to produce multiple products with different cost structures attached to them. When this situation is coupled with multiple market segments as described above the complexity of optimal decision making grows geometrically. The pure technical analysis will not be covered in class. Instead, a more simplified conceptual approach will be covered with a focus on the accounting problem of overhead allocation. LECTURE #14: MIXING GOVERNMENT AND MARKETS The extreme form of government intervention in the economy is ownership. This is the opposite of private property as a central assumption in the context of market driven economies. An example of government ownership is the Chinese economy (although even this system is undergoing a transition to a capitalist system). In the U.S. there is relatively much less government ownership, although government owned land is common, as is to a somewhat less degree, government corporations, such as the Tennessee Valley Authority. Government controls in a market driven economy are much more prevalent in taxing and spending policies which shape economic decisions. Particularly important in this framework is the role government can play when private and social costs and benefits diverge. The Salvatore chapter on regulation presents some simple examples of tax and subsidy policies on this matter. Besides protecting the safety and health of citizens through regulatory policies, government is also considered essential in creating the "rules of the economic game." Such rules include the prohibition of fraud. These rules encompass a wide range of activities including--the environment, health care, safety & health in the workplace, discrimination, financial services and insurance, utilities, and the shaping of market forces through such mechanisms as anti-trust legislation. Of recent interest has been the shift in policies toward de-regulation of some industries (e.g., utilities) and even the privatization of some government services. Once government creates the rules by which the economic system is supposed to operate (through laws), economic incentives are pretty much the main driving force in the system. Just as the rationale for government intervention may be to correct for market imperfections (such as externalities), government's direct regulation of economic activities can also create rather perverse incentives, even within the laws. An interesting point of departure which we take is the investigation of possible outcomes when government is directly involved in the pricing decisions of a regulated industry (typically utilities--e.g., electric, water, gas, telecommunications, and cable). Just because a corporation or individual abides by the law does not mean they must conform to any particular notion of fairness, especially in pricing. So, much of the study of regulation is the study of the comparison (however abstract) of profit maximizing price and output to other potential solutions, sometimes based on an idea of fairness. For example, two possibilities studied in class are the socially optimal outcome (P=MC) and the fair price (P=ATC). Recall from Friedman's "Social Responsibility of Business..." "One and only one social responsibility of business [is] to increase profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." Fair prices are not part of the above logic; profit maximizing price is everything. But sometimes competition is not "open and free." Recall Andrews' "Can the Best Corporations Be Made Moral," which warns of the condition when corporations can shape their own environment. Thus, when government is involved we must develop some notion of fair prices. Theories of justice, equity, and economic welfare have a lot to say about what is fair. For example, the utilitarian philosophy basically reduces to "the greatest good for the greatest number." Economic theory also gives us the concepts of Pareto optimality, the compensation principle, and measurements such as cross-subsidization. Other literature is specific to academic disciplines such as psychology (relative deprivation), sociology (referent group), and political science (voting theory). Recent studies point out the notion of community standards of fairness, which distinguish among notions of passing on cost vs. keeping savings, and out-of-pocket costs vs. opportunity costs. The popular press gives us numerous examples of fairness and equity issues in pricing--such as price differences in male and female haircuts, clothing, and auto repairs--or a recent court case alleging discrimination against minorities in the pricing structure of public transportation in New York City. Suffice it to say that regardless of how complex and abstract you may have thought economic models and theories to be, the realities of mixing in such concepts as fairness places even greater intellectual demands on understanding and applying guiding concepts. This is a powerful argument that the simplicity of economic principles and the profit maximizing model are potent standards of comparison. LECTURE #15: FAIRNESS IN PRICING Despite the mechanics of determining price, with or without government involvement, the nuances of human nature can not be ignored in the economics. There is actually a considerable body of theory directly applicable to the concept of "fairness" in price determination. The philosophical exploration of equity (e.g., as with Aristotle) and the theory of justice (as with Rawls) offer some very useful insights. Also the body of social welfare theory in economics (e.g., Pigou) is of direct interest. I will draw three principles from economic thought as illustrations. The first is utilitarianism, which espouses the general principle in economic affairs as "the greatest good for the greatest number." While this may be appealing, and aligns itself quite well with the neoclassical view of market systems (the market price being the only price of consequence, fairness being an alien concept in real markets), critics argue that this leaves open the gate for exploitation and maltreatment of minorities or individuals, to the extreme that such behavior would be an affront to our standards of decency. Hence, the idea of socio-economic safety nets. Second is the principle of pareto optimality. Actually, we can best illustrate this point by assuming a suboptimal solution (as within the production possibilities frontier), and then posing the question of who gets the increased distribution as we move toward the frontier (applying the northeast quadrant rule). In the technical manipulation of the theory the changes in relative prices is what gets us there. Hence, the consideration on who benefits/loses in these changes is as issue. Third, and related to the pareto principle is the compensation principle. Assume in the move mentioned above that only one individual is better off, but the second can block the move. Can the first party compensate the second (share the gains) to the point that resistance is eliminated? Other disciplines offer insights too. In psychology, the concept of relative deprivation is of interest because it focuses on how people "feel" about prices being charged them--relative to the prices being charged others. New car purchases are an example. (This theory is also of interest in the pricing of labor--wages.) Psychology also offers the idea of framing, which focuses on how product prices are packaged. Once the right frame of reference is tapped, the consumer's willingness to pay different prices can be altered. This concept is equally applicable in labor economics--e.g., in the mixing of wages and benefits. Sociology addresses the idea of what is fair in terms of the reference group. In short, different prices between groups may be deemed acceptable, but within a given group they are not. Political science brings us to perhaps the greatest antithesis of market pricing, whether prices are dictated in a command economy or are the result of interest group pressures. Conceivably, they might even be determined by voting. Finally, recent literature has focused in the concept of community standards of fair prices. This research is largely based on experiments and surveys which pose such questions as to whether it is fair for a firm to pass along costs vs. efficiency savings, to exploit fortuitous market developments, etc... GAME THEORY Game theory is useful in structuring how we think about market strategies. Putting potential outcomes into a payoff matrix makes us address our options more explicitly. As was illustrated in the model of oligopoly, game theory addressed the interdependence of the players. To be competitive, or successful, under most circumstances (an exception being a dominant strategy) each must take the strategies of others into account, and the most successful ones learn how best to play within this context. Such tactical considerations as the sequence of moves, (e.g., price leadership), gathering information (recording and studying past moves), cheating, threats, bluffs, retaliation, brinksmanship, bridge burning, commitment, credibility, pre-emption, and collusion are all embedded in these games. Some professors argue that game theory is such a powerful teaching tool that it should be given first priority in micro economics courses. Game theory also raises some very practical questions about competition vs. cooperation. For example, INSIDE the firm or organization which strategy is most beneficial (and to whom). Clearly, the real or perceived structure of payoffs is crucial. Think a minute about a compensation system based on individual merit vs. team merit (or bonus or cost savings awards). Understanding of and belief in the reward system in compensation structuring is obviously a very significant issue in modern organizations--and can be modeled and explained in the context of game theory. Game theory offers some powerful insights for price strategy and how markets work. Want examples? Think about how auctions vs. sealed bidding works, or information contained in sequential pricing announcements (signals), or designing contracts with different kinds of payoffs (penalties & bonuses), or tournament payoffs (purses). Finally, we can reverse the logic we have used thus far--the philosophical transition from perfect competition to other market structures--and pose the question: If we start with a "few" players and add more and more players, what happens to "the game?" LECTURE #16: RISK AND UNCERTAINTY Economists typically distinguish risk from uncertainty in the sense that risk is probabilistic, while we can not assign a probability to an outcome under conditions of uncertainty. Placing these concepts on a spectrum, we may think of them as follows: Ignorance-> Uncertainty-> Risk-> Certainty Ignorance, of course, is not going to get you very far in economic endeavors. As information is gathered and learning takes place, we can at least conceive of different possibilities in the world of economic cause and effect. These states of nature are obviously beyond our control, but nonetheless have profound influences on our success or failure. Learning and experience allow us to refine the prospect of certain outcomes given our actions (cause and effect). The assignment of risk may be subjective (based on intuition, etc...) or objective (based on observations of past events, to the point that we may be able to model this cause and effect statistically). We should also be clear as to whether we are assuming the future will be like the past and what changes we might incorporate to reflect expectations of the future (crucial assumptions in forecasting as well). More specifically from the perspective of business risk, the basic categorizations are: business cycle, industry fluctuations, technology changes, consumer demand changes, input cost changes, poor decisions or indecision, and information deficiency. Which of these can the firm influence? While there are very elaborate models built to assess risk in various businesses, our basic building blocks (or technical tools) can be computed on a calculator. They are the mean, standard deviation, and coefficient of variation. We also introduce the expected value (EV) of independent events (such as profit levels, cash flows, or other measures in money terms). The EV is simply the sum of events multiplied by their respective probabilities. EV=Pi($i) +Pj($j) + ....Pn($n) In economic theory an interesting twist is introduced, which examines decisions not based on EV of $, but EV of utility (U). This effectively gets to the psychology of decision makers with respect to whether they are risk averse or risk seekers. The simple theoretical principle is that it is the utility of $, or U($) which motivates economic behavior and not the $ themselves. The expression is: EV=Pi(U) +Pj(U) + ....Pn(U) Also noteworthy is that individuals or groups of individuals seek to reduce the risk of loss by pooling such risks--e.g., purchase insurance. Risk of loss is also controlled in other economic endeavors, such as portfolio management (asset mix, e.g., dedicated bonds for retirement system liabilities), hedging (exchange rates), futures contracts (commodities). Typically, games "against" nature are expressed as decision processes under uncertainty (or DPUU). There is a payoff matrix, but probability does not enter into the picture, and the potential outcomes, given the strategy you select as a firm, are determined by "states of nature." Of course, as we learn from experience and study, we eventually may be able to convert uncertainty to risk (or probability) assignment to different outcomes. But our strategy is still to outwit nature as opposed to another firm or human player. LECTURE #17: CAPITAL: ORIGIN, PROJECT ANALYSIS, AND FIRM BEHAVIOR In raw form we can consider capital as foregone consumption or utility (either being an opportunity cost). Alternatively, basic economics texts begin the discussion of capital as a resource derived from savings (the difference between earnings and consumption). From the corporate perspective, capital may generated internally, for example, from profits or retained earnings--or externally, by borrowing or issuing equity. Either way, the one issue then becomes how this capital is allocated to investment projects competing for this scarce resource. The economic principle of equating the marginal cost with marginal return is as true here as in other economic activities. The decision rules for allocating capital are many and varied. Typical textbook coverage includes: discounted payback, net present value, internal rate of return, modified internal rate of return, and the profitability index. One must be clear as to whether projects are being evaluated as independent of each other, or whether they are mutually exclusive. Learning the detailed analytics of these techniques is the best way to understand that no one method is universally correct, and that often the different methods yield conflicting results. Though on the surface the distinctions among terms such as interest rate, discount rate, and cost of capital may seem semantical--a deeper theoretical probing will reveal important insights. For example, consider the problem of what the appropriate discount rate might be if inflation and interest rates were the same. Is this logical? This inquiry also points out that variables must be clearly expressed as to whether they are in real or nominal terms, and thus appropriately compared. From a common sense business perspective, a useful analysis will also consider interdependent effects of project analysis. Examples might include how the economics of a project affect product lines, profit centers, or various operational or support divisions of a firm. These potential incremental effects on revenues and costs might be positive or negative, one influence being the economies of scale. Finally, a fully encompassed analysis would consider alternatives to simple project analysis. For example, if reasonable alternatives exist, they should be examined. These might be simply buying the production facilities from another firm (or buying the firm), gaining control of a complementing firm by purchasing its stock, or contracting for the good or service. Of course, if the firm can buy the product on the market at a lower price than the product can be produced internally, then the solution is provided by the market. In today's world of divestitures and outsourcing one must also consider the prospect of whether past projects have panned out. This particular topic brings in the analytics of transfer pricing. In a way this brings us full circle to one of the important questions which economics should answer. WHY DO FIRMS EXIST? Thus far we have studied firms from the central perspective that their behavior in a market economy is to maximize profit. This perspective focuses more on the analytics of what firms do to achieve this objective. Only tangentially did we address what brings them into existence within the context of this profit maximizing model--via entry to capture some of the economic profits accruing to already existing firms. However, entry may have been by firms already existing in other markets, rather than a result of a process of creation. Narrowing our inquiry to the process of creation requires a slight twist of the model. Extending the motive to capture excess profits from other firms, let's say firms also come into existence to exploit a heretofore unnoticed niche in the market (perhaps an evolving consumer demand for a new product, or the delivery of an existing product to an unserved market segment). But at the root of the creation rationale is the idea that a firm can organize and use resources internally--more efficiently than they can be be coordinated (or transacted) in an open market. In other words, the value added in this arrangement exceeds any alternative. This may result form such simple observations as coordinating production under one roof to coordinating global information flows. One recent phenomenon deserving of the cast of an attentive eye is the virtual corporation--which we might describe as the intentional creation and cessation of a firms existence. I don't use "death" here because the firm might be revived again, such as the virtual corporation set up by the Rolling Stones when they tour. This concept at least offers an alternate, and intriguing, paradigm in the world being predicted by futurists. LECTURE #18: THE CHANGING 'SCAPE OF AMERICAN MARKETS The 11/27/95 _Business Week_ article, "Reinventing the Store," describes the emerging combination (or bundling) of retail products and services which have previously been considered unrelated--e.g., MacDonalds and gas stations, and Wendy's and Wal-Marts. The underlying reason for this reshaping is time savings for shoppers. Time is apparently being viewed as an increasingly scarce resource in our economy--in part driven by the dual worker family, and increasing labor market participation rates of mothers. But the shifting patterns don't stop here. The growth of the service industry in general, and now the information industry in particular, increases consumer choices and the possibilities of distributed work, consumption, financial transactions, entertainment, and education. LECTURE #19: THE PROPOSITION OF UNIVERSAL ACCESS We have as a socio-economic system developed some rather interesting ways to accommodate those in our society who have for whatever reasons not fully participated in basic services, which we as Americans consider as essential. The primarily include utilities such as water, gas, electricity, and telephone. Public goods include education, and perhaps even that component of medical care resources dedicated to the uninsured. Perhaps in the future we will be musing over universal access to such services as child care or elder care. Basically, within certain parameters we attempt to ensure that all individuals have access to today's basic services. The obvious question is "at what price?" --an issue discussed in the economics of regulation. The balance is struck between how much distortion we will tolerate in the market system and how much deprivation can tear at the social and political frabric of our nation. The evolution of the Internet now can be added to the list for the universal access debate. The next lecture lays down some of the economics of this new medium. LECTURE #20: THE ECONOMICS OF THE INTERNET Few technical advances have touched so many lives as directly and as rapidly as the Internet. This phenomenon has crept into our economic, as well as our social and even psychological fabric and poses severe tests, and will likely be the cause of the destruction of many institutions. According to an article, "Internet 95," by Cynthia Bournellis in _Internet World_ (Nov. 95) there were approximately 1.8 million hosts in July of 1993, and by July of 1995 this number had increased to 6.6 million, with more than 120 million machines expected to be connected to the Net by the end of the decade. Bournellis cites estimates that there were 38 million users world wide in 1994, and this is expected to expand to 56 million by the end of 1995, and 200 million by 1999. North America is by far the most rapidly growing region in terms of number of hosts, followed by Western Europe, and then the Pacific and Asian regions. The domains identified in 1995 are proportionally as follows. Com 25.5% Edu 20.6% Gov 4.0% Mil 3.2% Org 2.9% Net 4.4% Other 39.4% Open market commercial sites on the Internet grew from 588 in September 1994 to over 6,000 in May 1995. Executives surveyed at 48 of the Forbes 500 predicted that on average 67% of their industries would enable customers to access marketing data and transact business online, and that 39 percent of a firm's annual sales would come from online services. For more information of the above nature consult the following source. Internet Domain Survey Clearly, the economic interest, and the economic potential, of the Internet appears anything but a passing fancy. But the stirrings of economic activity by the technological advances have also brought conflicts with many existing institutions. On one hand we might consider the issues such as copyright protection and freedom of speech. These are long-held and Constitutionally embedded values which must be brought to terms with the new world of cyberspace. In many ways observing the unfolding economic events on the Internet is not unlike watching and entire economy being birthed. The market structure is chaotic and yet to be discerned, and the nature is no more orderly. A new kind of "money" (digit or cyber cash) is being created to facilitate transactions. The very nature of firms and consumers is being defined locally and globally. From and economic perspective, we might characterize the Internet in four ways: the influence it will have on the behavior of economic agents (consumers, firms, and institutions), how it mediates the evolution of existing markets, how it evolves into a unique self-contained market niche, and how the cost and pricing structure of the Net influence the first three dimensions. With respect to this latter item, the abstract questions of ownership are but one puzzling question. From a more pragmatic perspective the current state of affairs is that there are considerable difficulties applying traditional economic rules such as average or marginal cost pricing to the Net. However, economic incentives and market forces have not yet failed to have great influence on any new frontier of humankind. While we are only beginning to explore the implications of access fees, congestion pricing, and suitable accounting practices, there will surely be some very creative work in this area. A good reference discussion such topics is given below. Select Hal Varian, then Jeff MacKie-Mason, and go down to "Economic FAQs About the Internet." This is an excellent overview, but this entire site is worth browsing. Economic FAQs About the Internet by H. Varian and J. MacKie-Mason One other dimension in the economic milieu is the concept of universal access (or service) to prevent a world of information "haves" and "have nots." This is not a trivial matter, and certainly one the Clinton-Gore position advances, but also a position supported in principle by the G7 nations.