An Introduction to the Economics of Business Decisions

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An Introduction to the Economics of Business
Decisions
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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

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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 toolsthe
  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, Im claiming that they are all about
  the creation of useful tools.
• Notice, by the way that tools dont 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.

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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.

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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 didnt help us
  launch rockets, it would still be a very good
  theory.

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Economics is Different

• An economic theory is good even if it isnt
  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
  dont 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 havent
  learned a single thing that will contribute
  directly to the success of whatever business
  youre involved with, that is fine.
• Before the entire class storms the Deans Office,
  I should quickly add that I dont think that will
  be the case. In fact, theres lots of good stuff
  that economics can contribute directly to the
  bottom line. But thats just a sidebar. The
  goal here is to make theory, not money.

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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.

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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.

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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, lets consider the
  following exercise

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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.

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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 its 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 Its not because we think people are
  shallow and materialistic.

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Why Do Students Demand Grades?

• They Dont. Employers and grad schools are the
  real users of grades, and so the demand for
  grades is actually a derived demand--the
  students demand for grades is actually derived
  from the employers demand. (In much the same way
  that GMs demand for steel is really derived from
  the demand for cars.)

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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.)

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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.

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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.

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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, Id use an absolute scale.
• If I believe students work harder when in
  competition against each other and that employers
  are interested in relative rankings, Id use a
  relative scale.

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A Final Note on How Economists See the
WorldMacroeconomics 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 cant really understand how interest rates
  are set if you dont 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.