Introduction and Review of Concepts
Reading Assignment: Chapter 2 in Koch (handed out), and The Broken Window Fallacy (posted) and Comparative Advantage Handout (posted)
What is economics? Science of Human Action
Purposeful –
Human –
Individual -
Action –
We all act with uncertainty. Much of what economics is all about -- and what entrepreneurs/managers have to constantly deal with -- is how to decrease uncertainty. What institutions have developed in order to help entrepreneurs deal with uncertainty and how are they used - both inside and outside the firm?
In looking at the macro economy we can see how errors were made on the micro level due to information problems, etc. that led to the macro issues we are experiencing. Really - there is no distinction between micro and macro -- it all starts with individual behavior.
Economist’s Assumptions About Human Action:
Self-interest Axiom:
The costs and benefits from actions are subjective and not measurable –
Revealed or demonstrated preference -
What Do Economist’s Do? What Questions Do Economists Specifically Address as Scientists?
There are two fundamental economic problems or questions:
First Problem - CHOICES: I
a. Scarce good –
b. Alternative ways to use scarce goods –
So the problem becomes one of which use of the resource is the “best” use?
Second Problem - COORDINATION:
So the problem becomes one of how does this coordination take place or how do we utilize the subjective individual knowledge of time and circumstances or personal knowledge in our decision making about the use of scarce resources? If you like oranges more than you like lemons, how can we utilize that knowledge such that resources are used to make more oranges and fewer lemons?
What Do Economists Do In An Attempt To Address These Problems?
Rules of the game:
Incentives matter:
So the process of analysis is such:
Rules - Incentives - Actions - Outcomes
It is the economist’s job to determine (or at least attempt to determine) which rules will lead to which outcomes.
Unintended outcomes or consequences (society is very complex - too complex to plan with any degree of success):
Rules Need to Be Predictable and Steady to be Followed:
Which Rules Are the Best? This depends upon what people want. If we want a higher standard of living in terms of more food, clothing, shelter and free time -- private property rights, free trade and the rule of law. Economic freedom and prosperity and the basic necessities of life seem to go hand in hand.
CIA Fact Book (Careful - there are a lot of problems with GDP as a measurement of prosperity)!
Therefore - this is what lead Koch to want to use similar rules within a firm that leads to prosperity in society. If certain rules and ideas lead to prosperity for a society, why can't they also lead to prosperity for a firm?
Therefore: Market-Based Management: based on the science of human action -- holistic approach to management that embraces change, competition, growth, etc.
Efficiency as a Goal:
Wealth (for society):
Wealth (for a firm):
This begs the question of "social responsibility" of business or the "stakeholder theory of the firm" - which we will discuss more later.
Efficiency and Wealth (society - how should economists be looking at this?):
1.
2.
3.
Efficiency and Wealth (firm):
Economists and Their Models
Model (to understand society and to understand and apply principles within firms):
Must reflect reality - must not be too complicated but also must not miss key drivers or secondary consequences (although sometimes - usually - impossible to know all consequences until you try).
Logic:
Assumptions:
Ceteris Paribus:
Predictions:
Pattern Prediction (for society, for the firm):
Specific Prediction (for society, for the firm):
Models that managers use must always be challenged and improved. What worked yesterday might not work today.
Managers must embrace change -- that is reality.
Creative Destruction (Schumpeter):
Continuous Improvement (Deming):
The Invisible Hand:
Natural Instinct of Self-Interest -
Economic or Spontaneous Order (Society Benefits - Smith and Hayek): (More on this - supply and demand)
How do private property rights increase wealth? Incentives.
The Concept of TRADE: When two people trade, what happens?
Does Trade Increase Wealth? Is it mutually advantageous in the absence of force and fraud? How do we know?
Economic versus Political Means of Allocating Scarce Resources:
THE CONCEPT OF OPPORTUNITY COST:
Application (society or economy): The Broken Window Fallacy
Application (within in the firm): Delegation
Marginal:
Marginal Opportunity Cost:
Other Cost Concepts:
Sunk Cost:
Example: Suppose you wait in a line in a grocery store. Another line opens up. What value should you place on the time you’ve spent waiting in your present line (answer - none)
Total Cost = Fixed Costs + Variable Costs
Variable Costs:
Fixed Costs:
Mainstream economist's definitions:
Short Run:
Long Run:
Example: Suppose you are losing money in your business and are trying to decide if you should shut down or continue operating in the short run. What costs are relevant? Only variable - why?
In Class Exercise One
COMPARATIVE ADVANTAGE
The concept of Comparative Advantage -- for a country, for a firm, inside the firm:
Division and Specialization of Labor:
Trade:
David Ricardo and Comparative Advantage
Absolute Advantage -
Comparative Advantage -
Trade should be based upon comparative advantage -- example (handout):
Comparative Advantage applied to a firm:
Delegation is a good example.
A manager should direct employees to those places where they have a comparative advantage. Sometime this is a trial and error process -- determining where someone's comparative advantage lies is not always easy. But certainly someone with a high opportunity cost should not be making coffee for the office staff!!
In Class Exercise Two - Let's see how specialization and trade (even within a firm) can increase productivity when comparative advantage is used.