brickley - cap.2

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 2: Economist’s View of Behavior

Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.


The economist’s view of behavior

• What price to charge?

• How much to produce?

• Whom to hire?

• What markets to enter?


Scarcity is the essential economic problem

Wants are unlimited...but

…resources are limited!So

we all must make choices!

Hence, choosing creates an specific (expected) gain but also a renounce to all other alternative

gains.


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


The nature of economic choice

ExampleThe 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?• A change in your preferences or tastes• A change in the relative “importance” or “urgency” (that is,

a change in the opportunity cost or relative prices) of some of your activities.


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


Getting Deeper into Marginal Analysis

Many important questions in economics involve “how much” or “how many” decisions:

• How many workers should be hired?• How many pants should we buy?• How many units should be produced?• How many sellers should we visit to get “the best”

price?• How much food should we eat?• How many persons should we meet (and date)

before choosing one to establish a formal relationship?


In all these questions there is a “benefit” obtained by performing each activity (production, income, savings, satisfaction, or happiness).

But there is also an associated “cost” to each of them (salaries, production costs, search costs, health costs, and “sentimental costs”).

The economic model assumes that individuals will decide about the optimal amount “how much….to” or “how many… to” by trying to maximize the total “net benefit” (gross rewards minus associated costs). So how is this operationalized?

The easiest way to identify such optimal amount is by identifying the marginal or incremental benefit and the marginal or incremental cost, and then learning at which amount they become equal.

Getting Deeper into Marginal Analysis


Ejemplos y mini-casos en clases

• Leer el ejemplo presentado en la aplicación académica de la pag.37. ¿Explica el modelo de optimización basado en el análisis marginal la conducta de los criminales?

• Leer, discutir y proponer una solución al problema Marginal Analisys (pag.21).

• Leer y discutir con sus compañeros más cercanos el problema 2-22 (pag.58), y responda: ¿Son relevantes en esta caso los costos hundidos (sunk costs)?


MAXIMIZACIÓN DEL BENEFICIO NETO

Net Benefit = Total Revenue – Total Cost

d(Net Benefit)/dQ = d(Total Revenue)/dQ – d(Total Cost)/dQ

Dado que d(Net Benefit)/dQ = 0 en su nivel máximo

Entonces, d(Total Revenue)/dQ – d(Total Cost)/dQ = 0,

O bien, d(Total Revenue)/dQ = d(Total Cost)/dQ

Es decir, Marginal Revenue = Marginal Cost


Total Cost

TotalRevenue

Q

TBTC

Marginal Cost

Marginal Revenue

Q

MBMC

Q1 creates maximum “gross” benefit

Q1Q2

Q2 creates maximum “net” benefit


Total Revenue

Total Cost

Q

TBTC

Marginal Cost

Marginal Revenue

Q

MBMC

There is no maximum total revenue

Q1 Q2

Q2 creates maximum “net” benefit

Q3


Lessons from Marginal Analysis

1. If the question begins with the words how much or how many, the answer involves marginal analysis.

2. Marginal analysis identifies the local optimum.

3. If marginal benefit crosses marginal cost only once and from above, then marginal analysis also identifies a global optimum.

4. If marginal benefit ever crosses marginal cost from below, then marginal analysis may or may not identify the global optimum.

In this last case, it becomes necessary to draw the benefit cost graph to find the global optimum


Total RevenueTotal Cost

Q

TBTC

Marginal Cost

Marginal Revenue

Q

MBMC

Q0 Q1

Q2 creates maximum “net” benefitQ2

Q= Q1 is a local optimum

Q= Q2 is a global optimum


Si ésta fuese la función desatisfacción total por comer colas delangosta en un bufett, el consumoóptimo sería X2 langostas.¿POR QUÉ?

¿Por qué en este buffet lo másprobable es que los comensales consuman una cantidad mayor a X2 colas de langosta?


BenefitsBenefits

CostsCosts

Organizational Decision Making

If the benefits of an action outweigh the costs, do itCreate and sell a new product (marketing, operations)Hire (or fire) an employee (human resources)Build a new plant (senior management team--capital budgeting)Select a new vendor (operations, purchasing)Issue bonds (finance)


Economics and the management disciplines

James March— “Business schools are basically schools of applied economics”

• Marketing• Finance• Human resources• Operations• Accounting


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


The nature of opportunity costs

Example

What are the costs of studying your MBA program?

What kind of costs you would consider?

Should all these costs be added-up?

Why?


Alternative models of behavior

• Only money matters• Very limited model: unrealistic

• Happy-is-productive• Promote employee satisfaction

• Good citizen• Facilitate people´s desires to behave well

• Product of the environment• Hire the right people –with good values and

attitudes

• Economic modelchange relevant costs and benefits (incentives)


Alternative models of behavior

Implication: Just manage monetary incentives. It is unrealistic !

Implication: Promote employee satisfaction and good results will come out !

Implication: Establish a good communication and eliminate your employees´obstacles !

Implication: Hire the right people –with good values and attitudes

Implication: Change relevant costs and benefits (incentives)


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


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


Indifference curvesdiagram


The budget constraint

I PfF + PcCWhich means: Income is spent in buying food and

clothing

which can be rearranged as

F = I/Pf - (Pc/Pf)C(by assuming that all income is spent)

and this can be drawn as …


The budget constraintdiagram

BUDGET CONSTRAINT:F = I/Pf - (Pc/Pf)C

Remember the equation of a straight line:

Y= b +mXWhere b=I/PfAnd m=-(Pc/Pf)


Shifting the budget constraintBUDGET CONSTRAINT:F = I/Pf - (Pc/Pf)C


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.

BUDGET CONSTRAINT:F = I/Pf - (Pc/Pf)C


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.

The slope of the indifference curve at (F*, C*) is dF/dC = -[MUc/MUf]

The slope of the budget line at (F*, C*) is: dF/dC = -(Pc/Pf)

Therefore: [MUc/MUf] = [Pc/Pf], or

[MUc/Pc] = [MUf/Pf]

And in a world of many goods:

[MUc/Pc] = [MUf/Pf] = [MUz/Pz] = [MUw/Pw]….= [MUn/Pn]

Note: MUc is the marginal utility or satisfaction obtained by consuming an additional unit of good C (clothing).


Let´s see if the model works to explain our behavior in our weekly visit to a supermarket

• How do we choose the articles and their amounts in a supermarket?

• Which articles are selected first? Why?

• What do we say when our companion puts to many units of an article in our bag?

• By the time we are ready to leave a supermarket we should comply (approximately) with this condition:

[MUc/Pc] = [MUf/Pf] = [MUz/Pz] = [MUw/Pw]….= [MUn/Pn] Why?

• What happens if you hear a sudden announcement of a 30% discount in beer (or jewlery)?

• What happens if a very attractive person comes to you in a very suggestive way and invites you to take a bottle of the new soda brand?


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.


The Attribute Model of Consumer Demand

• Developed by Kelvin Lancaster in his article: “A New Approach to Consumer Demand”, Journal of Political Economy, April, 1966.

• His attribute model of consumer behavior considers that it is a product´s characteristics, performance features or attributes that which creates utility.

• Thus, what causes a buyer to prefer one brand over another has to do with the different attributes of the brands, his preferences regarding the products´ attributes, and the diverse brands´prices.


For this consumer, the mix of attributes in brand C provides him (her) the maximum level of satisfaction (IC4) as compared to brands A, B, and D.


The Attribute Model of Consumer Demand

• Several questions arise that can be answered through marketing research:

1.- How many potential customers of each type (black, red or blue) exist in the market? How fast each type is growing?

2.- Are there potential customers for a new brand with a different combination of attributes?

3.- What is the maximum price increase that the current buyers of brand A will be willing to pay, before shifting to another brand?

4.- What is the minimum price reduction that will incentive current buyers of brand B to shift to another brand?


If brand B experiences a price reduction, the consumer will be able to buy more attributes from brand B, spending the same amount of money. Therefore, his (her) ray 0B will grow to 0B´, which in turn will provide him (her) a higher level of satisfaction than that provided by brand C [his (her) preferred brand until then]. As a consecuence, he (she) will shift from brand C to brand B.


If the preferred brand B experiences a gradual increase in its price, the consumer will be able to buy less and less attributes from brand B, spending the same amount of money. Therefore, his (her) ray 0B will decrease to 0B´ and then to 0B´´. At some point, brand B will provide him (her) a lower level of satisfaction than that offered by brand C. In that moment, he (she) will shift from brand B to brand C.


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. Base salary


Optimal Merrill Lynch analyst choice

two different compensation plans

Case 1 (A) reflects the original compensation plan in which integrity is expensive, while the compensation in Case 2 (B) encourages the analyst to choose a higher level of integrity, which has become less expensive.

A

B


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

iiVpVE )(

)( VVpSD iiV


Risk versus return

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

why?


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).


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.


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 (t1t’) and an income effect (t’t2).


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.


Convexity of indifference curves

brickley - cap.2

Documents