Microeconomics for Decision

Making

Dr. Jorge Mendoza

Session Content

• Basics of Microeconomics: Method and scope

• How competitive markets work: supply and demand

• The theory of demand

• Cost functions and the theory of production

• Demand estimation (time permitting)

What is Microeconomics?

• Seeks to explain the behavior and activities of specific economic units –individuals, households, firms, industries, and resouce owners.

• Seeks to explain and predict such things as:

1.The prices and outputs of particular firms and and industries,2.The choices of consumers in buying goods and services, 3.The drivers of technological change, production efficiency and costs, 4.Competitive behavior and government regulation and 5.The adjustments of markets to new conditions.

The Economist´s Approach

• The economist´s approach to making sense of everyday economic events involves:

1.Discovering good reasons why economic events happen as they do,

2.Carefully weighing more-or-less sound economic facts to arrive at more-or-less plausible cause-effect relationships,

3.Developing formal economic theories,

4.Building empirically based economic models.

Economic Thinking – Abstractions

• Economists think in terms of abstractions by reducing reality to the relationships that are important and that bring the inquiry down to manageable proportions.

• Therefore the analysis will lack a certain degree of realism.

• But theories and models are not acceptable according only to their degree of realism.

• Their power to explain events in the real world and to make correct (conditional) predictions are more fundamental criteria.

Economic Thinking – Rationality

• Economics assumes that individuals are rational in the sense that they prefer more satisfaction (subjectively defined) than less.

• Moreover, individuals will use their resources to achieve the highest or at least a minimum level of satisfaction, given the relevant environmental constraints and their resources.

• This does not mean that individuals are necessarily cold, calculating machines, who always pursue selfish interest with perfect precision.

• The kamikaze pilot, the religious hermit, the drug dealer and the philanthropic millionaire act rationally by maximizing their satisfaction given their preferences, resources and constraints.

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Economic Thinking – Values

• The economist´s approach tends to be (but not always) amoral

• Positive economics deals with explanations of real phenomena

• Normative economics deals with ´desirable´ economic results or behavior of economic agents (axiological view of the world)

• Economics analyzes criminal behavior, drugs markets, prostitution, or religious behavior, as economic phenomena. It does not judge them.

• Trying to eliminate undesirable´ behaviors may lead to costly regulation (prohibition of alcohol, drugs and pornography).

Is it necessary to “choose” between theory and practice?

“ To make a business decision, you simply have to be able to forecast the implications of your actions, and that is precisely what a theory does. Therefore, the choice a manager faces is not really between theory and no theory but between a carefully articulated, internally consistent (ideally, empirically verified) theory, or a shoot-from-the-hip, go-with-your intuition ´theory´ ”

Brickley, Smith and Zimmerman, “Teaching the Economics of the Organization”. Financial Practice and Education, Fall / Winter 1999.

What is a theory?

• A theory is a statement predicting which actions will lead to what results and why. Every action that managers take, and every plan they formulate, is based on some theory in the back of their minds that makes them expect the actions they contemplate will lead to the results they envision. But…most managers don't realize that they are voracious users of theory.

• Good theories are valuable in at least two ways. First, they help us make predictions… Second, sound theories help us interpret the present, to understand what is happening and why. Theories help us sort the signals that portend important changes in the future from the noise that has no strategic meaning.

Clayton M. Christensen & Michael A. Raynor. “Why Hard-Nosed Executives Should Care about Management Theory”. Harvard Business Review, September, 2003.

Why is it important to learn applied Microeconomics?

• To make sense of the events in your firm´s industry and markets.

• To understand the conduct and strategic behavior patterns of:

- Your firm´s suppliers- your firm´s buyers- your firm´s competitors- your firm´s partners - the government regulation- your firm´s stockholders and top management- your firm´s employees and executives.

• To support your ideas and proposals about the firm´s strategic alternatives and decisions.

Specific decisions that require the tools of applied Microeconomics

• A) Evaluation & selection of industries or sectors to invest in or to divest from.

• B) Definition of the vertical & horizontal frontiers of the firm.• C) Selection of technologies & inputs. • D) Pricing policies and decisions. • E) Competitive and cooperative relationships with competitors,

customers and partners.• F) Designing the organization´s architecture (structure) and

strategy.• G) Selection of the evaluation systems for the individual, group

and divisional performance.• H) Defining the incentive and monitoring systems in the firm and

between the firm and other organizations.

Can we infer a cause-effect relationship from observing a close correlation between two or more variables?

• This is a major source of mistakes in firms when executives try understand business phenomena !!

• Let´s watch a short video (cause-effect)from the movie Freakonomics

Chapter 1: Introduction

Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.

Determinants of architecture

Design Principle:form follows function.Changes in the business environment will affect business strategies and, hence, the firms´ architecture: Its decision making authority, performance evaluation, and incentive-compensation systems.

Organizational Architecture

• Systematic approach to identifying and correcting organizational problems.

• Three critical aspects of organization: the architecture

• Assignment of decision rights• Methods of rewarding individuals• Performance evaluation of individuals and business units

• “Three legs of the stool”

Fundamental concepts• People act in their own self interest

• which is not the same as being greedy!• Their interests are generally different or even contrary to those of their firms or

organizations.

• Information is asymmetric• we don’t all possess or share the same information.

• Oportunistic behavior may be incentived when information is asymmetric and individual´s and organization´s objectives differ.

• The implications for Architectural Design:• assignment of decision rights must be compatible with knowledge and access to

information.• reward and evaluation systems must in turn be compatible with decision rights.• Evaluation systems should be designed to reduce information assymetries.• All three elements of organizational architecture should promote decisions

oriented to create and capture value for the organization while respecting ethical standards.

The Economic Perspective

• How are resources allocated among competing uses?

• in society• in the firm

• How do individuals make decisions?• the role of incentives• incentive conflicts and opportunistic behavior

“Sells” labor “Buys” labor

Buys product Sells product

Household division of labor

Hierarchical decision making

Mechanisms for Allocating Scarce Resources

Markets

Role and functions of prices

• Coordination• Incentives• Rationing• Signaling