Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 2: Economists’ View of Behavior McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Managerial Economics and Organizational Architecture, 5e Economic Behavior People have unlimited wants Resources are limited Choices must be made on how to allocate these scarce resources among the unlimited wants 2-2

Managerial Economics and Organizational Architecture, 5e The Nature of Economic Choice Individuals choose the preferred option, subject to constraints of: limited resources costly and imperfect information Individuals learn from their mistakes 2-3

Managerial Economics and Organizational Architecture, 5e Thinking at the Margin When choices are made, people think at the margin Marginal benefits are the additional benefits obtained if the choice is made Marginal costs are the additional costs incurred if the choice is made Take an action if marginal benefits are greater than the marginal costs 2-4

Managerial Economics and Organizational Architecture, 5e Sunk Costs Benefits and costs that have preceded the decision are sunk and therefore irrelevant to the decision If you drive three hours to the Nelly Furtado concert and realize when you get to the door that you left your tickets at home, what should you do? 2-5

Managerial Economics and Organizational Architecture, 5e 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 2-6

Managerial Economics and Organizational Architecture, 5e Explicit costs are direct dollar expenditures Implicit costs reflect opportunity costs that are not direct dollar expenditures using your time to run a business using a storefront that you own to operate your own business the implicit cost and opportunity cost is the forgone rent The Nature of Opportunity Costs 2-7

Managerial Economics and Organizational Architecture, 5e The Use of Graphical Tools Desired goal: Maximize utility Utility = f(Food, Clothing) subject to a budget constraint This can be shown graphically with indifference curves and budget constraint 2-8

Managerial Economics and Organizational Architecture, 5e Indifference Curves For a utility function U=f(Food, Clothing) Indifference curves show all combinations of food and clothing that yield the same level of utility Indifference curves have negative slopes – indicates a tradeoff between food and clothing 2-9

Managerial Economics and Organizational Architecture, 5e Indifference Curves Diagram Quantity of Clothing Quantity of Food F C U=8 U=

Managerial Economics and Organizational Architecture, 5e The Budget Constraint I  P f F + P c C which can be rearranged as F  I/P f - (P c /P f )C and this can be drawn as … 2-11

Managerial Economics and Organizational Architecture, 5e C F Combinations below line are affordable Combinations above the line are unaffordable Quantity of Food Quantity of Clothing The Budget Constraint Diagram 2-12

Managerial Economics and Organizational Architecture, 5e C F Quantity of Food Quantity of Clothing Original Constraint Higher Income Lower Income The Budget Constraint Diagram 2-13

Managerial Economics and Organizational Architecture, 5e F C Quantity of Clothing Quantity of Food Original Constraint Increase in the price of clothing Decrease in the price of clothing 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. 2-14

Managerial Economics and Organizational Architecture, 5e Combining Indifference Curves and the Budget Constraint This individual is best off by choosing point a (F*, C*), where the constraint is tangent to curve 2. Points on curve 3 are preferred but infeasible. F C Quantity of Food Quantity of Clothing F*F* C*C*

Managerial Economics and Organizational Architecture, 5e Quantity of Food Quantity of Clothing F*0F*0 C*C* F C Original Constraint Constraint after increase in the price of food F*1F*1 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. 2-16

Managerial Economics and Organizational Architecture, 5e Using Budgets to Motivate Workers Merrill Lynch paid its analysts bonuses based on the analyst’s contribution to the banking side of their business If an analyst rated a company as a poor investment, that company may take its business elsewhere The analyst’s bonus would be smaller Analyst’s tradeoff is integrity for money 2-17

Managerial Economics and Organizational Architecture, 5e Hypothetical Constraint at Merrill Lynch This constraint shows the maximum amounts of money and integrity that are possible for the analyst, given the bonus plan and conditions at Merrill Lynch. Quantity of integrity I $ Income (in dollars) $ min $ max IcIc 2-18

Managerial Economics and Organizational Architecture, 5e Optimal Analyst Choice Two Different Compensation Plans Case 1 reflects the original compensation plan, while the compensation in Case 2 encourages the analyst to choose a higher level of integrity. Managers can motivate desired actions by establishing appropriate incentives. Quantity of integrity Income (in dollars) $ I Case 2 Case 1 $*2$*2 $*1$*1 I*1I*1 I*2I*2 2-19

Managerial Economics and Organizational Architecture, 5e Alternative Models of Behavior Happy-is-productive promote employee satisfaction Good citizen communicate, facilitate, and praise Product of the environment hire the right people Economic model change relevant costs and benefits incentives matter 2-20

Managerial Economics and Organizational Architecture, 5e 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 2-21

Managerial Economics and Organizational Architecture, 5e Risk Versus Return This risk-averse individual prefers higher expected value but lower standard deviation, a measure of risk. Standard deviation (in dollars) Expected value (in dollars) 81,650 $ $ Risk premium = $20, ,000 80, Increasing utility 2-22

Managerial Economics and Organizational Architecture, 5e Appendix Material

Managerial Economics and Organizational Architecture, 5e 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). 2-24

Managerial Economics and Organizational Architecture, 5e 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 –(MU C /MU F ). The absolute value of the slope is the marginal rate of substitution (MRS), which declines continuously along the curve. Quantity of Clothing Quantity of Food Indifference curve for 100 units of utility A (5, 20): MRS = 4 B (10, 10): MRS = 1 C (20, 5): MRS =

Managerial Economics and Organizational Architecture, 5e Income and Substitution Effects With budget line B 1 and indifference curve I 1, Tom chooses t 1. When food becomes more expensive, Tom moves to t 2. This includes a substitution effect (t 1  t’) and an income effect (t’  t 2 ). Quantity of Food Quantity of Clothing 25 F C t1t1 t’t’ t2t B1B1 B2B2 B’B’

Managerial Economics and Organizational Architecture, 5e 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. $600 $1,000$2,000 Leisure time (hr) Total income Budget line for wage = $10/hr. Budget line for wage = $20/hr. 2-27

Managerial Economics and Organizational Architecture, 5e Convexity of Indifference Curves Good X Good Y Perfect Complements Good Y Good X Perfect Substitutes Normal Case 2-28