Lecture 1 The Elements of Theory ■ Overview ► Microeconomic Theory Macroeconomic Theory Macroeconomic Theory

Economic Principles for Managers (what is behind what we will study) 1. The Role of Managers Is to Make Decisions 2. Decisions Are Always Among Alternatives 3. Decision Alternatives Always Have Costs and Benefits 4. The Objective of Management Is to Increase the Firm's Value 5. A Firm's Value Is Measured by Its Expected Profits 6. A Firm's Sales Revenue Depends on Demand for Its Product 7. A Firm Must Minimize Cost for Each Level of Output 8. A Firm Must Develop a Strategy Consistent with Its Market 9. A Firm's Growth Depends on Rational Investment Decisions 10. Successful Firms Deal Rationally with Laws and Regulations

Theories A part of the modern world Why use theories? They enable us to -Simplify-Organize -Speak the same “language” ■ They are simplified representations of the world ■ Everybody uses them ► Maps ► Crossing the street ■ The essentials of a good theory ► General ► Useful

Try navigating without a map – a tool that you follow carefully and consistently or you get lost.

More on methodology ■ Positive vs. Normative ► Positive: What is ► Positive: What is ► Normative: What should be ► Normative: What should be ► We stay with positive analysis as much as possible ► We stay with positive analysis as much as possible ■ But a theory can be wrong! ► Why complain if it will put a man in space? ► Why complain if it will put a man in space? ► It takes a theory to beat a theory! ► It takes a theory to beat a theory! ► New learning improves theories. ► New learning improves theories.

Let’s Use Accepted Science Example: Organics What is strychnine? What is strychnine? A toxic organic chemical. Many people believe organic chemicals are safer than inorganic (synthetic) chemicals. But, in the science of chemistry, chemicals are chemicals.

Believe what you want … but try to distinguish science from opinion “ Organic advocates operate under the pre-scientific delusion that substances produced by living organisms aren’t really chemicals, but just organic constituents of nature…. No approved crop pesticide, organic or not, has any detectable effect on the health of consumers. The premium paid to purchase organic foods is based on mythology, not fact.” Lee Silver, Prof. Molecular Biology, Princeton Univ.

The Essence of Economics ■ We live in a world of SCARCITY ► Limited resources ► Unlimited wants ■ Scarcity means: ► Choices must be made ► Something must be given up to obtain something else ► People, not society, choose ■ Scarcity creates conflicts ► Conflict or competition due to scarcity is among the demanders and among suppliers, not between demanders and suppliers

Competition Is everywhere and always ■ Scarcity means resource allocation must occur: How? Many ways possible: Lottery; need; contest; force; markets. All produce different results. ■ Competition cannot be avoided ► The form depends on the rules ► Objections to the rules common - Different rules favor different parties - Different rules favor different parties ► People respond to the rules (incentives) they face

Economic Cost: Highest valued foregone alternative ■ Every choice means a cost ► Something is given up - sacrificed ■ Opportunity cost ► The value of what is sacrificed ► The value of what is sacrificed ► The cost of any choice is the best opportunity sacrificed. It is the best (highest-valued) alternative not taken. ► The cost of any choice is the best opportunity sacrificed. It is the best (highest-valued) alternative not taken. ■ We assume people act as if they understand the costs of their actions. Decisions are rational in the mind of the decision-maker.

Remember Opportunity cost is the value of the most valuable alternative that must be forgone to undertake a given act. In decision making, we must look at opportunity cost rather than book costs. That is, we must look forward rather than backward.” Opportunity cost is the value of the most valuable alternative that must be forgone to undertake a given act. In decision making, we must look at opportunity cost rather than book costs. That is, we must look forward rather than backward.” Charles G. Koch, CEO Koch Industries, Charles G. Koch, CEO Koch Industries, p. 33, “The Science of Success”

Self-Interest Economic theory presumes that people are resourceful and maximizing. Decisions we observe in markets and organizations come from individual actions. People make decisions in their own best interest, given the constraints they face. People economize—based on what is most of interest to them. P.S. This seems to work pretty well as a model in the workplace when dealing with others.

Most Decisions Are at the Margin Much of what we do is concerned with marginal costs and marginal benefits. Much of what we do is concerned with marginal costs and marginal benefits. We are rarely in a position of a total change—most decisions affect margins. A little bit more or a little bit less. We are rarely in a position of a total change—most decisions affect margins. A little bit more or a little bit less. Example: Yahoo has learned that a very small change in the location of an icon for a search box results in millions more or fewer searches. Example: Yahoo has learned that a very small change in the location of an icon for a search box results in millions more or fewer searches.

Economic Postulates We assert these to be true 1. Every person desires many goods 2. For every person, some goods are scarce 3. Every person must sacrifice some good a to get more of other goods (people weigh Marginal Costs and Marginal Benefits) 4. As the consumption of a good rises, the total value rises but at a diminishing rate (diminishing marginal value) 5. People have different preferences 6. People are innovative but consistent, so we can make some sense of what we observe in the world

Questions about the Very Basics: True or False: 1. We cannot care for all humans the same. 2. The cost of a week of vacation is measured by the price we pay for the hotel, food and travel. 3. Friendship is scarce.