ECON 600 – Economics of Organizations
and Management
Fall 2004
Mondays: Minneapolis
Terrance Murphy Hall 446
Professor Spry
Section 21
6:00-9:00pm
Tuesdays: St. Paul
Roach Center LL01
Section 5
6:00-9:00pm
Thursdays: Mall of America Section 86
Metropolitan Learning Alliance, Room C 6:00-9:00pm
Topic 1: Applying Economics to Management
Today’s agenda
Syllabus & introductions
The Nature of Economic Thinking
• Opportunity Costs
• Information and Incentives
• Marginal decision making
• Optimization
• The equimarginal principle
Very marginal group work
Consumer Behavior
Interwest HealthCare: p. 37
Topic 1: Introduction
Applying Economics to Management
Introductions:
Name/nickname, employer & position,
educational background, goals for a
managerial economics course…
Syllabus, Readings and Course Overview
Brickley, Zimmerman, and Smith
Moneyball by Michael Lewis
• Author of Liars’ Poker about bond trading at Solomon Brothers
Coursepack
Allocation of Class time:
• Lecture
• Small group work
• Discussions
• Review assignments
• Optional Presentations of Course Projects
A Systematic Approach to Managerial Decisions
People in both fields [stock market and
baseball] operate with beliefs and biases. To
the extent that you can eliminate both and
replace them with data, you gain a clear
advantage… Actual data from the market
means more than individual perception/belief.
The same is true in baseball.
John Henry (Boston Red Sox owner) as quoted in Moneyball
p. 90-91
A Systematic Approach to Managerial Decisions
Billy Beane has proven to be an exceptional general
manager of the Oakland A’s
• External environment:
Small market baseball team battling Steinbrenner’s Yankees and other
large market teams
• Exceptionally low costs
Beane spends about $40 million on 25 players.
Yankees spend $126 million + cost of adding payroll in deals
during the season, p.119
Ratio of payroll of 7 highest and lowest teams
• Baseball 4:1
• NBA 1.75:1
• NFL: 1.5:1
A Systematic Approach to Managerial Decisions
Billy Beane has proven to be an
exceptional general manager of the
Oakland A’s
• Outstanding product quality
Performance with Beane as general manager
1998
1999
2000
2001
2002
2003
2004
74-88
87-75
91-71 playoffs
102-60 playoffs
103-59 AL West Champs
96-63 AL West Champs
81-56 currently in first place in the AL West
A Systematic Approach to Managerial Decisions
The New England Patriots
• External Environment: Collective bargaining agreement sets firm limits
on all teams’ payrolls
• Outstanding product quality: Two super bowl victories
• Coach Belichick's college degree is in economics.
• “He (Belichick) seems to view every decision as a chance to perform
better cost-benefit analysis than his peers do. “ - NYT
• Hired a Brandeis MBA to provide economic and statistical analysis of
player personnel decisions.
The A’s compete in different markets than your situation.
• How do we take lessons from other industries or firms and apply only the
relevant strategies to our unique situation???
Moneyball should be enjoyable, light reading
Fundamental Concepts
People act in their own self interest
which is not the same as being greedy!
Information is asymmetric
we don’t all share the same information
assignment of decision rights must be compatible with access
to information
reward and evaluation systems must in turn be compatible
with decision rights
Adverse Selection – asymmetric information about attributes
of agents
Moral Hazard – self interested actions taken because another
party has insufficient information to monitor performance
The Nature of Economic Analysis
Formulating individual’s economic problem.
Objectives or goals
Constraints
-Benefits
-Costs
Optimization
Rational behavior by agents.
Consumers, firms, and government.
No unexploited profit opportunities.
Equilibrium
All agent’s optimal choices are compatible with the
other agent’s choices.
Course Overview
managerial economics and organizational architecture
Competitive strategy
•products and markets
•product characteristics
•production choices
•product pricing
•competitor behavior
Internal structure
•decision rights
(empowerment)
•compensation practices
•performance evaluation
Organizational Architecture:
The Three-Legged Stool
• The assignment of decision rights
within the firm
• The methods of rewarding
individuals
• The structure of systems to evaluate
the performance of both individuals
and business units
Four level of economic analysis of firms
Neoclassical
• Firm is a “black box”
• Profit maximizing choice of price and quantity
Industrial Organization
• Market structure and game theory
Contractual
• Minimizing transaction costs and using
information optimally
Organizational Incentive
• Principal-Agent Problems
Incremental Analysis
Should you go for it on 4th down??
What is the conventional wisdom for coaches
( managers) on 4th down??
The equimarginal principle
Should you go for it on 4th down??
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
If there is uncertainty, the expected value can be
maximized by taking an action if the expected
marginal benefits exceed expected marginal costs
He (Belichick) seems to view every decision as a
chance to perform better cost-benefit analysis than
his peers do. “ - NYT
“
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
Discussion
It takes 1 hr. to travel from New York City to D.C. by
air, but it takes 5 hrs. by bus. If the air fare is $55
and the bus fare is $35, which is cheaper for someone
whose opportunity cost of travel time is $3 per hour?
For someone whose opportunity cost is $5 per hour?
$7 per hour?
If you worked for Greyhound, what demographics
would you target in your marketing? Why?
Would you expect Greyhound ticket sales to increase
over the next 10 years? Why or why not? What does
this suggest about future demand for products and
services that help save time?
Tools for Optimization: The Derivative
Slope = Rise / Run
Derivatives let us calculate slopes for “funky,” nonlinear functions, let Y=f(x)
Tiny change in the exogenous (x-axis) variable from x1
to x2
we examine change in y=f(x) from f(x1) to f(x2)
f’(x)=f(x2)-f(x1)
----------------- when x1-x2 is tiny
x2 - x1
If f(x) = axb then f’(x) =abxb-1
Marginal Analysis
Optimizing performance
Image climbing Mount Everest
As you climb the slope is positive and it is hard to climb up a
positive slope
If you fall, you notice that the slope is negative and you don’t
need to work to roll down like Wile E. Coyote
Only on the top is the hill flat  slope=f’(x)=0
To optimize the value of f(x) it is necessary for
f’(x)=0
Benefits and Revenues
Total revenue (TR) are the total receipts from selling a
good.
Profit is total revenue minus total cost.
Marginal revenue (MR) is the increase in total
revenue from producing another unit of a good.
Marginal cost (MC) is the increase in total cost from
producing another unit of a good.
Optimization: Profit Maximization
Price is a function of the quantity the firm sells.
P = d(Q)
The derivative of d with respect to Q is negative.
d’(Q) < 0
Mathematics of Choosing How
Much to Produce
The firm’s total revenue (TR ) equals quantity
times price.
TR = QP
TR = Q*d(Q) =TR(Q)
Marginal revenue is the derivative of total
revenue with respect to Q.
MR = TR’(Q)
Optimal Choosing How Much to
Produce
The firm’s total cost of producing goods is a
function of quantity.
TC = TC(Q)
Marginal cost is the derivative of total cost with
respect to Q.
MC = TC’(Q)
Mathematics of Choosing How
Much to Produce
Profit equals total revenue minus total cost.
Profit = TR – TC
To maximize profit, set its derivative equal to zero.
TR’(Q) – TC’(Q) = 0
TR’(Q) = TC’(Q)
so
This equation says that marginal revenue equals
marginal cost.
Special Case: A Price Taking Firm
A price taker faces perfectly elastic demand.
Marginal revenue equals price for a price-taking
firm.
The firm maximizes profit so that marginal cost
equals price.
P = TC’(Q) = MC(Q)
The equimarginal principle
The equimarginal principle: If an activity is
worth doing at all, it should be pursued until
the marginal benefit of the activity equals the
marginal cost of the activity.
For businesses: If a firm decides to produce at
all, it maximizes its net benefit by producing a
quantity for which its marginal benefit equals
its marginal cost.
Choosing a Quantity to Produce
•Let the New Kids on the Block Record Company face the
following demand and costs
•New Kids can sell all the CDs they want for $12 per CD
•The total cost of producing CDs is 2q2, where q is the
quantity of CDs produced.
•What is the optimal price quantity of NKOTB CD’s to
produce to maximize this firm’s profits?
Choosing a Quantity to Produce
Quantity Price
1
2
3
4
5
6
7
8
9
10
11
12
12
12
12
12
12
12
12
12
12
12
Total
Marginal
Revenue Revenue
12
12
24
12
36
12
48
12
60
12
72
12
84
12
96
12
108
12
120
12
132
12
Total
Cost=2Q^2
2
8
18
32
50
72
98
128
162
200
242
Marginal Profit=TRCost
TC
2
10
6
16
10
18
14
16
18
10
22
0
26
-14
30
-32
34
-54
38
-80
42
-110
Profit =12Q-2Q^2
0=12-4*2Q=12-4Q  12=4Q Q=3
Marginal Revenue=12 = 4Q = Marginal Cost
Discussion: Run this business
Mikaela Ziegler, 7, and her 4-year-old sister, Annika
run a refreshment business in St. Paul. They can sell
as much pop as they want for $1.00 per unit by the
fair each year.
Total cost are 0.1x2 , x=number of units sold
How much should they sell? (What is the best x?) At
what price? What are annual profits?
Discussion: Now there is a $60 annual license
fee in St. Paul
Mikaela Ziegler, 7, and her 4-year-old sister, Annika run
a refreshment business in St. Paul. They can sell as
much pop as they want for $1.00 per unit by the fair
each year.
Total costs are 0.1x2 + $60.00 Annual License
How much should they sell? (what is the best x?) At
what price? What are annual profits?
Should ACME Inc, discontinue gadget production?
Income Statement
Widgets
Gidgets
Gadgets
TOTAL
Sales
$120
$160
$70
$350
Less:
$70
$90
$55
$215
Allocated
overhead
$40
$40
$40
$120
Net
contribution
to profit
$10
$30
-$25
$15
Variable
costs
Overhead of $120 is allocated equally to each product.
On a full cost basis gadgets are sustaining a loss.
Vulcan Steel
Vulcan Steel is the only manufacturer of steel in
Rexville.
Trade barriers make it impossible for foreign
competitors to import steal into Rexville.
Vulcan sells steel for $680 per ton domestically.
The world price of steel is only $375 per ton.
The average cost of producing steel at Vulcan is
always at least $400 per ton.
Should Vulcan consider exporting steel? Or should it
focus on the profitable domestic steel market?
Consumer Optimization
Objective: Utility = f(Food, Clothing)
(what assumption is inherent in this expression?)
Indifference curves
show more preferred bundles to less preferred bundles
Constraint: Budget constraint
Shows limits on feasible consumption bundles
Utility Maximization:
Maximize Utility subject to the budget constraint
Indifference curves
Given a utility function U=f(X,Y)
Indifference curves portray the marginal
tradeoffs between X and Y that maintain a
constant U
Indifference curves
diagram
The budget constraint
I  PfF + PcC
which can be rearranged as
F  I/Pf - (Pc/Pf)C
and this can be drawn as …
The budget constraint
diagram
Shifting the budget constraint
Changing a price
Combining indifference curves and the budget
constraint
Changing the price of food
Hypothetical constraint at Merrill Lynch
Optimal Merrill Lynch analyst choice: two different
compensation plans
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
Discussion: Interwest HealthCare, p. 37
What are the potential sources of the problem?
What information would you want to analyze?
What actions would you recommend to increase
the accuracy of data entry?
How does your view of behavior affect how you
might address this assignment?
Looking Forward
Read
Managerial Economics Chapter 3
Moneyball
Lincoln Electric (A) and (B)
Navy Turns Into Auctioneer, WSJ
Its Just a Game, NYT
Lincoln Electric Questions
• Identify the objective and subjective components of the evaluation
system.
• How did the subjective components of the evaluation system add to the
integrity of Lincoln's rewards/evaluation scheme?
• What value-enhancing decisions and behaviors were motivated by
Lincoln’s rewards/evaluation scheme?
Navy Questions
• Why does the Navy care about whether sailors like their location?
• Should this program be terminated or expanded into other services?
Boxes Ltd. in isolated Sunrise Beach Texas
Shrinking working age population
Problems with hiring enough workers, despite $10
per hour wage (twice local going rate)
Needs to increase hours worked to meet its growing
demand for boxes and production targets.
The new manager launched a daily overtime wage of
$15 per hour for hours worked in excess of 8 per
day?
Why did the new manager institute the overtime plan
instead of simply raising the wage rate in an
attempt to attract more workers to the firm?