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 The Nature of Opportunity Costs • 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 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 F Quantity of Food 25 16 U=20 U=8 16 25 Quantity of Clothing C 2-10 Managerial Economics and Organizational Architecture, 5e Changing a Price F I PF Quantity of Food 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 Increase in the price of clothing Original Constraint Decrease in the price of clothing I PCHI I PC I PCLO C Quantity of Clothing 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 Points on curve are preferred but infeasible Quantity of Food F F* C* Quantity of Clothing C 2-15 Managerial Economics and Organizational Architecture, 5e Changing the Price of Food F Original Constraint Quantity 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 Constraint after increase in the price of food F*0 F*1 C C* Quantity of Clothing 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 $ $max Income (in dollars) 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 $min I Ic Quantity of integrity 2-18 Managerial Economics and Organizational Architecture, 5e Optimal Analyst Choice Two Different Compensation Plans Case reflects the original compensation plan, while the compensation in Case encourages the analyst to choose a higher level of integrity Managers can motivate desired actions by establishing appropriate incentives Income (in dollars) $ $*1 $* Case Case I * I * Quantity of integrity 2-19 I 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: E (V ) piVi • The amount of risk is measured by the standard deviation of the value of the outcomes: SDV pi (Vi V ) • 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 Expected value (in dollars) $ Increasing utility 100,000 Risk premium = $20,000 80,000 81,650 2-22 Standard deviation (in dollars) $ 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 Quantity of Food Indifference curve for 100 units of utility 20 A (5, 20): MRS = B (10, 10): MRS = 10 C (20, 5): MRS = 25 5 10 20 Quantity of Clothing 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/MUF) The absolute value of the slope is the marginal rate of substitution (MRS), 2-25 which declines continuously along the curve Managerial Economics and Organizational Architecture, 5e Income and Substitution Effects With budget line B1 and indifference curve I1, Tom chooses t1 When food becomes more expensive, Tom moves to t2 This includes a substitution effect (t1t’) and an income effect (t’t2) Quantity of Food F t’ 70.6 50 t1 t2 B2 B’ B1 C 12.517.7 25 Quantity of Clothing 2-26 Managerial Economics and Organizational Architecture, 5e Income Effects in Labor Supply Leisure time (hr) 100 Budget line for wage = $10/hr 60 40 Budget line for wage = $20/hr $600 $1,000 $2,000 Total income 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 2-27 Managerial Economics and Organizational Architecture, 5e Good X Perfect Complements Good Y Good Y Good Y Convexity of Indifference Curves Good X Good X Normal Case Perfect Substitutes 2-28 ... 80,000 81,650 2-22 Standard deviation (in dollars) $ Managerial Economics and Organizational Architecture, 5e Appendix Material Managerial Economics and Organizational Architecture, 5e Tom’s Utility... 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... 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