Managerial economics and organizational architecture 5e ch002

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 addition

Managerial Economics and Organizational Architecture, 5e

Chapter 2: Economists’

View of Behavior

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

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

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

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?

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

• 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

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

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

Indifference Curves Diagram

25 16

U=20

2-10

The Budget Constraint

P I

P I

F

LO P I

LO

P I

Original Constraint Higher Income

Lower Income

The Budget Constraint Diagram

HI C

P

I

LO C

P I

C P I

Original Constraint Increase in the price of clothing

Decrease in the price of clothing

line, and lower prices

produce a flatter line.

2-14

and the Budget Constraint

This individual is best

off by choosing point

C *

F

C

Original Constraint Constraint after increase in the price of food

F * 1

Changing the Price of Food

An increase in the price

of food changes the

optimal choice In this

example, the amount of

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

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

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

$ * 1

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

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

i

i V p V

Risk Versus Return

80,000

1 2

3

Increasing utility

2-22

Appendix Material

With clothing purchases held constant at 10, the marginal

utility of food is 10 (the slope of the utility line).

2-24

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 –(MUC/MUF) The

absolute value of the slope is the marginal rate of substitution (MRS),

Income and Substitution Effects

With budget line B1 and

indifference curve I1, Tom

chooses t1

When food becomes more

expensive, Tom moves to

B1

B2 B ’

50 70.6

2-26

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.

100 Budget line for

wage = $10/hr.

Budget line for wage = $20/hr.

Convexity of Indifference Curves

Perfect Substitutes Normal Case

2-28