Managerial Economics

Week 6 -- Pre-midterm

2009-03-13T06:22:00.000-07:00

Relax. Take a deep breath. And another.

For many of you, this will be your first midterm; for some of you, this will set the stage for future academic greatness. For others, this is one of your last classes, the rumors have scared you enough that you’ve been putting this off until the last possible moment… and that’s ok.

Here is some advice for the midterm.

1) Take your time to understand each problem
Always understand what the problem is asking for; ManEc is unlike most of the other classes because there isn’t a set way to approach every problem. Indeed, if you’ve been coming to the Saturday sessions, I’ve been trying to push the fact that there are usually multiple correct ways to find the right answer. So whatever you do…

2) Show your work
Especially in this course, partial credit may make a significant impact on your grade. If your line of thinking is correct, logical, and can be followed, you will get some credit.

3) Don’t take this too seriously
This is for the FTers… given that it’s your first midterm, you may be anxious. Don’t be. After this is done, remember that there are 19 more classes to take including this one; even those gunning for McKinsey jobs will have at least 2 full terms of grades on the transcript (3 without an exchange) before interviews roll around in around a year. If you ace this midterm, there are plenty of grades to be had; if you fail, there is plenty of time to recover. That is the way of things.

Good luck! I’ll be pulling for you.

^_^

Week 5 -- Market Clearing Price

2009-03-13T06:21:00.001-07:00

This week was mostly a procedural review of the other concepts. However, one gem was introduced. A market clearing price is a price where the number of buyers = the number of sellers. That’s it. If a price is set too high, so that a person wants to sell but can’t find a buyer, or if it’s too low, so that a person wants to buy but can’t find a seller, then the price is NOT a market clearing price.

Notice that MCPs are probably the quickest and easiest way to find out which prices create competitive distributions. If a price is market-clearing, then we know the distribution will be competitive. We’ll be going over this on Saturday.

Week 4 -- Multilateral negotiation

2009-03-13T06:18:00.000-07:00

These words might sound frightening… Multi-lateral. Negotiation. They’re not English, or at least, they’re not really used that much on this continent or any others.

The meaning is straightforward, though. A multi-lateral negotiation (condensed hereafter to ‘multilateral’) is a negotiation with multiple buyers AND/OR multiple sellers AND the people are selling are all buying and selling the same thing. In other words, whenever you have more than 2 people buying / selling something, we call that multilateral. There are many more rules than bilateral (bilateral means 2 people), enough to make your head spin. This is because symmetry does not necessarily apply anymore (see below) because we have to add something called competition that affects the price ranges we can agree on.

If there is a greater number of buyers than sellers (or vice versa), then the potential exists for competition to play a role in the price that’s agreed upon. In other words, if there are three buyers and only two sellers, the three buyers might bid the price up of the single good that is being bought and sold in this multilateral negotiation. Think of an auction, or a reverse auction. If more people want the item being purchased and are willing to pay for it, the price will rise; if there are three basketballs being sold and only one potential buyer, the price will fall. That’s what the graph is talking about in the class notes; that’s what Sven was trying to prove with his Red card / Black card example in class. Only one catch…

Week 4 -- Law of one price

2009-03-13T06:17:00.000-07:00

If there are multiple sellers AND multiple buyers AND all the goods bought / sold are identical THEN the price of the good will be the same for every transaction. Notice this does NOT necessarily hold for monopolies with multiple buyers or sellers (though it might). Notice this is not exactly real life either… but it’s close enough that it’s one of the easier leaps of faith to make in this class.

Week 4 -- Pure Bargaining

2009-03-13T06:16:00.000-07:00

Bargaining is the only thing that affects the agreed upon price. In other words, competition has no role in the price you agree on.

Week 4 -- Pure Competition

2009-03-13T06:15:00.000-07:00

Competition is the only thing that affects the agreed upon price. In other words, bargaining has no role in the price you agree on.

This one’s a little harder to think about, but consider this; you need to buy a washing machine and are willing to pay $200 for it, but you have two friends who are moving out of country; each one wants to sell his washing machine and has a WTS of only $50. Your BATNA is 0; the price of a washing machine in the store is $200. Even though your WTP is $200, you’ll get one of the machines for $50, because you only want one machine, and your friends will bid each other down until the price reaches $50. Congratulations! You get all of the surplus, and your bargaining skills had nothing to do with it.

Week 4 -- Competitive Advantage

2009-03-13T06:13:00.000-07:00

This concept is not English, at least, not the English most people speak.

In this class, Competitive Advantage means that, if a person transacts, competition ensures that he or she is going to get some utility above and beyond his or her BATNA. In the washing machine example, you would have a competitive advantage, because the competition between the two sellers ensures that you’ll get $150 of utility. If you don’t transact? You’ll get your BATNA, which is less than that. But we say you have competitive advantage because, just by transacting, you're guaranteed some surplus. Simple, right?

Week 4 -- Monopolist and capacity restriction

2009-03-13T06:12:00.001-07:00

If a monopolist seller decides to restrict capacity, it’s possible that the competition generated by the overabundance of buyers might actually give the monopolist more profits than otherwise, even though the overall surplus may decrease. The same argument holds true for a monopsonist buyer. I am saying ‘may’ and not ‘will’ because it would depend on the various WTP and WTS of the various parties. Take a look at the monopolist example at the end of week 4’s lecture notes if you have any doubt.

Week 4 -- Competitive Distribution

2009-03-13T06:11:00.001-07:00

A distribution is competitive when everybody decides to do business together; nobody (or no group) could do better by going off on their own. Notice this is NOT real life; in real life, people go off on their own all the time. In this class, they do also (think BATNA)… but if they do, then we say the distribution is not competitive.

Week 4 -- Competitive Allocation

2009-03-13T06:09:00.000-07:00

The allocation of surplus. In a test question, if this comes up, Sven’s asking for the utility values of the various players. The terminology is rather vague, though; the notes use competitive distribution / allocation almost interchangeably so it’s always best to write out the entire allocation (or, distribution of value) every time he asks for one or the other.

Week 3 -- Bilateral Negotiation

2009-02-23T22:34:00.000-08:00

This week's concepts are pretty easy... there aren't any!

Just kidding. There's one: Bilateral Negotiation.

All this means is that two people (or parties, etc.) are doing business with each other. So if you go to your friend and sell him or her your textbook, this would be what we’re calling a bilateral negotiation; you’d have a WTS (your bare minimum to sell), and he or she would have a WTP, which would be the highest amount he’d pay (generally the cost of a new textbook, if it were his best alternative... we’ll get to this later).

Easy, right? Let’s keep going.

There are a few assumptions, which make some amount of sense;

1) We’re assuming the two people want to maximize the total happiness of the group (efficiency).

2) We’re assuming that people split the trade surplus (also called gains from trade) equally (symmetry).

3) We’re assuming that Added Value (AV) is important… but we’ll hold off on this for now and come back to it during multilateral negotiation.

Important concept! In bilateral negotiation, the value (or surplus) created = the value with the transaction minus the value with no transaction (not the difference between various trades we can make). This equals the individual values retained by each party without trade. Keep this in mind when solving problems.

The next concept in particular makes limited sense.

1) We’re assuming that we KNOW the other person’s WTP and WTS. Obviously this is false, but we have to use this for computational purposes.

In computing, we can use 3 methods, which are equally valid.

1) Find WTS, WTP, take midpoint (works only for Bilateral)
2) BATNAs (stands for Best Alternative To Negotiated Agreement).
3) Group decision tree

See below.

^_^

Week 3 -- BATNA

2009-02-23T22:32:00.000-08:00

When we do problems with BATNAs, we’re just saying that the surplus for the buyer = the surplus for the seller. In other words, the buyer and seller are better off by equal amounts (symmetry). That sum is what we’re trying to solve for.

So, Payoff for B – BATNA B = Payoff for A – BATNA A.

If you keep it this simple, it should give you the right answer every time. We hope :)

^_^

Week 3 -- Added Value

2009-02-23T14:14:00.000-08:00

All right. Added Value is in the homework. So we should put something up about that here.

Added Value is what we’d use when deciding how big of a group to form. In real life, this is sort of like… planning a trip to Tasmania, for instance. Say one of your ‘friends’ is miserable, mean to everyone, and will make everyone slightly upset during the trip. You wouldn’t invite him, would you? Probably not. In English, his added value would be negative. That’s sort of what we’re talking about, but not completely… This is one of those concepts that doesn’t quite make common sense.

In economics, the added value of a person is the value of the group’s payoff with him minus (the value of the group’s payoff without him + the value of the individual’s payoff). In other words, just like in WTP / WTS, our ‘group’ payoff includes everyone in our possible transaction. Here, it even includes the guy we’re not inviting to come out with us.

Here’s the example: Your mean friend would LOVE to come to Tasmania, and if he were to come with you, his happiness from the trip would be really high. Furthermore, if he was home by himself, he’d be absolutely miserable. You and your friends mind him, but not THAT much, so the group’s happiness is higher with him going to Tasmania. After all, if he were at home, the ‘group’ would be worse off, largely because your mean friend hates being home by himself and he counts as part of the group. Notice again that the group is defined as every person involved in the possible transaction.

Again, this will become a crucial concept in a few weeks when we’re talking about multilateral negotiation.

old problem sets

2009-02-21T15:18:00.000-08:00

Are no longer here! :-(

Copyright, and also we're trying to limit access for possible future students. Two reasons that unfortunately make good sense.

Still looking into a solution that makes everyone happy, will keep you posted. In the meantime, it might be a good idea... well, you know what I'm NOT saying :)

Have a good weekend, see you Tues.

^_^

Week 2 -- Marginal Analysis

2009-02-20T20:19:00.000-08:00

Welcome to the Week 2 recap!

The first concept we'll go over is Marginal Analysis. This one is tough to explain in a blog, but here goes…

When we’re deciding about work / production optimization, the important decision should be based on the revenue and cost of the last unit provided. The definition in the slide is REALLY GOOD and definitely worth looking at again.

But basically, all we care about is the actual costs that show up in one branch of the tree and not the other. So if a cost shows up in both sides, we can include it... or not!

For applicability's sake, in production, the cost of that last unit of production tends to rise with quantity. Considering the benefits and costs of only that last unit is how we optimize production. In the relatively simple curves we’ll see in this class, if the cost of producing an additional unit exceeds the revenue generated, do not produce it! It’s that easy.

However, if we haven't decided whether to produce, then we must ensure that any production makes some positive economic profit, otherwise it's better off to pursue your next best alternative.

Swing by the CUB tomorrow (1:30), we’ll go over this again if there’s time. Hopefully there will be.

Week 2 -- Willingness To Pay (WTP), Willingness to Sell (WTS)

2009-02-20T20:17:00.000-08:00

Dare I say it? This concept is one of my favorite and one of the most applicable. Somehow it works its way into conversation long after this course is over.

Say I really like guitars, and I want to buy a particular one. How much am I willing to pay for it?

Well, gee. In this course, the amount I’m willing to pay is called my Willingness To Pay (WTP).

What if I’m selling something, and I want some amount of money? The bare minimum amount of money I’ll take for something I’m selling… we’ll call this our Willingness To Sell (WTS).

Notice that WTP and WTS are NOT price… often, a buyer’s WTP is higher than a seller’s WTS, so surplus is created, which is a major part of our next topic of…

Week 2 -- Bilateral Trade

2009-02-20T20:12:00.000-08:00

The coconut / fish example we covered in class is a good example of some of the benefits of bilateral trade. We call it bilateral because there are only two parties involved; we’ll eventually get to multilateral trade, which has multiple buyers and multiple sellers. Don’t worry, it’s not that hard…

But we start here first.

First condition; A buyer’s Willingness to Pay (WTP) must be at least as high as a seller’s Willingness to Sell (WTS) – in English, this is the same thing as saying the buyer must be willing to spend at least the bare minimum the seller wishes to sell for. If the buyer values the thing more than the seller, then the buyer can buy and both people can be better off.

And that’s it. Concept’s easy, right? The amount of ‘better off’ is called surplus, and we generally measure this with something called utility, which is a measurement of happiness in dollars. Yes, you read that right; the economists measure happiness in dollars and cents.

Notice the price that's agreed on allocates the surplus between the two parties, but note that this price will create the same amount of surplus no matter what, as long as it's between the seller's bare minimum price (WTS) and the buyer's highest price (WTP). We'll go over this on Saturday in more detail.

Week 2 -- Discounting

2009-02-20T20:08:00.000-08:00

Another important topic (one that you’ll cover in greater detail in Finance subjects) is called discounting. We’ll keep this basic since the class example explained this pretty well.

Bascially, we’re assuming a dollar today is worth more than a dollar next year. This is true for a number of reasons, none of which are really central to this course. All you have to know is that, unless noted otherwise, the discount rate is equal to the interest rate (r). To get to the Present Value of the cash we will get in the future, use the simple formula

Present Value = Future Value / [(1+r)^n]

where n is the number of years and r is the discount rate. Future Value is the money (or equivalent) you'll have in the future, and the Present Value is how much that money is worth NOW.

That’s basically it; you need to know this for question 1 in this week’s homework. This concept is easy to understand but application intensive, and it will pop its head up throughout the course.

^_^

Week 2 -- Complements and Substitutes

2009-02-20T19:53:00.000-08:00

A complement is something that goes with something else; the value of both of these things together exceeds the sum of the values of each of the parts.

Yes, this sounds complicated. But all it’s saying is that a left shoe and a right shoe are complements; the left shoe by itself is pretty worthless, the right shoe by itself is pretty worthless, but having both shoes is worth something. Specifically, in order for the left and right shoe to be complements, the WTP for the pair of shoes must be greater than (WTP for left shoe by itself + WTP for right shoe by itself).

The opposite of this is a substitute; two goods are substitutes if they’re easily replaceable. In other words, having one of the two goods satisfies you, so you don’t need the other good as badly as before. An example might be a cane and a wheelchair (having a wheelchair means you may not need a cane), or perhaps contact lenses and glasses, since people tend to wear one or the other. If you are blind like me, your willingness to pay for either glasses or contacts would be astronomical, but once you have either a pair of glasses or a pair of contacts, you might not be willing to pay that much to have the other option available. In order for the glasses and contacts to be substitutes, the WTP for a set of glasses and contacts must be less than (the WTP for contacts by themselves + WTP for glasses by themselves).

Does that make sense? Comments welcome. We'll go over it Saturday.

Week 1 -- Questions on exercises

2009-02-14T19:02:00.000-08:00

If you have any questions about the Week 1 HW, keep in mind I can't answer specifics about it until after it's graded. But! I am more than happy to answer all other questions, either about the class example or practice problem set.

I'm attaching the two questions I've received so far as anonymous comments; if there are any other Qs about the practice problems, class example, please comment directly on the site.

^_^

Introduction -- The problem with Managerial Economics

2009-02-12T07:04:00.000-08:00

People tend to find ManEc difficult. Really difficult.

This is an understatement. In fact, some people do not understand the material after literally devoting tens or even hundreds of hours to its study.

It doesn’t have to be like this. There’s no reason for it.

ManEc is undoubtedly one of the toughest classes in MBS’s core curriculum. This is rather odd, because all the course tries to do is teach us a better framework for making decisions. That’s it.

At first glance, it doesn’t seem that hard… we already know how to make decisions, right? Obviously we do. We’re adults, and we’re bright… obviously! Only… it doesn’t work like that. Because although we’ve been making decisions all of our lives, and though most of these decisions turned out well, there might just be a better methodology to evaluate alternatives. Being a rational player, coming up with a best response… these ideas are extremely important, but they aren’t always the easiest to intuitively visualize. In fact, some of the things we’ll teach you won’t make sense… at least not at first.

And therein lies the dilemma in ManEc. In order to properly learn how to better make decisions and better evaluate options, we basically need to unlearn everything our experience has ever taught us about decision making and choosing between alternatives.

This is not easy, and many people have trouble doing this. The stubborn people tend to have the most trouble; ManEc teaches one point of view and leaves no room for others. This is not Managing People; there is usually only one right answer. I wish it were different, but it is not.

So my heartfelt advice is as follows; if you see a concept that initially doesn’t make sense, immediately think of ways how it might. Because in the end, the material WILL make sense, after your brain has a chance to wrap itself around the sometimes convoluted logic. Give your brain the freedom to do this, and you’ll be fine. You might even (gasp!) find the material engaging.

Yes, it is possible. This might actually become one of your favorite classes. It will definitely help you make better managerial decisions :)

^_^

Week 1 -- Opportunity Cost

2009-02-12T07:03:00.000-08:00

Ok. What exactly is opportunity cost?

The notes say it’s the ‘true cost of foregoing the value of the next best alternative,’ I say it’s just the cost of the missed opportunity... the one we've decided to not take. However you want to think about it, in practice, it goes something like this:

Imagine your job search goes well, and you are evaluating two job offers. You can either:

Work at BCG for $150,000
or
Work at JP Morgan Chase for $140,000

If you chose to work at BCG, your opportunity cost would be $140,000, because you’re essentially not taking advantage of JP Morgan Chase’s $140,000 offer.

Learn this using whatever words you want to, but make sure you know what this is. Opportunity cost is part of calculating economic profit, which is just one measure of how good our decision really is. A variation on this concept will come up in a few weeks when we study BATNAs, (or best alternative to a negotiated agreement, taken directly from Fisher and Ury’s Getting to Yes). If you’re having trouble with this idea, take the time to wrap your head around it now. And then keep reading.

Week 1 -- Economic Profit

2009-02-12T07:02:00.001-08:00

Ok. So we’ve gone over opportunity cost. What about Economic Profit?

This one’s simple; economic profit is simply the value of our choice minus the opportunity cost.

In the BCG / JP Morgan example, our economic profit would be the value of our BCG offer ($150K) minus the value of JP Morgan’s offer ($140K) = $10,000. Notice this is not how most people generally tend to measure things; most people would say Alex Rodriguez, the highest paid baseball player in America, makes an astronomical $30 million, not $30 million minus the second best offer he had on the table. No one would ever think this way… right?

Wrong. Here’s a better example:

Imagine you were lucky enough to get accepted into two MBA programs; Harvard and Wharton. Harvard charges $90,000 in tuition fees while Wharton charges $80,000. Harvard gave you a full-tuition scholarship. Tuition fees are the only discriminating factor (i.e. you'll will definitely go to the school that charges less tuition), and you value both schools equally. What’s the value of the scholarship… and how much economic profit does this scholarship lead to?

Many people would say the value of the scholarship is $90,000, because, well, that’s what it’s worth, right? Sure. After all, Harvard does charge $90,000 in tuition. But there’s more to it.

With a scholarship, you go to Harvard for free. Lucky you!
If there was no scholarship, you would’ve gone to Wharton at a cost of $80,000.

Do you see how you could argue that this scholarship only saved you $80,000... even though it might have been 'worth' $90,000? The $90,000 ‘value’ of the scholarship is not as important as the $80,000 you save because of the new choice that the scholarship makes available. This is the concept we're trying to teach.

The opportunity cost (i.e. the cost of the opportunity you left on the table by deciding to not attend Wharton) is -$80,000. The cost of attending Harvard = 0. So the economic profit = the value of our choice (0) minus the opportunity cost (-80,000). Crunching the math, economic profit = (0 minus -$80,000) for a grand total economic profit of $80,000. In qualitative terms, taking the scholarship means your costs went down (from $80,000 to zero), and that $80,000 saving is economic profit.

In the spirit of Managerial Economics, this $80,000 is actually what we're concerned with, because we're concerned with the choices we make relative to the other choices we have available. Yes, it may be backwards, and yes, it may be confusing.

But it will make sense, if it doesn't already. If it doesn't yet make intuitive sense, don't worry about it... instead stare at it, wrap your brain around it, dream about it… and get it to make sense because this idea is crucial to the course. Learn this concept as fast as you can. And then read on.

This idea of economic profit has limitations. The biggest one is that it's extremely hard to measure. Imagine talking about your salary relative to all the other salaries you might have in different jobs. It wouldn't make any sense, would it? Because in order to find out the salaries you might have as, say, a sports player or musician, a financier or consultant, you'd need to do some major research to find out what these salaries are, and somehow factor in the likelihood of getting the job in the first place. Crazy, right? But if we could do it, maybe we'd be able to better value our choices in a more applicable way.

It'll be our next topic. Decision trees.

^_^

Week 1 -- Decision Trees

2009-02-12T07:01:00.000-08:00

We covered this in class, and we’re going to cover it in detail during our first Saturday review session, so I’m only going to skim over it here. The most important thing you need to know:

The point of a decision tree is to help us make a decision.

Sounds obvious, right? But think about what that means. It means that while we care about the odds of getting hit by a car while walking to work, we care more about using these odds for something useful, namely, deciding whether it might be safer to drive, take the tram, etc. A decision tree, then, is a tool that classifies our choices in a way that helps us make a decision. That’s all it is.

Decision trees always start with a choice, i.e. a square node, also called a decision node. After all, the point of all this is to tell us which choice(s) to make. Circle nodes (defined in this class as nature nodes) give us nature’s chance selection of a particular outcome occurring.

I would use different words to describe ‘nature' nodes. When I think of nature, I think of trees and parks… especially since I associate these with decision ‘trees,’ which are in fact not trees at all. So I think it might be confusing. If I could, would call these nodes ‘random’ nodes, or something like that. As in, if you were trying to figure out whether to gamble, this node would tell you that a coin will randomly come up heads 50% of the time. If we put money in the stock market, we will gain money 60% of the time, that sort of thing. Each circle node contains a probability, which is random because we have no control over it… even though we have the choice as to whether we want to pursue the path.

Don’t worry about the terminology too much. In terms of designing a tree, take a look at the practice problems, and we’ll spend significant time on this during the first review session on February 21st. Bring your questions then, because they’re hard to answer in this forum.

^_^

Week 1 -- sunk cost, fixed cost

2009-02-12T07:00:00.000-08:00

These two ideas… well, they’re English words, but their meaning isn’t really the English we’re used to. And that’s what makes them hard.

We define them in certain ways; sunk cost is any kind of cost that affects the entire decision tree (not just a specific branch) with equal magnitude. In other words, any cost that makes every branch of the tree lower by the same amount is a sunk cost. The fizzie example in class was good -- we’ll cover this in person as well.

A fixed cost is generally used for cost allocation; it’s constant, regardless of the amount produced. An example of fixed cost is an ATM fee; the bank charges $4 no matter if you take out $50 or $500.

The point of these costs… the big picture idea is that the decision tree has to be written correctly, and fixed costs / sunk costs are a way to classify costs to help us do that. Many people get caught up in whether costs are sunk / fixed… although that can be useful to do, the main point is to be able to correctly map out a decision tree. As long as we can do that, we’ll be ok.

^_^