Economics and the Business Manager
What is Economics all About?
Mention the word “economist” and one conjures up a vision of an academic who scours over macroeconomic data and utilizes sophisticated statistical techniques to make forecasts. Indeed, many economists do just that. But some people may be surprised to learn that economics is a social science, not a business science. Like psychology, sociology, anthropology, and the other social sciences, economics studies human behavior. That includes consumer behavior, firm behavior, and the behavior of markets.
In its simplest form, economics is a study of how human beings behave when they cannot be at two places at the same time. If you take a job that requires extensive travel, the income and opportunities for advancement come at the expense of spending time at home with the spouse and children. No matter how badly you may want the career opportunity and still spend quality time at home with the family, you cannot have both. You’re going to have to choose. The idea that we cannot have all the things we want is called scarcity, and it plays a role in every decision we make; not just financial decisions, but nonfinancial ones as well. Do you want to stay up late to watch the ballgame on TV if it means you won’t get a full night’s sleep? Do you want to read the financial pages on the Internet or watch your son pitch in the Little League game? Scarcity forces us to lay out our opportunities, prioritize our activities, and choose accordingly.
Consumers do the same with their incomes. They cannot spend the same money twice, so scarcity (in the form of a finite income) forces them to determine what they can afford, prioritize the possibilities, and decide what to purchase and what to do without. The latter point, “what to do without,” is relevant to both spending decisions and the uses of one’s time. As long as you cannot be at two places at once, whatever you choose implies the alternatives you must forego. Likewise, because you cannot spend the same money twice, each purchase decision you make implies those you cannot make. Economists refer to this as opportunity cost. In understanding human behavior, most economists will acknowledge that opportunity cost is the most critical concept in decision-making.
Let’s begin with a simple example of the role of opportunity cost in business: negotiating the price of a new car. Most consumers dread negotiating with the salesperson. They assume the salesperson has superior information and will take advantage of them. In fact, the salesperson and customer are negotiating to find a mutually beneficial price; the final act of negotiating is more an act of cooperation than confrontation.
When a consumer decides to buy a new car, he recognizes that monthly car payments supplant the purchase of other goods and services he values. Moreover, the better the car, the higher the price, and the greater the opportunity cost. Opportunity cost helps him determine how much he is willing to spend on a car, and what types of vehicles fall within that price range. Once he decides on a vehicle, it’s time to sit down with the salesperson and negotiate. The critical element of negotiating is recognizing that both the buyer and seller have alternatives. The seller doesn’t have to sell to you. But if the salesperson sells the car to you, he cannot sell it to someone else. The opportunity cost of selling the car to you is the foregone profit he would earn by selling the car to someone else. This represents the lowest price he will accept in a deal. As a prospective buyer, you can go elsewhere. If you buy from this dealer, you will not buy the car from another dealer. Thus, your opportunity cost of buying from this dealer is the price you could likely obtain from a competing dealer. This represents the maximum price you would ever pay to this dealer.
Assume you’ve staked out the inventories at competing dealerships, you’ve determined your willingness to trade away options for a lower price, and you’ve researched dealer cost and average regional sales prices through the Internet. You have a good idea of the opportunity cost of buying from this dealer. This represents the maximum you would be willing to pay this dealer for the car. The dealer’s costs and the price he expects to get from other prospective buyers represent his opportunity cost of selling to you, and it serves as his minimum price. The price that drives the deal necessarily lies between the opportunity costs of the buyer and seller and will be mutually beneficial.
Let’s review that last point again, as it will prove to be the crucial point in understanding the marketplace. All transactions between a buyer and a seller are mutually beneficial. If either party believed it would be worse off by making the transaction, no transaction would take place. Thus, to make a profit, your firm must make an offer that’s at least as attractive to the consumer as the available alternatives. In essence, then, the only way to maximize profits is to attract the consumers’ money; to offer a product and price that’s at least as desirable as those he would forego if he buys from your firm.
What Does Economics have to Offer to the Business Manager?
Economics studies how individuals deal with scarcity. The theory of the firm is based on the notion that firms seek to maximize profits, but must deal with constraints that inhibit their profitability. The constraints incorporate the opportunity costs of those with whom you wish to do business. The most obvious constraint that confronts a firm is the cost of production. Without production, the firm has nothing to sell, and production costs money. Your firm is going to need workers to produce your good. They expect to be compensated for their time and effort. Clearly, higher salaries for your employees mean less profit for the firm. How much, at a minimum, must you pay them? The wage needed to attract labor is driven by opportunity cost. If an individual works for you, he cannot work for someone else. Hence, if you want to hire a worker, you must offer a salary that’s at least as good as what he can get from another employer. The salary does not necessarily have to be identical to what competing employers offer. If your workplace is especially unpleasant or dangerous, you may have to pay a premium to lure the individual to your firm. At the opposite extreme, if your work environment is unusually pleasant or offers desirable perks, you may not have to match competing salaries to attract a workforce. The salient point is that, whatever salary you offer, it’s going to be driven by the opportunity cost of the employees you seek to hire.
The same is true for the suppliers of your raw materials. Any item they sell to you cannot be sold to someone else. If you want their business, you must offer a price that’s at least as attractive as what they can get from another firm. Note that when it comes to hiring workers or buying materials from prospective suppliers, the opportunity cost of doing business with you drives the wages and prices you must pay.
Beyond the costs of production, the firm’s actions are constrained by the opportunity cost of the consumers. From their perspective, the price implies foregone goods and services from other firms. Thus, when consumers see your price, their first instinct is to determine whether they can lower the opportunity costs by buying the identical product at a lower price elsewhere. As a result, the more substitutable your good is, the less flexibility you have in setting a price.
Suppose your good has no identical substitutes. You may have the only BMW dealership within 100 miles of town. Does that give you market power to set a price of your own choosing? Not really. The consumers don’t have to buy a BMW; they can buy another make of car. As the only BMW dealer in town, you’ll have more flexibility in setting a price than if there were several BMW dealers in the region, but as long as consumers can find close substitutes, the opportunity cost of purchasing from you will still influence the price you can charge.
But what if you have no competitors of any kind? To begin with, it’s difficult to imagine many circumstances in which no substitutes exist. If you owned every car dealer in town, the consumers may deal with out-of-town dealers. If you owned every dealership in the world, consumers might consider buying a bicycle. The price-setting power for the firm increases as the ability to substitute becomes more distant. But the opportunity cost of the consumer still affects the price even if no viable substitute exists. Even without substitutes, the customer doesn’t have to buy your product. He can choose simply to do without. Thus, even when no apparent substitutes exist, the opportunity cost of the buyer creates boundaries for the price.
It should be obvious that there are innumerable obstacles that can get in the way of profitability, and economists dedicate themselves to studying how profit-seeking firms deal with these constraints. And that’s what economics has to offer the business manager. Managers have to the deal with the threat of competition, legal constraints, changing consumer tastes, a complex, evolving labor force, and a myriad of other obstacles. The essence of economics is to determine how to deal with the forces of nature that get in the way of the firm’s goals.
But what does economics, or more specifically, managerial economics, have to offer that cannot be found in other business disciplines? Managerial economics should not be viewed as a substitute for other business disciplines. Rather, it serves as the theoretical foundation for the other disciplines. Whereas other business disciplines may tell a manager what to do, the managerial economist will rely on his background as a social scientist to tell you why. A top-selling marketing textbook may list and describe several pricing strategies. A managerial economics textbook will explain when they will work and when they will not. A finance textbook will teach you how to discount future after-tax cash flows to their present value to make capital budgeting decisions. A managerial economics textbook will explain the market forces that will help the manager project the after-tax cash flows as well as the interest rate that should be used to discount the projected income stream.
How Does this Text Differ from Managerial Economics Textbooks?
Now there’s a good question! Before I pursued a PhD in economics, I had an MBA and several years of experience with a Fortune 500 company. When I completed the doctorate and began my academic career, I spent many years teaching managerial economics to my MBA classes and became quite familiar with the array of textbooks. Along the way, a family member enrolled in an MBA program and I had a chance to re-familiarize myself with the standard MBA coursework. I began to realize how useful the other courses were, but how useless the managerial economics textbooks were. Not that economics didn’t have anything to offer the business manager, rather, most managerial economics textbooks sidestepped issues that business managers would deem useful, and devoted significant space to topics that were far too abstract or esoteric for the manager to use. Indeed, in a survey of over 100 business programs accredited by the Association to Advance Collegiate Schools of Business (AACSB), 54% of the respondents described the economics courses required in their programs as either “unpopular” or “very unpopular.” The most common reasons for their lack of popularity were that the economics courses were “too theoretical” (30%), “too difficult” (23%), and “too quantitative” (21%).1
None of this surprised me. Most managerial economics textbooks devote an inordinate amount of space to elements of the theory of the firm which, although useful to economics as a social science, are of minimal use to the practicing business manager. Virtually all managerial economics texts, for example, demonstrate that if a firm wishes to maximize production subject to a budget, it will allocate its resources such that the marginal rate of technical substitution is equal to the ratio of input prices. Confused? Would it help if I drew a graph and showed that production would be maximized where the isoquant is tangent to the ratio of the price of labor relative to the price of capital? I didn’t think so. I’ve yet to hear someone from the business community say to me “Boy, I’ve been sitting on these isoquants all these years, and I never knew what to do with them until I took a course in managerial economics.”
The criticism that managerial economics is too quantitative also rings true. There’s nothing wrong with quantitative tools. Indeed, MBA programs teach a great number of tools that can help the business manager make better decisions. I teach statistical tools in my managerial economics class that I think will be very helpful to the manager. But what’s the point in teaching quantitative skills that business managers will never use? Most managerial economics texts place special emphasis on using algebra and differential calculus to make pricing and output decisions. Curiously, textbooks in the other business disciplines fail to include the use of algebraic equations and calculus to make decisions; in fact, many specifically advise against attempting to do so. To that end, it seems rather illogical to devote time and space to quantitative skills that do not translate particularly well to the real world of the business manager.2
The purpose of my contributions to the economics series for Business Expert Press is simple: to bring microeconomic theory into the world of the business manager rather than the other way around. If an element of theory has no practical application, there is no reason to discuss it. Further, if an economic concept does have practical value, it is incumbent upon me to repackage it to suit the manager. In short, my intent is to expound on microeconomic theory that can be taken back to the office and put into use.
Is it necessary for a manager to have a background in economics to read this text? The answer is “no.” My objective is to help managers make better decisions, not to preach to economics majors. I assume that many readers may have had a course or two in microeconomics, and some of the more basic concepts may already be familiar to them. But I’ve written the textbook under the assumption that some readers may never have had an economics course before. For them, it will be necessary for me to start from scratch. Of course, there may be more than a few readers who have had an economics course in their distant past (like during the Dark Ages) who have long forgotten what they’d been taught, and may welcome a quick primer on the more basic concepts.