Economic analysis is composed of a collection of scientific principles (we call them theories) and analytic tools for solving business problems and puzzles. It is a way of thinking about economic puzzles. Why did customers stop buying from us? How is it that firms pay some workers more than others for the same work? How can we best slow down the horrid habit of smoking? Why does the economy seem to stagnate at time, and then go through periods of rapid expansion?

Economics looks at business and situations in society and asks Why is this Happening? Demand is dropping off for our product. WHY? The economy is losing jobs. WHY? Women don’t make as much as men. WHY? Most bookstores closed in Harvard Square. WHY? Doctors make more than teachers. WHY? Retailers use coupons, but auto dealers don’t. WHY? Minorities are disproportionately undereducated and incarcerated. WHY? Health care services are more often used in Florida than in Minnesota. WHY? Economists are very curious people. When they see variations across groups, locations, types of organizations, they ask WHY? They look for reasons. Systematic reasons. Reasons that hold up in other similar situations. Reasons that can be tied to behaviors of people, consumers, businesses, or government. Economic theories lay out such behaviors (consumers of books stopped going to bookstores because internet shopping saved them time).

Economics is not like other management courses; it is a social science, where researchers test and ‘prove’ theories about the way the economy works. Then these theories are part of the body of knowledge to be “used” to answer questions and solve puzzles. There is a body of such knowledge relating to the way the entire economy behaves: what causes the economy to grow, to shrink, to create jobs, to fight inflation, etc. This is called Macroeconomics. The body of knowledge we call Microeconomics attempts to predict behavior of individual economic actors (firms, workers, shoppers) and the consequences of their interaction: how market prices are determined, how wages are determined, and business decisions are influenced by circumstances around them changing (competitors raises price, resources becoming more expensive, new technologies appear, foreign competition increases, etc.).

In microeconomics there are a number of basic principles we rely on to understand these kinds of choices of ‘micro’ units with regard as to how they manage their assets (time, capital, other private property) and to predict the impact of related policies of government:

1. scarcity and economic choice
2. specialization and exchange
3. marginal decision making

In a narrow sense, economics helps us understand behavior of entities and relationships between them, and why differences in behavior and result can exist. Most economic relationships we want to focus on are of the following types

1. For some groups of consumers or group of producers, why do variations exist in how they behave or how much they achieve? What kinds of relationships explain the systematic patterns we see in these variations? Economic theory helps explain this stuff.
2. For all economic entities, what happens when circumstances change? What kinds of relationships between entities and their circumstances that can help us explain the effects of change on the fortunes of the economic entities? How do behaviors relate to circumstances? Economics explains this stuff too.
3. Historically, microeconomics was concerned about the forces that determine price or value of various things in society using market-based theories in most of these circumstances. This works in situations where people are choosing to exchange private property.
4. Modern microeconomics also tries to explain choices made by persons who are inside groups or inside firms where private property is not being exchanged. In such situations, persons still choose to work hard, or not, and they cooperate or they don’t, and so forth. Game theoretic models of economic choice are used to examine these situations and help economists understand how to alter behavior using incentives or other means.

In a broader social sense, economics shows/explains how it is possible that social harmonization can result from unorganized, self interested behaviors of people and firms acting according to the three principles above. This is a basic tenant of western political economy that generally advocates capitalism and individual liberty. It is all rooted in the work of Adam Smith and his rejection of the prevailing view that society would crumble if people were left to their own selfish, animalistic tendencies. Modern political economy now stresses (in the west) the roles of capitalism and individual liberty as the key to achieving economic gains, and wherein the proper role of government is regulating/guiding the free markets and liberty of the individual in those circumstances where the “invisible hand” does not result from private property and free markets (eg where markets fail).

Economics explains relationships by using testable ‘theories’. They are of the form “if this situation X presents under these circumstances, then we can expect that Y will occur”. These theories are basically oversimplifications of the actual relationships being represented. One well known and quite robust theory says that “ when the consumer notices that price of something they intend to buy has gone up, they will buy less of it”. This “theory of demand” is usually true under a wide range of circumstances, but it is not always true. Sometimes, prices of other products change at about the same time, and our prediction isn’t true. Or maybe a recession intervenes and appears to “disprove” our theory. Sometimes, for some products, consumers are so ignorant of the product that they look at price as an indicator of product quality. Under these circumstances higher prices cause more to be sold, not less. So, the circumstances are important.

Theories and the models of economic relationships from which they stem are offered in several ways in this course. Models (stylized situations that offer simplifications of reality in order to isolate key relationships) are shown in ways like:

• Graphical models (depicting market situations, where transacting buyers and sellers determination of equilibrium price).
• Game theoretic models (characterizing situations of codependence or rivalry between individuals)
• Mathematical models ( Where it may be that demand is characterized by an equation such as Y=MX + B)

Economic models are used to examine and understand the way relationships work that connect the fortunes of entities with each other, with their circumstances, and with change. Microeconomics gives us a way of thinking about these relationships. The predictions of these models are theories—- they may be proved true or false (if price goes down, people will buy more) . Some of these theories of the relationships are bad, and don’t predict what really happens. Others are better. Studying these ways of framing the relationships gives us a power to connect the dots about the important relationships and how they may be working. Economics is basically a tool kit for studying relationships.

Economists keep revising their theories based on continuous testing against the real world. The way theory is used to explain economic relationships is exactly the same thing that people to when they are trying to examine the results of other kinds of relationships. “what can be expected to happen to that kind of person under this sort of circumstance”. As more and more data is collected, the theories get perfected. The theories concocted about life and relationships by a group of 15 year olds are not as refined as those of a group of 25 year olds.

Economics provides a basis for systematically analyzing (making general predictions) about how competitors, customers, markets, prices, profits and other things will respond when circumstances change. It provides a framework for thinking about what the consequences might be of taking a business action, or what the consequences might be if you don’t. Yes, it includes a bunch of concepts (demand, supply, prices, normal profits, marginal cost, etc etc) and includes some calculations too (contribution margin, elasticity, breakeven point, etc.). But, the main thing for you to get out of the course is the application of these concepts to sorting out common business problems. To improve shrinking profits, should we be considering raising or lowering our prices? What primary factors might we focus on to assess why wages for a position in one of our plants are higher than the same position in another plant? Under what circumstances should we agree to accept a one time offer by a customer to buy our product at a bargain price? It does not give us rules or exact answers to such business questions. Instead, economics gives us frameworks and approaches for thinking about these and other business problems. It provides a way of reasoning. This is the main reason you are here.

Economics is the general science behind the business disciplines of Marketing and Strategy.

This is not a math or statistics course either. Yes, economics uses concepts that can be calculated (like the profit margin as a %, or other concepts). And, advanced economic research uses math to formulate new theories and to test them to see if they are able to explain the real data. But here, in this class, we use math mainly to compute concepts or metrics measurements. The importance of economic training is not the computations anyway (anyone could be trained to do the math on a calculator). The important part of this course is the economic reasoning you will learn. If, for example, we know how steep the demand curve is for our product (something we measure and call elasticity of demand) then we know through economic theory how changes in price will translate into revenue changes for the firm. This can be important in decision making. Economists do not carry around calculators. And, they don’t spend their time creating formulas on their computers. For the most part, they are useful to business by doing economic analysis (research) to help management make better decisions by helping managers frame their thinking about business issues.

Economics is basically a stark simplification of the complex realities of the economy and all the stakeholders who participate in it from consumers, successful businesses, investors, regulators, entrepreneurial hopefuls, and others. Economic theory is too simplified (abstract, unrealistic, overly simplified) to be a guide to operating a real business. The subtleties of a particular business environment including product attributes, customer expectations, competitor behavior, regulatory issues, and other details are too specific, and management must be guided by a myriad of information much more detailed than could ever be included in economic theory. So why bother with this course? Economics provides a way of thinking strategically (long term) about markets, products, resources and competitors. It helps problem solvers cut through the complexities and data to focus quickly on the powerful strategic forces often underlying business performance; (1) demand theory is used to explain how and why consumers behave when they have fixed time and incomes, and face choices in the marketplace; (2) production and cost theory explains how businesses compete in the marketplace when they face different competitive circumstances for getting resources and for selling their products. (3) human capital theory is used to understand the priority forces at work as people make decisions about jobs and education, and as firms decide who to hire to optimize investments in OJT, among other things. (4) decision analytic concepts that help us to see the choice issues confronting interdependent decision makers such as the principal agent problem, the prisoners dilemma, the tragedy of the commons, moral hazard, and others.

Successful business leaders don’t need to study a lot of economics. They already understand their customers, their competitors, their suppliers, and their circumstances in a way that could never be described by economic theories. Their knowledge about circumstances and how it influences their fortunes is extensive and detailed. Their knowledge of the behavior of their competitors and their customers and how they will respond to each other and to management actions is not abstract, but almost clinical, and very personal. Business people generally understand most of the business relationships that matter as they relate to their products and markets. Though, they rarely understand costs very well, and often hire consultants to do special studies. But, in general business leaders know more about their businesses than an economic theory could ever explain. But the frameworks of economic decision-making, and some of the tools, may help members of the management team sharpen their analytic abilities and get noticed faster.

 

Economic Analysis

 Economics does not tell the business what to do, or what the salary should be for a job, or what the price should be for a pack of cigarettes. It is not a prescriptive science. Economists would say it is not generally normative in nature, but is mainly value free. There is a branch of economics that does aim to study how society can get the “most for the least” or the biggest bang for the buck. This is called “welfare economics” and it is used to compare the performance of different ways markets might be operating, or functioning.

Mostly, we want to focus here on understanding economic analysis; how to analyze data and situations from an economic perspective. There are a number of analysis techniques we will study.

1. Comparative static analysis — this is the name given for making predictions about the consequences of events or changes on outcomes like prices, wages, production levels, and on who wins, and who loses. This is the analysis technique that will allow you to understand how things you read in the newspaper are going to effect your business or the U.S. economy.

Comparative statics is about making predictions about the direction of change, or movement, and it is NOT about forecasting the levels or magnitude of result. It is essentially qualitative not quantitative.

This technique is based on the concept of a market (an abstract notion of how buyers and sellers of things in the economy interact to determine things like prices and the amounts of goods traded) and how the markets will respond to some change. Making predictions it is like a thought experiment, where we imagine how the change that is happening will work itself thru the economy of buys and sellers. We will conclude, for example, that a huge western demand for special Ethiopian coffee beans will:

• cause the prices farmers are paid for these beans to rise
• which will cause the amount of land farmers devote to the production of such beans to rise (and less land will be devoted to producing other crops)
• which will cause the prices paid by consumers of the other agricultural crops to go up in Ethiopia
• which will result in some people not being able to afford to buy the products any longer, and some increase in malnutrition and starvation in the country.

This rather harsh result is only one avenue of impact of the western interest in Ethiopian products. Other lines of impact would conclude that new jobs will be created in the country, people will move to locate in the places with those jobs, and incomes will rise, rents will go up in those places, and a lot of people will be better off. Both scenarios, and others, can be spun as predictions stemming from somebody in a Starbucks research lab concluding that the Ethiopian blend is a good bet for a hot seller.

These predictions about the linkages and impacts of some change are what comparative statics does. You will learn to do it too. It is based on understanding how “markets” work, and how markets adjust to perturbations.

2. Demand Analysis

Demand analysis is a collection of tools to help understand and measure the quantitative impacts of customer behavior on the quantity a firm can sell at particular prices. Topics considered here are demand and other elasticities that measure the responsiveness of demand to price, income, and other product prices. Demand (own price) responsiveness is essentially a measure of customer loyalty. This topic also looks at price discrimination (market segmentation). Demand analysis is a foundation for marketing and pricing.

3. Cost Analysis

Cost analysis provides tools for measuring unit costs and making business decisions based on unit costs. The categories of cost we consider important are marginal (incremental), variable and fixed. Economic cost analysis is not a replacement for good, rule based accounting practice. Rather, it is a set of concepts and techniques for using accounting data to make decisions.

4. Forecasting and Time Series Analysis

Forecasting is something that happens a lot in organizational and business planning. Mechanisms for doing it range from simple projection methods, to sophisticated model building to systematic review of pundits on the web who are paid to worry about what’s happening in a segment of industry.

5. Profit and Risk Analysis

Profit is a key source of financing for most enterprises. And, it is a key entrepreneurial signal in the economy, predicting where investor’s capital will be flowing. That flow, the lifeblood of capitalism, depends on level of risk and return for investment alternatives. Understanding ways to analyze profit variances is important and will the Dupont identity, beta (a measure of risk, or profit variability) and over-under value of P/E ratio of stock.

6. Explaining Variances

Managers learn much of what they know by analyzing variances. When they see differences in unit costs across suppliers, or different levels of loyalty across segments, or differing profitability across retail outlets, or differences in labor productivity across lines run by different managers — they ask WHY? What it means is not always easy to determine. But what is clear is that variances like these are symptoms of poor organizational performance. Variances always mean that eliminating them will improve performance. Always. We will see how techniques like regression analysis can be used to find the underlying explanation for otherwise unexplained variances.