Microeconomics

for Decision
Making
Dr. Jorge Mendoza

Session Content
Basics of Microeconomics: Method and
scope
How competitive markets work: supply
and demand
The theory of demand
Cost functions and the theory of
production
Demand estimation (time permitting)

What is Microeconomics?
Seeks to explain the behavior and activities of specific
economic units individuals, households, firms,
industries, and resouce owners.
Seeks to explain and predict such things as:
1.The prices and outputs of particular firms and and
industries,
2.The choices of consumers in buying goods and services,
3.The drivers of technological change, production
efficiency and costs,
4.Competitive behavior and government regulation and
5.The adjustments of markets to new conditions.

The Economists Approach

The economists approach to making sense of
everyday economic events involves:
1.Discovering good reasons why economic events
happen as they do,
2.Carefully weighing more-or-less sound economic facts to
arrive at more-or-less plausible cause-effect
relationships,
3.Developing formal economic theories,
4.Building empirically based economic models.

Economic Thinking Abstractions

Economists think in terms of abstractions by reducing
reality to the relationships that are important and that
bring the inquiry down to manageable proportions.
Therefore the analysis will lack a certain degree of
realism.
But theories and models are not acceptable according
only to their degree of realism.
Their power to explain events in the real world and to
make correct (conditional) predictions are more
fundamental criteria.

Economic Thinking Rationality

Economics assumes that individuals are rational in the
sense that they prefer more satisfaction (subjectively defined)
than less.
Moreover, individuals will use their resources to achieve the
highest or at least a minimum level of satisfaction, given the
relevant environmental constraints and their resources.
This does not mean that individuals are necessarily cold,
calculating machines, who always pursue selfish interest
with perfect precision.
The kamikaze pilot, the religious hermit, the drug dealer and the
philanthropic millionaire act rationally by maximizing their
satisfaction given their preferences, resources and constraints.

Economic Thinking Values

The economists approach tends to be (but not always) amoral
Positive economics deals with explanations of real
phenomena
Normative economics deals with desirable economic
results or behavior of economic agents (axiological view of the
world)
Economics analyzes criminal behavior, drugs markets,
prostitution, or religious behavior, as economic phenomena. It
does not judge them.
Trying to eliminate undesirable behaviors may lead to costly
regulation (prohibition of alcohol, drugs and pornography).

Is it necessary to choose between

theory and practice?
To make a business decision, you simply have
to be able to forecast the implications of
your actions, and that is precisely what a
theory does. Therefore, the choice a manager
faces is not really between theory and no theory
but between a carefully articulated, internally
consistent (ideally, empirically verified) theory,
or a shoot-from-the-hip, go-with-your intuition
theory
Brickley, Smith and Zimmerman, Teaching the Economics of the
Organization. Financial Practice and Education, Fall / Winter 1999.

What is a theory?
A theory is a statement predicting which actions will lead
to what results and why. Every action that managers
take, and every plan they formulate, is based on
some theory in the back of their minds that makes
them expect the actions they contemplate will lead
to the results they envision. Butmost managers
don't realize that they are voracious users of theory.
Good theories are valuable in at least two ways.
First, they help us make predictions Second, sound
theories help us interpret the present, to
understand what is happening and why. Theories
help us sort the signals that portend important
changes in the future from the noise that has no
strategic meaning.
Clayton M. Christensen & Michael A. Raynor. Why Hard-Nosed Executives Should Care
about Management Theory. Harvard Business Review, September, 2003.

Why is it important to learn applied

Microeconomics?
To make sense of the events in your firms industry and
markets.
To understand the conduct and strategic behavior
patterns of:
-

Your firms suppliers

your firms buyers
your firms competitors
your firms partners
the government regulation
your firms stockholders and top management
your firms employees and executives.

To support your ideas and proposals about the firms

strategic alternatives and decisions.

Specific decisions that require the

tools of applied Microeconomics
A) Evaluation & selection of industries or sectors to
invest in or to divest from.
B) Definition of the vertical & horizontal frontiers of the
firm.
C) Selection of technologies & inputs.
D) Pricing policies and decisions.
E) Competitive and cooperative relationships with
competitors, customers and partners.
F) Designing the organizations architecture (structure)
and strategy.
G) Selection of the evaluation systems for the individual,
group and divisional performance.
H) Defining the incentive and monitoring systems in the
firm and between the firm and other organizations.

Can we infer a cause-effect

relationship from observing a
close correlation between two or
more variables?
This is a major source of mistakes in
firms when executives try understand
business phenomena !!
Lets watch a short video (causeeffect)
from the movie Freakonomics

Brickley, Smith, and Zimmerman, Managerial

Economics and
Organizational Architecture, 4th ed.

Chapter 1: Introduction

Determinants of architecture

Design Principle:
form follows function.
Changes in the business
environment will affect
business strategies and,
hence, the firms
architecture: Its decision
making authority,
performance evaluation,
and incentivecompensation systems.

Organizational Architecture
Systematic approach to identifying and
correcting organizational problems.
Three critical aspects of organization: the
architecture
Assignment of decision rights
Methods of rewarding individuals
Performance evaluation of individuals and
business units

Three legs of the stool

Fundamental concepts
People act in their own self interest

which is not the same as being greedy!

Their interests are generally different or even contrary to those of
their firms or organizations.

Information is asymmetric

we dont all possess or share the same information.

Oportunistic behavior may be incentived when information is

asymmetric and individuals and organizations objectives differ.

The implications for Architectural Design:

assignment of decision rights must be compatible with knowledge

and access to information.
reward and evaluation systems must in turn be compatible with
decision rights.
Evaluation systems should be designed to reduce information
assymetries.
All three elements of organizational architecture should promote
decisions oriented to create and capture value for the organization
while respecting ethical standards.

The Economic Perspective

How are resources allocated among
competing uses?
in society
in the firm

How do individuals make decisions?

the role of incentives
incentive conflicts and opportunistic behavior

Mechanisms for Allocating

Scarce Resources
Markets

Sells labor

Buys product

Household
division of
labor

Buys labor

Sells product

Hierarchical
decision
making

Role and functions of prices

Coordination
Incentives
Rationing
Signaling