Chapter 19

Ten Critical Concepts

In This Chapter

Remembering economic decision-making’s fundamental elements

Avoiding errors by knowing essential concepts

A great line from the movie Kung Fu Panda is “there’s no charge for awesomeness.” In this chapter, I cover ten of the most awesome economic concepts — and there’s no extra charge. Remembering these critical concepts when making economic decisions helps you avoid bad decisions. And what’s really awesome is that you have just ten of them to remember!

Opportunity Cost

Every economic decision incurs a cost. Reading this sentence means you’re giving up the opportunity to do something else — perhaps watch television. Decision-making is all about weighing alternatives, so it’s critical that you recognize the opportunity cost associated with your decisions.

Opportunity cost is the cost of a decision measured by the next best alternative given up. An important condition in this definition is the best alternative. You don’t have to evaluate every possible alternative; you simply need to think about the best alternative. As you make managerial decisions, you need to compare the decision you’re making to its best alternative. For example, if you select the low bid contractor, you need to consider what you’re missing or losing that the second-lowest bid would have offered. Obviously, the lowest bid is cheaper, but perhaps the second lowest bidder does better and more timely work. You must recognize the opportunities you miss if you decide to go with the lowest bid.

Opportunity cost affects how much you pay for inputs. During a recession, a lot of workers are unemployed, and college graduates have trouble finding jobs. Some graduates consider themselves fortunate to have one job offer. When you offer a graduate a job, the graduate’s opportunity cost of taking your job is very low (because they don’t have any competing offers), so you don’t have to pay as much. On the other hand, if unemployment is very low, each graduate may have numerous offers. Therefore, the opportunity cost of taking your job is much higher because the graduate is comparing your offer to other offers that may pay more. The applicant expects to be paid more.

One critical opportunity cost managers sometimes forget is the opportunity cost of money — interest. If you decide to hold cash, you give up the opportunity to earn interest. Similarly, if you invest cash to renovate a business, at the very least, you give up the opportunity to earn interest by saving.

Opportunity costs also include nonmonetary costs. Nonmonetary costs include things like the different levels of supervision in two alternatives, different levels of stress in the two alternatives, or employee morale. Quite frequently, these nonmonetary costs become monetary costs, such as when experienced employees quit due to low morale.

Supply and Demand

Supply and demand is a great example of the KISS principle: Keep It Simple Silly. In some ways, the silly here applies to economists who have developed lots of very complicated theories describing price determination. However, the basic idea of the price-quantity relationship is embodied in demand and supply. As price goes up, customers buy a smaller quantity — their quantity demanded decreases. This relationship is represented by the downward-sloping demand curve. On the other hand, as price goes up, producers provide a larger quantity — the quantity supplied increases. An upward-sloping supply curve represents this relationship.

Consumers and producers want exactly the opposite thing: Consumers want low prices, and producers want high prices. Demand and supply determine a compromise price — what economists call the equilibrium price. The equilibrium price corresponds to the point where the demand and supply curves intersect. At the equilibrium price, the quantity demanded determined off the demand curve is exactly the same as the quantity supplied determined off the supply curve. At the equilibrium price, the quantity consumers want to purchase exactly equals the quantity producers want to sell. Everyone’s happy.

The most important aspect of the demand and supply relationship is what happens when the price is not at equilibrium — a situation where the price is too high or too low. If your price is too high, a surplus exists; you want to sell more of the product than customers want to purchase. Because you have a surplus, your inventories grow, and you should lower your price. It’s time for a sale. As you lower price, consumers want to buy more, so your inventories start to go down. At the lower price, you’ll also want to produce less because you can’t sell the good for as much as you thought you could.

If your price is too low, customers want to buy more than you have to sell. This situation leads to a shortage, and you have very little product available to sell; it has already been bought. You should raise price in this situation. As a result, customers will want to buy less at the higher price (quantity demanded decreases), while you will want to provide more (quantity supplied increases). These changes in quantity demanded and quantity supplied eliminate the shortage.

Although customers want to purchase less of your product at the higher price, it really doesn’t matter because you weren’t producing enough to sell to all of them in the first place. Think of a restaurant with a very long line of waiting people — this represents the shortage. Some people may walk away because they have to wait too long. If you raise the price of a meal, your waiting line is going to be shorter, but that doesn’t matter if all your tables are still full. You don’t make money by people waiting.

The Price Elasticity of Demand

The law of demand states that consumers purchase less of a good at a higher price. This scenario is the general relationship. You also need to know how responsive quantity demanded is to a price change. When you raise price a little, does quantity go down a little or a lot? The price elasticity of demand measures how sensitive consumers are to price changes.

The price elasticity of demand, η, is simply a number that compares the percentage change in quantity demanded divided by the percentage change in price:

But be careful with this formula; it works only for very small percentage changes in price.

The larger the price elasticity of demand, the more responsive customers are to a price change. This situation is an elastic demand. When you raise price, you lose a lot of customers. Quantity demanded decreases a lot more than price increases, and, as a result, your sales revenue decreases.

Conversely, the smaller the price elasticity of demand, the less responsive customers are to a price change. This is an inelastic demand. As you raise price, quantity demanded decreases by a very small amount; you lose very few customers. Because the decrease in quantity demanded is a lot less than the increase in price, your sales revenue increases.

Three factors make demand more elastic — a large number of substitutable goods, goods that cost a large proportion of income, and a longer period of time for consumers to adjust to the price change. If these factors apply to your situation, be careful about raising price. An elastic demand doesn’t mean you shouldn’t raise price and sell a smaller quantity; it simply indicates that in order to increase profits, your cost savings associated with selling a smaller quantity would have to be greater than the revenue you lose.

Utility Maximization

Everybody wants to maximize satisfaction — what economists call utility. However, everybody is constrained by the amount of income they have and how much various goods cost. (Even Bill Gates has constraints, but I digress.)

In order to maximize satisfaction, you want the additional satisfaction, or marginal utility, you get from the last dollar’s worth of a good to be equal for all goods. Therefore, utility maximization requires that the marginal utility per dollar spent be equal for all goods — goods a, b, c, and the rest of the goods’ alphabet.

The great thing about consumer behavior is you can influence it. Your advertising increases the marginal utility — I assume you have good advertising — and you obviously control the price you set. If you want customers to buy more, simply increase their marginal utility or lower the price.

Marginal Revenue Equals Marginal Cost

In order to maximize profits, the additional revenue you obtain from the last unit of the good sold, marginal revenue, must equal the additional cost of producing the last unit, marginal cost. The output level where marginal revenue equals marginal cost maximizes profit.

To find the profit-maximizing output level, you simply need to find the point where the marginal revenue and marginal cost curves intersect or cross. That’s it; it can’t get much simpler. Awesome!

Mutual Interdependence

Your decisions affect others. That comment seems obvious enough, but too often, managers forget this simple rule. Think of a major highway intersection with two gas stations: yours and mine. I decide to lower the price of gasoline by 2 cents a gallon in order to steal your customers. Clever strategy — and it doesn’t take much of a guess to think that you quickly respond by lowering your price 2 cents. So we both end up making 2 cents less a gallon for the gasoline we sell. I wish I’d thought of mutual interdependence.

With mutual interdependence, incentives matter. If you’re motive is to increase your happiness, you respond to expected cost and benefits. As Adam Smith said long ago, appealing to the baker’s self-interest by buying bread is a lot more likely to get you bread than relying on the baker’s charity. And because incentives matter, you and I respond to changing net advantages that our interactions generate. Thus, mutual interdependence leads to mutual adjustment as incentives change.

By recognizing mutual interdependence, you can avoid unintended consequences. Unintended consequences are outcomes you didn’t anticipate. For example, asking your colleagues to put a “rush” on a project may get the project done, but it also can lead to them not wanting to work with you. That’s an unintended consequence you don’t want.

Risk

Everybody loves to take chances, and people often take chances without thinking about them.

As a manager or entrepreneur, you have to make decisions given an uncertain future. If you make well-informed decisions — that is, you correctly anticipate the future — you’re rewarded with profit. On the other hand, bad decisions lead to losses.

Risk falls into two types:

Insurable: With insurable risks, you can accurately estimate the frequency of occurrence. Fire, natural disasters, theft, and accidents are all examples of insurable risks. In the case of insurable risks, you can pay a fee — insurance premium — to avoid the potential losses. You don’t have to take these chances if you buy the insurance.

Uninsurable: Uninsurable risks are uncontrollable and unpredictable. These risks change your revenue and costs in ways that you can’t anticipate. Because you can’t anticipate these risks, insurance companies don’t offer policies on them. They’re insurance companies, not casinos (although, to be honest, casinos are a great example of “insurable” risks).

There are three sources of uninsurable risks. First, structural changes occur in the economy. Consider how the world has changed because of cellphones. As just one example, consider how Kodak’s success depended on old technologies for taking pictures. Kodak has suffered tremendous loses because the new technology has made their products obsolete, or at the very least, less desirable.

A second source of uninsurable risks are changes in the general economic environment — think national or global recession. When the housing market collapsed, construction companies lost business with fewer new homes being built. Similarly, the resulting recession caused a significant decrease in new car purchases resulting in losses and layoffs in the automobile industry.

Finally, government policy changes. For example, a local government grants an exclusive contract to a private company for trash collection. Hopefully, it’s your company and not a rival. Or, the federal government reduces a tariff on imports. Domestic firms producing the same good face greater competition.

If you successfully anticipate and prepare for these uninsurable risks, your firm earns greater profit.

Externalities and Rent-Seeking

Markets work well — awesome! Not perfectly — shucks! Externalities refer to situations where some of the benefits or costs spill over to nonparticipants in the market transaction.

Positive externalities exist when the nonparticipant receives a benefit. Honey is an example of a positive externality. The beekeeper takes care of bees in order to collect honey for sale that customers purchase. The beekeeper and customers engage in a market transaction. However, even though I don’t buy honey or keep bees, I benefit from a positive externality as the bees pollinate the flowers in my garden. I receive a benefit without paying the beekeeper anything.

A negative externality exists when a cost is imposed on the nonparticipant. When the beekeeper’s bee stings me while I work in my garden, that’s a negative externality. A more important example of a negative externality is pollution. Frequently, government tries to reduce negative externalities through taxes or regulation.

Rent-seeking occurs when someone seeks to gain special benefits from government at taxpayers’ or someone else’s expense. Examples of rent-seeking include getting special tax incentives or tariff protection from cheaper foreign goods.

Present Value

Do not confuse a dollar today as being worth the same as a dollar one year from now. Time is money!

Time matters because you can use the money you have today to earn interest. A dollar today will be worth $1.05 one year from now if the interest rate is 5 percent. And you would much rather have the $1.05 than $1.00 next year. (Okay, the nickel may not matter much, but what happens if you’re considering a $10 million investment that won’t start generating revenue for three years?)

The time value of money and present value are especially important in investment decisions. But they are also important with accounts receivable — the money you’re owed. In a big business, letting invoices go unpaid for several months can represent big losses in potential interest earnings.

The present value of money is determined by the formula

where PV represents the present value, Rt – Ct represents the net revenue or cash flow in year t, i represents the interest rate, and t represents how many years in the future you’ll receive the net revenue.

Calculus

I’ve saved the best for last — calculus. Okay, calculus may not be the best, and I’ve made my share of jokes about calculus in various sections of this book. Nevertheless, many situations are simply too complicated to analyze with two-dimensional graphs. Business decisions, even when simplified, can involve many variables. Normals enable you to specify more variables in the decision-making process.

After you have an Normal with multiple variables, calculus is the tool that enables you to optimize the Normal in order to maximize profit, minimize cost, maximize sales, and so on. And even better, calculus allows you to use a Lagrangian function (see Chapter 3) — and a Lagrangian is sure to impress any boss or significant other. (My wife still wonders what I do at work when I say I’ve been using Lagrangians all day.)