Introduction to Business Economics

Business Economics

Business economics is defined as the study of how businesses manage scarce resources. Microeconomics is the study of the decisions of individuals, households, and businesses in specific markets, whereas macroeconomics is the study of the overall functioning of an economy such as basic economic growth, unemployment, or inflation. Scarcity in microeconomics is not the same as poverty. It arises from the assumption of very large (or infinite) wants or desires, and the fact that resources to obtain goods and services are limited.

• wants exceed resources necessary to obtain them
• therefore we must make choices
• every choice leads to a cost

Principles of Economics:

1. People face trade-offs.

Every decision involves choices, and more of one good means less of another good. Income and wealth are not limitless, since there is only so much time available. Trade-offs apply to individuals, families, corporations and societies.

2. Cost of something is what you give up to get it.

When we make a decision we implicitly compare the costs and benefits of our choices. Opportunity cost is whatever must be given up to obtain something. Some costs are obvious – out-of-pocket expenses; other costs are less obvious but must be included in total opportunity cost.

3. Rational people think at the margin.

Basic economics assumes that people act rationally and try to act so as to gain the most benefit for themselves compared to the associated costs. Microeconomics focuses on small or marginal) changes, and it is often rational to consider the marginal rather than the average effects of decisions.

4. People respond to incentives.

If rational people compare costs and benefits, then changes in either one may change decisions. An example of an incentive that people respond to, are changes in prices. In general, people are more likely to buy something if it is cheaper. If an action becomes more costly, then there is an incentive to switch to other choices. Note that all actions have substitutes.
Sometimes people will encounter emergencies with costs that are beyond the cash they have available. In these situations, they may consider getting a cash advance to ease the pressure of liquidity in the present.

Explicit costs vs. Implicit costs

The cost of something, say a business, includes both the explicity cost (usually the price) and the implicit costs. One major implicit cost is the opportunity cost. Opportunity costs includes the next best opportunity given up. Only actions have costs; if there are no choices, then there are no costs. Be aware that cost is subjective. For example, compare the psychological benefit of a new computer. Decide whether you would rather have the a vacation to Europe, or a brand new computer.
Another example is in credit card comparison. Some people might only compare the annual fees, but you should compare the added benefits and features too. Certain features may be more valuable to you and be worth the cost, while others may be more valuable to another individual.

Disagreement in Economics

Business economics is both a science and a study of policy – united by a common “way of thinking”. As a science, economists develop models and deliberately simplify accounts of how cause and effect work in some part of the economy. Based on assumptions of what is important, models are created and used to make suggestions about policy and improve basic economic outcomes. Policy involves decisions about scientific theories, personal values and particular circumstances.
Positive statements are claims about what the world is like, although they may be false. For example, "Minimum wage laws cause unemployment". Normative statements are claims about how the world ought to be, and are based on values as well as positive knowledge. For example, "The government should raise minimum wage". Economists may disagree over either positive or normative statements or both, but the great majority tend to agree over basic positive propositions. As such, most disagreements are over normative/policy issues.

Public Goods

Public goods include things such as fireworks displays, and basic research. According to basic economics, a free market is unlikely to provide enough public goods, due to the “free rider” problem. A free-rider is a person who consumes a good without paying for it. Public goods create a free-rider problem because the quantity consumed is not directly related to the amount paid. As a result:

• there may not be enough incentive to pay for public goods through individual action;
• you cannot be prevented from consuming the good even if you do not pay for it and;
• it creates an external benefit on those not involved.

Business economics state that we can decide how much of a public good to produce, by considering a cost-benefit analysis of public goods. The total benefit is equal to the total dollar value that an individual places on a given level of production of a public good. Total Cost is what we must give up to get more of the public good. These are often difficult to calculate - especially the benefits. For example, what is the benefit of saving a human life, and what is the benefit of more flowers in the downtown?
Once we decide on the benefits, then we want to provide enough of the public good to maximize net benefits. That is, total benefits - total costs. The private market will usually not produce enough of a public good. However, it is often done by government because it can compel everyone to contribute through taxes.
The problem is not that people are selfish, per se, but the free-rider problem. If some people do not voluntarily contribute, others who do contribute will feel that it is unfair and may stop contributing as well.

Common Property Resources

These resources include clean air, oil pools, congested roads, fish, whales and other wild life. The problem here is that it is hard to exclude people, but one person’s use reduces that of others'. Over-use of these resources is sometimes dramatically referred to as, "Tragedy of the Commons". This tragedy refers to the common grazing rights in medieval England, in which:

• all families could graze sheep on the common land which was collectively owned and;
• as population and number of sheep increased, common land became over-grazed.

People did not reduce their use, because social and private incentives differed. Each individual’s best move is to get as much of the resource as possible before it is gone. The social optimum is to restrict use. The problem is that each individual creates a negative externality by reducing amount available to others. A few possible solutions were:

1. Custom or regulations could put a maximum on how much each family could use the resource;
2. They could have internalized the externality by auctioning off rights to graze and;
3. They could have created private property rights.

Property Rights

Economists realize that property rights are very important for efficient use of resources. When an individual owns and controls the resource, they have an incentive to increase its value. When everyone owns a resource, or rather, no one owns the resource, there is no one to charge for use, or who can attach a price. An example of such, is air that we breath.

For some goods we can establish property rights, like the pollution permit. For other goods, like national defence or clean air, the government can improve the outcome by regulating or providing the product.

Theory of Consumer Choice

Consumers face trade-offs in their purchase decisions, since their income is limited and choices are numerous. In order to make choices, consumers must combine budget constraints (what they can afford), and preferences (what they would like to consume).
A budget contraint, means what a consumer can purchase is constrained by income. The slope of the budget constraint measures the rate at which one consumer can trade off one good for another, and the relative prices of the two goods. Budget constraints are determined by both the income of the consumers, and the relative prices.
If a consumer equally prefers two product bundles, then the consumer is indifferent between the two bundles. The consumer will get the same level of satisfaction (utility) from either bundles. Graphically speaking, this is known as the indifference curve. This curve shows that all bundles are equally preferred, or have the same utility or same level of satisfaction. The slope of indifference curve is the rate at which a consumer is willing to trade one good for another, which is also known as the marginal rate of substitution (MRS).

Properties of Indifference Curves

1. Higher indifference curves are preferred to lower ones, since more is preferred to less (non-satiation).
2. Indifference curves are downward sloping. If the quantity of one goods is reduced, then you must have more of the other good to compensate for the loss.
3. Indifference curves do not cross (intersect), since this would imply a contradiction.
4. Indifference curves are bowed inward (in most cases). The slope of indifference curves represent the MRS (rate at which consumers are willing to substitute one good for the other). People are usually willing to trade away more of one good when they have a lot of it, and less willingto trade away goods which are in scarce supply. This implies that MRS must increase as we get less of a good.

Nota bene that two extreme examples exist. Perfect substitutes have straight-line indifference curves. As we get more of the good, we trade off with the substitute at a constant rate because we are indifferent between them (i.e. Coke and Pepsi). Perfect complements have right-angled indifference curves. If goods can only be used together, there is no satisfaction in having more of A without additional amounts of B (i.e. left and right shoe). In general, the better substitutes goods are, the straighter the indifference curve.

Consumers' Optimal Choice

We must combine what a consumer can obtain (budget constraint) and the preferences (indifference curve). The optimum is the highest point on the indifference curve that is still within the budget constraint. This will usually occur where the indifference curve is tangent to budget constraint. At the optimum point, MRS = relative prices of goods since MRS = slope of indifference curve, and relative price = slope of budget constraint. The marginal rate of substitution is the rate at which consumers are willing to trade-off, and is equal to rate at which they can trade.
Changes in income will undoubtedly affect the optimal choice. The budget constraint will shift parallel to the original - upwards for an increase in income, and downwards for a decrease in income. The new equilibrium for a higher income will be on a higher indifference curve, and since income is higher, more of both products could be consumed. For normal goods, as income increases, more of the good will be preferred. For inferior goods, as income increases, less of the good will be chosen.

Changes in Prices

A change in price will change the slope of the curve. A fall in price will rotate the budget constraint outwards, and an increase in price will rotate the budget constraint inwards. Thus a change in price will change both the relative prices of the two products and also the amount that can be bought, ceteris paribus (income). Changes in price has two effects:

1. Substitution Effect
   • arises from the tendency to buy less of goods which are more expensive
   • can be measured by keeping satisfaction constant (stay on same indifference curve and finding where MRS = new relative prices
2. Income Effect
   • arises from change in price effect on total amount that can be purchased
   • change in consumption when we shift to a new indifference curve as a result of the price change