A Way to think about Ecomonic Business

Frank Knight was a wise professor. Through long years of teaching he realized that
students, even those in advanced business programs, beginning a study of
economics, no matter the level, face a difficult task. They must learn many things
in a rigorous manner that, on reflection and with experience, amount to common sense. To do that, however, they must set aside —or “unlearn”—many pre-conceived notions of the economy and of the course itself. The problem of “unlearning” can be especially acute for MBA students who are returning to a university after years of experience in industry. People in business rightfully focus their attention on the immediate demands of their jobs and evaluate their firms’ successes and failures with reference to production schedules and accounting statements, a perspective that stands in stark contrast to the perspective developed in an economics class.
As all good teachers must do, we intend to challenge you in this course to rethink your views on the economy and the way firms operate. We will ask you to develop new methods of analysis, maintaining all the while that there is, indeed, an “economic way of thinking” that deserves mastering. We will also ask you to reconsider, in light of the new methods of thinking, old policy issues, both inside and outside the firm, about which you may have fixed views. These tasks will not always be easy for you, but we are convinced that the rewards from the study ahead are substantial. The greatest reward may be that this course of study will help you to better understand the way the business world works and how businesses might be made more efficient and profitable. Much of what this course is about is, oddly enough, crystallized in a story of what happened in a prisoner¬of-war camp.
The Emergence of a Market
Economic systems spring from people’s drive to improve their welfare. R.A. Radford, an American soldier who was captured and imprisoned during the Second World War, left a vivid account of the primitive market for goods and services that grew up in his prisoner-of-war camp.1 A market is the process by which buyers and sellers determine what they
are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods that are to be bought and sold. Because the inmates had few opportunities to produce the things they wanted, they turned to a system of exchanges based on the cigarettes, toiletries, chocolate, and other rations distributed to them periodically by the Red Cross.
The Red Cross distributed the supplies equally among the prisoners, but “very soon after capture . . .[the prisoners] realized that it was rather undesirable and unnecessary, in view of the limited size and the quality of supplies, to give away or to accept gifts of cigarettes or food. Goodwill developed into trading as a more equitable means of maximizing individual satisfaction.”2 As the weeks went by, trade expanded and the prices of goods stabilized. A soldier who hoped to receive a high price for his soap found he had to compete with others who also wanted to trade soap. Soon shops emerged, and middlemen began to take advantage of discrepancies in the prices offered in different bungalows.
A priest, for example, found that he could exchange a pack of cigarettes for a pound of cheese in one bungalow, trade the cheese for a pack and a half of cigarettes in a second bungalow, and return home with more cigarettes than he had begun with. Although he was acting in his own self-interest, he had provided the people in the second bungalow with something they wanted—more cheese than they would otherwise have had. In fact, prices for cheese and cigarettes differed partly because prisoners had different desires and partly because they could not all interact freely. To exploit the discrepancy in prices, the priest moved the camp’s store of cheese from the first bungalow, where it was worth less, to the second bungalow, where it was worth more. Everyone involved in the trade benefited from the priest’s enterprise.
A few entrepreneurs in the camp hoarded cigarettes and used them to buy up the troops’ rations shortly after issue—and then sold the rations just before the next issue, at higher prices. An entrepreneur is an enterprising person who discovers potentially profitable opportunities and organizes, directs, and manages productive ventures. Although these entrepreneurs were pursuing their own private interest, like the priest, they were providing a service to the other prisoners. They bought the rations when people wanted to get rid of them and sold them when people were running short. The difference between the low price at which they bought and the high price at which they sold gave them the incentive they needed to make the trades, hold on to the rations, and assume the risk that the price of rations might not rise.
Soon the troops began to use cigarettes as money, quoting prices in packs or fractions of packs. (Only the less desirable brands of cigarette were used this way; the better brands were smoked.) Because cigarettes were generally acceptable, the soldier who wanted soap no longer had to search out those who might want his jam; he could buy the soap with cigarettes. Even nonsmokers began to accept cigarettes in trade.
This makeshift monetary system adjusted itself to allow for cha nges in the money supply. On the day the Red Cross distributed new supplies of cigarettes, prices rose, reflecting the influx of new money. After nights spent listening to nearby bombing, when Today, markets for numerous new and used products spring up spontaneously in much the same way. At the end of each semester, college students can be found trading books among themselves, or standing in line at the bookstore to resell books they bought at the beginning of the semester. Garage sales are now common in practically all communities. Indeed, like the priest in the POW camp, many people go to garage sales to buy what they believe they can resell—at a higher price, of course. “Dollar stores” have sprung up all over the country for one purpose, to buy the surplus merchandise from manufacturers and to unload it at greatly reduced prices to willing customers. There are even firms that make a market in getting refunds for other firms on late overnight deliveries. Many firms don’t think it is worth their time to seek refunds for late deliveries, mainly because there aren’t many late deliveries (because the overnight delivery firms have an economic incentive to hold the late deliveries in check). However, there are obviously economies to be had from other firms collecting the delivery notices from several firms and sorting the late ones out with the refunds shared by all concerned.
Today, we stand witness to what is an explosion of a totally new economy on the Internet that many of the students reading this book will, like the priest in the POW camp, help develop. More than two hundred years ago, Adam Smith outlined a society that resembled these POW camp markets in his classic Wealth of Nations (see the “Perspective” on Smith page after next). Smith, considered the first economist, asked why markets arise and how they contribute to the social welfare. In answering that question, he defined the economic problem.
The Economic Problem
Our world is not nearly as restrictive as Radford’s prison, but it is no Garden of Eden, either. Most of us are constantly occupied in securing the food, clothing, and shelter we need to exist, to say nothing of those things we would only like to have—a tape deck, a night on the town. Indeed, if we think seriously about the world around us, we can make two general observations.
First, the world is more or less fixed in size and limited in its resources. Resources are things used in the production of goods and services. There are only so many acres of land, gallons of water, trees, rivers, wind currents, oil and mineral deposits, trained workers, and machines that can be used in any one period to produce the things we need and want. We can plant more trees, find more oil, and increase our stock of human talent, but there are limits on what we can accomplish with the resources at our disposal.
In fact, most people want far more than they can ever have. One of the unavoidable conditions of life is the fundamental condition of scarcity. Scarcity is the fact that we cannot all have everything we want all the time. Put simply, there isn’t enough of everything to go around. Consequently, society must face several unavoidable questions:
1 What will be produced? More guns or more butter? More schools or more prisons? More cars or more art, more textbooks or more “Saturday night specials”?
2 How will those things be produced, considering the resources at our disposal? Shall we use a great deal of labor and little mechanical power, or vice versa? And how can a firm “optimize” the use of various resources, given their different prices?
3 Who will be paid what and who will receive the goods and services produced? Shall we distribute them equally? If not, then on what other basis shall we distribute them?
4 Perhaps most important, how shall we answer all these questions? Shall we allow for individual freedom of choice, or shall we make all these decisions collectively?

These questions have no easy answers. Most of us spend our lives attempting to come to grips with them on an individual level. What should I do with my time today— study or walk through the woods? How should I study—in the library or at home with the stereo on? Who is going to benefit from my efforts—me or my mother, who wants The problem of allocating resources among competing wants is not as simple as it may first appear. You may think that economics is an examination of how one person or a small group of people makes fundamental social choices on resource use. That is not the case. The problem is that we have information about our wants and the resources at our disposal that may be known to no one else. This is a point the late Leonard Reed made decades ago in a short article in terms of what it takes to produce a product as simple as a pencil (see the reading “I, A Pencil” at the end of the chapter), and it also is a point that F. A. Hayek stressed throughout all of his writings that, ultimately, gained him a Nobel Prize in economics (see the reading “The Use of Knowledge in Society” in your course packet). For example, you may know you want a calculator because your statistics class requires you to have one, and even your friends (much less the people at Hewlett-Packard or Casio) do not yet know your purchase plans. You may also be the only person who knows how much labor you have, which is determined by exactly how long and intensely you are willing to work at various tasks. At the same time, you may know little about the wants and resources that other people around the country and world may have. Before resources can be effectively allocated, the information we hold about our individual wants and resources must somehow be communicated to others. This means economics must be concerned with systems of communications. Indeed, the field is extensively concerned with how information about wants and resources is transmitted or shared through, for example, prices in the market process and votes in the political process. Indeed, the “information problem” is often acute within firms, given that the CEO often knows little about how to do the jobs at the bottom of the corporate “pyramid.” The information problem is one important reason that firms must rely extensively on incentives to get their workers (and managers) to pursue firm goals.
Markets like the one in the POW camp and even the firms that operate within markets emerge in direct response to scarcity. Because people want more than is immediately available, they produce some good and services for trade. By exchanging things they like less for things they like more, they reallocate their resources and enhance their welfare as individuals. As we will see, people organize firms, which often substitute command-and-control structures for the competitive negotiations and exchanges of markets, because the firms are more cost-effective than markets. Firms can be expected to expand only as long as they remain more cost-effective than competitive market trades. Jacob Viner, an economist active in the first half of this century, once defined economics as what economists do. Today economists study an increasingly diverse array of topics. As always, they are involved in describing market processes, methods of trade, and commercial and industrial patterns. They also pay considerable attention to poverty and wealth; to racial, sexual, and religious discrimination; to politics and bureaucracy; to crime and criminal law; and to revolution. There is even an economics of group interaction, in which economic principles are applied to marital and family problems. And there is an economics of firm organization and the structure of incentives inside firms. Thus, although economists are still working on the conventional problems of inflation, unemployment, international monetary problems, and pricing policies, they are also studying the delivery of housing to the disadvantaged or of health care to the very young and the elderly. In one way or another, today’s economists are tackling a wide variety of subjects, including committee structure, the criminal justice system, firm pay policies, ethics, voting rules, and the legislative process. Before this book and course have been completed, much will be said of how firms like General Electric, Microsoft, or Netscape can be expected to price their products, and we will touch on the conditions under which firms can be expected to give away their products (or even pay buyers to take their products). In fact, because we understand your professional goals for pursuing an MBA degree, we will never present theory for theory’s sake. We will, in each and every chapter, show you how the theory can be used in practice by managers.
What is the unifying factor in these diverse inquiries? What ties them all together and distinguishes the economist’s work from that of other social scientists? Economists take a distinctive approach to the study of human behavior. They employ a mode of analysis based on certain presuppositions about human behavior. For example, much economic analysis starts with the general proposition that people prefer more to fewer of those things they want and that they seek to maximize their welfare by making reasonable, consistent choices in the things they buy and sell. These propositions enable economists to derive the “law of demand” (people will buy more of any good at a lower price than at a higher price, and vice versa) and many other principles of human behavior. A theory is a model of how the world is put together; it is an attempt to uncover some order in the seemingly random events of daily life. Economic theory is abstract, but not in the sense that its models lack concreteness. On the contrary, good models are laid out with great precision. Economic theories are simplified models abstracted from the complexity of the real world. Economists deliberately concentrate on just a few outstanding features of a problem in an effort to discover the laws that govern the relationships among them. Generally, a theory is a set of abstractions about the real world in which we work. An economic theory is a simplified explanation of how the economy or part of the economy functions or would function under specific conditions.
Quite often the economist must also make unproved assumptions, called simplifying assumptions, about the parts of the economy under study. For example, in examining the effects of price and availability on the amount of food sold, the economist might assume that people eat only oranges and bananas in the model society in question. Such a simplifying assumption is permissible in constructing a model, for two reasons. First, it makes the discussion more manageable. Second, it does not alter the problem under study or destroy its relevance to the real world.
As following chapters will reveal, economic theorizing is largely deductive—that is, the analysis proceeds from very general propositions (such as “more is preferred to less”) to much more precise statements or predictions (for example, “the quantity purchased will rise when the price falls”).4 Economic theories sometimes vary in their premises and conclusions, but all develop through the following three steps.
First, a few very general premises or propositions are stated. “More is preferred to less” or “People will seek to maximize their welfare” are examples of such propositions. The premises tend to be so general that they are beyond dispute, at least to the economists developing the theory.
Second, logical deductions, which are tentative predictions about behavior, are drawn from the premises. From the premise “People will seek to maximize their welfare” we can deduce how people will tend to allocate their incomes at certain prices. We can then conclude that they will purchase more of a good when its price falls. Mathematics and graphic analysis are often very useful in deducing the consequences of premises. Although a theory is not a complete and realistic description of the real world, a good theory should incorporate enough data to simulate real life. That is, it should provide some explanation for past experiences and permit reasonably accurate predictions of the future. When you evaluate a new theory, ask yourself: Does this theory explain what has been observed? Does it provide a better basis for prediction than other theories?
Positive and Normative Economics
Economic thinking is often divided into two categories—positive and normative. Positive economics is that branch of economic inquiry that is concerned with the world as it is rather than as it should be. It deals only with the consequences of changes in economic conditions or policies. A positive economist suspends questions of values when dealing with issues suck as crime or minimum wage laws. The object is to predict the effect of changes in the criminal code or the minimum wage rate—not to evaluate the fairness of such changes. Normative economics is that branch of economic inquiry that deals with value judgments—with what prices, production levels, incomes, and government policies ought to be. A normative economist does not shrink from the question of what the minimum wage rate ought to be. To arrive at an answer, the economist weighs the results of various minimum wage rates on the groups affected by them—the unemployed, employers, taxpayers, and so on. Then, on the basis of value judgments of the relative need or merit of each group, the normative economist recommends a specific minimum wage rate. Of course, values differ from one person to the next. In the analytical jump from recognizing the alternatives to prescribing a solution, scientific thinking gives way to ethical judgment.

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