I, The Absolute

Archive for June 10th, 2005

Microeconomics in short

Posted by itheabsolute on June 10, 2005

I had written in one of the blogs that, of the four subjects of Term I, econ was most interesting subject for me. What is econ about?

Microeconomics deals with the issues that concern the manager of a firm. For instance, demand for his product; how much to be supplied at what price; at what point should he shut down the plant, etc. As against macroeconomics which deals with issues mainly concerning a finance minister. For example, inflation, GDP growth rates; exchange rates, etc. Certainly, macro issues also affect managers of firms. But there is not much a manager can do about macro issues – they are beyond his control. Whereas many, not all, of the issues dealt with in microeconomics are under his control. He can control his costs, not his competitors’ price; he can control how much to produce; not how much will be consumed.

Microeconomics equips a manager with some tools to be able to handle various situations and provide him framework within which he can make other finance, marketing, etc decisions.

“Opportunity Cost” – this is fundamental. For example, the cost of MBA education at ISB is not the same for all the students. Why is it when the fee is same for all? This is because each one had a different salary and he had to give up this salary to pursue the course. The cost associated with loss of salary (for one year) is called opportunity cost. So, each one should evaluate MBA decision in the light of his opportunity.

But what should I do about it if I felt that ISB education did not offer any value proposition. Should I continue with the education because I have paid the fee or should I look at alternatives? Since the fee is already paid and there is nothing that I can do about this, I should not consider the cost of fee. The fee is “sunk cost”. It is a cost which I should not take into consideration to make my future decisions.

Is then the investment waste and unrecoverable. No. The cost is sunk to the extent that it will not impact my decisions; but when I decide to not continue education and take a job immediately, I should always include this cost in calculating my long term return on investment and profits. I should recover this cost.

Since I am continuing with the education, I will end up getting an interview offer. How should I bargain my salary with prospective employer? Should I quote my fixed investment/cost of the fee I paid to ISB and ask the employer to consider it in making a salary offer. Nope. It will surely be not acceptable. I should not be looking at recovering my entire fixed costs in short term. I should be okay if I am able to recover my variable costs and quote my price to equate my “marginal costs”/ the employer’s “marginal benefit” (perceived benefit by recruiting me). In the long run, if the job does not give me returns on my fixed costs, then I am going wrong.

But can I really get the price equating my marginal costs or what I want. Not necessarily. If there is too much “competition” for the job I have applied to, then no. If there is no competition, then yes. If there is too much competition, the employer (the buyer in this case), will choose the student who has the least marginal cost but offers highest marginal benefit to him. If there is no competition, then the student can set his price above his marginal cost and get paid much higher (“monopolistic or oligopolistic” behavior).

But what will decide which employer will short list me. It depends on my past experience and grades. “Externality” comes in here. Every student who studies better than I and secure higher grades than I, creates a “negative externality” to me. It causes loss to me. There is not much that as an individual I can do about it. If there was job reservation to someone who has secured lower grades then this negative externality can be offset. Students who secure lower grades create “positive externality” to those who secure higher grades.

How will I choose the employer, assuming I get more than one offer? It depends on when I get these offers. If the offers come simultaneously, then my equation is different (Stackelberg). But if the offers come one after the other, then I will need to make a decision whether to accept first job or not, based on my assumption of whether I have a reasonable chance of getting other jobs. In such a situation, the equations are different (Cournot).

But all through the year, all the students play games against each other. My preparation is not necessarily absolute. This is because grading is relative. What grade I receive depends on how others fare. So clearly there is a trade-off possible here. I will allocate only that much time that is required to get best grades. There is no point putting more effort than getting A+ grade. But much before this I set some expectations on how someone in my immediate circle of reference is going to fare and adjust my performance accordingly. This behavior is discussed in “Game Theory”. The game of competition will continue based on how others have fared at the end of each term. I will always try to have a dominant strategy to ensure that irrespective of how others study, I will allocate maximum time for studies and target A+ grades and get them. Under calculated circumstances, I will assume how others will perform and allocate my time optimally to ensure I get at least good grades (“Nash equilibrium”). In worst case scenario, I will have a “maximin strategy” and allocate minimal time to studies and ensure that at least I get a pass grade.

As it can be seen, the application of economics can be almost everywhere. Hence, my liking to this subject.

PS: As time passes, I hope to able to improve my understanding. Apologies if you find the text too sketchy. Or was it too long to be called short?

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