Sunday, September 21, 2008

Stanford GSB, Entry 6, Microeconomics: What we Learned in Pre-Term

In the Sloan program at Stanford, we don’t have to buy textbooks. Why not? They’re provided as part of the program – it’s one of the many perks of paying beaucoup bucks to Stanford.

As I left my dorm room on the first day of class, I was in a rush. I took a cursory glance at the various textbooks that we’d been given, and grabbed the only one I saw that had economics prominently written on it. I didn’t notice until I pulled it out during econ class that it was for the wrong class; the book was for Macroeconomics rather than the class we actually had that day, Microeconomics. (OK, perceptive ones will notice that this obviously means either I didn’t do the reading we were supposed to do before the first day of class, or I read the wrong book; I'm not saying which one is true).

Since I’ve already given you an overview of our Strategy class, let’s talk about Microeconomics. This brings us (not because it is a sequitor, but because this is where the class actually began) to two questions:

Question #1: What’s the difference between Micro and Macro?
Question #2: Why is it that Economists can never agree on anything?

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On the first day of class, Professor Flanagan was introduced as our Microeconomics teacher (incidentally he’s also going to be teaching us Macro in the real-term so we’re going to get to know him well). He was an older, skinny gentleman, with angular features and a commanding but friendly demeanor and a soft voice. He used no projection equipment, but wrote everything on the whiteboard.

On the second question, he told us about a large number of famous quips about economists and their inability to agree on, well, anything, really. At least that’s the public perception. As a member of the public, I am inclined to agree.

I remember Rudi Dornbusch, who was a famous economist that taught at the Sloan School (MIT, not Stanford), telling us about a president (may have been Truman too, can't remember) who complained that he never seemed to be able to find a “one-handed” economist.

This was a problem only because all the economists he did find would begin with “On the one hand, blah blah blah”, and then after some time, they would inevitably continue with: “But, on the other hand, blah blah.”

Professor Flanagan gave us what may be an actual Truman quote, who once complained that if you lined up all the economists in the world end-to-end, they would never reach a conclusion!

But them’s just jokes, right?

Economists aren’t really like that, are they? Actually, Professor Flanagan pointed out to us, that there was surprisingly little disagreement between economists about Microeconomics – the disagreements tended to be about Macro-economic issues, which affect the economy as a whole: unemployment, monetary policy, economic growth, etc.

Our class during the pre-term, Microeconomics, was concerned with markets at the level of a firm selling products or services (called the supply side) and an individual or household as a buyer of these products or services (the demand side).

In general, we are concerned with three questions in Micro: How much should a firm or industry produce? How should it be produced? And for whom to produce it?

Since economists generally agree on these, the class should have been fairly non-controversial, right? Not exactly. Professor Flanagan explained to us that politicians will make it look like there’s disagreement on issues where most economists tend to agree.

Economics and public policy is a broad subject, of course. But Flanagan told us that when studied with economics, the policies that governments follow to affect the market almost always end up creating unintended consequences. These consequences often reduce (or even remove) whatever benefits the policy was intended to produce. These examples, such as the “War On Drugs” (more on this example later in this post), provided much of the more colorful moments in this class.

The disagreements usually come up because of the difference between what economists call normative vs. positive economics.

On the one hand, Normative economics is about making judgmental statements and calls. You can identify a normative statement about economics when someone uses the word “should”. As in “We should raise the minimum wage”, or “We should cut taxes”.

On the other hand, Positive economics refers to evidentiary statements and deals strictly with the facts, or at least with standard, agreed upon economic theories. "At a higher price, consumers will buy less of X" would be a positive statement, at least as far as economists are concerned (if it is true and can be domenstrated). They don’t mean it as in positive in the sense, which is the opposite of negative.


Words and Words: If Shakespeare were an Economist
As you may have noticed, economists tend to have their own definitions for words that we think we already know the meaning of. We learned this very quickly.

For example here are just a few terms which mean one thing in everyday terms, and mean something else or very specific to economists. Here are just some examples:


Short term.
The short term has a specific meaning in economics: is when one element of supply (capacity) is usually fixed.
Elasticity.
Elasticity in econ specifically means the percentage change of one thing in response to a percentage change in another thing. More commonly, this commonly means elasticity of demand, which means the percentage at which quantity changes when there is an effective change in price.
Rent.
I still don’t know what the economic definition of this is, but trust me, it’s different from what you and I think of as rent.
Positive. This, as mentioned above, has nothing to do with positive vs. negative. It’s positive vs. normative. Confused? Reread above.
Perfect Competition.
Again, another term with a very specific meaning in econ. It means when a market has many competitors with no differentiated products, such that no one single player has the ability to set the price.
Profit.
We usually think of profit as sales minus expenses. In economics it means total sales minus total economic cost. What’s total economic cost? I’ll give you a hint: it includes more than just what we think of as cost. It includes the normal rate of return (and maybe even opportunity cost).
Normal Rate of Return.
We might “normally” think of this as the interest rate, which is the return you can get on your money by putting in the bank (theoretically). Not exactly in econ. In economics it means the normal rate of return for capital in a given industry. It’s another kind of abstract term among many abstract economic terms.
Opportunity Cost.
We usually think of this as something else we could be doing. Again, econ has a more specific definition: the cost of the next best alternative.
Marginal.
In everyday speak we might think of something as “marginal” if it is small and not enough to make a difference. Marginal in econ means “extra”. Marginal cost is the cost of adding one additional unit of production. Marginal revenue is the revenue that comes from selling an additional product.
Average Cost.
We usually think of average cost as: take the total costs of producing products and dividing by the number of units. That is actually “average total cost” in economics. There is average variable cost, average marginal cost, average marginal variable expialadocious costs. Actually, I made that last one up, but you get the idea.


Should I go on? The point is that I could go on, perhaps even ad infinitum. If it’s Saturday night and you have nothing better to do, you can start reading your econ book and find all kinds of different definitions for words we use in everyday language. It’s called economics.

Which bring us to perhaps the most important question related to Economics.



What do economists know, really?
Professor Flanagan insisted to us that there were only two things economists really know. I suspect he meant this in non-literal sense; if this was literally true, perhaps the class could have been a lot shorter. Nevertheless, he was quite adamant about this point. The two things are:



  • That Supply and Demand are equal

  • That Marginal Revenue equals Marginal Cost


We spent a lot of time talking about demand curves and supply curves. Where they meet, the so-called equilibrium is the point where supply equals demand. This is the price and quantity set by the market.

The arguments that they use for both points are variations of the original, well known “invisible hand” argument put forward by the Scotsman Adam Smith some 230 years ago.

Let’s suppose you start at a point where supply and demand aren’t equal. There will be either a shortfall or a surplus of supply, affecting the price of the product. If there is a shortfall, then the price will go up, increasing profit. More firms come in to the market, eventually pulling the price back to equilibrium.

Similarly if there is too much supply, the price will come down, increasing demand for the product, and the market reaches equilibrium again (eventually!).

This argument has been part of the public understanding of economics long enough that it's not too controversial. What about the second point, that marginal revenue equals marginal cost?

Well this point is a little more “subtle”. Flanagan says that “subtle” is what academics say when something is actually difficult.

I’m an engineer by training, (“A Quant”, as they call it in business school, vs. a “Poet”, someone whose undergrad degree was in liberal arts), and we usually say something is “non-trivial” when it’s difficult.

Why don’t we just say that it’s difficult? Beats me.



The Marginal Way
As for the second point, Marginal Revenue = Marginal Cost, we had a case study about Continental Airlines related to this point. The team presenting it did a good job with supply and demand and marginal cost and marginal revenue curves. The question was whether Continental airlines should continue certain routes if these routes were not profitable?

The trick is how you define the word “profitable”.

The Marginal Revenue (I’m sure you remember what this means from the definitions above) is the additional revenue from selling one more product. The marginal cost is the additional cost of adding/producing one more product (or providing one more unit of service, like a flight).

The Average Total Cost tells you if you have made a profit on all the units sold thus far.

The Average Variable Cost tells you if you are making a profit on the next unit (if it’s less than Marginal Revenue).

The Marginal Cost tells you the cost of the next incremental unit. Professor Flanagan explained that if Marginal Cost is less than Marginal Revenue, then adding another unit will add some contribution to your overall profit. If Marginal Cost is less than Marginal Revenue, then you will be adding a loss onto your overall profit by producing and selling the next unit.

The subtle point is that it’s possible that by selling another unit, you will still be unprofitable because the Average Total Cost may still be less than the average sales price. However, if MR > MC (Marginal Revenue is greater than Marginal Cost) then you are contributing to the total profitability, even if it means you are only helping the company reduce its loss.

Back to the Scotsman’s invisible hand: If MR <> MC, then you’ll want to keep producing units, because you will be contributing to your profit. How many more should you produce?

Up to the point just before MR < MC.

What point is that? You guessed it, the point where Marginal Revenue is equal to Marginal Cost, and that’s why the economists “know” that this is true.

Does that make sense? If not, pay a hundred grand to attend Stanford Business School, and Professor Flanagan will explain it quite well, I assure you.



Real Economists Draw Curves

The way we reached some of these conclusions is by drawing Supply and Demand curves. Economists love to draw Supply and Demand curves, and after many days of sitting still watching our professor draw them, I have to say, they are quite useful, though it’s still a bit of a mystery how such a simple drawing can convey so much information.

Economists draw a simple graph with a horizontal and a vertical axes. Then they draw one line which slopes downward, say the red line. And the draw one line which slopes upward, say the blue line. Where the red line and the blue line meet is called the equilibrium point.


If you look closely you’ll notice that the curves aren’t curved at all. They are just lines sloping upwards and downwards. This means that you could just draw a big X on the board and refer to its two lines as being the “supply" and "demand" curves, and you'd generally be correct.

What does a simple picture like this, which even a five year old could draw, reveal about the markets?

Plenty, if you’re an economist.

Take a graph with only a single line sloping downwards (the “red line” above). Economists might say that this to represents the demand curve of an individual. Why does it slope downwards? Because of the principle of diminishing marginal utility. When the professor asked us this, one of our classmates answered without hesitating: “You eat one In-and-Out Burger, it tastes really good. The next one doesn’t taste quite so good. By the sixth burger, you’re sick of them and don’t want any more.”

This is because quantity is on the horizontal axis and price is on the vertical axis. A downward sloping curve shows a lower price as the quantity increase. According to this principle, an individual is willing to pay less for each additional unit of something – whatever that something is. The proper economic term is “widgets and gidgets”.

Turns out this same principle applies not only for individual, but to aggregate market level supply and demand curves.

It also turns out that the same graph can be applied to the labor market if you change the vertical axis to be “wages” and the horizontal axis to be “employment”. I’m pretty sure as we get into macroeconomics the same X will represent something entirely different, but still prove equally useful.

Vouchers, Price Controls, and Heroin, Oh My!
Professor Flanagan, who won an award from the previous Sloan class for his teaching, has plenty of experience with public policy. His discussions of what an economist think of certain government or political policies provided part of the “fun” of this class. The other “fun” was usually provided by the study groups doing their cases.

It turns out that Professor Flanagan was on the President’s Council for Economic Advisors a long time ago. One of our classmates commented: “Wow, I didn’t realize this guy was so famous and well known. And here is teaching us basic freshman economics – I wonder how he puts up with that?” The answer is probably that he likes what he does, which is a good thing for us.

As for policy discussions, to illustrate the point of “unintended consequences” I mentioned earlier, he presented us the example of The War on Drugs:

In fighting this “War”, the US government is focused intensively on the supply side of the equation - in fact, our efforts are almost exclusively focused at getting the “bad guys” - drug dealers. We do very little, comparatively on the demand side of the equation – in reducing the demand for drugs.

If we follow this scenario out logically using supply and demand curves, as the government gets some heroin dealers, then supply goes down in the short term. Once supply is restricted, and if demand doesn’t change, this only led to an increase in the price of heroin. (Same number of people want it, less of it to go around). And since the number of people who are addicted to heroin hasn’t changed, how do they go about getting the extra money for it? Any ideas?

Increased crime, says Professor Flanagan, is one of many unintended consequences of the government’s policies in the War on Drugs. This was an eye-opener for me. Perhaps the politicians need to not just hire, but actually listen to economists like Bob Flanagan.

He had many more examples of government policies, including the gas tax or a vice tax, and the unintended consequences of these policies, from an economic point of view.

The rest of the color came from each of our study groups, who were required to present on one of the cases using the tools of microeconomics to understand what happens to supply and demand. The issues were (from what I can remember off-hand) things like Vouchers for Education, Price Controls, Food Shortages, Mergers, Monopolies, the Congestion Tax in London, and so on.

The case presentations started out as very simple PowerPoint slides, accompanied with drawings of Supply and Demand curves on the whiteboard. But each group learned from the last one, and presentation quality steadily increased throughout the pre-term. By the end, we had professional looking supply-and-demand curves in the PowerPoints, and some groups started to use skits to illustrate the ideas to make them more interactive. Pretty soon, YouTube videos started to be appear in the presentations to make them more fun and interesting (which they did).

For example, in the case about Mergers, the XM / Sirius satellite merger was discussed, and a YouTube clip was used to show the news reports of when the merger was finally approved. To top it off, we actually had someone in our class who was working for XM at that time.

On the case about monopolies, they actually showed the trailer from the Hollywood movie, “There will be Blood”, about a Texas oilman, to show how a malevolent monopolist acts. On the case involving the congestion tax in the city of London, actual video clips of news reports about the results of the tax were shown.

This is one of the things that’s pretty interesting about going to b-school today rather than 10 years ago. The availability of these video clips makes it much more fun to be in class. Especially since economics can be a little dry on its own, except of course when Professor Flanagan brings up what he now affectionately calls “Our Old Friend” (because it keeps coming up again and again, and again): the Elasticity of Demand.

Let’s play Monopoly
Many of the principles of Micro we learned seem to apply only to markets where there was perfect competition (again, see the definition above). A perfect market relies not only on competitors not being able to do anything to affect the price of their product; they aren’t even able to differentiate their products in any way. It also relies on perfect information in the market (an unlikely scenario in any market).

Commodities are as close to a perfect market as we get, but it’s not clear to me that’s even a perfect market. Does a perfect market really exit? Maybe not.

But towards the end of the pre-term, Professor Flanagan began to relax the restrictions on the markets we were learning about and moved to “imperfect competition". A market with imperfect competition market is one where products have differentiation, have some influence over how much they sell their products for, and can respond to the competition.

I could be wrong, but it seems to me there’s a simpler name for “imperfect competition”: it’s what we call the real world.

Surprisingly, when this restriction was reduced, the basic principles we’d learned - supply and demand, marginal this and average that - continued to apply reasonably well even in imperfect markets.

To illustrate this, we went to an extreme example: Monopolies. The monopolist also faces a demand curve - which means that fewer consumers will buy their product at higher prices, and more will buy at lower prices. Ignoring our old friend, the Elasticity of Demand for the moment, where will the monopolist set his price?

The morning of this lecture, I was very tired, having stayed up late the night before (must have been doing the readings for econ, though it’s more likely I was blogging or playing on Second Life). I was on the verge of dozing when Professor Flanagan began to talk about monopolies. Of the many reasons why monopolies arise, one is that governments mandate that only one firm is allowed to serve an area, as in utilities.

I don’t know how or why but in my half asleep state, I began to see images of nuclear power plants, and this brought me to images of the The Simpsons. Those of you who have watched the Simpsons at some point (which practically includes the entire population of the US, I think, since it’s one of the longest running prime-time TV shows), will know that Homer Simpson, the lovable clown, works at a nuclear power plant just outside Springfield, USA.

I don’t know why, but an image of Homer’s boss, the unscrupulous monopolist, Mr. Burns, flashed into my mind as Professor Flanagan talked on about monopolists. Mr. Burns is an older gentleman, very skinny with angular features. I opened my eyes and for an instant (only or an instant mind you), our professor (if he took off his glasses) was the spitting image of Mr. Burns! I jolted awake, half expecting our professor to tap his fingertips together and say in the very measured soft voice of Mr. Burns, “Now we have a monopoly. Excellent!”

Now, in reality Professor Flanagan’s personality (who is a nice, friendly guy quick to smile and laugh) is nothing like Mr. Burns (who is a ruthless monopolist trying to make money by squeezing the residents of Springfield). Maybe it was my half-dazed state, but the physical resemblance was uncanny, if only for that moment. If nothing else, it kept me awake during the rest of the discussion about Monopolies!

Which brings us back to the earlier question, where will the monopolist set his price and how much will he produce?

The answer, surprisingly to me (but not to economists) is the same as before: he will produce up to the profit-maximization point where Marginal Revenue equals Marginal Cost, and will stop there. Whatever quantity is equated with that price is the amount that the monopoly will produce.

What the bleep do we know, really?
This is all nice, in theory, but does this actually happen in the real world? Does Supply=Demand and does Marginal Revenue=Marginal Cost, or are these more concepts and principles which help to guide the market?

Do perfect markets exist? Perfect information, I’m pretty sure, doesn’t exist. Entry or Exiting a market requires a significant amount of resources and rarely happens easily, as we know from our Strategic Management class, because of barriers to entry. And is there really such a thing as a “normal rate of return” which is different in each industry?

These questions started nagging at me early on in our economics class, as I struggled to try to apply the material we were learning to business (at least apply it in my head). No doubt everything we learned will apply in a general sense about how consumers buy from producers. But would it apply specifically to a situation any of our companies are likely to come up with?

It seems to me that in the real world, companies are entering and exiting markets and adjusting supply and trying to figure out what the heck demand really is for a product. It seems to me that the only way to figure this out is through trial and error, since there is no way to know exactly how many people will buy car X at price Y. If General Motors could have figured out the demand for hybrid cars, perhaps they would have reduced the supply of SUV’s and increased the production timeframes of their hybrid cars years ago and not have lost more money than anyone else over the last year.

Similarly, if “Marginal Revenue = Marginal Cost” is the profit maximization point then firms should stop producing there. I don’t know of any public companies who choose to not to produce any more products. Which means that they must not be at this point yet, or if they’ve crossed it, then they’re reducing supply.

Maybe the two things that economists know should come with an asterisk and two additional comments:

1. Supply and Demand, while theoretically equal, are rarely actually equal. Rather, the market is in constant motion trying to get to that equilibrium point.
2. Marginal Revenue rarely equals Marginal Cost. But firms are in constant motion trying to get to (or get back to) this profit-maximizing point.

Those are my two cents worth of contribution to the field of Microeconomics. But then, what the hell do I know? I’ve only had 12 days of Microeconomics class, and it wasn’t even graded!

Excellent!


SPECIAL DISCLAIMER: the opinions and experiences recounted in these blog entries about my year at Stanford Business School for the Sloan Program are my own personal observations and ranting. This blog is not endorsed by either the Stanford GSB or by any of my fellow Fellows.



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