Where does Economics fit in a business school? • Almost every discipline that is taught at a modern university can be described as fitting in one of three categories: • Art and Humanities • Science • Technology • Think about where business and economics belong • Hint: Not in the same place
To understand where economics and business fit in this trilogy (and why they don’t belong in the same place) let’s take a few moments and consider what distinguishes the three. • How does the creation or study of art differ from the pursuit of science of technology? • What makes the development or study of technology a unique intellectual pursuit? (Hint: a good way to frame this question is to ask (1) what do we mean by technology? and (2) how do we judge whether technology is a “success”?
Now that we’ve talked about art and technology, we’re close to the most critical point that needs to be made. Let’s think about what scientists do that distinguishes their work from art or technology. (A big question and while this isn’t a class in the philosophy of science, one worth considering at least for a few minutes. • First, the focus of all science is what can be observed (perhaps indirectly and with great difficulty, but if isn’t “real” it isn’t science). • Scientists, however, aren’t just bookkeepers, they also formulate and test “theories”
The notion of a theory is so abused, let’s be clear about the meaning. This best understood by asking what it means to accept(notice I didn’t say prove) a theory.A theory is not rejected if • If it is logical (next slide please) • It is consistent with what is observed. • We believe the law of gravity because apples really do fall down, not up. We believe that law of demand because when the relative price of oil goes up, people really do buy less oil. • Helps us lead understand a wide range of phenomena. • The law of gravity also explains the position of the planets and, there is a pursuasive argument that the law of demand also explains the choice of marriage partners. • So ultimately the distinction between science and technology is that science is all about observing and building theories to better understand what we observe. Science isn’t about building anything practical • Even if the “law” of gravity didn’t help us launch rockets, it would still be a very good theory.
So, where does economics and business fit? • This must meant the business schools like engineering schools and maybe some other locations on campus are in the technology part of the university. They are all about the creation of useful tools. • [Notice, by the way that “tools” don’t have to have a physical dimension. An accounting system or a business plan can be good tools but lousy paper weights.] • Economics is a science. It doesn’t have to be useful! • Before the entire class storms the Dean’s Office, I should quickly add that I don’t think that will be the case. In fact, there’s lots of good stuff that economics can contribute directly to the bottom line. But that’s just a sidebar. The goal here is to make theory, not money.
Why You Are Here: #1 • The obvious reason is that, many of the tools that are part of the practical training are based on economic theory. Learning the theories will help you build better tools • In fact, our Dean, who is an economist, is sometimes fond of reminding his colleagues that economics “is the mother discipline”. • For example, in finance you will learn all about the “efficient market hypothesis” which is an amazingly important tool for investment analysis that really makes sense only if you understand the law of demand and supply. • As an analogy, think about how important it is for a good engineer to understand certain aspects of physics, or a physician to understand biology.
Why You Are Here: #2 • A less obvious reason is that economics relies on some specific tools--especially mathematics and statistics--that are used in other classes. This is a good opportunity to sharpen your skills. • In other words, econ is to Business School what boot camp is to the Marine Corp. • Just as in boot camp, you will endure sleepless nights of seemingly pointless activity designed by an arrogant, humorless sociopath, all with the goal of toughening you for the grim years of combat that lie ahead.
Why You Are Here: #3 • I think most compelling reason is that economics examines the world in a very particular way. And this approach can be useful to non economists. This is a big claim and rather than try and express it as an abstraction, let’s consider the following exercise
An Example of How Economists Think: Why Give Grades? • Grades are expensive and complicated. Large amounts of resources are devoted to the giving and getting. An economic analysis is often begun by asking why resources are used in a particular way. • This question is way to broad and so the next step will be to break it down into smaller questions. • Grades are a relationship, thus an economic approach to the puzzle begins by asking • why do professors supply them and • why do students demand them.
Why Do Professors Supply Grades? • Money: By offering tests and promising grades, the class becomes more valuable to the student (why?) and so the student is willing to pay more. • Non Pecuniary Rewards (Utility): Most Profs enjoy their subject, think it’s important and want their students to learn (or at least stay awake during part of the lecture). Grades motivate the student to learn. • But think about why most economists would begin with the pecuniary motive. • Hint: It’s not because we think people are shallow and materialistic.
Why Do Students Demand Grades? • They Don’t. Employers and grad schools are the real users of grades, and so the demand for grades is actually a derived demand--the student’s demand for grades is actually derived from the employers demand. (In much the same way that GM’s demand for steel is really derived from the demand for cars.)
Why do employers and grad schools demand grades?Two Possible Theories • Grades are an absolute measure of knowledge. (Consistent with the HUMAN CAPITAL theory of education.) • Grades are a relative measure of knowledge and other important characteristics. (Consistent with the SIGNALING/SORTING theory of education.)
Does This Constitute a Theory of Grades? • Sure. The “theory” we have just described has two important characteristics. • It is logically consistent and more important • Give explanations that can, at least in principle, be refuted.
Even It Is a Theory, What Good Is It? • Theories are just good. • There seems to be something about the human mind that likes the order and connections that obtain from a good theory. Most of us could live long and healthy lives without ever having heard about the theory of evolution. But most of us also crave a better understanding of our surroundings and find a really good theory (one that is both simple and fits the evidence) very satisfying.
Even It Is a Theory, What Good Is It? • Theories can be a good guide to policy. • There are two basic grading policies: You can be graded on an absolute scale (e.g.,everybody who scores a 90 or better gets an A), or on a relative scale (the top 20% of the class gets an A) • If I believe that students work harder when in competition against an absolute scale and that employers are interested in the absolute level of achievement, I’d use an absolute scale. • If I believe students work harder when in competition against each other and that employers are interested in relative rankings, I’d use a relative scale.
Take-Aways: What characterizes an “economic way of thinkings”? • Economics tends to be a science of the ordinary in that most economists are attracted to problems and patterns of behavior that are common to many people. • In one way or another an economic problem tends to focus on decisions that affect the allocation of resources, either for consumption or further production. • Whenever possible economists like to break up a big complicated problem into small more managable problems. • Economists assume that behavior is purposeful and almost all economic analysis begins by asking who is making the decision and what the decision maker is trying to achieve. • Economists tend to focus on self-interest and pecuniary motives because we believe that these kinds of things matter to almost everybody and we want our theories to be as broad as possible.
A Final Note on How Economists See the World: Macroeconomics and Microeconomics • Macroeconomics: The Study of Aggregate behavior and the flows between producers and consumers • GDP, Price Levels, Interest Rates • Microeconomics: The study of individual producers, consumers and markets. • Pricing, internal organization of firms, strategic interaction between firms • The first part of this class is microeconomics. This are at least two good reasons for this • Micro is the foundation for macro (for example, you can’t really understand how interest rates are set if you don’t understand supply and demand. • Micro is where one really learns “the economic view of the world”, which I believe is a remarkably useful analytical framework.