@ INSEAD : Introduction to Prices and Markets This pote was written by H, Landis Gabel, The Novartis Chair in Management and the Environment, Professor of Economics and Management at INSEAD. Copyright © 2004 INSEAD, Fontainebleau, France.When the discussion of a group of questions referring to interrelated phenomena has {gone on for some time, people discover that certain arguments and chains of reasoning, tend to repeat themselves and that certain concepts recur again and again. These arguments, ways of reasoning, and concepts are soon found to be capable of being stated or defined in a more general way which makes them applicable not only to any fone of the particular questions in the discussion of which they made their first ‘appearance, but to all questions of a certain class, even such ones which nobody has as yet asked. (As soon as this is being done, first unconsciously and later consciously, “theory” in the true sense of the word emerges. Science or theory is nothing but systematised and refined common sense, a technique, leamed by experience, of getting hold of the world, not as practical life does, in every given practical instance, but in a way which will hold good for many or all instances of a given class of phenomena. These refinements have first to be found, and when ‘once found, they have to be leamed by every successive generation and improved. In this process, a stock of habits and techniques, of methods and concepts evolves, foreign and unknown to the untutored mind. What one ought to leam is how to work with such theories, how to analyse concrete situations and how to solve problems with them. If this is not done, these theories remain lifeless and barren. The teacher who does no more than to teach them acts as a teacher of fencing would who confined himself to showing the different weapons to his pupil without ever training him to use them. Joseph Schumpeter (1883-1950) ‘The subject area of Prices and Markets is microeconomic theory. More precisely, this is a course on the theory of how consumers and producers make economic decisions and how these decisions interact to make prices and markets. Microeconomics is usually distinguished from macroeconomics (which you will study in Period 3) by the focus of the former on the individual decision maker and of the latter on ‘aggregate economic phenomena. But whereas this distinction is generally valid, one should lnderstand that microeconomics is also concerned with how an entire economy works. In this course we will study how rational individuals make economic decisions as well as how an ‘economy characterised by such decisions answers the economic questions fundamental to all, societies - What should be produced? How should it be produced? Who should get it? The purpose of this introduction, in addition to stating the subject and objectives of the course, is to say something about the methodology of economics with the hope that this will make the course objectives easier to achieve than they would otherwise be. Those of you who have the untutored minds that Joseph Schumpeter spoke of will find that we will develop an array of models and concepts, each with a name that paradoxically sounds familiar (composed of ordinary words like “demand” and “elasticity”) yet that is given a very precise and often novel meaning. But there is a purpose to all these models which Schumpeter Identifies quite clearly. Each of the economist’s models is a general statement of a recurrent situation, and each model answers the questions that arise in the situation it addresses. For Copyngh ©2003 INSEAD, Fonuieba, France.2 cesample, if problem surfaces in a situation that the economist labels “price discrimination”, «can immediately be solved using an existing and readily available technique for dealing with all price discrimination problems. The economist’s models are like a company’s standard operating procedures (SOPs). Sets of ‘OPS exist in all firms, each having been developed to solve a type of recurrent problem. A. Rood SOP defines the characteristics of the problems to which it is addressed, and it solves them correctly. A good set of procedures will cover most or all recurrent problems, and it should provide some guidance by analogy for solving totally unfamiliar problems. The objective of this course, stated simply, isto teach you to understand economists’ SOPs, to recognise the characteristics of problems that determine which SOP is relevant, and ~ very importantly - to give you practice using economists’ SOPs to solve problems. This set of SOPs, or “stock of habits and techniques, of methods and concepts” may be tedious and difficult to learn, but mastery of economics is a very productive investment. Because this is explicitly a course on theory, it is important to understand something about the role of theory in management education. Most cf us who have spent much time teaching. economic theory to business practitioners have heard remarks like, “What does a practical businessman need theory for?” or “That's fine in theory but not in practice.” What is to be made of the implication that theory is irrelevant or even antithetical to practice? John Maynard Keynes said in his General Theory, ‘The ideas of economists and political philosophers, both when they are right and when they ere wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. | am sure the power of vested interests is vastly exaggerated compared to the gradual encroachment of ideas. ‘One lesson you will learn here, if you don’t already know it, is that the past is “sunk” and irrelevant to today's decision making. Only the future consequences of our decisions have any relevance. But in another sense, the past is relevant because it is only from our experiences in the past that we can form expectations about the future consequences of our decisions. And the link - the only link - between our experiences in the past and our expectations of the future is theory.' The most practical man or woman - the least conscious of any intellectual influence - contemplating decision and imagining its likely consequences is using some theory to make a bridge between past and future. Theory and practice, in other words, arc not antithetical, All rational practice is based on some kind of theory. So what is the real meaning behind the claim that theory is not necessary to the practitioner? We believe that since “the world is ruled by little else”, the criticism often levelled at theory is either directed at bad or inappropriate theory, or it is due to a misunderstanding of the methodology of theory. And in order to minimise such misunderstanding. in this course, we should discuss some of its most frequent sources " So the joke that economists drive down the road looking inthe rearview mizror is figuratively true. Ifyou can't sce he road ahead, the best guide you have isthe road behind. Wht ©2003 INSEAD, Fails, Face3 Ue Gist is the methodology that we will use. This methodology - the methodology of model building - i familiar to engineers and scientists but may be Jess so to others. Theory based on ‘model building and manipulation is called “deductive” theory, and it proceeds from general to specific. As you will see, we will make some very general assumptions about individuals’ behaviour and then, using only logical reasoning, deduce the specific consequences of those assumptions. For example, we will assume that consumers are rational, we will define ‘characteristics of behaviour that constitute rationality, and then we will deduce logically how ‘consumers will react to a change in their incomes or in the prices of goods they purchase. ‘This methodology is extremely powerful and is very widely applicable. The basic microeconomic model is nothing more than a model of rational choice - a model of optimisation subject to constraint - and itis applicable to virtually all business disciplines. As you will see, it has contributed immensely to our understanding of many of the “practical” fields in business like finance, marketing, accounting, and competitive strategy. It is for this reason that Prices and Markets eppzars in Period 1 in the MBA Program. One reason why the deductive method is difficult for some to learn is that it reverses the way most of our leaming takes place. The classical methodology of science - the “inductive” method - proceeds from specific to general. One starts with many specific observations and then induces a general theory. In addition to being the classical methodology of science, the inductive method is used in the case study approach to business education. The objective of case studies is to present relatively realistic business situations from which you must induce generalisations. These generalisations are, of course, theories, although they may never be rigorously or formally expressed as such. The important point to appreciate, however, is that Just as all practice is based on theory, alll your courses here at INSEAD are theoretical courses. What may differ is how theory is built and used. In a case study course, the challenge to you is to find the theory. If you do not discover some generalisation (j.e., some theory) from a case, all you have done is read a story. In Prices and Markets, the theory will be presented explicitly, and the challenge you face is to apply it to specific problems. To help make the deductive method a bit easier to accept, there are a few common objections to it that should be addressed up front. The first and most common is that the general assumptions of economic models ere not true. Producers do not single-mindedly maximize profits and consumers are not perfect utility maximizers. But if these assumptions are not true, how can the specific conclusions drawn from them be valid? (Our response is that the assumptions are certainly not precise descriptions of reality. They are simplifications that make it possible to build a tractable model of reality. Any model based on ‘assumptions that are complete and realistic would be so overwhelmingly complex that it ‘would be impossible to formulate, let alone manipulate. In the extreme it would cease to be @ model of reality at all. It would be reality itself. So assumptions must be “unrealistic” if they are to be useful. The challenge to the mode! builder is to ensure that the simple assumptions do not omit or falsely represent aspects of reality that affect the usefulness of the models conclusions. And clearly this depends on the use to which the conclusions will be put. To give ‘an example from another field, a land surveyor usually assumes that the earth is flat. Although false, the assumption makes his or her work easier and does not significantly distort the usefulness of the results. In other cases, such an assumption would not be satisfactory, and ‘more realistic and more complex assumptions Would have to be made instead. ‘opr ©2003 INSEAD, Fontmnabley, FaceINSEAD 1 \ sccond problem some students have with economic models is the widespread use of sraphical construction. We use the lunguage of diagrama because it is substantially more rewerful and efficient than French or English, Nonetheless, we will always seek common pinse verbal explanations for what may be first demonstrated graphically, Long after you forget the diagrams, you should remember the principles that they revealed. A final common objection is that practical use of nearly all of the economists’ models requires calculations of marginal changes (or rates of change) that individuals find very ‘lifficult to do and that are rarely actually done. For example, we will see that if a manager is ‘o seta price that will maximise profit, he or she will choose the price that results in an output st which the cost of another unit of output precisely equals the revenue it ears, Yet managers Jo not usually think in these terms, they are often totally unfamiliar with the concepts that lead to this result, and the data that are needed to make these calculations are not produced by business information systems. So of what use can our models be, either positively - as a description of how prices are set - or normnatively - as a guide to how prices: should be set? A number of replies can be made to this criticism. The first is that in a reasonably competitive economy, those managers who survive and prosper behave as though they make the economists’ rational calculations even if they do not explicitly do so. Those who consistently behave differently are likely to go bankrupt. So we can legitimately build a model of an ‘economy assuming that managers make rational calculations, Second, as formal business education becomes more common and as business operations become mire sophisticated, explicit optimising models appear in actual use more and more frequently. Regarding data availability, many times the relevant date are difficult to construct, but this does not defend the use of readily available but irrelevant data, There is an old joke about a drunkard who looked for his lost watch under a streetlight rather than in a dark alley where he dropped it. Presumably a sober person would struggle in the darkness, difficult though it may be, if that is where the object of search lies. Finally, while it is true that many successful managers do not use the economist’s “stock of habits and techniques, of methods and concepts”, but rely on instinct or luck as substitutes, your decision to spend this year in formal business education indicates that you are unwilling, to count on instinct and good luck to ensure your successful career: Before starting the course, a few remarks about the conduct of the class sessions and how to prepare for them are in order. Before each class, you should go through the text assignment and the class notes and work on the problem set. You should try hard to understand the key concepts which are featured in the class notes. We will stress those key concepts in class with an occasional short lecture but most often in the context of solving the assigned problems. Le,, we will do the theory by doing the problems. So it is very important that you try conscientiously to do these problems. You probably will not succeed with all of them, but you ‘cannot learn economics just by reading the text. Frustrating though it may be, you can only learn to use the tools of economics (like the weapons of fencing) by practice. You should find thet there is a mixture of economics expertise in your study groups that can ‘be pooled to everyone's benefit. Those of you who have never studied economics should. ‘expect help from those who have lots of economics in their repertoires. They, in turn, will be challenged to communicate their knowledge in everyday terms to those who know less, And ‘Copyioht ©2003 INSEAD, Fontana, FaeINSEAD 5 most of the problems that are assigned can be answered at different levels of sophistication, “hich should provide a challenge and an opportunity to learn for everyone in the class. Copyright © 2009 PYSEAD, Fommeben, Face