This topic examines not just what goods and services consumers buy, but why they buy them. The standard neoclassical model, based on expected utility theory and indifference curve analysis, examines the ‘what’ question, but is too narrow in focus and involves numerous anomalies. To gain a better understanding of what people buy it is necessary to understand the psychology of consumers and examine the ‘why’ question. This approach reveals several important biases which cause the anomalies: biases in expectations, biases in estimating and maximizing utilities and biases in discounting. These biases are often a result of bounded rationality, social preferences and emotional or visceral influences. The field of behavioural economics has developed a body of theory, based on the concepts of prospect theory and mental accounting, which accounts for these biases and anomalies. The fundamental concepts here are the use of reference points and loss aversion. These and other behavioural factors are in turn based on evolutionary psychology. The process of natural selection has caused our brains to evolve not as utility maximising machines but as biological fitness maximising machines.

This topic examines relationships between inputs and outputs in the production process. The starting point is the explanation of various concepts that are fundamental in production and costs: factors of production, fixed and variable factors, short and long run, scale, productivity and efficiency. The increasing importance of intangible factors is discussed, along with their main features of scalability, sunkenness, spillover effects and synergy. Production functions can take various mathematical forms. The significance of average and marginal product is explained. The concepts of the law of diminishing returns, isoquants, economies of scale, diseconomies of scale and returns to scale are introduced and interpreted. The determination of the optimal use of factors of production is explained, using mathematical analysis. Case studies play an important role in this topic in terms of demonstrating the application of theoretical concepts to real-life situations, particularly in a digital age where intangible assets and network effects are important. The leading case study relates to the so-called ‘productivity puzzle’, and various explanations of the puzzle are presented.

This second chapter on business strategy examines marketing mix decisions. In particular, it focuses on more complex aspects of pricing not covered in the context of Chapter 9 on market structure and pricing. This starts with a discussion of price discrimination, and its various degrees and types. It then moves on to examine multi-product pricing, transfer pricing and dynamic aspects of pricing over the product life cycle (PLC). A detailed discussion of psychological pricing is included, and this covers behavioural aspects not normally considered within the scope of managerial economics, but highly prominent in real-life applications. Advertising decisions are also discussed in the context of the marketing mix, examining the different strategy variables in terms of content and choice of media. Recent trends in strategy related to digital and social media are discussed. There is also a discussion on the controversial topic of the effects of advertising on welfare. Finally, there is an advanced section at the end of the chapter related to optimising the marketing mix, which is mathematical in nature and involves some counterintuitive conclusions.

This topic examines the various concepts related to the costs of a firm, and in particular relationships between costs and output, and why these relationships are important for managerial decision making. The starting point is a discussion of the types of cost that are relevant, and irrelevant, for decision making. Distinctions are drawn between explicit and implicit costs, historical and current costs, sunk and incremental costs, and private and social costs. Cost relationships with output, and various types of unit cost, are explained, and the reasons for these relationships based on production theory. Distinctions between short-run cost relationships and long-run cost relationships are explained, and factors that can cause costs to change, aided by graphical presentation. Economies and diseconomies of scale, and returns to scale, are explained in cost terms, along with economies of scope. Cost-volume-profit (CVP) analysis is discussed, and its implications for managerial decision making. There is an extensive problem-solving section with many different types of example. More complex CVP problems are presented in case studies, for example battery charging for electric vehicles.

This topic examines how demand relationships can be estimated from empirical data. The whole process of performing an empirical study is explained, starting from model specification, through the collection of data, statistical analysis and interpretation of results. The focus is on statistical analysis and the application of regression analysis using OLS. Different mathematical forms of the regression model are explained, along with the relevant transformations and interpretations. The concept of goodness of fit, and the coefficient of determination, are explained, along with their application in selecting the best model. The advantages of using multiple regression are discussed, and its implementation and interpretation. Analysis of variance (ANOVA) is explained, and how this relates to goodness of fit. The implications of empirical studies are also discussed, and the light they shed on economic theory. More advanced aspects, related to inferential statistics and hypothesis testing, are covered in an appendix, along with the assumptions involved in the classical linear regression model (CLRM) and consequences of the violation of these assumptions.

This chapter is the first of two chapters relating to business strategy and covers the most fundamental aspects in terms of strategic planning and positioning. The starting point is a discussion of the concept of competitive advantage, and how this relates to value creation. Different types of competitive advantage, based on costs and benefits, are discussed, and these are related to market positioning, targeting and segmentation. The relevance of price elasticity is explained in the context of positioning and competitive advantage. Various forms of integration are discussed, in terms of vertical, horizontal and diversification aspects. The nature, costs and benefits of each of these forms is explained. Recent trends in diversification are discussed, along with empirical studies. As with other chapters, case studies are vital in order to illustrate the management principles; in this case, three prominent tech firms are discussed in terms of their strategy development since their origins: Apple, Netflix and Tesla. Although all of them are high-cap tech firms of global reach, they each have quite different prospects.

Almost all economists, left and right, love markets. Studies show that markets are more efficient than government because, in the private sector, managers and owners reap the rewards when they efficiently respond to consumer demand. The power of markets increases when, as in the modern world, the uses of resources have multiplied beyond measure.

Dedicated policy professionals are focused on improving their programs. Economists are more likely to also focus on opportunity cost, the damage to other programs when too many resources go to any single one. They are aware that “setting priorities” should not mean our top priority gets all the resources. In some absolute sense, safety is more important than recreation. But we should not abolish all youth baseball leagues, because a child is very rarely struck in the head by the ball.

Despite their frequent usefulness, economists place unbalanced emphasis on narrow self-interest as both compelling motive and route to happiness. Competing disciplines can lead to a deeper perspective. Positive psychology reminds us that friends and family lead to more happiness than wealth. That discipline focuses on admiration and elevation, as does the discipline of virtue ethics. These very different disciplines also agree on the importance of gratitude; it is both a virtue and a feature of the road to happiness. We should be grateful for our economy, which has led us to income per capita that is 25 times what it was in 1820. Liberty sparks our economic dynamism and is also at the heart of our constitutional democracy. In difficult times in particular, we should be grateful for our freedom.

When doing policy analysis, economists assume that a good policy is a consumer-preferred policy. When economists think about the policy process or political institutions, their normative standard is the same. The good representative is a clerk-like aggregator of consumers’ preferences. This normative standard leads many economists to be supportive of direct democracy, such as initiatives and referenda.

The founders viewed direct democracy with great alarm, because their study of history showed that the political ignorance and strong passions of the people frequently brought down democratic regimes. They favored a representative democracy, because it tended to refine and enlarge the public’s views through a deliberative process. Initiatives and referenda lead to “We win, you lose” decisions. Representative institutions are more likely to reach conclusions that reflect some minority points of view, and such compromises are more likely to be enforceable.

By encouraging deliberation, our large republic’s legislative process also encourages the selection of representatives with temperaments predisposed to consider the needs of others and the “permanent and aggregate interests of the Community.” Although the sharp splits in our nation and thus in our political institutions make deliberation less likely, the splits also make it more necessary. In Congress there are many recent examples of a deliberative process at work.

Dedicated public policy professionals are focused on improving their programs. Understandably, they neglect other worthy goals. Economists insist on focusing on the big picture: the opportunity costs for other departments and for taxpayers of spending more and more to address a single problem.

Economists find themselves at odds with experts, who singlemindedly pursue worthy ends without regard to costs. Consider megaprojects such as supersonic transport airplanes and high-speed trains. The engineers who design them want to show what they can do with “adequate” funding. Politicians want to be credited with spearheading such megaprojects. Economists, by contrast, want to be sure that consideration is given to less glamorous projects that may bring greater benefits at far less expense.

Opportunity costs are especially neglected when it comes to saving lives. It’s an easy applause line: “We should pay any price to save a life.” But some projects will reduce very small risks at a cost of hundreds of millions of dollars. Economists remind us that we all take very small risks in our daily living, and there are many programs that will reduce risk. We can’t “fully fund” them all without neglecting, for example, our education and environmental goals.

Economists find they can make useful predictions if they assume that selfishness dominates market behavior. They assume people want more goods, services, and leisure. Selfishness will often get one more goods, services, and leisure. Not surprisingly, then, studies show that economists are somewhat more selfish than the rest of us. Economists place unbalanced emphasis on narrow self-interest as both controlling motive and route to happiness.

Major economists of the past, such as Smith, Marshall, Pigou, and Knight, thought it was part of their task to remind readers that there are high and low pleasures, that many of the high ones require reason and the sometimes painful acquisition of knowledge, that we aspire to better tastes, and that such aspirations are sometimes hindered by businesses that cater to vices and overemphasize the importance of what money can buy. Today’s economists are more likely to feel a professional obligation to combat such sentiments.

Actual human beings look up to people who are virtuous. They get pleasure from selfless behavior such as volunteering. We are fortunate to have two growing schools of thought, virtue ethics and positive psychology, that combat economic relativism.