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YOU are the one who needs to learn from your student. Many of the central sientific lessons of economic science are contained in this fact which your student is bringing to your attention. And the Econ profession shows it's scientific incompetence by not "getting it" about the lesson for scion e of these facts.

I've been the student, and I've seen the incompetence of the professor on the other side of the question who remains oblivious to the signal import of the fact articulated by the student.

Mike wrote.

"Anyone who has taught microeconomics has, at one time, had to deal with the question, That's all very nice, professor, but how am I supposed to use any of this in the real world? If I'm running a business, I'm not going to know the demand curve for the product and I'm not going to be in a perfectly competitive or a monopoly market. What's the point?

From my own personal experiences as an economist and a business person, there are a number of useful lessons the business world can learn from microeconomics."

Not quite sure this is game theory but at least vaguely on subject.

I run a little company (three people) which acts as a wholesaler and expert in a couple of the very weird and wonderful metals. Very small markets (a few tonnes a year globally) and we're the largest company in these markets. No, we don't make a fortune but a living.

There's essentially two ways you can be a wholesaler.

1) Have a pot of $ to use as capital. Purchase materials and stock and or refine them using said capital.

2) Use "trust capital" to do the same thing. Sure, it's not easy getting 45 day credit terms out of a Chinese or Russian supplier. But it can be done.

A transaction might involve purchasing material on credit in one country, refining it in another and then shipping to a customer in a third. No money is flowing until the final customer gets it, approves it and pays for it.

That trust capital needs to be nurtured of course: there have been times when we've delivered under quality goods. The reaction has to be, Ooops, yes, agreed, we'll get you some more, no worries, please send back the bad stuff at your leisure.

There was one time when a customer went into Chapter 11 before paying us....we had to turn to the supplier and tell them this and then say, well, give us an extra 6 weeks will you and we'll get your money from somewhere.

After 15 years of this we still run on no $ capital (we've a few thousand $ in the bank right now) and yet there's $550,000 of material in shipment to us right now, supported essentially by our word that payment will be forthcoming: trust capital.

As an example of quite how far such trust can go. A long term customer, I just had to impose a 140% price rise on him. Tim, you sure the global price has gone up that much? Yes, sorry, it really has. OK then.

If I ever tried to be tricky with any of the people in this little network, suppliers or customers, the entire edifice would fall over immediately.

Funny how that archaic English phrase "my word is my bond" still seems to have some relevance really.

"Life is a repeated game and in the long-run, you'll do much better being closer to the 'pie larger' side of the spectrum. Robert Axelrod and microeconomics taught me that."

I think that outcome is rather contextual. A tit for tat strategy does well in tournament settings, but its success is based on a number of factors - namely the presence of repeated interactions and the possibility of mutual gains. However, there are many settings in life where there are no repeated interactions. If I were a pimply-faced food service worker in an airport, for instance, I would have little reason to develop rapport with customers.

Similarly, there are many occasions where interactions involve relative, not absolute gains. If you are playing chess there is no potential to make both players better off, since the object of the game is to destroy one another. In international relations (where security is a big deal - you can't repeat interactions if you are forced out of the system), for instance, the implications of game theory tend to have a darker tone than in economics/business (and even then, if I'm Blue Ray and you're HD DVD, you are going down, pal).

What I get from Axelrod isn't that it is a good idea to be a nice guy. Rather that it is a good idea to be a nice guy in the right institutional settings. If I am the one building institutions, of course, it might make sense to incorporate some of the insights of the reciprocity argument. For instance, Japanese Keiretsu tend to have long-term relationships with suppliers, rather than jumping from low cost supplier to low cost supplier. This has enabled them to perform well in industries characterized by economies of scale, but less well elsewhere.

PS: I think you may also be talking as much about social capital vs. physical capital here.

"That's all very nice, professor, but how am I supposed to use any of this in the real world?"

Give economics some credit! Businesses use isocosts/isoquants to optimize input use. When selling into two different markets, they set marginal revenues equal in both markets. When operating two factories, they set marginal costs equal in both factories. They set marginal costs equal to marginal revenues, they set transfer prices equal to marginal manufacturing costs. They choose investments to maximize net present value. Economics tells them what to expect when there are price ceilings, price floors, taxes, and subsidies.

With all that useful stuff to talk about, I hope you're not wasting students' time talking about quasi-concave utility functions, but if you are, students will naturally ask how this applies to the real world.

Business don't set marginal costs equal to marginal revenues. Or equivalently, you need to define "marginal costs" to include a variable profit requirement that makes "marginal costs" mostly meaningless, as it is a function not only of the specific businesses actual costs, but of return expectations and growth expectations.

Businesses have a required internal return on capital, which is a function of how quickly the business expects to grow, and this is the dominant factor in setting required margins. As the business grows, it either continues to innovate and maintain high margins (high returns on capital and re-investment), or it slows down over time, eventually becoming a cash-flow pig. The typical return on capital is in the 8-10% range, and they set costs in order to meet that required return.

Good data on this is here:

Food for thought.

Imperfection is defined by the criteria of a)asymmetry, b)heterogeneity, c)disintegration and d)dispersion. Let us deal with asymmetry in this comment.
An asymmetry of advantages implies imbalanced scarcity of secure resources that bounds practices and unbalanced danger of estimates of value that bounds decisions.For example, a buyer of complex products of forward performance and delivery has an inferior ex ante estimate of performance (issue of diversity) and an inferior ex post resource constraint of delivery (issue of evasion) than the seller who knows more about performance and can control approximately forward delivery. Thus asymmetry implies that the price is set by the seller, not neccessarily equal to the notional value of the buyer and the quantity is set by the buyer, also not neccessarily equal to the notional level of resources and production of the seller. (This is ONE source of the Keynesian solution of equilibrium stasis). Games that are played must take asymmetry into consideration.

"If I were a pimply-faced food service worker in an airport, for instance, I would have little reason to develop rapport with customers."

Direction of causality may be the other way, or at least be reinforcing: would those who have the right skills, including social skills/capital, be here in the first place? If the pimply-faced worker proves good at developing that rapport, will they stay in that job or be offered something better, where those skills have a higher value, by someone with a nose for talent?

I'm not (intentionally) being facetious here. The institutional setting is both a sorting system and a reinforcement mechanism (of what behaviour is rewarded in that institution); the exact mix and direction of change depends on a lot of other issues.

Or going back to the original post: there's a strategy proposed that tends to be rewarded highly over time. It may be poorly rewarded in particular contexts - and yet, over the repeated interactions of a lifetime/career still be the dominant strategy.

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