Lecture 2 Rational Behaviours - Lakehead Universityflash.lakeheadu.ca/~kyu/B5017/B2.pdf · Lecture 2 Rational Behaviours Business 5017 Managerial Economics Kam Yu Fall 2013. ... People

Lecture 2 Rational BehavioursBusiness 5017 Managerial Economics

Kam Yu

Fall 2013

Outline

1 Rationality: Some Basic Concepts

2 Constraints

3 Utility Maximization: The Cost-Benefit Principle

4 Social and Business Group Behaviours

5 Prisoners’ Dilemma within a Firm: The Problem of Shirking

Kam Yu (LU) Lecture 2 Rational Behaviours Fall 2013 2 / 27

Rationality: Some Basic Concepts

What People Want

In classical economics, we start with some simple assumptions abouthuman behaviours:

People are self-interested, that is, we care about ourselves and ourfamily more than other people.

Well-being or welfare is measured by a quantity called utility. Infacing two choices, say A and B, A has a higher utility than B meansthat the decision maker prefers A to B.

In making economic decisions, people behave rationally.

Given our cognitive limitation, rationality does not mean that we donot make mistakes. This is sometimes called bounded rationality.



What is Rational Behaviours?

A few assumptions:

1 Individuals have well-defined preferences. Given two choices, we areable to decide we prefer one or the other, or we are indifferentbetween them.

2 We are consistent with our ranking. For example, if we prefer A to Band B to C , then we must prefer A to C .

3 There is always something that we want more. That is, we are nevertotally satisfied with what we have.

An implication of these assumptions is that people always maximize theirutility subject to the constraints that they face. The constraints can befinancial, physical, social, or legal.



Are the Assumptions of Rationality Reasonable?

As in any branch of science, the purposes of the assumptions are tosimplify and to isolate the important features that we want toinvestigate. “All models are essentially wrong, but some are useful.”

For example, in studying mechanics, we frequently start with anobject with mass m resting on a frictionless surface. We can put thefriction back into the model if it is important.

One of the objectives of behavioural economics, also called economicpsychology, is to investigate whether people systematically behavedifferently from the classical model.

From this perspective, models based on rationality can be used as aguide to improve decision making.


Constraints

Financial Constraint

In consumer analysis, a financial constraint is often called a budgetconstraint.

For example, a consumer buys two goods, food and shelter. Let Fand S denote their quantities, and PF and PS their market pricesrespectively. With income or budget M, the constraint is

PFF + PSS = M.


Constraints

Physical Constraint

Time is a physical constraint. For example, the day before a test, you canchoose between studying and playing golf:


Constraints

Institutional Constraints

1 Social constraints are often called informal institutions. Examples are

Religious: Hindus don’t eat beef, Muslims and Jews don’t eat pork,Buddhists are vegetarians.Cultural: Japanese women don’t work after marriage.

2 Legal constraints are often called formal institutions. Examples are

Illegal drugs, alcohol and tobacco to minorsSlavery and prostitutionSunday shoppingHealth and safety regulations


Utility Maximization: The Cost-Benefit Principle

Opportunity Cost

The opportunity cost of a valuable resource is the benefit one can get byputting it in the best alternative use. Such resources can be time, money,talent, or options.

For example, getting a MBA degree involves

Direct costs: tuition fee, books and other expenditures, studying time

Opportunity cost: lost incomes, lost work experience, spending timewith family and friends

Other options: getting an advanced degree in engineering



The Cost-Benefit Principle

A rational individual will undertake a course of action if the the totalbenefit is at least as high as the total cost.

Changes in external factors can affect costs, benefits, and theconstraints.

Optimal choices can vary across economies with different endowmentsand constraints.

A lot of decisions we make today will incur costs and benefits in thefuture. We need a framework for comparing monetary values of thepresent and the future.



Intertemporal Rational Decisions

What is the opportunity cost of capital investment? It is the return ofputting the investment in the best alternative use.

For an economy with a well-functioning financial sector theopportunity cost of holding money is the interest rate. This interestrate r is the key factor in linking the present and the future.

Suppose the market interest rate is 5% per year. What is $100 nowworth next year? By putting the money in a bank, the amount willbecome $100(1 + 0.05) = $105 next year.

Conversely, the present value of $105 a year from now is

PV =105

1 + 0.05= $100.



Present Value

In general, the present value of any sum of money M in a futureperiod is

PV =M

1 + r,

where r is the interest rate between now and the future period.

In cost-benefit analysis, all future benefits and costs are converted topresent values to be aggregated into total cost and total benefit.

A piece of equipment that cost $200 now will increase a firm’s profitby $90 at the end of this year and $120 at the end of next year. Themarket interest rate is 10%. Should the firm invest in the equipment?

The present value of the future profits is

PV =90

1 + 0.1+

120

(1 + 0.1)2= $180.99,

which is less than the cost of the equipment. Therefore the firmshould not invest.



Rational Decision Rules

In general, the term 1/(1 + r) is called a discount factor. Any futurecost or benefit is discounted to get its present value.

Consequently, the further the sum of money in the future, the heavierthe discounting and the less it worth now.

This leads to the following rule of thumb:

1 Postpone costs as long as possible and collect revenues as soon aspossible.

2 The higher the interest rate, work all the more diligently to follow thefirst rule.



Risk and Uncertainty

Former US Secretary of Defence, Donald Rumsfeld, on the distinctionbetween risk and uncertainty:

“There are known knowns; there are things we know we know. We alsoknow there are known unknowns; that is to say, we know there are somethings we do not know. But there are also unknown unknowns—the oneswe don’t know we don’t know.”

The analysis of risk in economics mainly deals with known unknowns.That is, although we are not sure which outcome will be realized but weknow the objective or subjective probability distribution of the outcomes.



Incorporating Risk in Decision Making

Suppose that an investment will result in a benefit M next periodmeasured in dollars.

With interest rate r , the present value of the benefit is M/(1 + r).

There is a probability p that the project will fail. The risk adjustedreturn is then

PV =(1 − p)M

1 + r≈ M

1 + r + p.

The approximation works for small values of r and p (less than 10%).

The term p is sometimes called a risk premium of an investment.


Social and Business Group Behaviours

Common-Interest Theory

Two characteristics:

1 Mass of Interdependency — The group as a whole is more forcefulthan the sum of individual efforts. Examples: labour unions,environmental groups, political parties.

2 Common Interest — Individuals have incentive to work with others topursue a common interest. The connections can be cultural, national,ideological, or political (lobby groups).

I am a

Canadian

Northern Ontarian

Port Arthurian

ThunderWolves fan

Member of Professional Engineers Ontario



Involuntary Membership

Group memberships are often involuntary and sometimes under coercion:

Nationality: Some countries forbid dual citizenships.

Culture, religion, and language: Globalization is a form of culturalinvasion?

Race and ethnicity

Social caste: Brahman (priest), Kshatriya (warrior), Vaishya(merchant or farmer), and Shudra (labourer).

Labour union: Some U.S. states have right-to-work legislations.

Family

When memberships are voluntary, economic logic often applies.



Economic Logic of Group Behaviour

Decisions to join a group is based on rational cost-benefit principle.

Private benefits may include companionship, security, recognition, andsocial status.

Public goods (non-rivalry and non-excludable) are also produced bycollective action.

Input efforts may suffer from “free riders” problem.

Fundamental question: under what conditions can spontaneouscooperation be realized without the coercion of a third party?

Small groups often need to rely on some commitment mechanisms:1 Cult: a small group of people engaging in exotic activities.2 Culture: a large group of people engaging in exotic activities.



Free Riders: Some Examples

SkyTrain: The pride of Vancouver

Paul Feldman’s honour plan on bagels: 10 to 13 percent of thecustomers do not pay.

Right-to-work laws that make union fees voluntary: portion of freeriders ranged from 9 percent in Georgia to 39 percent in SouthDakota.

Babu, a restaurant in New York, experimented with a priceless menu:some people over-ordered food, some people over-paid, some peopledid not pay.

Open-source softwares, Wikipedia


http://flash.lakeheadu.ca/~kyu/B5017/RightToWork.pdf

http://flash.lakeheadu.ca/~kyu/E2017/Check.pdf


Game theory: The prisoners’ dilemma revisited

Repeated games: players tend to cooperate if1 the game is played indefinitely, and2 the players know the history of other players’ behaviour, and3 the number of players is relatively small.

The other side of the coin: cooperation is difficult to achieve if1 the game is finite, or2 information on other players is lacking, or3 there is a large number of players.

Modern industrial production does not always have repeatedcontracts; dealings are mostly impersonal; and involve a large numberof specialized labours.

Example: A Boeing 747 contains some 6 million parts, all of whichhave to be ordered, tracked, assembled and often carefully monitoredthroughout their service life.



Overcoming the Cooperation Dilemma

How do real life human activities in a modern economy overcome thegame-theoretic impossibility? Suggested solutions by Ronald Coase:

Transaction costs seem to be inhibitive if the negotiating parties startfrom scratch.

If, however, formal and informal institutions exist to1 constrain the opportunistic or defective behaviour,2 reduce incomplete and asymmetric information,3 police and punish defecting players,

the average transaction cost can be low and a socially desirableequilibrium may exist.

Neoclassical economics: a survival-of-the-fittest process will eliminatedeviant behaviour and the efficient institutions will eventually evolve.At the end institutions can be ignored in economic analysis.



But Things Can Go Wrong . . .

Individual often act on incomplete information and subjectiveerroneous models.

Feedback is insufficient to correct the models.

Institutions are designed to serve the interests of the powerful and notto be socially efficient.

Transaction costs in social bargaining can be high to prevent anefficient outcome.


Prisoners’ Dilemma within a Firm: The Problem of Shirking

Shirking and Productivity

Individual productivity is positively related to work effort of eachworker.

Overall productivity of the firm relies on team work.

Remuneration depends on overall productivity and individual effort.

Utility of individual workers increase with income but decrease witheffort.



Shirking and Productivity

Individual productivity is positively related to work effort of eachworker.

Overall productivity of the firm relies on team work.

Remuneration depends on overall productivity and individual effort.

Utility of individual workers increase with income but decrease witheffort.



I Caught you Fooling Around at the Photocopying Machine

Both the workers and the firm suffer from the dilemma.

A potential solution is to hire a tough boss to penalize any workerscaught shirking.

This changes the incentive of the workers to shirk on their jobs.



Who Wants to be a Tough Boss?

With a tough boss, the payoffs of the workers increase from 30 to 100in our example.

Therefore both the workers and the firm would want a tough boss inchange of the firm.

A tough boss is similar to a commitment device.

But who will watch the watchdog?

The top manager’s payoff must be related to the profit of the firm.That is, he or she should be a residual claimant.

This may not work for government departments and not-for-profitorganizations.



The Art of Cooperation: Battle of the Sexes

Marsha and Tom love each others’ company in watching movies.

Marsha prefers drama but Tom prefers action.

Their utilities depend on whether they can watch their favouritemovie and being together.

The one with a stronger will is better off.



Battle of the Sexes at Work

Team works may require all participants to conform to the samemethodology, work habit, time schedule, etc.

Conflicts arise when workers have different preferences.

A “democratic” process to resolve the problem can lead to hightransaction costs.

A tough manager who can balance the interests of the workers andthe firm can make a more efficient decision. This is where leadershipskill comes in.

This explains why democracy rarely happens in private organizationalstructures.


Documents

Lecture 2 Rational Behaviours - Lakehead Universityflash.lakeheadu.ca/~kyu/B5017/B2.pdf · Lecture 2 Rational Behaviours Business 5017 Managerial Economics Kam Yu Fall 2013. ... People