Business Economics - Apuntes de Negocios Internacionales

TOPIC 1: THE INDIVIDUAL AS DECISION MAKER

1. Motivation

The agents are the people making decisions. They choose the products according to their

preferences. But since individuals have unlimited wants and limited resources (resource

contraint: time and money), the alternatives we can choose are limited. Each time we are choosing

an alternative, we are discarding another, this is the opportunity cost. People always try to

maximize their wants given the constraints.

2. Methodological individualism

The classical economic view’s framework is called Methodological individualism. It states that

people are rational decisions-makers who decide in an autonomous way and because of that, if we

want to understand the behaviour of an organization, we first have to understant the behaviour of its

individuals.

3. Cost benefit analysis

Economic decisions have two features: two or more alternatives and some constraint limiting the

number of alternatives that can be selected.

Cost-benefit analysis takes into account the total costs plus the opportunity cost (the value of the

resource in its best alternative use).

Note I: So if you have three options A, B and C the opportunity cost if you choose A is the

value of only B because is the next best alternative.

Note II: Accounting analysis, we only look at the total cost, we don’t include the

opportunity cost. We calculate the value by its original or nominal value.

Common mistake 1: Failure to recognize an opportunity cost, remember that resources used

on one choice have an outside value.

Common mistake 2: When we are calculating the opportunity cost we shouldn’t take the

sunk cost (amount of money that has already been paid and so we can’t recuperate) in

consideration. Sunk cost: has already been incurred, cannot be recovered, irrelevant for present and

future economic decisions.

Example I: You’re a lawyer and you don’t have much time, so you have to decide whether to

not type and attend a case (you win $100/h) or not pay someone to type for $20/h and do it yourself.

The resource constraint is money, the opportunity cost of typing is $100.

Example II: You’re a student and you can pay 4.000 to study, the government subsides 8.000

or work and earn 20.000. The cost for studying is 4000 (for the student) + 8000 (for the

government). The true cost for studying is 32.000.

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TOPIC 1: THE INDIVIDUAL AS DECISION MAKER

1. Motivation The agents are the people making decisions. They choose the products according to their preferences. But since individuals have unlimited wants and limited resources ( resource contraint : time and money), the alternatives we can choose are limited. Each time we are choosing an alternative, we are discarding another, this is the opportunity cost. People always try to maximize their wants given the constraints. 2. Methodological individualism The classical economic view’s framework is called Methodological individualism. It states that people are rational decisions-makers who decide in an autonomous way and because of that, if we want to understand the behaviour of an organization, we first have to understant the behaviour of its individuals. 3. Cost benefit analysis Economic decisions have two features : two or more alternatives and some constraint limiting the number of alternatives that can be selected. Cost-benefit analysis takes into account the total costs plus the opportunity cost (the value of the resource in its best alternative use). Note I: So if you have three options A, B and C the opportunity cost if you choose A is the value of only B because is the next best alternative. Note II: Accounting analysis , we only look at the total cost, we don’t include the opportunity cost. We calculate the value by its original or nominal value. Common mistake 1: Failure to recognize an opportunity cost, remember that resources used on one choice have an outside value. Common mistake 2: W hen we are calculating the opportunity cost we shouldn’t take the sunk cost (amount of money that has already been paid and so we can’t recuperate) in consideration. Sunk cost: has already been incurred, cannot be recovered, irrelevant for present and future economic decisions. Example I: You’re a lawyer and you don’t have much time, so you have to decide whether to not type and attend a case (you win $100/h) or not pay someone to type for $20/h and do it yourself. The resource constraint is money, the opportunity cost of typing is $100. Example II: You’re a student and you can pay 4.000 to study, the government subsides 8. or work and earn 20.000. The cost for studying is 4000 (for the student) + 8000 (for the government). The true cost for studying is 32.000.

Implications for organizations Managers are interested in affecting the behaviour of individuals. Understanding what motivate individuals is critical. The outcome of individuals making economics choices is a functino of both constraint and preferences. Enterprises focus on constraints, not preferences (since these are hard to change or observe). A manager can motivate desired actions by establishing appropiate incentives. However, managers must be careful because individuals are clever at maximazing thir utility, therefore, setting improper incentives can motivate perverse behaviour.

Limitations of the framework Since people usually aren’t completely rational, the framwork has some limitations due to the fact that it cannot predict irrational behaviour. Intellectual rationality vs evolutionary rationality → some decisions about primitive needs come to be instinctual and based on past experiences. Rationality vs self-interest → people only value their own material well being. Actual preferences vs ideal preferences → should vs do. Example: People give to Charity, but there isn’t any reason to do so, following the cost-benefit analysis, because you give money but you don’t receive anything in exchange. Self-control vs time consistency → If we were completely rational, if today we say that we prefer A rather than B, tomorrow and always our preferences would be the same. However, usually we are time-inconsistent because today we say that we prefer A but tomorrow we choose B instead. To avoid time-inconsistency we have to find a commitment device, a restriction to our future choice. It has to be something that makes us stick with what we said (force us to do it).

4. Assymetric value function A rational person should evaluate equally gains and losses, however we prefer to avoid losses rather than acquiring gains.

People evaluate their well-being from a wealth outcome relative to some reference point rather than in isolation.
Diminishing sensitivity: the rate at which happiness is increasing in gains is decreasing. The rate at which happiness is decreasing in losses is decreasing.
Loss aversion: the decrease in happiness from losing x is strictly bigger than the increase in happiness from gaining x, we prefer to avoid losses rather than acquiring gains.
People evaluate their well-being event-by-event rather than as some aggregate outcome. Associated Marketing Strategies :

Business Economics, Apuntes de Negocios Internacionales

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TOPIC 1: THE INDIVIDUAL AS DECISION MAKER