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TOPIC 1: THE INDIVIDUAL AS DECISION MAKER
• Motivation
• Methodological individualism
• Cost-benefit analysis
• Theory of asymmetric value function
• Decision making under uncertainty
1- Why do we care about decision-making?
-What determines how much effort workers put into their jobs? -What determines the kinds of investment that managers make? -What determines which products consumers buy? In each case an individual is taking decision, so to provide answers we need some theory to KNOW HOW an individual makes a decision.
2- Classical economic view.
Traditionally, economists view choices as the outcome of individual cost-benefit calculations. Some conclusions are:
• People make choices autonomously
• Understanding the behavior of organizations requires understanding de behavior
of its individual members. Who is society? There is no such thing! This framework is called methodological individualism.
Eg: A 25 September 2011 La Vanguardia article quoted an expert who claimed that Greeks do not pay taxes because Ottoman Rule made them distrust the State. An economist would say that they have computed the costs and benefits of doing so, and determined that not paying taxes has a higher value.
3- Economic decision making
• Economic decisions have two features:
• Two or more alternatives. They can be anything.
• Some constraint limiting the number of alternatives that can be selected.
Often money or time.
4- Cost-Benefit Analysis
Economic cost-benefit analysis can be quite subtle. The main difference with accounting is that the cost of a decision must include the value of the best foregone alternative, the opportunity cost.
Resource constraints are what make opportunity costs relevant à choosing one alternative means not choosing the other, the value of the foregone alternative is relevant for individual choice.
The opportunity cost: the value that you loose when you choose one of the X choices you have. The opportunity cost of choosing A is the value of B. The opportunity cost of X is the value of the next best thing.
Eg: This morning all of you made a choice between two alternatives: Stay in bed or coming to UPF. Suppose the day’s lectures at UPFare worth 10€ to you, while staying in bed is worth 8€. Suppose further the cost of today’s train ticket is 3€.
BENEFIT- COST
VALUE OPPORTUNITY COST
TOTAL ECONOMIC COST
TOTAL ECONOMIC PAYOFFS
UPF 10 -3 7 8 3+8=11 -
BED 8 0 8 7 0+7=7 1
5- Two common mistakes
1) Sunk cost error
Sunk cost: A cost that is paid independently of the choice made. A cost that is paid regardless of the choice made. A common confusion in economic decision making is treating a sunk cost as relevant for making a choice. Example of Toledo.
2) Failure to recognize opportunity cost
It consists in not recognizing that resources used on one choice have an outside value. For example shopping in developing countries often involves extensive bargaining, what do you prefer, a little bargain and spending time in it, or don’t bargain and have more time?
6- In summary
• The kind of cost-benefit analysis that economists consider is not straightforward
(senzill).
• Even professional economists have difficulty getting the correct answer
sometimes.
• This can lead to serious mistakes in business decisions. For instance continuing to
do research and development on a potential new product just because a lot of money has already been invested.
7- Implications for organizations
Changing behavior requires changing the costs and benefits of alternative actions. New incentive schemes can lead to perverse behaviors if they end up rewarding actions that are not the ones intended (“gaming the system” or “creativity”).
8- Limitations of the Framework
3) Intellectual versus evolutionary rationality
Intellectual Rationality: is the capacity to reason through problems to come up with solutions. This is what economic agents do, but people don’t. (Make tables) Evolutionary Rationality: instead of intellectual Rationality, people use evolutionary rationality to decide. Don’t have to think when we do some things. Much of our instinctual behavior is the result of accumulated past adaptations. This does not necessarily make it bad, indeed the opposite may be the case. Organizations are often the outcomes of evolutionary rather than conscious design. We can still seek to make incremental improvements as managers and policymakers.
4) Rationality versus self-interest
It is often assumed that people only value their own material well being, but this does not have to be the case even if people are rational. If you saw an old lady drop 50€, What would you do? Why?
5) Actual versus ideal preferences –Should versus Do-
It is difficult to argue that cost-benefit analysis is incorrect, but substantial evidence that people do not follow it (cadaques llafranc). One stream of economic research analyzes how people actually make decisions. We will study one such framework (discussed in Arruñada but not BSZ)
Asymmetric Value Function*
6) Self-control and time-consistency
Defining truly “irrational” behavior in the context of one decision is difficult. It is less difficult in the context of repeated choice. If today you state that you prefer A over B tomorrow, then when tomorrow comes a rational person should choose A over B.
A failure to do so is called Time-inconsistency****. Eg of time inconsistency: Fruit versus chocolate; gym membership, Smoking, Savings plan.
Suppose you want to sell car with leather seats:
c) Sell the car for 30,
d) Sell the car for 32,000 and include “leather seats for free”
Markets with suppliers with asymmetry value function In NY, cab drivers tend to drive until they reach a target (reference point) money level, then they go home.
• Why do they do this?
Avoiding losses is more motivating than trying to increase gains (loss aversion)
• What happens to supply when demand high/low?
Raining: there is a higher demand à target hit fat à go home à descend the supply August: there is less demand à target difficult à keep drivingà supply more
• Are old or young drivers more likely to do this?
Old drivers don’t follow targets
13- Decision Making and uncertainly
The last idea we will cover in this topic is decision making under uncertainly. That happens when you take one action and you don’t know what will happen. In many contexts, especially business, the exact payoff of a particular action is unknown. You know the distribution of payoffs, but not the payoff that will be realized, they can be probabilities.
“When you invest money today, what will be your payoff tomorrow?”
a) EX ANTE (before) versus EX POST (after)
When the consequences of actions are not known exactly, the optimality of an action cannot be judged on the realization of the payoff, must be judged before the payoff is realized This is the distinction between “ex ante” and “ex post” (explained later in the course)
(Example of the two choices)
b) INFORMATION ACQUISITION
In some cases, the degree of uncertainty about an action’s payoff is something the decision maker himself can choose. For example: I hope you made some effort to discover the implications of choosing UPF over other schools, at the same time many people seem to not know very much
(Example of survey on spending habits+EUA)
c) MARGINAL BENEFITS AND COSTS
(see the slides)
d) BEHAVIORAL PREDICTION
If you behave optimally, you will acquire information up until the point that the cost of searching a little bit more (which is costly in terms of time) equals the increase in happiness of your boyfriend/girlfriend of searching a little bit more (which you value).
The key search is: a little bit, but not forever.
e) BOUNDED RATIONALITY
Our ability to maximize utility is limited by TIME, INFORMATION and COGNITIVE CONSTRAINTS (memory) Rather than optimizers, economic actors may be satisficers : they may search for an alternative that is satisfactory and sufficient for meeting their needs rather than the best available alternative.
