Business Economics: Term 1

TOPIC 1:The individual as Decision maker

Why Do We Care about Decision-making? Consider the following questions:
What determines the kinds of investment that mangers make?
What determines how much effort workers put into their jobs?
What determines which products consumers buy?
In each case an individual is taking a decision, so to provide answers we need some theory

Which individuals make economic decisions?

Consumers
Managers
Shareholders
Employers

Economic decisions are important because the resources are limited and we cant choose
to buy or invest on everything so its restricted by constraints.

CLASSIC ECONOMIC VIEW

Its the way the economistsve viewed choices, thinking that the important part of the result is the cost-benefit calculations.

 Traditionally, economists view choices as theoutcome of individual cost-benefit calculations

People make choices autonomously
Understanding the behavior of organizations requires understanding the behavior of its
individual members
This framework is called methodological individualism.
Economic cost-benefit analysis can be quite subtle
Themaindifferencewithaccountingisthatthecost of a decision must include the value of
the best foregone alternative (opportunity cost)
Resource constraints are what make opportunity costs relevantchoosing one alternative
means not choosing the other, the value of the foregone alternative is relevant for individual choice

Features of economic decisions:

There are two or more alternatives
Theres a constraint thats limiting the number of alternatives we can choose (ex: money,
time, theyre limited resources)

Alternatives can be anything (choosing one product or another, choosing to go out with
friends or to study,..). Economic cost-benefit analysis doesnt give you only a right decision, its quite subtle. When we look at the alternatives, we have to see the opportunity
cost of choosing each option: if you choose option 1 then you cannot get the benefits of
option 2.

*Ex: lawyer ppt: The opportunity cost of studying for the student is the money he pays
plus the money hes not wining (the salary hed have if he was working), but if we look at

the quantity of money its wasted on studying we have to add the money the government
gives to the college.

Ex 2: First-Year Student Choice

Most first year students have two goals:
To be academically successful
To integrate socially / make new friends
Time constraints mean that pursuing one goal often reduces the chance of meeting the
other

The constraint is often money, but time is probably more relevant for many people.

SUNK COST

Irrelevant cost, we cant recuperate it so we dont have to care about it. Lets think weve
invested money and weve lost it. The future decisions shouldt be based on the fact that
weve wasted capital, so you wont recuperate it and trying to reactivate it by investing
more would probably result loosing more and more money. We should base our future decisions on the fact that nowadays weve got less money.

Example: You have to go to a concert, and youve waited 20 minutes for the bus but it
hasnt arrived yet. Should you wait more for it or should you take a taxi?- What you decide
instinctively is that you have to wait more for the bus so you have invested time on it, but
actually you shouldnt be based on this theory, so you wont recuperate the 20 minutes
anymore, you only ought to base it on the fact that now you own 20 minutes less, so
theres not only one correct answer to this question, you can decide to wait for the bus
thinking that now its more probable that the bus comes, or you can decide to take the
taxi to be sure you arrive to the concert at time. You also have to think about the oppor-

tunity cost of doing each option, so you may waste more money if you take a taxi and you
could not be able to take it immediately, so it might also cost a period of time. Otherwise,
the bus is probably the cheapest option, but the time you are risking to waste is probably
much more than the taxi one, so you have a bigger risk of not arriving to the concert at
time.

We have to take in account that if you choose one option youre not earning something. If
you can choose between wining 5 or 10 and you choose to win 10, you have to know
that youre choosing not-to-win 5 even if your choose is the one that gives you more
benefits.

Limitations of the framework:

Do we have to use our intellectual or our evolutionary rationality?
*Book to read: Think fast and slow- Daniel Kahneman [its about the way we can react to things when we
take economic and social decisions, we can react instinctively (think fast) or rationally (think slow)].

ASYMMETRIC VALUE FUNCTION

The choices we take are not totally rational (theyre not only taken by cost/benefit calculations). In a rational way a x benefit its as relevant as x cost. For humans its more important not-to-loose rather than winning. They prefer not investing in something that
could make you win till 100 and loose till 80, even the quantity you could be able to win is
grater than the quantity you could lose. Psychologically our value function is represented
this way: we give more importance to losses than to gains. If you lose 10 its more important to you (in a negative way) than if you win 10 (in a positive way.
The main properties of the function are:
Reference point: its the state where the decision maker is before it takes the decision
Diminishing sensitivity

 Loss aversion: refers to the tendency of decision makers to strongly prefer avoiding
losses to acquiring gains (irrational behavior)
Event-by-event

There are some marketing strategies to change the perspective of the decision maker who
is irrational:
-

If you combine losses it will have less negative value than if you segregate them: for
someone its more valuable to lose 10$ 10 times rather than loosing 100$.

If you segregate gains it will have the opposite effect: its more valuable to win 10$
10 times rather than wining 100$.

Offset small loss with larger gain: wining 60.000 and loosing 1.000 its less valuable
than just winning 59.000.

Segregate small gain from large loss: loosing 60.000 and winning 1.000 its less valuable (in a negative way, so its better) than just loosing 59.000.

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.

Example: you daily have to choose between chocolate and fruit, and you want to choose
fruit, but even you think the fruit option its more rational you sometimes chose the
chocolate one, even its worth for you health. You can find more examples in gym membership, smoking, savings plan, etc..

Commitment Device

One way around the time-inconsistency problem is to find commitment devices. These
are restrictions on future choices that force an individual to take a decision. Notice that in
standard economics, limiting choice can never make an individual better off.
-

A commitment device is something that makes you choose the rational decision,
the one that even its the less attractive, for example, if you have a really annoying
clock alarm, you will prefer waking up rather than listening to it.

Decision-making and uncertainty

In economics you mostly dont know what the future payoff will be exactly. If you dont
have enough information about the investment you are on a situation of uncertainty.
Ex ante: the situation where you are before you decide what to do: to invest in something,
etc You have to think about the consequences of the decision before you do it, not after
it or during the realization.
Ex post: the scenario you are when youve decided what to do.

TOPIC 2: Market and organizations