BINGHAM UNIVERSITY

REGISTRATION NUMBER: BHU/20/PGD/MGT/001

NAME: HALIMA SAM-ODE

COURSE: PRINCIPLES OF FINANCE (BUS 705)

QUESTION: ECONOMY THEORY OF CHOICE

The theory of choice in economics describes the rational decision making of the market
based on context, options and available information. This concept is commonly broken
down into 4 categories: commodity-choice theory, labor-supply theory, uncertainty
theory, and intertemporal choice theory (Kagel et. al., 1995). Each of these concepts are
parameters that apply to the decision-making process of business analysts and investors.

To begin with, the commodity-choice theory explains how the budget constraints of a
business analyst can affect their purchasing power based on available capital (Henry,
1991). The combination of products and services that are acquired to improve the
processes, products or services a business provides is a decision that analysts must make
based on the available data they have to work with. This economic principle is commonly
described as consumer demand, and it remains a major influence over the management
and analysis of an investor or analyst. The context of market cycles, market demand,
direct and indirect competitors, and the price points of all concerned products or services
are data points that guide the strategies of analysts (Chehtman, 2017). Budget curves and
indifference curves provide useful information on the higher net utility of goods or
services in direct comparison, while budget curves ensure any combination of purchases
can be afforded. The application of both analysis tools guarantees an informed optimal
commodity-choice for any business or investor to make.

Labor-supply theory demonstrates the considerations of labor in business operations and

investment contexts by an analyst overseeing workforce management or related
decisions. The principle illustrates the relationship between the amount of work
performed and the amount of consumption (e.g. wages) that is received. Labor supply in
its broad economic definition shows the relationship between the wage rate and the
quantity of labor involved in the production of any business good or service (Heckman,
1993). Although this concept seems simple, the application is quite complex due to the
number of factors that can affect this otherwise linear correlation. Business analysts
consider other pieces of information such as the size of the working population, migration
statistics, non-wage benefits, length of training required, barriers to entry and
unionization in their decision-making process (Appelbaum & Schmitt, 2009). These
factors can influence recommendations on the ideal size of personnel necessary to
complete tasks or render services, setting criteria for required qualifications or training
necessary for providing quality services, and what types of net-advantages to work
besides pay incentivize behavior that is beneficial to the bottom-line of the business.

The concept behind uncertainty theory explores the choices of the market over uncertain
outcomes and how individualized risk preferences translates to investment and business
decision making. Risk can be defined as the probability of an outcome, clearly outlined
with all possible future events or consequences known, and the tolerance for analysts and
investors is based on varying levels of resource availability (Knight, 1921). This
knowledge provides an applicable approach for risk management, cost/benefit analysis,
budget planning and insurance on the sound basis of what is possible. Uncertainty is
often defined as separate from risk due to an event’s higher degree of unknown possible
outcomes (Harin, 2006); it is also considered the basis for profits and the cause for the
effect of money and liquidity, which are viewed as a hedge against uncertainty
(Holmstrom & Tirole, 2000). Analysts use these principles of uncertainty and risk to
guide their capital management strategies, investments internally or externally, and how
much liquidity should be available based on profit targets or risk management strategies.

Intertemporal choice is the last of the major categories of economic choice theory, and it
describes how current consumption habits or decisions are likely to affect the consumer
options that are available in the future. Business analysts not only take risks based on
future probabilities, but also make these decisions based on how their consumer choices
in the present may influence these markets later (Johnson et. al, 1993). This
psychological approach to business requires foresight and self-control, characteristics
which are regarded as pivotal for the success of any business analyst or investor.
Intertemporal choice helps those in this category to properly allocate the right amount of
resources at the right time. At certain times, conducting business investments in a slow,
staggered approach is crucial to its success, while at other times aggressive disruption is
the most profitable way to administer financing. Understanding the concept of
intertemporal choice also has the added benefit of putting any analyst in a position to take
advantage of the monetary policies they are governed by, which can be used in
circumstances when business management takes decisions on saving, investing, or
borrowing resources (Webley & Nyhus, 2008).

Despite the ways in which these theories can be beneficial to businesses and investors,
they each still possess their own limitations based on how these concepts are applied.
With respect to the commodity-choice theory, one limitation that affects businesses and
investors is the law of diminishing marginal utility (Levin & Milgrom, 2004). This
describes the phenomena behind increased commodity ownership and diminished utility
for each additional unit thereafter, and it governs the limits at which purchasing power
and capital is distributed. This limitation is considered as important as a budget limitation
from an analyst’s perspective, due to the incentives of a business to save as much
resources as possible, making the capital at hand go further in efforts to grow the business
or an investment fund.

Constraints of labor-supply theory are also related to commodity-choice theory

limitations in a few ways. The relationship between the number of employees assigned to
a task and the productivity or output is not directly proportional, as personnel are also
considered a business commodity that is subject to the law of diminishing marginal utility
(Byrne, 2001). Additionally, the advantages of training and other non-wage benefits
offered to the existing supply of the labor force cannot be assured because these resources
are not all equally efficient in the production of all goods and services, or equally
productive when used to produce an alternative good (Reeves & Deimler, 2011). The
challenges of wage rates and labor quantity increase when factors of specialization and
barriers to entry are involved, due to the decreased supply of personnel that can complete
these objectives efficiently.

Practical cases of uncertainty theory in business and investing can manifest in the form of
inflation or innovation. Simply put, inflation can be caused when spending exceeds the
rate of output and aggregated demand exceeds available supply, or it can originate from
the increase in the costs of producing goods and services such that supply is
overwhelmingly high, which is referred to as stagflation (Kolodko & McMahon, 2007).
Both inflation and stagflation cause uncertainty amongst business owners and investors
with respect to future prices and operating costs. As stated earlier, uncertainty involves a
greater unknown, and in economic periods such as inflation, uncertainty theory limits a
businesses ability to exercise their purchasing power and encourages postponed capital
outflow in efforts to preserve liquidity or secure profits. Profits secured from the
introduction of successful innovative ideas are also a product of uncertainty, because new
concepts have little or no precedent for performance expectations (Lambert, 2018). The
uncertainty of innovation can also be considered as a limitation in circumstances where
the launch of a proposed idea, good or service is unsuccessful in meeting the business’
objectives.

Barriers to business activity exist within the concept of intertemporal choice theory, and
these obstacles indicate the importance of the association between risk and management
in business and investing (Arestis & Sawyer, 2009). For example, the risk of taking on
credit to gain purchasing power of an asset or commodity which has the likelihood of
appreciating in value over time is a calculated investment that involves choosing to use
purchasing power now to make profits in future. The compounded effect of actions such
as these create a frenzy of investors all with the same business plan, creating an economic
cycle of rapid escalation of market value commonly termed a ‘bubble’ (Congressional
Research Service, 2019). This cycle is often detrimental to most stakeholders and only
benefits a few, also giving the impression of instability or volatility, neither of which
offers an acceptable environment to properly manage risk.

The economic theory of choice provides insight into the best ways a business or
investment decision can be conducted. The limitations of each principle also highlight the
boundaries and challenges that may be faced and indicates pitfalls to avoid. Theories of
labor-supply and uncertainty propose a good starting point for the conduct of business
and investments, with a few areas for improvement that could prove useful within
frameworks such as SMEs or developing nations.

Firstly, the focus of labor-supply theory needs to shift from seeing each worker as having
an equal potential of output to different categorizations of labor commodities. Migrants
from other countries are already seen by many types of businesses as a preferable labor
option due to their lower wage rates and tendency to work longer hours (Datta et. al.,
2006). Even within the laws of diminishing marginal utility, almost any business that can
outsource cheaper labor will be profitable in the long term, and the labor-supply theory
needs to emphasize this distinction more so than other principles.

Secondly, uncertainty theory is based on the assumptions of economic instability or any

hardship that results in a lower outcome of goods and services than was envisaged.
Further categorization of the different types of uncertainty a business might face would
be improving upon this theory. For example, the effects of politics, international
relations, disease, trade, inequality, and other factors can contribute to the uncertainty of
a nation’s future and harm the prospects of any business or investment (Sheng et. al.,
2011) (Bapuji & Mishra, 2015) (Salcito et. al., 2014).

In summary, these divergences would help any business analyst or investor to have a
clearer understanding of the specific elements to focus on in their line of business to yield
the best results over time.
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