Business Organization 2023-24

1. Economists’ view of Behaviour

Prof. Ramon Xifré

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 Course Pillars
• Course Goals - to understand & to communicate
effectively on business topics
• Active Learning – read the slides before lectures,
and cases before seminars (not all slides will be
covered in lectures)
• Psychological Safety – don’t be afraid of
participating or expressing doubts, questions or
ideas. Lectures & classes are a working time for all

• My Goal: Your experience of Learning-By-Doing

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 Contents
1. Economic behaviuor: an overview
2. Alternative models of behaviour
3. Decision making under uncertainty

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 1.1 Economic Behaviour. An Overview
• People have unlimited wants
• Resources are limited
• Choices must be made on how to allocate these
scarce resources among the unlimited wants
• People face TRADE-OFFs or exclusive
alternatives: there is no “free lunch”.

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 The Nature of Economic Choice
• Individuals choose the preferred option, subject
to constraints of:
• limited resources (money, water; time,
information,…)
• costly and imperfect information
• Individuals learn from their mistakes – evolution
and rationality.

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 Economists’ view
• Main Question. Is there any common pattern that
helps explain how people make decisions like
those?
• Economists typically approach decisions with theses
key concepts:

§ Forget about Sunk costs

§ Focus on Opportunity costs
§ Consider marginal costs

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 Examples of (Economic) Choice
• To buy a computer
• To study this degree at ESCI-UPF
• To smoke
• To get married
• To refurbish a store

Ø Not of all of them are directly economic, but all of

them:
Ø Have economic implications
Ø Can be analyzed from a “rational” (i.e. economic) point of
view

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 Sunk Costs
• Benefits and costs that have preceded the
decision are sunk and therefore irrelevant to
the decision
• These costs somehow pose a conflict with the
marginalist decision making.
• By definition, sunk cost are not recoverable
• Why do they matter: Decision biases!

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 Sunk Costs - Example
• You and your couple paid 18 euros for two
cinema tickets for the film “The Secret Life of
Walter Mitty”.
• Once you’re watching the movie, none of
you is enthusiastic about it and you even think
you two are “losing your time”…
• What should you do?
• Why different people react differently in this situation?
(External Options or Opportunity Costs)

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 Opportunity Costs
• Explicit costs are explicit, direct money
expenditures
• Opportunity costs reflect the indirect, implicit
costs (beyond direct money expenditures) in
terms of the “trade-off” or “sacrifice” you
make by choosing a given option and forgoing
the others.
• The value of the (best) foregone option is the
opportunity cost of the option selected

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 Examples. Opportunity Cost vs Direct Cost

Decision Direct Opportunity

Cost Cost
To buy a computer

To study this degree

at ESCI-UPF
To smoke

To get married

To refurbish a store

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 Consider Marginal Costs
• When choices are made, people think at the
margin
• Marginal benefits are the additional benefits
obtained if the choice is made
• Marginal costs are the additional costs incurred
if the choice is made
• Take an action if marginal benefits are greater
than the marginal costs

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 Example – Marginal Decisions
• In Spain, with a progressive Personal Income
Tax (IRPF), the marginal tax rate for the largest
incomes can be higher than 50%?
• Do you think this has any impact on the well-
paid professionals’ decisions on how much
extra (marginal) hours work?

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1.2 Alternative Models of Behavior
The “economic model” is not assuming that
individuals are selfish (altruism can be explained
economically) or that they only care about money

We will review two alternative models of

behaviour:
a. Only money matters
b. Happy-is-productive
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 Alternative Models
• Only Money Matters
o Reductionist and simplistic model: “everything and everyone
has a price” – the “economic model” is richer and more
subtle than this
o The only (or main) component of job is monetary
compensation;
o Therefore, anyone can get anybody to do anything for a
sufficiently high compensation; the economic model cannot
guarantee that!

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 Alternative Models
• Happy-is-productive
o Employee satisfaction and happiness is not a mean in itself
but rather instrumental to firms’ goals
o It is the view of the managers who believe that “happy
employees are more productive”
o In this way of thinking, employees exert higher effort and
dedication in the job not when they are better paid, but
when they feel better treated

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 Comparing models
• Compare the “Economic Model” and the
“Happy is productive Model”
• Suppose that an employee is guaranteed
lifetime employment with a large salary
– What’s the prediction about the employee’s effort
and performance under the economic model? Easy
job life and poor results
– Idem, under the “happy-is-productive”? High
motivation, high effort and high performance.
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 1.3 Decision Making Under Uncertainty

a. Describing Risky Outcomes

i. Lotteries and Probabilities
ii. Expected Values
iii. Variance and Standard Deviation
b. Evaluating Risky Outcomes
i. Risk preferences
ii. Utility functions

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1.3.a Describing Risky Outcomes
Definition: A lottery is any event with an uncertain
outcome.

Examples: Investment, Roulette, Football Game.

Definition: A probability of an outcome (of a

lottery) is the likelihood that this outcome occurs.

Example: The probability often is estimated by the

historical frequency of the outcome.

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 Probability Distribution
Definition: The probability distribution of the lottery depicts all possible
payoffs in the lottery and their associated probabilities.

Properties:

• The probability of any particular outcome is between 0 and 1

• The sum of the probabilities of all possible outcomes equals 1

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 Probability Distribution - Example
Example. A Catalan SME is considering to expand to
Probability Mexico. The expansion process can be considered a
“lottery” described by the following probability distribution
1 for the outcomes after 5 years:
.90 Making €25M with prob. 0.67
.80 .67 Making €100M with prob. 0.33
.70
.60
.50
.40 .33
.30
.20
.10
0
€25M €100M Payoff
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 Expected Value

Definition: The expected value of a lottery is a measure of

the average payoff that the lottery will generate.

EV (Lottery) = Pr(A)xA + Pr(B)xB + Pr(C)xC + …

Where: Pr(.) is the probability; A,B, and C are the payoffs

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 Expected Value - Example

In our example lottery, which pays €25M with probability .67

and €100M with probability 0.33, the expected value is:

EV = .67x€25M + .33x€100M = €50M

Notice that the expected value need not be one of the

outcomes of the lottery.

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Variance & Standard Deviation

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 Variance & Std. Dev. Example
Expected value EV = €50M

Squared deviation of losing =(25-50)2 = 252 = €625M

Probability of losing = .67

Squared deviation of winning =(100-50)2 = 502 = €2500M

Probability of winning = .33

Variance = .67 * 625 + .33 * 2500 = €1243.7M

Standard deviation = 1243.75 = €35.2M

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 1.3.b Evaluating Risky Outcomes - Example
Suppose that Company is considering two alternative countries where to
expand:
• Expand to Mexico; or
• Expand to France

The outcomes of each expansion plan are represented by these lotteries:

Expand to Mexico Expand to France

value Prob. value Prob.

€80M .3 €80M .1
€100M .4 €100M .8
€120M .3 €120M .1

Where to Expand: Mexico or France?

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 Evaluating Risky Outcomes - Example

Each expansion plan is a lottery, and we can use the

tools we have learned to evaluate them:

• EV (Mexico) = EV (France) = €100M

• Var (Mexico) = €240M
• Var (France) = €80M

In general, most companies would prefer expanding to

France.
ü The same (expected) return with lower variance (risk)

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 Risk Preference
• All companies think this way?
• Is there any Reason to prefer the expansion plan to
Mexico?
• May be, if the individual is Risk Lover…

Expand to Mexico Expand to France

value Prob. value Prob.

€80M .3 €80M .1
€100M .4 €100M .8
€120M .3 €120M .1

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 Utility Functions
• Utility functions, U(.) are mathematical
simplifications that economists use to represent
the human behaviour.
• Regarding the risk, empirically, most people &
companies are RISK AVERSE and this can be
represented by means of particular type of
utility functions.

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 Risk Averse Utility Function
Utility function
U(100)

U(50)
Example
U(25) U ( x )= x

0
Income
€25 €50 €100
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 Expected Utility
Definition: The expected utility of a lottery is a
measure of the average utility that the lottery will
generate.

EU (Lottery) = Pr(A)xU(A) + Pr(B)xU(B) + Pr(C)xU(C)

Compare
Where: Pr(.) is the probability of (.) A,B, and C are the
with:
payoffs if outcome A, B or C occurs.

Definition: The expected value of a lottery is a measure of the

average payoff that the lottery will generate.
EV (Lottery) = Pr(A)xA + Pr(B)xB + Pr(C)xC

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 Expected Utility - Example
• Compute the expected utilities of both expansion
plans assuming that

U ( x )= x

Expand to Mexico Expand to France

value Prob. value Prob.

€80M .3 €80M .1
€100M .4 €100M .8
€120M .3 €120M .1

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 Expected Utility - Example
𝐸𝑈(Mexico) = 0.3 €80𝑀 + 0.4 €100𝑀 + 0.3 €120𝑀 = 9969

𝐸𝑈(Italy) = 0.1 €80𝑀 + 0.8 €100𝑀 + 0.1 €120𝑀 = 9989

NO Monetary Units –
These are utility terms

Expected Variance Expected

Value Utility
Mexico €100M €240M 9969
France €100M €80M 9989

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 Risk Averse Utility Function
Utility function
U(100)

U(50)
Example
U(25) U ( x )= x

0
Income
$25 $50 $100
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 Risk Preferences, different from Risk Aversion

Risk Neutral Preferences Risk Loving Preferences

Utility Utility

U ( x )= x 2
Utility Function Utility Function
U ( x )= ax

0 Income

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 Exercise
Compute the Expected Utility of the Expansion
Plans to Mexico and France under two different
utility functions and discuss the results:
Export to Export to
Mexico France
U(x) = x
U(x) = x2

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