But it seems to us altogether reasonable that long -- term contracting must be grounded in factors other than culture and affluence. One economic explanation may start with a recognition of the extent to which firms are integrated in Japan. The fact of the matter is that in some industries Japanese production is far less integrated into identified “firms” than, say, in the United States and other countries. In the United States and Western Europe, for example, 50 to 60 percent of the automobile manufacturing costs are incurred “in -- house.” In Japanese firms, on the other hand, only 25 to 30 percent of the automobile production costs are typically incurred “in -- house,” or inside Japanese firms. 16 Only 20 percent of Honda’s production costs are incurred inside, which means it buys 80 percent, or $6 billion, of its inputs from outside suppliers.17 Because of the lack of integration, Japanese firms may need to develop long -- term buyer -- supplier relationships to a much greater degree than more highly integrated firms do just to overcome the potential last-period problems, if nothing else.
Put another way, Japanese firms are able to engage in what is called strategic outsourcing, and do so competitively, because they are willing and able to develop long ¬
- term working relationships. If they didn’t, they would have to endure the added costs associated with the ever -- present closing of those relationships. It doesn’t surprise us that many buyer -- supplier relationships in Japan give the “look and feel” of integrated firms with buyers and suppliers helping each other and investing in each other (which is what happens, to more or less degree, within unified firms).
When Honda signs a contract with a supplier, it expects the working relationship to continue for 25 to 50 years, which effectively means that the last-period problem is set back considerably.18 Moreover, the permanence of the buyer -- supplier relationship is two -- way, with commitments on the parts of both buyers and suppliers. Buyers agree to stay with the suppliers, and vice versa, through ups and downs (at least up to a point). Hence, Honda can justify incurring the costs associated with helping its suppliers increase productivity, even provide the needed technology and specialized equipment. Moreover, such expenditures, plus investments in the specific assets of the suppliers, by Honda have the added advantage of being a bond, the value of which is forgone if Honda does not abide by its agreement. Managers at Honda are basically saying to suppliers, “Look at what we are doing. We are serious in our commitment. If we renege, our up -¬front investment will be worth very little. We will lose our projected income stream from the investment. Because of those costs, you can count us in for the long run.” Such tie -¬ins aid in making the contracts self -- enforcing and durable; they help to make the long run a viable perspective.
Should production be rigidly integrated as in American firms or more loosely integrated as in Japanese business consortiums? We surely cannot answer that question with the certitude that many readers will want. Japanese firms obviously gain the benefits of keeping their suppliers in a position that is marginally more tenuous and, maybe, more competitive with other potential suppliers, but they have to deal with the marginally more severe last-period problems. Many factors, which are offsetting and subject to change with the costs associated with contracting and with principal/agency problems we have discussed, are involved. We suspect that different organizational forms will suit different situations and eras (as has obviously been the case in Japan where relational contracting has not always been prevalent19).
Answers will come from real -- world experimentation in the marketplace. We suspect that competition will press firms to adjust their organization forms, and the inherent incentive structures, as some variation of organizational form is relatively more successful. Many American firms have had to seriously consider and, to a degree, duplicate the added organizational flexibility of Japanese firms. Why? Their management methods have obviously worked in some industries, most notably the automobile industry. It takes 17 hours to assemble a car in Japan and 25 to 37 hours to assemble a comparable car in the United States and Europe. Japanese firms can develop a new car in 43 months, whereas it takes American and European firms over 60 months, and Japanese cars come off the production lines with 30 percent fewer defects. The worst American -- made air conditioning units have a thousand defects for every defect in the best Japanese -- made units.20
Firm integration and relational contracting are hardly the only means of moderating last-period problems. Joint ventures, which more often than not require up -¬front investments by the firms involved, can also be seen as extensions of firm efforts to reduce last-period problems, with the potential of enhancing the quality of the goods and services produced and lowering production costs. Joint ventures might lower production costs because they give rise to economies of scale and scope through the application of technology, but they also can lower production costs by lowering the potential costs associated with opportunistic behavior and monitoring. They make the future income streams of each party a function of the continuation of the relationship.
* * * * *
The “last-period” problem is nothing more than what we have tagged it, a “problem” that businesses must consider and handle. It implies costs. At the same time, firms can make money by coming up with creative ways of making customers and suppliers believe that the “last period” is some reasonable distance into the future. Failing firms have a tough time doing that, which is one explanation why the pace of The “hollow corporation,” in which everything is “outsourced,” or nothing is produced directly, is sometimes viewed as the organizational ideal, given that the firm owners can rely on competitive forces to keep the prices of what they sell as low as possible. We doubt that the “hollow corporation” will ever dominate the economic landscape of any country for a simple reason that comes out of the analysis of this “Manager’s Corner”: The absence of the continuing association of employees under one roof would mean that the last-period problems would arise in spades. This is because the direct association of people under one roof has an unappreciated benefit: as in the keiretsu in Japan, the firm permits the creation of abiding relationships that reduce the incentive individuals have to behave opportunistically in the short run and enhance their incentives to work with their long -- term goals in mind. “Bonding” is something that firms do.
Concluding Comments
The concept of rational behavior means that the individual has alternatives, can order those alternatives on the basis of preference, and can act consistently on that basis. The rational individual will also chose those alternatives whose expected benefits exceed their expected costs.
Traditionally economics has focused on the activities of business firms, and much of this book is devoted to exploring human behavior in a market setting. The concept of rational behavior can be applied to other activities, however, from politics and government to family life and leisure pursuits. No matter what the activity, we all tend to maximize our well -- being. Any differences in our behavior can be ascribed to differences in our preferences and in the institutional settings, or constraints, within which we operate.
Institutional settings affect people’s range of alternatives and thus the choices they make. It makes sense to examine the constraints of institutional settings. In this part of the book we will investigate the specific characteristics of the market system, the subject of microeconomic theory. Later we will look at the constraints of government. In both cases the range of choices open to individuals affects the ability of the system to produce the results expected of it.
We have also indicated in this chapter how individual rationality can give rise to a nontrivial problem for managers, the last-period problem, which can make deals costly. At the same time, we have indicated how thinking in terms of rational precepts can suggest ways managers can deal with their last-period problems to lower firm costs and raise firm profitability.
Review Questions
What are the costs and benefits of taking this course in microeconomics? Develop a theory of how much a student can be expected to study for this course. How might the student’s current employment status affect his or her studying time?
Some psychologists see people’s behavior as determined largely by family history and external environmental conditions. How would “cost” fit into their explanations?
Why not base a course on an assumption of widespread “irrational” behavior?
Okay, so no one is totally rational. Does that undermine the use of “rational behavior” as a means of thinking about markets and management problems?
How could drug use and suicide be considered “rational”?
If your firm were consistently dealing with “irrational behavior” among the owners and workers, what would happen to correct the problem? More to the point, what might you do to correct the problem?
Analyse these questions and think.............its not too late...!
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Thursday, May 14, 2009
Friday, May 1, 2009
Disincentives in Poverty Relief
Our discussion of rational behavior can be used to understand one of the biggest policy issues of our time, welfare reform. We can do this by assuming that welfare recipients are tolerably rational.
So much of the public discussions about welfare programs, especially cuts in them, assumes that since Congress has the authority to change the programs, it can alter the programs any way it wishes without creating problems. However, as we can easily see, Congress is in something of an economic, if not political, bind on welfare relief, given how incentives change when the program is adjusted. The basic problem is that the practice of scaling down welfare benefits as earned income rises creates an implicit marginal tax on additional earned income that discourages the poor from working. Why not lower the implicit marginal tax rate?
Our graphic analysis suggests that there may be economic as well as altruistic limits to the government’s ability to transfer income from the rich to the poor. As more and more income is allocated to the poor, either the guaranteed income or break -- even income level must go up. If only the guaranteed income level is raised, the implicit marginal tax rate facing the poor increases. If that problem is avoided by raising the break -- even income level, poverty relief will cover more people, and the taxes paid by the remaining workers will go up. Increased aid to the poor thus should have three consequences. A higher explicit tax burden will fall on fewer taxpayers. Because of this burden, higher -- income groups will have less incentive to work, and lower -- income groups, because of the higher implicit tax rate, will also be less inclined to work.
MANAGER’S CORNER: The Last-Period Problem
Much of this chapter has been concerned with how people behave rationally. Here, we introduce “opportunistic behavior” as a form of rational behavior that people in business will want to protect themselves from. We suggest ways different parties to business deals can take advantage of other parties and how managers can structure their organizational and pay policies to minimize what we call “opportunistic behavior.” More specifically, this section is concerned with how an announced end to a business relationship can inspire opportunistic behavior. Its goal is, however, constructive, structuring business deals – and the embedded incentives -- in order to maximize the durability and profitability of the deals. To do that, business relationships must be ongoing, or have no fixed end, to the extent possible. Having a fixed termination date can encourage opportunistic behavior, which can reduce firm revenues and profits. That is to say, a reputation for continuing in business has economic value, which explains why managers work hard to create such a reputation.
The basic problem is that during the last period of any business relationship, there is no penalty for cheating, which implies maximum incentive to cheat. As a consequence, cheating on deals in the last period is more likely than at any other time in the relationship.
Consider a simple business deal. Suppose that you want a thousand widgets of a given quality delivered every month, starting with January and continuing through December, and that you have agreed to make a fixed payment to the supplier when the delivery is made. If you discover after you have made payment that your supplier sent fewer than a thousand units or sent the requisite thousand units but of inferior quality, you can simply withhold future checks until the supplier makes good on his or her end of the bargain. Indeed, you can terminate the yearlong contract, which can impose a substantial penalty for any cheating early in the contract. Knowing that, the supplier will tend to have a strong incentive early on in the contract period to do what he or she has agreed to do.
However, the supplier’s incentive to uphold his or her end of the bargain begins to fade as the year unfolds, for the simple reason that there is less of a penalty -- in terms of what is lost from your ending the working relationship -- that you can impose. The supplier might go so far as to reason that during the last period (December), the penalty is very low, if not zero. The supplier can cut the quantity or quality of the widgets delivered during December and then can take the check before you know what has been done. The biggest fear the supplier has is that you might inspect the shipment before handing over the final check. You may be able to get the supplier to increase the quantity or quality somewhat with inspection, but you should expect him or her to be somewhat more difficult to deal with. And you should not expect the same level of performance or quality.
The problem is that you have lost a great deal of your bargaining power during that last month, and that is the source of what we call and mean by the last-period (or end -- period) problem, meaning the costs that can be expected to be incurred from opportunistic behavior when the end of a working relationship approaches. It is a problem, however, that can be mitigated in several ways. The simplest and perhaps most common way is by maintaining continuing relationships. If you constantly jump from one supplier to another, you might save a few bucks in terms of the quoted prices, but
you might also raise your costs in terms of unfulfilled promises by suppliers during the last period of their association with you. “Working relationships,” in other words, have an economic value apart from what the relationship actually involves, for example, the delivery of so many widgets. This is one important reason businesses spend so much time cultivating and maintaining their relationships and why they may stick with suppliers and customers through temporary difficulties.
Solutions to the Last-Period Problem
Nothing works to solve the last-period problem, however, like success. The more successful a firm is -- the greater the rate of growth for the firm and its industry -- the more likely others will recognize that the firm will continue in business for sometime into the future. The opposite is also true -- failure can feed on itself as suppliers, buyers, and workers begin to think that the last period is near. Firms understand these facts of business life. As a consequence, executives tend to stress their successes and downplay their failures. Their intent may not be totally unethical, given how bad business news can cause the news to get worse. Outsiders understand these tendencies. As a consequence, many investors pay special attention to whether executives are buying or selling their stock in their companies. The executives may have access to (accurate) insider information that is not being distributed to the public.
Another simple way of dealing with the last-period problem in new relationships is to leave open the prospect of future business, in which case the potential penalty is elevated (in a probabilistic sense) in the mind of the supplier. When there is no prospect of future business, the expected cost from cheating is what can be lost during the last period. When there is some prospect of future business, the cost is greater, equal to the cost that can be imposed during the last period plus the cost (discounted by the probability that it will be incurred) incorporated in the loss of future business.
When dealing with remodeling or advertising firms, for instance, you can devise a contract for a specified period, but you can suggest, or intimate, in a variety of creative ways, that if the work is done as promised and there are no problems, you might extend the contract or expand the scope of the relationship. In the case of the remodeling firm, you might point out other repairs in the office that you are thinking of having done. In the case of the advertising firm, you might suggest that there are other ad campaigns for other products and services that you are considering.
You should, therefore, be able to secure somewhat better compliance with your supplier during the last period of the contract, and how much the compliance is improved can be related to just how well you can convince your supplier that you mean business (and a lot of it) for some time into the future. However, we are not suggesting that you should outright lie about uncertain future business. The problem with lying is that it can, when discovered, undercut the value of your suggestions of further business and bring back to life the last-period problem. You need, in other words, to be prepared to extend, from time to time (if not always), working relationships when in fact they work the way you want them to work.
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So much of the public discussions about welfare programs, especially cuts in them, assumes that since Congress has the authority to change the programs, it can alter the programs any way it wishes without creating problems. However, as we can easily see, Congress is in something of an economic, if not political, bind on welfare relief, given how incentives change when the program is adjusted. The basic problem is that the practice of scaling down welfare benefits as earned income rises creates an implicit marginal tax on additional earned income that discourages the poor from working. Why not lower the implicit marginal tax rate?
Our graphic analysis suggests that there may be economic as well as altruistic limits to the government’s ability to transfer income from the rich to the poor. As more and more income is allocated to the poor, either the guaranteed income or break -- even income level must go up. If only the guaranteed income level is raised, the implicit marginal tax rate facing the poor increases. If that problem is avoided by raising the break -- even income level, poverty relief will cover more people, and the taxes paid by the remaining workers will go up. Increased aid to the poor thus should have three consequences. A higher explicit tax burden will fall on fewer taxpayers. Because of this burden, higher -- income groups will have less incentive to work, and lower -- income groups, because of the higher implicit tax rate, will also be less inclined to work.
MANAGER’S CORNER: The Last-Period Problem
Much of this chapter has been concerned with how people behave rationally. Here, we introduce “opportunistic behavior” as a form of rational behavior that people in business will want to protect themselves from. We suggest ways different parties to business deals can take advantage of other parties and how managers can structure their organizational and pay policies to minimize what we call “opportunistic behavior.” More specifically, this section is concerned with how an announced end to a business relationship can inspire opportunistic behavior. Its goal is, however, constructive, structuring business deals – and the embedded incentives -- in order to maximize the durability and profitability of the deals. To do that, business relationships must be ongoing, or have no fixed end, to the extent possible. Having a fixed termination date can encourage opportunistic behavior, which can reduce firm revenues and profits. That is to say, a reputation for continuing in business has economic value, which explains why managers work hard to create such a reputation.
The basic problem is that during the last period of any business relationship, there is no penalty for cheating, which implies maximum incentive to cheat. As a consequence, cheating on deals in the last period is more likely than at any other time in the relationship.
Consider a simple business deal. Suppose that you want a thousand widgets of a given quality delivered every month, starting with January and continuing through December, and that you have agreed to make a fixed payment to the supplier when the delivery is made. If you discover after you have made payment that your supplier sent fewer than a thousand units or sent the requisite thousand units but of inferior quality, you can simply withhold future checks until the supplier makes good on his or her end of the bargain. Indeed, you can terminate the yearlong contract, which can impose a substantial penalty for any cheating early in the contract. Knowing that, the supplier will tend to have a strong incentive early on in the contract period to do what he or she has agreed to do.
However, the supplier’s incentive to uphold his or her end of the bargain begins to fade as the year unfolds, for the simple reason that there is less of a penalty -- in terms of what is lost from your ending the working relationship -- that you can impose. The supplier might go so far as to reason that during the last period (December), the penalty is very low, if not zero. The supplier can cut the quantity or quality of the widgets delivered during December and then can take the check before you know what has been done. The biggest fear the supplier has is that you might inspect the shipment before handing over the final check. You may be able to get the supplier to increase the quantity or quality somewhat with inspection, but you should expect him or her to be somewhat more difficult to deal with. And you should not expect the same level of performance or quality.
The problem is that you have lost a great deal of your bargaining power during that last month, and that is the source of what we call and mean by the last-period (or end -- period) problem, meaning the costs that can be expected to be incurred from opportunistic behavior when the end of a working relationship approaches. It is a problem, however, that can be mitigated in several ways. The simplest and perhaps most common way is by maintaining continuing relationships. If you constantly jump from one supplier to another, you might save a few bucks in terms of the quoted prices, but
you might also raise your costs in terms of unfulfilled promises by suppliers during the last period of their association with you. “Working relationships,” in other words, have an economic value apart from what the relationship actually involves, for example, the delivery of so many widgets. This is one important reason businesses spend so much time cultivating and maintaining their relationships and why they may stick with suppliers and customers through temporary difficulties.
Solutions to the Last-Period Problem
Nothing works to solve the last-period problem, however, like success. The more successful a firm is -- the greater the rate of growth for the firm and its industry -- the more likely others will recognize that the firm will continue in business for sometime into the future. The opposite is also true -- failure can feed on itself as suppliers, buyers, and workers begin to think that the last period is near. Firms understand these facts of business life. As a consequence, executives tend to stress their successes and downplay their failures. Their intent may not be totally unethical, given how bad business news can cause the news to get worse. Outsiders understand these tendencies. As a consequence, many investors pay special attention to whether executives are buying or selling their stock in their companies. The executives may have access to (accurate) insider information that is not being distributed to the public.
Another simple way of dealing with the last-period problem in new relationships is to leave open the prospect of future business, in which case the potential penalty is elevated (in a probabilistic sense) in the mind of the supplier. When there is no prospect of future business, the expected cost from cheating is what can be lost during the last period. When there is some prospect of future business, the cost is greater, equal to the cost that can be imposed during the last period plus the cost (discounted by the probability that it will be incurred) incorporated in the loss of future business.
When dealing with remodeling or advertising firms, for instance, you can devise a contract for a specified period, but you can suggest, or intimate, in a variety of creative ways, that if the work is done as promised and there are no problems, you might extend the contract or expand the scope of the relationship. In the case of the remodeling firm, you might point out other repairs in the office that you are thinking of having done. In the case of the advertising firm, you might suggest that there are other ad campaigns for other products and services that you are considering.
You should, therefore, be able to secure somewhat better compliance with your supplier during the last period of the contract, and how much the compliance is improved can be related to just how well you can convince your supplier that you mean business (and a lot of it) for some time into the future. However, we are not suggesting that you should outright lie about uncertain future business. The problem with lying is that it can, when discovered, undercut the value of your suggestions of further business and bring back to life the last-period problem. You need, in other words, to be prepared to extend, from time to time (if not always), working relationships when in fact they work the way you want them to work.
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Principles of Rational Behavior at Work in Society and Business
Microeconomics rests on certain assumptions about individual behavior. One is that people are capable of envisioning various ways of improving their position in life. This chapter reviews and extends the discussion begun in Chapter 1 of how people – business people included -- go about choosing among those alternatives. According to microeconomic theory, consumers and producers make choices rationally, so as to maximize their own welfare and their firms’ profits. This seemingly innocuous basic premise about human behavior will allow us to deduce an amazing variety of implications for business and every other area of human endeavor.People’s wants are ever expanding. We can never satisfy all our wants because we will always conceive of new ones. The best we can do is to maximize our satisfaction, or utility, in the face of scarcity. Utility is the satisfaction a person receives from the consumption of a good or service or from participation in an activity. Happiness, joy, contentment, or pleasure might all be substituted for satisfaction in the definition of utility. Economists attempt to capture in one word—utility—the many contributions made to our well being when we wear, drink, eat, or play something
Of course individuals in a group affect one another’s behavior. In fact, the size and structure of a group can have a dramatic effect on individual behavior. When economists speak of a competitive market, they are actually talking about the influence that other competitors have on the individual consumer or firm.
Rational Behavior
When individuals act to satisfy their wants, they behave rationally. Rational behavior is consistent behavior that maximizes an individual’s satisfaction. The notion of rational behavior rests on three assumptions:
• First the individual has a preference and can identify, within limits, what he or she wants.
• Second, the individual is capable of ordering his or her wants consistently, from most preferred to least preferred.
• Third, the individual will choose consistently from these ordered preferences to maximize his or her satisfaction.
Even though the individual cannot fully satisfy all her wants, she will always choose more of what she wants rather than less. Furthermore, she will always choose less rather than more of what she does not want. In short, the rational individual always stands ready to further her own interests.
Some readers will find these assertions obvious and acceptable. To others, they may seem narrow and uninspiring. Later in the chapter we will examine some possible objections to the concept of rational behavior, but first we must examine its logical consequences.
Rational Decisions in a Constrained Environment
Several important conclusions flow from the economist’s presumption of rational behavior. First, the individual makes choices from an array of alternatives. Second, in making each choice, a person must forgo one or more things for something else. All rational behavior involves a cost, which is the value of the most preferred alternative forgone. Third, in striving to maximize his or her welfare, the individual will take those actions whose benefits exceed their costs.
Choice
We assume that the individual can evaluate the available alternatives and select the one that maximizes his utility. Nothing in the economic definition of rational behavior suggests that the individual is completely free to do as he wishes. Whenever we talk about individual choices, we are actually talking about constrained choices—choices that are limited by outside forces. For example, you as a student find yourself in a certain social and physical environment and have certain physical and mental abilities. These environmental and personal factors influence the options open to you. You may have neither the money, the time, nor the stomach to become a surgeon, or your career goal may not allow you the luxury of taking many of the electives listed in your college catalog.
Although your range of choices may not be wide, choices do exist. At this moment you could be doing any number of things instead of reading this book. You could be studying some other subject, or going out on a date, or playing with your son or daughter. You could have chosen to go shopping, to engage in intramural spots, or to jog around the block. You may not be capable of playing varsity sports, but you have other choices. Although your options are limited, or constrained—you are not completely free to do as you please—you can still choose what you want to do. In fact, you must choose.
Suppose that you have an exam tomorrow in economics and that there are exactly two things you can do within the next 12 hours. You can study economics, or you can play your favorite video game. These two options are represented in Figure 3.1. Suppose you spend the entire 12 hours studying economics. In our example, the most you can study is four chapters, or E1. At the other extreme, you could do nothing but play games—but again, there is a limit: eight games or G1.
Neither extreme is likely to be acceptable. Assuming that you aim both to pass your exam and to have fun, what combination of games and study should you choose? The available options are represented by the straight line.
An individual who behaves rationally will choose an option only when its benefits are greater than or equal to its costs. Furthermore, individuals will try to maximize their satisfaction by choosing the most favorable option available. That is, they will produce or consume those goods and services whose benefits exceed the benefits of the most favored opportunity not taken.
Economists see cost-benefit analysis as the basis of much (but certainly not all) of our behavior. Cost-benefit analysis is the careful calculation of all costs and benefits associated with a given course of action. Why do you attend classes, for example? The obvious answer is that at the time you decide to attend class, you expect the benefits to attending the exceed the costs. The principle applies even to classes you dislike. A particular course may have no intrinsic value, but you may fear that by cutting class, you will miss information that would be useful on the examination. Thus the benefits of attending are a higher grade than you would otherwise expect. Besides, other options open to you on Tuesday morning at 10:00 AM may have so little appeal that the cost of going to class is very slight.
Take another example. Americans are known for the amount of waste they pile up. Our gross national garbage is estimated to be more valuable than the gross national output of many other nations. We throw away many things that people in other parts of the world would be glad to have. However morally reprehensible, waste may be seen as the result of economically rational behavior. Wastefulness may be beneficial in a limited personal sense. The food wrappings people throw away are “wasted,” but they do add convenience and freshness to the food. In the individual’s narrow cost-benefit analysis, the benefits of the wrapping can exceed the costs.
Is life priceless? Although we like to think so, many of us are not willing to bear the cost that must be paid to preserve it. Several million animals—dogs, opossums, squirrels, and birds—are killed on the highways each year. Most of us make some effort to avoid animal highway deaths. If saving lives were all -- important, we could drive less -- but that would bring a significant cost. Even when human beings are involved, we sometimes refuse to bear the cost of preserving life. People avoid helping victims of violent crime, and doctors routinely pass by highway accidents although they might save lives by stopping to help. Indeed, revolutions succeed through people’s willingness to sacrifice lives—both others’ and their one -- to achieve political or economic goals.
The behavior of business people is not materially different from that of drivers or consumers. People in business are constantly concerned with cost-benefit calculations, only the comparisons are often (but not always) made in dollar terms: For example, whether the cost of improving the quality of a product is matched by the benefits of the improvement. Will consumers value the added benefits enough to pay for hem? In assessing the safety of their products, business people must consider whether consumers are willing to pay the cost of any improvements.
The Effects of Time and Risk on Costs and Benefits
When an individual acts, costs are not necessarily incurred immediately, and benefits are not necessarily received immediately. The decision to have a child is a good example. At turn of the century prices, a college -- educated couple’s first child can easily cost more than $500,000, from birth through college.2 Fortunately this high cost is incurred over a relatively long period of time (or people would rarely become parents!).
Benefits received in the future must also be compared with present benefits. If you had a choice between receiving $10,000 now and $10,000 one year from now, you would take $10,000 today. You could put the money in a bank, if nothing else, where it would earn interest, or you could avoid the effects of future inflation by spending the money now. In other words, future benefits must be greater than present benefits to be more attractive than present benefits.
To compare future costs and benefits on an equal footing with costs and benefits realized today, we must adjust them to their present value. Present value is the value of future costs and benefits in terms of current dollars. The usual procedure for calculating present value -- a process called discounting -- involves an adjustment for the interest that could be earned (or would have to be paid) if the money were received (or due) today rather than in the future.3
If there is any uncertainty about whether future benefits or costs will actually be received or paid, further adjustments must be made. Without such adjustments, perfectly rational act may appear to be quite irrational. For example, not all business ventures can be expected to succeed. Some will be less profitable than expected or may collapse altogether. The average fast-food franchise may earn a yearly profit of $1 million, but, but only nine out of ten franchises may survive their first year (because the average profits is distorted by the considerable earnings of one franchise). Thus the estimated profits for such a franchise must be discounted, or multiplied by 0.90. If 10 percent of such ventures can be expected to fail, on average each will earn $900,000 ($1 million x .90).
The entrepreneur who starts a single business venture runs the risk that it may be the one out of ten that fails. In that case profit will be zero. To avoid putting all their eggs in one basket, many entrepreneurs prefer to avoid putting all their “eggs” in the To estimate the actual cost faced by the burglar who is caught, sentenced, and sent to jail for a year, we might multiply the cost if caught, $10,000, by 0.10. That calculation indicates that to a burglar who is sent to jail for an average of one out of ten burglaries, the cost of any one burglary is only $1,000 ($10,000 x 0.10). Thus the actual cost of the burglary is less than the benefits received, $1,500. Although it may be morally reprehensible, the criminal act can conceivably be a rational one.
Surveys of criminal activities and their rewards tend to support such a conclusion. A study of burglary and grand larceny cases in Norfolk, Virginia, showed that for the unusual criminal who committed just one crime and was caught in the act, crime did not pay. The typical criminal, however, convicted the average number of times and sentenced to the average number of years in prison, more than tripled the lifetime income he could have earned from a regular salaried job—even allowing for one or more years of unsalaried incarceration.5 When this study was replicated in Minnesota, the results were not quite as dramatic, but the criminal’s lifetime income still doubled.6 For criminals who are never caught, crime pays even more handsomely.
The concept of rational behavior often proves bothersome to the noneconomist. Most of the difficulties surrounding this concept arise from a misunderstanding of what rationality means. Common objections include the following:
1. People do many things that do not work out to their benefit. A driver speeds and ends up in the hospital. A student cheats, gets caught, and is expelled from school. Many other examples can be cited. To say that people behave rationally does not mean that they never make mistakes. We can calculate our options with some probability, but we do not have perfect knowledge, nor can we fully control the future. Chances are that we will make a mistake at some point, but as individuals, we base our choices on what we expect to happen, not on what does happen. We speed because we expect not to crash, and we cheat because we expect not to be caught. Both can be rational behaviors.
2. Rational behavior implies that a person is totally self -- centered, doing only things that are of direct personal benefit. Rational behavior need not be selfish. Altruism can be rational; a person can want to be of service to others, just as he can want to own a new car. Most of us get pleasure from seeing others happy—and particularly when their happiness is the result of our actions. Altruism may not always spring from rational cost-benefit calculations; however, it is not always inconsistent with economic rationality. Self -- interest, moreover, does not necessarily stop at the individual. For many actions, “self” includes members of one’s family or friends. When a father spends a weekend building a tree house for his children, economists say that he has been engaged in self -- interested behavior.
3.People’s behavior is subject to psychological quirks, hang -- ups, habits and impulses. Surely such behavior cannot be considered rational. Human actions are governed by the constraints of our physical and mental makeup. Like our intelligence, our inclination toward aberrant or impulsive behavior is one of those constraints. It makes our decision-making less precise and contributes to our mistakes, but it does not prevent our acting rationally. Moreover, what looks like impulsive or habitual behavior may actually be the product of some prior rational choice. The human mind can handle only so much information and make only so many decisions in one day. Consequently, we may attempt to economize on decision making by reducing some behaviors to habit. Smoking may appear to be totally impulsive, and the physical addition that accompanies it may indeed restrict the smoker’s range of choices. Why might a person pull a cigarette from the pack “without smoke".
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Of course individuals in a group affect one another’s behavior. In fact, the size and structure of a group can have a dramatic effect on individual behavior. When economists speak of a competitive market, they are actually talking about the influence that other competitors have on the individual consumer or firm.
Rational Behavior
When individuals act to satisfy their wants, they behave rationally. Rational behavior is consistent behavior that maximizes an individual’s satisfaction. The notion of rational behavior rests on three assumptions:
• First the individual has a preference and can identify, within limits, what he or she wants.
• Second, the individual is capable of ordering his or her wants consistently, from most preferred to least preferred.
• Third, the individual will choose consistently from these ordered preferences to maximize his or her satisfaction.
Even though the individual cannot fully satisfy all her wants, she will always choose more of what she wants rather than less. Furthermore, she will always choose less rather than more of what she does not want. In short, the rational individual always stands ready to further her own interests.
Some readers will find these assertions obvious and acceptable. To others, they may seem narrow and uninspiring. Later in the chapter we will examine some possible objections to the concept of rational behavior, but first we must examine its logical consequences.
Rational Decisions in a Constrained Environment
Several important conclusions flow from the economist’s presumption of rational behavior. First, the individual makes choices from an array of alternatives. Second, in making each choice, a person must forgo one or more things for something else. All rational behavior involves a cost, which is the value of the most preferred alternative forgone. Third, in striving to maximize his or her welfare, the individual will take those actions whose benefits exceed their costs.
Choice
We assume that the individual can evaluate the available alternatives and select the one that maximizes his utility. Nothing in the economic definition of rational behavior suggests that the individual is completely free to do as he wishes. Whenever we talk about individual choices, we are actually talking about constrained choices—choices that are limited by outside forces. For example, you as a student find yourself in a certain social and physical environment and have certain physical and mental abilities. These environmental and personal factors influence the options open to you. You may have neither the money, the time, nor the stomach to become a surgeon, or your career goal may not allow you the luxury of taking many of the electives listed in your college catalog.
Although your range of choices may not be wide, choices do exist. At this moment you could be doing any number of things instead of reading this book. You could be studying some other subject, or going out on a date, or playing with your son or daughter. You could have chosen to go shopping, to engage in intramural spots, or to jog around the block. You may not be capable of playing varsity sports, but you have other choices. Although your options are limited, or constrained—you are not completely free to do as you please—you can still choose what you want to do. In fact, you must choose.
Suppose that you have an exam tomorrow in economics and that there are exactly two things you can do within the next 12 hours. You can study economics, or you can play your favorite video game. These two options are represented in Figure 3.1. Suppose you spend the entire 12 hours studying economics. In our example, the most you can study is four chapters, or E1. At the other extreme, you could do nothing but play games—but again, there is a limit: eight games or G1.
Neither extreme is likely to be acceptable. Assuming that you aim both to pass your exam and to have fun, what combination of games and study should you choose? The available options are represented by the straight line.
An individual who behaves rationally will choose an option only when its benefits are greater than or equal to its costs. Furthermore, individuals will try to maximize their satisfaction by choosing the most favorable option available. That is, they will produce or consume those goods and services whose benefits exceed the benefits of the most favored opportunity not taken.
Economists see cost-benefit analysis as the basis of much (but certainly not all) of our behavior. Cost-benefit analysis is the careful calculation of all costs and benefits associated with a given course of action. Why do you attend classes, for example? The obvious answer is that at the time you decide to attend class, you expect the benefits to attending the exceed the costs. The principle applies even to classes you dislike. A particular course may have no intrinsic value, but you may fear that by cutting class, you will miss information that would be useful on the examination. Thus the benefits of attending are a higher grade than you would otherwise expect. Besides, other options open to you on Tuesday morning at 10:00 AM may have so little appeal that the cost of going to class is very slight.
Take another example. Americans are known for the amount of waste they pile up. Our gross national garbage is estimated to be more valuable than the gross national output of many other nations. We throw away many things that people in other parts of the world would be glad to have. However morally reprehensible, waste may be seen as the result of economically rational behavior. Wastefulness may be beneficial in a limited personal sense. The food wrappings people throw away are “wasted,” but they do add convenience and freshness to the food. In the individual’s narrow cost-benefit analysis, the benefits of the wrapping can exceed the costs.
Is life priceless? Although we like to think so, many of us are not willing to bear the cost that must be paid to preserve it. Several million animals—dogs, opossums, squirrels, and birds—are killed on the highways each year. Most of us make some effort to avoid animal highway deaths. If saving lives were all -- important, we could drive less -- but that would bring a significant cost. Even when human beings are involved, we sometimes refuse to bear the cost of preserving life. People avoid helping victims of violent crime, and doctors routinely pass by highway accidents although they might save lives by stopping to help. Indeed, revolutions succeed through people’s willingness to sacrifice lives—both others’ and their one -- to achieve political or economic goals.
The behavior of business people is not materially different from that of drivers or consumers. People in business are constantly concerned with cost-benefit calculations, only the comparisons are often (but not always) made in dollar terms: For example, whether the cost of improving the quality of a product is matched by the benefits of the improvement. Will consumers value the added benefits enough to pay for hem? In assessing the safety of their products, business people must consider whether consumers are willing to pay the cost of any improvements.
The Effects of Time and Risk on Costs and Benefits
When an individual acts, costs are not necessarily incurred immediately, and benefits are not necessarily received immediately. The decision to have a child is a good example. At turn of the century prices, a college -- educated couple’s first child can easily cost more than $500,000, from birth through college.2 Fortunately this high cost is incurred over a relatively long period of time (or people would rarely become parents!).
Benefits received in the future must also be compared with present benefits. If you had a choice between receiving $10,000 now and $10,000 one year from now, you would take $10,000 today. You could put the money in a bank, if nothing else, where it would earn interest, or you could avoid the effects of future inflation by spending the money now. In other words, future benefits must be greater than present benefits to be more attractive than present benefits.
To compare future costs and benefits on an equal footing with costs and benefits realized today, we must adjust them to their present value. Present value is the value of future costs and benefits in terms of current dollars. The usual procedure for calculating present value -- a process called discounting -- involves an adjustment for the interest that could be earned (or would have to be paid) if the money were received (or due) today rather than in the future.3
If there is any uncertainty about whether future benefits or costs will actually be received or paid, further adjustments must be made. Without such adjustments, perfectly rational act may appear to be quite irrational. For example, not all business ventures can be expected to succeed. Some will be less profitable than expected or may collapse altogether. The average fast-food franchise may earn a yearly profit of $1 million, but, but only nine out of ten franchises may survive their first year (because the average profits is distorted by the considerable earnings of one franchise). Thus the estimated profits for such a franchise must be discounted, or multiplied by 0.90. If 10 percent of such ventures can be expected to fail, on average each will earn $900,000 ($1 million x .90).
The entrepreneur who starts a single business venture runs the risk that it may be the one out of ten that fails. In that case profit will be zero. To avoid putting all their eggs in one basket, many entrepreneurs prefer to avoid putting all their “eggs” in the To estimate the actual cost faced by the burglar who is caught, sentenced, and sent to jail for a year, we might multiply the cost if caught, $10,000, by 0.10. That calculation indicates that to a burglar who is sent to jail for an average of one out of ten burglaries, the cost of any one burglary is only $1,000 ($10,000 x 0.10). Thus the actual cost of the burglary is less than the benefits received, $1,500. Although it may be morally reprehensible, the criminal act can conceivably be a rational one.
Surveys of criminal activities and their rewards tend to support such a conclusion. A study of burglary and grand larceny cases in Norfolk, Virginia, showed that for the unusual criminal who committed just one crime and was caught in the act, crime did not pay. The typical criminal, however, convicted the average number of times and sentenced to the average number of years in prison, more than tripled the lifetime income he could have earned from a regular salaried job—even allowing for one or more years of unsalaried incarceration.5 When this study was replicated in Minnesota, the results were not quite as dramatic, but the criminal’s lifetime income still doubled.6 For criminals who are never caught, crime pays even more handsomely.
The concept of rational behavior often proves bothersome to the noneconomist. Most of the difficulties surrounding this concept arise from a misunderstanding of what rationality means. Common objections include the following:
1. People do many things that do not work out to their benefit. A driver speeds and ends up in the hospital. A student cheats, gets caught, and is expelled from school. Many other examples can be cited. To say that people behave rationally does not mean that they never make mistakes. We can calculate our options with some probability, but we do not have perfect knowledge, nor can we fully control the future. Chances are that we will make a mistake at some point, but as individuals, we base our choices on what we expect to happen, not on what does happen. We speed because we expect not to crash, and we cheat because we expect not to be caught. Both can be rational behaviors.
2. Rational behavior implies that a person is totally self -- centered, doing only things that are of direct personal benefit. Rational behavior need not be selfish. Altruism can be rational; a person can want to be of service to others, just as he can want to own a new car. Most of us get pleasure from seeing others happy—and particularly when their happiness is the result of our actions. Altruism may not always spring from rational cost-benefit calculations; however, it is not always inconsistent with economic rationality. Self -- interest, moreover, does not necessarily stop at the individual. For many actions, “self” includes members of one’s family or friends. When a father spends a weekend building a tree house for his children, economists say that he has been engaged in self -- interested behavior.
3.People’s behavior is subject to psychological quirks, hang -- ups, habits and impulses. Surely such behavior cannot be considered rational. Human actions are governed by the constraints of our physical and mental makeup. Like our intelligence, our inclination toward aberrant or impulsive behavior is one of those constraints. It makes our decision-making less precise and contributes to our mistakes, but it does not prevent our acting rationally. Moreover, what looks like impulsive or habitual behavior may actually be the product of some prior rational choice. The human mind can handle only so much information and make only so many decisions in one day. Consequently, we may attempt to economize on decision making by reducing some behaviors to habit. Smoking may appear to be totally impulsive, and the physical addition that accompanies it may indeed restrict the smoker’s range of choices. Why might a person pull a cigarette from the pack “without smoke".
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