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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