Managerial Economics and Organizational Architecture
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Ch 2 – Economists’ View of Behavior
Individuals have unlimited wants.
(Yet they are not selfish, caring only about their own personal consumptions)
In contrast: resources are limited.
2.1. Economic Behavior
Economic Choice
Economic analysis is based on the notion that individuals assign priorities to
their wants.
Marginal Analysis
Marginal costs/benefits are the incremental costs/benefits associated with
making a decision.
An action should be taken when Marginal benefits > Marginal costs.
Cost that have already incurred are ‘sunk’ costs: irrelevant for the current
economic decision.
2.2. Graphic Tools
Theory of Consumer Choice.
Individual Objectives
Goods are things that people value. The economic model of behavior posits
that people acquire foods that maximize their personal satisfaction, given
their resource constraints. Satisfaction is referred to as “Utility”.
Utility = F (a, b) => the Utility function is the total of the Utility of goods a.
and b.
Example: Utility = Food½ x Clothing½
With: F = 16 and C = 25 the Utility = 20 (4x5)
With: F = 25 and C = 25 the Utility = 25 (5x5)
Utility Functions ranks alternative bundles of goods in order of most to least
preferred.
Indifference Curves
“Willing to give up amount X of A for amount Y of B” or the “Willingness to
substitute”.
Food
25
16 2: U = 20
4 1: U = 8
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Anne Aantjes
, Opportunities and Constraints
I = Income is introduced as a constraint along with product prices for Food
(Pf) and Clothing (Pc).
I ≥ PfF + PfC
or
F ≤ I/Pf – (Pc/Pf)C
Individual Choice
Utility is maximized at the point of tangency between the constraint and an
indifference curve.
These are point b. and c. in figure 2.5. On curve 2 point a. would be preferred.
On 3 each point.
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, Changes in Choice
Changes in opportunities change with changing prices and/or income. Or
changes in preference.
Relative price increases change the slope of the constraint.
Individuals typically choose less of that good.
2.3. Alternative Models of Behaviour
- Only-Money-Matters Model => monetary compensation is leading in
behavior
- Critique: Individual’s interests are more diverse.
- Happy-Is-Productive Model => satisfaction is leading (Maslow’s,
Herberg’s)
- Contrast with the Economic model, where ‘reward’ is the motivator.
- Good-Citizen Model => strong personal desire to do a good job
- Communicate goals and objective of the organization
- Help employees discover how to achieve these
- Provide feedback on performance, to allow for improvement
Contrast with the Economic model, where maximization of the
individual’s Utility is key, and not the Company’s interest.
- Product-of-the-Environment Model => largely determined by upbringing
2.4. Decision Making under Uncertainty
Expected Value: the EV of an uncertain payoff is the weighted average of
all possibilities.
Example: Bad year: earn nothing, Normal year: earn 100.000, Good year:
earn 200.000
Expected value = (1/3 x 0) + (1/3 x 100.000) + (1/3 x 200.000) =
100.000
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, Variance = 1/3 (0 – 100.000)2 + 1/3 (100.000 – 100.000)2 + 1/3 (200.000
– 100.000)2
= 6.7 billion
Variation: squared difference between each payoff and the expected
value.
Standard Deviation = (6.7 billion)1/2 = 81.650
Standard Deviation: square root of the variance.
Higher SD = more risk.
2.5. Risk Aversion
Risk averse = preferring a lower SD, where Risk Neutral = indifferent to SD.
- Increase in Expected Value = increase in Utility
- Increase in SD = decrease in Utility
2.6. Certainty Equivalent and Risk Premium
On expected payoff of 100.00 and certain income of 80.000, 80.000 is the
Certainty Equivalent.
The difference (20.000) is the Risk Premium, possible reward for taking the
risk.
In this example there would be preference to a same job with guaranteed
90.000.
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