1 business economics i human behavior and economic rationality i

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Business Economics I

Human Behavior and Economic Rationality I

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Plan of the Topic

1. Human Behavior2. Methodological

Individualism3. Rational Behavior4. Consequential and

Procedural Rationality

5. Intellectual and Evolutionary Rationality

6. Economic Rationality7. Methodological

Guidance8. The Economic Model

of Human Behaviour9. Other Models of

Human Behaviour10.Illustration: Interwest

Healthcare Corp.

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Examples to start with

Sears: repair services Parmalat: accounting fraud Chrysler: Lee Iacocca

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What is Human Behavior?

A behavior can be anything an individual does that affects its environment

What the individual does is called an action

The effect is a consequence

Any behavior is composed of an action and a consequence

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Examples of Behaviors

Buying a computerWriting a contract

Producing a good or a servicePlaying a game

Discussing an issueDeciding to study management

Attending a classSmoking Tobacco

Missing a class

Why do individuals behave like this? What determines their behavior? Is it determined at all?

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Methodological Individualism

According to methodological individualism, the society is explained by the behavior of the

individuals that compose it.

The main idea is that a society of individual actors is the result of individual behaviors

Individual actors can be human beings, teams, organizations, nations, etc.

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Methodological Individualism I

For example, we understand an organization by explaining the behavior of its managers, of its

employees, of its suppliers, of its consumers, of its shareholders, etc.

Important: Individuals decide – firms don’t

BUT there are limitations:individual behavior is often constrained and

influenced by the society and the environment. Thus, it is important to identify and understand the social

factors that influence behavior.

Some consider that behavior is totally determined by the society and the environment.

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Methodological Individualism II

Individual

Firm

Society

EnvironmentSense of

Explanation

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What is Rational Behavior?

An individual behaves rationally when he chooses the behavior he prefers

A rational individual has the intention to take a particular action

A rational individual expects the consequences of a particular action

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Examples of Rational Behavior

Buying a computerWriting a contract

Producing a good or a servicePlaying a game

Discussing an issueDeciding to study management

Attending a classSmoking Tobacco

Missing a classAre these behaviors chosen? Are they preferred?

For each of them, what is the intention? What is the expected consequence?

What matters the most?

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Limitations of Rational Behavior

Some individual behaviors are not chosen by the actor.

Not all behaviors are consciously chosen; Not all consequences are expected; Some behaviors are emotional reactions; Some behaviors are traditional habits.

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Remark on Rational Behavior

A Behavior can be preferred and chosen rationally because of its expected

consequence for the actor (self-interest) or because the action is valued for itself, as an

end in itself.

Can you think of an example for each case?

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Consequential and Procedural Rationality I

Behavior is consequentially rational when it is solely motivated by the expectation of its

consequences.

Behavior is procedurally rational when it is solely motivated by the action itself, independently of its

consequences

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Consequential and Procedural Rationality II

The choice of the preferred behavior reflects the selection of the best

consequence.

Within consequentialism, preferences over

behaviors are equivalent to preferences over

consequences.

The choice of the preferred behavior

reflects the selection of the right action.

Preferences over behaviors are

equivalent to intrinsic preferences over

actions.

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Examples of Consequential Rationality

A firm sells a product because it makes profit.

An individual chooses to study management because he will be able to find a well-paid

job.

A manager hires an employee because it will increase the performance of the firm.

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Examples of Procedural Rationality

An individual votes because he believes it is a civic duty.

An artist sculpts because he likes the process of it, although he expects difficult consequences. He has a vocation.

An employee does not steal money even if he knows he cannot be caught. He is honest.

An employee in an administration does a good job although he knows nobody will give him extra money or consideration for it. He has goodwill.

An individual smokes because he feels pleasure.

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Limitations of Consequential Rationality I

For ethical reasons, individuals may like to do the “right thing”. Depending on the context and on individuals: “The end may not justify the means”.

We never expect all the possible consequences: some always remain unexpected: this is the idea of “bounded rationality”.

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Limitations of Consequential Rationality II

Depending on the context and on individuals, we develop “heuristics and biases” for certain types of actions.

All these subjective and context-dependent aspects are very important in an organization: for the motivation of individuals and also for the efficiency of the firm.

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Limitations of Procedural Rationality I

•By reducing behavior to the choice of the right action, procedural rationality denies individuals also care about the consequence.

Maybe one individual will prefer not to lie if he can gain 100 euros (not lying) rather than 200 euros (with lying); but he may lie if he can gain 1 000 000 euros (lying) rather than 100 (not lying): the result also matters.

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Limitations of Procedural Rationality II

Some rules or heuristics may not be adapted to some context or to some individuals. Rules can be very inefficient.

When our knowledge of the environment and of ourselves improve, it can be difficult to modify the rules that guide actions. There is a “procedural inertia”.

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Evolutionary and Intellectual Rationality

Consequential rationality – we are concerned about the result.

What does a result mean? The result in terms of behaviour is a

response (to a situation, to a problem).

Rational action is the best response. How can we reach the best response?

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Intellectual Rationality

We can reach the best response through analysis, thinking

This is the way we produce science Intellectual Rationality – the result of intellectual

effort, thinking Examples: Invention of a new drug; The discovery of the

laws of physics; drafting a law in the Parliament; However…

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Evolutionary Rationality The best response can also just happen: is the family

the best response to the problem of the having and raising children for the human species?

Evolutionary rationality – the unconscious result of human interaction.

Why unconscious? Because the problem has not been deliberately

considered. Examples: Moral codes and norms, the structure of the price

system

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A Moment for Thought

Is the invention of a new drug really intellectual rationality?

What about paper?

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Economic Rationality

The standard economic approach to human behavior supposes that actors are rational individuals and

that choice reflects preferences over consequences for themselves.

It is a consequential rationality based on self-interest.

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Economic Rationality (Individual)

1. An individual identifies the available actions;

2. The individual anticipates all the consequences of each available action;

3. The individual chooses the action that leads to the best consequence.

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Economic Rationality (Firm)

1. The firm identifies the available resources;

2. The firm identifies the possible purposes for its resources;

3. The firm allocates its resources to their best purpose.

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Limitations to Economic Rationality

Many studies have demonstrated that individuals do not behave according to economic rationality (Simon,

Kahneman & Tversky, Hogarth, Gigerenzer).

In experimental economics, economic rationality is not empirically verified. It is not a descriptive theory.

Some say that individuals should behave according to economic rationality. They view economic rationality

as a normative theory.

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Limitations to Economic Rationality

The economic approach to human behavior tends to neglect:

1. The social context and its influence on individuals;

2. The subjective values specific to individuals (cultural, aesthetical or spiritual);

3. The importance of emotional reactions and traditional habits;

4. The importance of procedural rationality.

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Example: M&M 5

What is the consequence for Miguel of firing Maria?

What is the consequence for Miguel of not firing Maria?

What is the best consequence?

What should Miguel do as a rational economic actor?

What should Miguel do as a manager?

How should Miguel behave if Maria is also a friend?

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Methodological Advice

We cannot understand the human dimension of business activity if we restrict ourselves to economic rationality.

A rational individual can be economically irrational when he chooses an action that does not lead to the best consequence. Rational behavior is not identical to economic behavior.

Understanding the human dimension of business requires to combine procedural rationality with consequential rationality.

When we use economic rationality (consequences for the actor only), then the consequences for others or for the environment must be treated as procedural concerns because economic rationality only takes the point of view of the actor.

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Useful Questions to understand Behavior

Self-interest: Are the consequences to the interesting of the actor?

Utilitarianism: Are the consequences interesting for the majority of actors?

Altruism: Are the consequences to the interest of other parties?

Hedonism: Is the process pleasant for the actor?Deontology: Does the process respect social or

organizational rules?Ethics: Is the process ethical?

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Methodological Advice

There are different explanations on human behavior and people use different ones depending on their values and on the context.

In general, several perspectives need to be combined to have a good understanding of what happens.

A recommendable approach consists in learning to search for explanations using different perspectives and to combine them to form your own judgment.

This will help you to better understand what happens, to better act, to better support your position and to better understand the position of others.