Santafe Ps1 - Markets and organizations, firms as legal entities... PDF

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Markets and organizations, firms as legal entities......

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Mar Santafè Business Economics Universitat Pompeu Fabra Facultat de Ciències Econòmiques i Empresarials. Curs 2019-2020 Business Economics (First trimester) Problem Set 1 Seminar no.: 1 Topics. 1. Human Behavior and Economic Rationality Seminar week: October 21 to October 27 Rules: i. Answers must not exceed 2000 words. (Use the integrated word count tool.) Any text exceeding the first 2000 words will not be considered. ii. The filename should be the last name of the author. (E.g., “Rodriguez_PS1.pdf”) iii. The deadline for submitting answers via Aula Global is Friday, October 18, at 23:59.

1. Rationality vs. Kahneman and Tversky’s Asymmetric Value Function Last week Ernest bought a football game ticket for €40. Unfortunately today, on the day of the match, it is raining cats and dogs. Ernest hates to get wet. What will Ernest do if he is economically rational? Ernest should decide basing his choice on individual cost-benefit calculations. Therefore, he will have to decide whether getting wet is worth the cost. Nevertheless, the cost of the match is now on a sunk cost, given that it is irrelevant for present and future decisions and it cannot be incurred. Thus, if Ernest would be perfectly rational he wouldn’t attend to the match because the cost he paid is now meaningless to him given the fatal weather conditions. Establish the assumptions you are making. What would he did not behave rationally and how would he justify it? So, given the chance that Ernest would, as a matter of fact, decide to attend to the match even though he had made the observation above, he would not be behaving rationally. However, humans tend to have a bounded rationality because we choose more over instincts than over cost-benefit analysis. He could justify his attendance by saying it was worth going, e.g.: saying that it was his most preferred team playing whatsoever. What if his behavior corresponds to the asymmetric value function of Kahneman and Tversky? If his demeanour were to correspond to that function, Ernest would have definitely attended the match given that loss aversion is a better motivation than actually winning. Hence, the subjective value of this function would indicate that the option that leaves Ernest better off is

Mar Santafè Business Economics going to the match, even though the loss is truly none given that it is already a sunk cost and Ernest would have a toxic attachment to cost spending. 2. Imperfect decision-maker As we have explained during the course, the human being can be an imperfect decision maker. Provide a real example for each of the following behaviours: (a) Irrational behaviour: A good example would be following a cognitive bias by making decisions based on irrational assumptions. For instance, eating heaps of chocolate just because experts agree that black chocolate is good (for diverse health reasons). (b) Self-incentive: Given that our behaviour is dictated by a desire for external rewards, a selfincentive action would be for example one in which someone works way harder for a project with the goal of obtaining recognition amongst society as well as more bonuses. (c) ex-post sub-optimal behaviours: That would be a case in which the decision done would cause us regret given that the outcomes weren`t as expected. For example, buying an invaluable masterpiece and let the years come along till its price actually falls out because the author is no longer recognised. Additionally, a more usual type of this behaviour would be paying the lottery ticket for getting nothing backwards. Thus, both decisions end up in regret. 3. Solar Panels In August 2017, Laura created a company that installs solar panels. After a month of activity, it receives an offer of 30,000€ for installing new solar panels. Laura estimates that the opportunity cost of her work and other operating expenses (excluding solar panels) totals 26,000€. In addition, she has the solar panels to do this work in inventory, which cost her 9,000€ at the time. Due to several falls in prices, these same panels have now a market value of 3,000€ (value that will remain constant in the near future). Should Laura accept the contract? Give also an example of a situation in which she would decide otherwise. Laura should not accept the contract given that the opportunity cost plus the inventory cost result in an amount greater than the profits themselves: 35,000>30,000. Also, if the market value of the solar panels would fall to 3,000€, she wouldn’t have to accept at all this offer and she should also reconsider her activity: 35,000>3,000. If she would decide otherwise, it would have to be because the offer done was greater than the total cost, therefore, the offer should be bigger than 35,000€. Nonetheless, that would be quite random if the market value were to fall so dauntingly. 4. Illegal behaviour The following text is an excerpt of the Nobel Prize in Economics lecture by Gary Becker in 1992: “My research uses the economic approach to analyze social issues that range beyond those usually considered by economists. This lecture will describe the approach, and illustrate it with examples drawn from past and current work. Unlike Marxian analysis, the economic approach I refer to does not assume that individuals are

Mar Santafè Business Economics motivated solely by selfishness or gain. It is a method of analysis, not an assumption about particular motivations. Along with others, I have tried to pry economists away from narrow assumptions about self-interest. Behavior is driven by a much richer set of values and preferences. The analysis assumes that individuals maximize welfare as they conceive it, whether they be selfish, altruistic, loyal, spiteful, or masochistic. (...) I began to think about [economics of] crime in the 1960s after driving to Columbia University for an oral examination of a student in economic theory. I was late and had to decide quickly whether to put the car in a parking lot or risk getting a ticket for parking illegally on the street. I calculated the likelihood of getting a ticket, the size of the penalty, and the cost of putting the car in a lot. I decided it paid to take the risk and park on the street. (I did not get a ticket.) As I walked the few blocks to the examination room, it occurred to me that the city authorities had probably gone through a similar analysis. The frequency of their inspection of parked vehicles and the size of the penalty imposed on violators should depend on their estimates of the type of calculations potential violators like me would make. Of course, the first question I put to the hapless student was to work out the optimal behavior of both the offenders and the police, something I had not yet done. In the 1950s and 1960s intellectual discussions of crime were dominated by the opinion that criminal behavior was caused by mental illness and social oppression, and that criminals were helpless “victims.” A book by a well-known psychiatrist was entitled The Crime of Punishment, see Menninger, (1966). (...) I was not sympathetic to the assumption that criminals had radically different motivations from everyone else. I explored instead the theoretical and empirical implications of the assumption that criminal behavior is rational (see the early pioneering work by Bentham [1931] and Beccaria [1986]), but again “rationality” did not necessarily imply narrow materialism. It recognized that many people are constrained by moral and ethical considerations, and did not commit crimes even when they were profitable and there was no danger of detection. GARY BECKER (Nobel Lecture, December 9, 1992) Entire speech available at: https://www.nobelprize.org/uploads/2018/06/becker-lecture.pdf) 4. A) Gary Becker explained, using cost-benefit analysis, his rational decision to park illegal on a street in New York. What monetary and non-monetary factors would you analyze - as an expert economist to the Government - to reduce the number of illegally parked cars? Three incentives that would, in my opinion, aid the individual decisions to be steered in a legal direction, would be these: 

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Facilitate the action of getting a ticket, for example by putting in more ticket boxes around the street so that people wouldn’t have to lose so much of their precious time by wandering around searching for one. Increase the number of revisers or of times each reviser does a full review of the cars parked in the street so as to upsurge the likelihood of getting a fine for the cars parked that lack tickets. Imposing grater fines based on the time that the cars are parked illegally. For this reason, it would be unfair to put the same fine to a car that was parked illegally for 10 minutes than to a car that was parked unlawfully for a whole day. Anyway, if the fines

Mar Santafè Business Economics were greater, loss aversion would motivate people to pay for the ticket even though their time or/and money were indeed limited resources. 4. B) Suppose that instead of illegal parking we analyse the decision to become a pickpocket in the Metro of Barcelona. Use the concept of “opportunity cost” to explain when this might be a rational decision. If we were only focused on the cost-benefit analysis, pickpocketing in the underground of Barcelona would be an amazing choice to be done if there was a very small risk of getting caught. For instance, if there wouldn’t be any police or workers that aim for the safety of their clients, the opportunity cost of not robbing would be huge since we are always exposed to a great deal of stuff (e.g.: cell phones, PC’s, bags, wallets, etc.). However, if cops increased their presence in the undergrounds, “pickpocketters” would have a higher risk of getting caught and therefore the opportunity cost would be smaller than the actual profit (since the fine they would have to pay would be bigger than the items stolen, which would as well be taken away from them). However, stealing should never be an option even if it was the most profitable economic decision ever....