1 1 BA 445 Lesson A.5 Rationality ReadingsReadings Baye 6 th edition or 7 th edition, Chapter 4

1 1BA 445 Lesson A.5 Rationality

Readings

Readings

Baye 6th edition or 7th edition, Chapter 4


Overview

Overview

3 3

Overview

BA 445 Lesson A.5 Rationality

Explicit Assumptions identify a type of customer or employee that can be manipulated using economics. That leaves “tools” and others to be manipulated using psychology.

Rational Choice means what you consume makes you happiest among all available alternatives. Rationality is the root of most controversies in business ethics and public policy.

Indifference Curves help analyze consumer choices. The curves graph the combinations of 2 goods that give a consumer the same level of happiness.

Implicit Assumptions embodied in typical indifference curves include decisiveness, more is better, and variety is better.


Explicit Economic Assumptions



Overview

Explicit Economic Assumptions identify a type of customer or employee that can be manipulated using economics. That leaves other types to be manipulated using psychology.



Knowing your customers and employees is evidently

useful for your own profit maximization. The better you know them, the better you can manipulate them.• Different types of customers and employees can be

manipulated in different ways. • What is the most manipulable and profitable type of

customer?



A tool:• Someone who is a complete

idiot• One who is used by other

people, and usually doesn't even realize it

• Someone who can't think for themselves

• People who wear huge logos on their shirts are tools.

~ Urban Dictionary



Customers and employees covered by economics

satisfy three assumptions.• Those customers and employees may be acting as

individuals or as part of a family.



Assumption 1: Customers and employees care only

about the commodities they consume. In particular: • People do not care about the consumption of others (outside of their own family).

• Here is an ancient example: Suppose a brother or a sister is without clothes and daily food. If one of you says to them, “Go in peace; keep warm and well fed”, but does nothing about their physical needs, what good is it?• Do modern people sacrifice to meet the physical needs of others?

• People do not care how they get their commodities (whether they earned them , received them as a gift, stole them, …).

Note: Economics does not suggest you should steal, but that you should guard against others stealing.



Assumption 2: Customers and employees know all

about all commodities. (We consider alternatives in Part C.) In particular:• Chubby people know the long-term consequences of

over-eating and under-exercising.• Smokers know about smoking.• Drinkers know about drinking alcohol.• Drug users know about taking drugs.



Assumption 3: Customers and employees are

rational. Their actions make them happiest among all alternatives. To be precise, think of both types of people as consumers: customers consume your product and employees consume the goods earned from working.• Consumer Opportunities are the possible bundles of goods a

consumer can consume (like two burgers and one Coke). “Goods” are desirable things that can be measured and traded between people.

That includes “services”, like manicures.

• Consumer Preference orders or prioritizes the bundles of goods consumers want to consume by what makes them happiest (like one steak is better than two hamburgers).

• Rational Choice selects the most preferred bundle of goods among all opportunities.

You might prefer steak but can only afford hamburger. You might want a meal but only have time to snack.



The Assumption that consumption is the result of

rational choice combines the economic assumption

that consumers are rational with the assumption that consumption is a choice: the combination is the assumption that what you consume actually does make you happiest among all your opportunities.



The Assumption that consumption is the result of

rational choice means • Chubby people think the taste of eating an entire

container of cake frosting today is worth the extra fat tomorrow.

• Smokers think the satisfaction of smoking today is worth the chance of lung cancer tomorrow.

• Drinkers think the giddiness of drinking today is worth the chance of liver cancer tomorrow.

• Drug users think the high of taking drugs today is worth the chance of brain damage tomorrow.



The Assumption of rational choice may not be true

for all people at all times. • Name some questionable choices (chocolate, …)• What does it mean to say “I ate too much”?• Can eating chocolate then getting sick be rational (make

you happiest overall)?• Have you ever made a choice that was a mistake?

(Ever eaten raw peanut butter cookie dough then had all-you-can eat fried clams?)



Application: What gift should you give?• A gift in kind is a gift of a good (like a bike), rather than a

cash gift.• What gift should you give to a person that has no

emotional attachment to you? What gift do kids want from relatives they do not care about?

Do kids fit the economic assumption that commodities are all that matter and the assumption of rational choice?

• How should a parent respond to a child asking for a coke in a restaurant?



Rational Choice

Rational Choice


Overview

Rational Choice means what you consume makes you happiest among all available alternatives. Rationality is the root of most controversies in business ethics and public policy.

Rational Choice


Controversy surrounds the economic assumption of rational choice. Should one boycott goods made in sweatshops?

Rational Choice


Controversy• Many other controversies are over whether gifts should

be gifts in kind. • There is an argument that all gifts in kind are wasteful:

Assume the recipient of the gift in kind is rational. The recipient could be better off if they were given

cash instead of the gift or (equivalently) the right to trade the gift for cash.• If the recipient would choose to buy the original gift

with the cash, then cash is the same as being given the gift.

• If the recipient would not choose to buy the original gift with the cash, then cash is better than the gift.

Rational Choice


Controversy 1: Is it good to help the poor by giving

them equal access to

medical care?

Rational Choice


No; not if the poor are rational. For equal access to medical care is a gift-in-kind, and the recipient could be made even better off if they were given cash instead or (equivalently) the right to trade some of the gift for cash.

For example, suppose Bill Gates needs hip replacement but a poor person is given the next available replacement. • If medical care must remain equal, Bill has to wait. • But if unequal medical care were allowed, Bill could trade money to

the poor person to let Bill have the next available replacement. • That trade results in unequal access to medical care, but makes

everyone better off. Bill values the medical care more than the money, so he is happier. The poor person values the money more, so he is happier; otherwise,

the rational poor person could just refuse the trade.

Rational Choice


Controversy 2: Is it good to help senior citizens by

giving them Medicare or Social Security?

Rational Choice


No; not if seniors are rational. For Medicare

(reduced cost medical care) is a gift-in-kind, and the recipient could be made even better off if they were given cash instead.

Rational Choice


Social security gives cash to senior citizens. But it is

also a type of gift-in-kind, and so is not a good gift because the recipient could be made even better off if they were given cash instead.• Rational people that survive to be senior citizens have chosen

between two goods: consumption when young (Good Y), consumption when old (Good R).

• Social security gives only Good R (you only get cash if you survive to old age).

• Some seniors could have been made even better off if they were given cash when they were young.

With cash when young rather than Social Security, some people that survive to old-age may choose to have more when young.

All people that do not survive to old-age are better off with cash when young.

Rational Choice


Controversy 3: Are any of the following public

programs a good idea?• Food stamps to the poor? • Free lunches for poor kids? • Natural disaster relief?

As of 2008, New Orleans’ levee system is still being rebuilt after Katrina at a cost of $17.5 billion, and Hurricane Gustav will add to the financial strain of reconstructing a region still reeling from that devastation three years ago.

What would it be like to give N.O. residents cash rather than levees?

Each of those programs is a gift-in-kind, so the recipients could be made even better off if they were given cash instead.

Rational Choice


Controversy 4: Are any of the following private

programs a good idea?• Make-a-Wish foundation?

Are wishes restricted? What would rational kids wish for?

• Reimbursement for employee’s child care expenses?

Each of those programs is a gift-in-kind, so the recipients could be made even better off if they were given cash instead.

Rational Choice


Likewise, is C.R.A.C.K. good?• Project Prevention (founded and formerly known as Children Requiring a

Caring Community or C.R.A.C.K.) is an American non-profit organization which pays drug addicts $200 for volunteering to receive long-term birth control or sterilization. As of January 2006, the amount offered has been increased to $300.

• Barbara Harris founded the organization in 1997 after she and her husband adopted four children from a drug-addicted mother. After the experience of helping the children through withdrawal and other health problems, she attempted to have legislation passed in California which would have mandated long-term birth control for mothers who gave birth to drug-addicted babies. After this failed, she opted instead to start what is now called Project Prevention.

• Despite the fact that all patients are volunteers, the organization has incited a large amount of controversy. Some claim that it is a human right to have children that should not be restricted. Critics also make comparisons to the eugenics (selective breeding) movement of the early 20th century.

• As of July 16, 2006, Project Prevention has paid and treated 1854 women and 27 men.

Rational Choice


Is C.R.A.C.K. good?

Rational Choice

"We do not stand alone": Nazi poster from 1936 with flags of other countries with compulsory sterilization legislation.

What is the biggest difference between the C.R.A.C.K. and compulsory sterilization?


Controversy 5: Should the drinking age be 21? 18?• Business managers may decide it is unethical to supply some goods

people demand if they decide customers are not rational. • Selling alcohol is perhaps unethical if customers are drunk.

That is an issue of rational choice because a rational consumer will never drink more than what is best for him.

• Salespeople are perhaps unethical when they try to convince consumers to buy those goods that earn the salesperson the highest commission.

That is an issue of rational choice because a rational consumer will never be convinced to buy anything that is not the best for him.

Rational Choice

30 30A.1 Demand and Supply

Application: Since poverty levels in the U.S. depend on the number of children in a household, the U.S. assumes having children is not a rational choice. Otherwise, having more children makes you wealthy, not poor and needing government subsidies. • Here are 2013 federal poverty levels used as guidelines

for government-subsidized health programs.

Rational Choice

Household Size Income Level

1 $11,490

2 $15,510

3 $19,530

4 $23,550

5 $27,570

6 $31,590


Indifference Curves

Indifference Curves


Overview

Indifference Curves help analyze consumer choices. The curves graph the combinations of 2 goods that give a consumer the same level of happiness.

Indifference Curves


Consumer choices and preferences are for bundles of goods since the value of one good (a car) typically depends on whether you have other goods (gas).• One way to represent consumer preferences over

bundles is a preference order.• Given the choice between 2 bundles of goods, a

consumer either Prefers bundle A to bundle B: A B. Prefers bundle B to bundle A: A B. Is indifferent between the two: A B.

Indifference Curves


Indifference Curves are another way to represent consumer preferences over bundles of goods.• Each indifference curve

defines the combinations of 2 goods that give a consumer the same level happiness.

Sad

Happy

Happier

Good Y

Good X

Indifference Curves


Exercise: Extreme Indifference Curves• Consider 2 goods:

hot dogs and buns.• Draw indifference

curves between hot dogs and buns if you only want hot dogs.

Indifference Curves

Sad

Happy

Happiest

Buns

Hot Dogs


Exercise: Extreme Indifference Curves• Draw indifference

curves between hot dogs and buns if you only want buns.

Indifference Curves

Sad

Happy

Happier

Buns

Hot Dogs



curves between hot dogs and buns for a rich consumer.

• The rich person occasionally goes “slumming” and eats hot dogs and buns, but only in 1-to-1 proportion.

Indifference Curves

Sad (consume 1 of each)

Happy (2 of each)

Happier (3 of each)

Buns

Hot Dogs



curves between hot dogs and buns for a starving consumer.

• The starving person only cares about calories.

Have you ever eaten a hot dog without a bun?

Have you ever eaten a bun without a hot dog?

Indifference Curves

Sad (500 calories)

Happy (600 calories)

Happier (1200 calories)

Buns

Hot Dogs


Indifference Curves

Example: White Trash cooking differs from other kinds of cooking in the use of three ingredients: bacon or ham, cornmeal, and molasses. Every vegetable eaten is seasoned with bacon or ham. Cornbread is a must with every meal. Of course, nothing makes cornbread better than a spoon or two of bacon or ham drippings.

So draw indifference curves between bacon and ham by typical white trash:


White Trash Indifference Curves• Draw indifference

curves between bacon and ham for a White Trash consumer.

• The consumer seeks drippings to spread over a mess of cornbread.

Indifference Curves

Sad (5 spoonfuls)

Happy (6 spoonfuls)

Happier (12 spoonfuls)

Ham

Bacon


Implicit Economic Assumptions



Overview

Implicit Economic Assumptions embodied in typical indifference curves include decisiveness, more is better, and variety is better.



Implicit Economic Assumptions embodied in typical indifference curves include completeness (decisiveness), non-satiation (more is better), diminishing returns (variety is better), and transitivity (another form of decisiveness).• Those assumptions limit when you can apply

indifference curves because the assumptions are not always true.

• Typical indifference curves are bowed inward toward the origin

• The graph on the right shows three typical curves (three happiness levels) out of a continuum.

I.

II.

III.

Good Y

Good X



Completeness Assumption means the consumer is capable of deciding preference or indifference between all possible bundles. • The consumer is indifferent between

A and C (they are on the same indifference curve).

prefers B to A. prefers B to C.

• Complete preferences are extreme, and only approximately true: Is bundle (1.234,1.333) of apples and oranges better than (1.324,1.232)?

I.

II.

III.

Good Y

Good X

A

C

B



Non-Satiation Assumption means having more consumption is preferred.• Bundle B is preferred to A

since B contains at least as much of good Y and strictly more of good X.

• Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y.

The Buddha was satiated with one mouthful of rice per day.

Are you satiated?

I.

II.

III.

Good Y

Good X

A

C

B

1

33.33

100

3



Diminishing Returns Assumption means variety is good. • Bundle A contains only 1 unit of

Good X. To get one more of Good X, the Consumer is willing to give up 50 units of Y.

• Bundle B contains 2 units of Good X. To get one more of Good X, the Consumer is willing to give up 20 units of Y.

• The pattern is the more X you have, the less Y you would give up for even more X. (X is less valuable.) The consumer thus seeks variety.

Violations are goods where having more makes you want more: margaritas, potato chips, …

I.

II.

III.

Good Y

Good X1 32

100

50

30

A

B

C



• For the three bundles A, B, and C, the transitivity property implies that if C B and B A, then C A.

• Transitive preferences along with the more-is-better assumption imply that

indifference curves will not intersect.

the consumer will not get caught in a perpetual cycle of indecision among consumption bundles like A, B, C.

I.

II.

III.

Good Y

Good X21

100

5

50

7

75

A

B

C

Transitivity Assumption



Transitivity Assumption means another form of decisiveness. Here is an example where household preferences are not transitive and the household is indecisive. Consider Dad, Mom, and a single kid choosing between alternative household consumption A, B, C.• Suppose Dad has preference C B A. • Suppose Mom has preference B A C.• Suppose The Kid has preference A C B.• That household makes decisions by majority voting.• Majority voting can violate the transitivity property that

if C B and B A, then C A. Between bundles C and B, the majority prefers C B Between bundles B and A, the majority prefers B A Hence, transitivity requires C A. But between bundles A and C, the majority prefers A C

• Majority voting does not decide which of A, B, C is best.


49 49

Review Questions

Review Questions You should try to answer some of the review questions

(see the online syllabus) before the next class. You will not turn in your answers, but students may

request to discuss their answers to begin the next class. Your upcoming Exam 1 and cumulative Final Exam will

contain some similar questions, so you should eventually consider every review question before taking your exams.


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End of Lesson A.5

BA 445 Managerial Economics


Documents

1 1 BA 445 Lesson A.5 Rationality ReadingsReadings Baye 6 th edition or 7 th edition, Chapter 4