Behavioural Economics: The Behavioural Theory of the Firm

Question 1

Simple optimising view of decision making

Answer 1

1, Define the problem 2, Establish Goals and Objectives 3, Generate ALL possible alternatives 4, Consider consequences of all alternatives 5, Evaluate all alternatives 6, Select the best alternative 7, Implement and Evaluate the Decision

Question 2

Optimising

Answer 2

Question 3

Optimising View

Answer 3

1, This is a simple – linear model
2, Assumes perfect information
3, Assumes unbounded rationality
4, Assumes environment is stable and predictable
5, Ignores culture, politics, values, beliefs, biases, subjectivity, etc.

Question 4

Behavioural economics

Answer 4

incorporates insights from psychology and sociology into standard economic analysis with the aim of generating more realistic theories about how individuals make decisions and the impact this has on markets.

Assumption: individuals are rational and self-interested

Question 5

3 core ideas

Answer 5

1, Bounded rationality
2, Imperfect environmental matching
3, Unresolved conflict

Question 6

Bounded rationality

Answer 6

1, Limitations to information and calculation

2, Set targets and try to satisfy these, as opposed to optimising the best possible solution

SATISFICING – A result of Bounded Rationality

• human beings lack the cognitive resources to maximize
• Our memory is week and unreliable, we cannot evaluate all possible outcomes with sufficient percision, we do not know the relevant probability of outcomes

We should know

• Not all consequences are known, alternatives are considered and not all preferences are evoked at the same time
• Decision makers tend to consider few alternatives sequentially rather than simualtaneously
• Firms do not maximize an objective function but making rough estimate of several consiquence of decision alternatives
• Do not focus on all consequence but some instead and ingnore others
• Relevant informative is not sought and available information is not used
• Having incomplete and inconsistent goal which are not considered simualtaneously
• Searching for “good enough” instead of “best possible” action
• The core notion is individual is indendly rational
• Decision makers are constrained by limited cognitive capabilities and incompleted information so their decision may be less rational

Question 7

Unresolved conflict

Answer 7

Consist of many actors with potential conflicting interest. Individual and sub-group interests are continuously re-negotiated because Consistency is hard to obtain and sustain.

Firms are made up of paticipant groups with multiple/conflicting goals while Organization is characterised by operational sub-goals.

Multiple/conflicting goals are resolved through bargaining and different paticipants exert different degrees of bargaining power

Example: The committee is made up of 3 people and each wants to maximise their own objectives. Each objective is quatifiable. The committee can only maximise when 3 objectives can be combined into 1 objectives. If the member of committee cannot accept each other’s objectives and agree on the weight of each objectives, Satisficing is a alternative procedure

Question 8

Behavioural Approach

Answer 8

1, Only people have objectives - not organisation

2, Firm is a set of coaliation of individuals

3, Individual and Group don’t maximise, they Satisfice

4, Information is limited

5, Does not assume that firm has only 1 objective of maximising profit

6, Information cannot be transfered without cost (assume)

7, Assume that human decision makers are bounded rational

8, Not deterministic, not optimistics and a dynamic model

9, Aspiration level according to experience

10, Problem-oriented “rule of thumb” based on past experience

Question 9

Approach

Answer 9

• Provides an insight into the internal operations of the firm
• Provides a powerful critique of decision making as optimising
• Analysis is at the level of the firm not the market/industry