Understanding Opportunity Cost: The Value of Given Up Alternatives in Economic Decisions -, Apuntes de Negocios Internacionales

¡Descarga Understanding Opportunity Cost: The Value of Given Up Alternatives in Economic Decisions - y más Apuntes en PDF de Negocios Internacionales solo en Docsity! BUSINESS ECONOMICS – TOPIC 1 Topic 1- The Individual as Decision Maker • Opportunity cost: an opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. An opportunity cost represents an alternative given up when a decision is made. When choosing one event, a person cannot choose the other. Individuals have unlimited wants. In contrast to wants, resources are limited. OUTLINE • MOTIVATION – we want to improve our understanding of how individuals make economic decisions (cost-benefit analysis). To make this decisions, they use: I. Price  (but mainly price and preferences) II. quality III. quantity IV. Preferences • METHODOLOGICAL INDIVIDUALISM (Classical Economic View) – At a starting 4, we should look at people, we all have limited resources, that's why we have to make choices. Choices: outcome of individual cost-benefit calculations (choose the alternative with higher value) Traditionally, economists view choices as the outcome of individual cost-benefit calculation. People make choices autonomously, understanding the behaviour of organizations requires understanding the behaviour of its individual members, and this framework is called methodological individualism. If people make decisions about products one way to make them to choose the product, is to create incentives. People act by following its personality, that’s why we need to search something that satisfies the majority (or something that satisfies the market you are working on). It's assumed that consumers compute or compare the costs and benefits of the alternatives in their head, to finally choose the one giving them the most possible benefit or profit. For that is important to understand the behaviour of the organizations but also the individual's organizational behaviour. 1. Economic Decision Making: Economic decisions have two features: - Two or more alternatives. - Some constraint limiting the number of alternatives that can be selected. In general, alternatives can be anything, but we know that to make decisions there's always some constraint because if not, we would't need to choose. But since we have limited resources we are forced to that. Even if the principal constraint is money, time constraint is probably more relevant for many people because you can never take time back. "You can do anything but not everything". So, from the classical economic view, we make choices based on our cost-benefit analysis. Economic analysis is based on the notion that individuals assign priorities to their wants and choose their most preferred options from among the available alternatives. Within this economic framework, individuals maximize their personal happiness given resource constraints. Indeed, people are quite creative and resourceful in minimizing the effects of constraints. Goods are things that people value; the economic model of behaviour posits that people acquire goods that maximize their personal satisfaction. Economists traditionally use the term "utility" in referring to personal satisfaction. • COST-BENEFIT ANALYSIS Economic cost-benefit analysis can be quite subtle, but the main difference with accounting is that the cost of a decision must include the value of the best forgone alternative (opportunity cost). And its resource constraints what makes opportunity costs relevant --> Choosing one alternative means not choosing the other, the value of the forgone alternative is relevant for individual choice. Opportunity cost: is the value of the best forgone or alternative use. When you make a choice, is not the accounting cost or choice the one that counts but also it includes the opportunity cost or the value of the alternative. If you choose something, you cannot do the other thing and that's opportunity cost. So, the cost of a choice is: accounting cost + opportunity cost (e.g. what you earn or won doing the alternative you left would be the opportunity cost). When making a decision, you have to think about the best use of your resource to maximize your utility.  Accounting cost: the assumed or taken decision.  Opportunity cost: the no chosen and its value.  True cost: opportunity cost + the total price Most people fail to recognize their opportunity cost. us. e.g. for a millionaire to win 10€ will be different than for a poor man. b) Diminishing sensitivity: the function isn’t linear. In the beginning near to the reference point, the increasing or decreasing is stronger than further in the graphic. Then this shows that we feel stronger when close to the reference point than when you are further (you have less sensitivity then). The higher the gain, the less additional happiness I get from further gains. The higher the loss, the less additional pain I get from further losses. c) Loss aversion: is connected to the symmetry. When you gain 10€ for example, you gain less than the amount you lose when you loss 10€. Loss aversion refers to the tendency of decision makers to strongly prefer avoiding losses to acquiring gains (--> irrational behaviour). *People behaves differently depending on how the situation is framed and it has to do with psychology (money game VIDEO!). Is much more motivating working to avoid losses than to increase gains. The increase in happiness from x gains is less than increase in pain from x loss. d) As the reference point, can change, people evaluate their well-being event-by-event rather than as some aggregate outcome. Loss aversion refers to the tendency of decision makers to strongly prefer avoiding losses to acquiring gains (  irrational behaviour). Implications of the asymmetric value function: * Prize-framing *Associated marketing strategies: I. Segregate Gains: Smaller gains but more times. How do you present your gains to a costumer? e.g. that you have gained 1€ ten times, or only one gain of 10€. Presenting that as ten gains of 1€ gives you a greater value increase. Consumers are happier if gains are given in small pieces of happiness rather than getting all at once. II. Combine Losses: with the same example, it would be better to say that you have lost all at once because it is respectively less harmful than keep losing it in fewer amounts but for more time. It’s better to losing everything at once. III. Offset small loss with larger gain: you can present your costumer this situation:  A large gain and a small loss.  A slightly smaller gain with no losses. It is better to present it as the second option because in that case the costumer won't dare of the losses because maybe he/she doesn’t realize is losing. However, if you tell them, the emotion of losing would be stronger than the happiness of gaining as described in the loss aversion. (like taxes, IVA...) IV. Segregate small gain from large loss: you have to present this situation: - an outcome with a loss. - an even larger loss and a small gain It is better to present that loss with a gain because even if the feeling of the loss would be strong; the feeling of gain would compensate a little. What is given for free is perceived as a gain. (We tend to compensate our losses even if that's irrational). 4. SELF-CONTROL AND TIME-CONSISTENCY: It is the irrational behaviour in the context in which taking a decision is difficult. That is when in time we change our mind about something. That would be an irrational behaviour without self-control but although, someone that doesn't change his mind in time would be a rational behaved self-controlled person. A failure to do something you have proposed to yourself is called time-inconsistency. Time-consistency: today you say you prefer A over B, tomorrow you choose B (repeated choice). Irrational behaviour: someone has preferences to doing something despite saying he/she does not have any. Commitment Device: a way to solve a previous problem. This are the restrictions we make for future choices to force an individual to take a decision. - Eliminating a choice. - Increasing the costs of that choice. - Limiting choice can never make an individual better off. e.g. if we have problems to go out of bed, we can buy a clock which jumps and runs over the room so that we can't stop the alarm without waking up from the bed. So, commitment devices are some little restrictions that prevent you from breaking your rules. The classical economic model with intellectually rational, self-interested, time-consistent agents requires some major qualifications when brought to real decisions. 5. DECISION MAKING UNDER UNCERTAINTY No one has the complete information when making a decision so we always have little uncertainty in our decisions. That's why the more information you acquire, the less uncertainty you have. However, we know that information is not free so that you will have to invert to get that sometimes, in money, in time and also in attitude. e.g. the exact payoff of a particular action is unknow. if I invest today, I don't know which will be the payoff tomorrow. Ex-ante vs. Ex-Post: When the consequences of an action are not known exactly, the optimality of an action cannot be judged on the realization of the payoff, must be judged before the payoff is realized.  If an action is judged before the payoff is realized: ex-ante  PROBABILITY.  If an action is judged after the payoff is realized: ex-post  REALIZATION. e.g. The example of the homework (the mayor decision) would be an ex-post decision or situation because once the forest burned, he realized he should have taken more information or at least consider what the experts told him about the high probability of burning. In making decisions uncertainly, there are also some items such as the expected value, the variability, the risk aversion or the risk premium (difference between the expected value and the real value). 6. INFORMATION ACQUISITION: (TO REDUCE UNCERTAINTY) Sometimes the degree of uncertainty about an action's payoff is something the decision maker can choose. We always have the change to get more information even if getting it is difficult or costly. So that's why sometimes people decide to stay ignorant. Opportunity cost of getting information is all those things I could do during that time. A Mysterious Chart:  Cost of information: the more information you get, the more it costs.