1 Business Economics I Human Behavior and Economic Rationality I

2 Plan of the Topic 1. Human Behavior 2. Methodological Individualism 3. Rational Behavior 4. Consequential and Procedural Rationality 5. Intellectual and Evolutionary Rationality 6.Economic Rationality 7.Methodological Guidance 8.The Economic Model of Human Behaviour 9.Other Models of Human Behaviour 10.Illustration: Interwest Healthcare Corp.

3 Examples to start with Sears: repair services Parmalat: accounting fraud Chrysler: Lee Iacocca

4 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

5 Examples of Behaviors Buying a computer Writing a contract Producing a good or a service Playing a game Discussing an issue Deciding to study management Attending a class Smoking Tobacco Missing a class Why do individuals behave like this? What determines their behavior? Is it determined at all?

6 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.

7 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.

8 Methodological Individualism II Individual Firm Society Environment Sense of Explanation

9 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

10 Examples of Rational Behavior Buying a computer Writing a contract Producing a good or a service Playing a game Discussing an issue Deciding to study management Attending a class Smoking Tobacco Missing a class Are these behaviors chosen? Are they preferred? For each of them, what is the intention? What is the expected consequence? What matters the most?

11 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.

12 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?

13 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

14 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.

15 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.

16 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.

17 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”.

18 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.

19 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 euros (lying) rather than 100 (not lying): the result also matters.

20 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”.

21 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?

22 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…

23 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

24 A Moment for Thought Is the invention of a new drug really intellectual rationality? What about paper?

25 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.

26 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.

27 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.

28 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.

29 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.

30 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?

31 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.

32 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?

33 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.