Chapter 2 Competitive Product Markets 40 the price at the pump remains constant at the price ceiling, does that mean that the “real price” of gasoline has remained constant? 9. If the government imposes a price floor on whole milk and buys the resulting surplus, can it later sell what it has bought and recoup its expenditure? What else can the government do with the milk surplus? Why would you, as a milk producer, want the price floor? Show the industry benefits in a graph. 10. Henry Ford more than doubled his workers’ wages. Did worker real income double by Ford’s pay policy? Reflecting on the general principles behind Ford’s pay action, when should any firm – your firm – stop raising the pay of workers (not in terms of actual dollar amount but in terms of some economic/management principle that you can devise)? 11. Workers and their employers often talk about how workers “earn” their wages but about how firms “give” their workers health insurance (or any other fringe benefit). Should the different methods of pay be discussed in different terms? 12. In state universities, why does the state subsidize full-time MBA programs but not executive MBA programs? Should the two programs be treated differently? Does the state subsidy explain the price differential for students in the two programs? READING: The Effect of Airline Deregulation on Travel Safety William F. Shughart II, University of Mississippi Before 1978 airlines in the United States were strictly controlled by government agencies. The safety of airlines was, and remains today, regulated by the Federal Aviation Administration (FAA). In addition, the Civil Aeronautics Board (CAB) controlled airline fares and routes. The effect of CAB regulations was to restrict the ability of airlines to compete by price and entry into markets. Without CAB approval, for example, Delta Airlines could not lower its air fares or enter new markets to expand its business. In 1978 Congress passed legislation to eliminate gradually most of the economic controls the CAB had over the domestic airline industry. However, airlines were not totally free to set prices and change routes until 1983. Many commentators fear that airline deregulation may have resulted in a reduction in the safety of air travel in the United States. 1 From the perspective of economic theory, there are several reasons for believing that air safety may have been compromised. First, airline deregulation has led to reductions in the prices of many popular flights, especially long-distance flights (say, between New York and Los Angeles), and travel by air may have increased. Deregulation may have increased the opportunity for air accidents. Second, with the expansion of air travel, airlines may have had to draw on less experienced, qualified, and careful pilots and mechanics. Third, with greater competition in the airline industry, several airlines may have become unprofitable and mangers may have reduced expenditures on needed plane repairs in order to increase airline profits. Fourth, before airfares were deregulated, airlines may have competed in many nonprice ways—for example, meals and in-flight service, movies, interiors of planes, and safety records. When they could compete by price after deregulation, airlines may have sacrificed safety competition for price competition. All of these factors may have led to increased air accidents and deaths. Chapter 2 Competitive Product Markets 41 Economists have statistically investigated the effect of airline deregulation on airline safety. While the debate continues, recent studies show that airline deregulation has in fact led to significantly more air travel but that the number of airline accidents and deaths has not been affected. 2 Airline deaths have been on a downward trend for decades, and airline deregulation does not appear (to date) to have slowed the pace of decrease. 3 Economists have reasoned that the greater freedom given airlines by deregulation may have been held in check by the considerable costs that airlines incur when they do have accidents. Airlines, in other words, may have continued to maintain their safety records because of the fear and cost of liability suits that are brought against them when they do have crashes. In addition, Congress never deregulated safety. Various government policies often have hidden, secondary market effects that economists and policymakers must consider. Airline deregulation is a good case in point. Airline deregulation could have reduced total travel deaths in the country by its indirect impact on highway travel and accidents. By deregulating airlines fares, Congress increased air travel. At the same time, Congress increased the relative cost of travel by car on the nation’s highways. This is because, as noted, after deregulation, air travel became more convenient and often cheaper. Therefore, car travel became relatively expensive relative to air travel. Airline deregulation has had two distinct effects on automobile travel. It has had a price (or substitution) effect. Less automobile travel would be expected with relatively lower airfares. Airline deregulation has also had an income effect because greater efficiency in air travel may have led to more national production and income. The greater national income may have led to more travel by air and cars. Because the price and income effects of airline deregulation on automobile travel are not expected to be in the same direction, theory alone does not give a clear answer to the question, “How has airline deregulation affected automobile travel?” Statistical analysis is required, and the only study currently available on the issue found that airline deregulation has, indeed, reduced travel by automobiles (by an annual average of nearly 4 percent between 1979 and 1985). 4 However, because miles traveled on highways and automotive accidents and deaths are likely to be directly related, the small estimated decrease in automobile travel may have reduced automotive accidents and deaths by a sizable number. In fact, one of the authors estimates that airline deregulation has probably reduced automobile accidents by an annual average of several hundred thousand and deaths by an annual average of several hundred. 5 The indirect effects of policy changes, which are revealed through economic analysis, cannot be ignored by policymakers. Policymakers need to be mindful of the fact that efforts to resurrect the type of airline regulation abandoned in the late 1970s may, or may not, improve airline safety records. Re-regulation, however, may cause people to shift from air travel to highway travel. Unfortunately, highway travel remains far more dangerous than air travel, and unless precautions are taken, overall travel deaths can be increased by airline re-regulation. This does not mean that re-regulation should not be undertaken but only that care must be taken in designing any new economic controls on airlines. 1 See Hobart Rowen, “Bring Back Regulation,” Washington Post (National Weekly Edition), August 31, 1987, p. 5. 2 See Nancy L. Rose, Financial Influences on Airline Safety, no. 1890-87 (Cambridge, Mass.: Sloan School of Management, Massachusetts Institute of Technology, 1987; and Richard B. McKenzie and William F. Shughart II, “The Impact of Airline Regulation on Air Safety,” Regulation (January 1988), pp. 42-47. 3 Establishing the effect of airline deregulation on air travel and air accidents and deaths is more difficult than it appears. This is because many factors affect air travel and deaths, including the amount of income people in the economy have to spend. The very valuable statistical methods used by economists to separate the impact of airline deregulation from people’s income are called econometrics. 4 Richard B. McKenzie and John T. Warner, The Impact of Airline Deregulation on Highway Safety (St. Louis: Center for the Study of American Business, Washington University, December 1987). Chapter 2 Competitive Product Markets 42 5 Ibid., p. 4. CHAPTER 3 Principles of Rational Behavior at Work in Society and Business We are not ready to suspect any person of being defective in selfishness. Adam Smith ith this chapter we begin a detailed examination of key issues in microeconomics, namely the study of how prices are determined in individual markets. Prices are important – or, rather, should be important – to managers because of their unavoidable impact on the decisions of managers within individual firms. We have already seen how the forces of supply and demand determine prices (Chapter 2). Now we will explore the determinants of the supply and demand for goods, services, and resources. Microeconomics rests on certain assumptions about individual behavior. One is that people are capable of envisioning various ways of improving their position in life. This chapter reviews and extends the discussion begun in Chapter 1 of how people – business people included -- go about choosing among those alternatives. According to microeconomic theory, consumers and producers make choices rationally, so as to maximize their own welfare and their firms’ profits. This seemingly innocuous basic premise about human behavior will allow us to deduce an amazing variety of implications for business and every other area of human endeavor. Rationality: A Basis for Exploring Human Behavior People’s wants are ever expanding. We can never satisfy all our wants because we will always conceive of new ones. The best we can do is to maximize our satisfaction, or utility, in the face of scarcity. Utility is the satisfaction a person receives from the consumption of a good or service or from participation in an activity. Happiness, joy, contentment, or pleasure might all be substituted for satisfaction in the definition of utility. Economists attempt to capture in one word—utility—the many contributions made to our well being when we wear, drink, eat, or play something. The ultimate assumption behind this theory is that people act with a purpose. In the words of von Mises, they act because they are “dissatisfied with the state of affairs as it prevails.” 1 1 Ludwig von Mises, The Ultimate Foundations of Economic Science: An Essay on Method (Princeton, N.J.: D. Van Nostrad, 1962), pp. 2—3. W Chapter 3 Principles of Rational Behavior at Work in Society and Business 2 The Acting Individual If people act in order to satisfy their consciously perceived wants, their behavior must be self -- directed rather than externally controlled. However, there is no way to prove this assertion. Economists simply presume that individuals, as opposed to groups, perform actions. It is the individual who has wants and desires, and looks for the means to fulfill them. It is the individual who attempts to render his or her state “less unsatisfactory.” Group action, when it occurs, results from the actions of the individuals in the group. Social values, for instance, draw their meaning from the values held collectively by individuals. Economists would even say that group action cannot be distinguished from individual action. Although economists do not deny the existence of group psychology, they leave the study of social groups to others. Thus to understand group behavior, the economist looks to the individual. Of course individuals in a group affect one another’s behavior. In fact, the size and structure of a group can have a dramatic effect on individual behavior. When economists speak of a competitive market, they are actually talking about the influence that other competitors have on the individual consumer or firm. Rational Behavior When individuals act to satisfy their wants, they behave rationally. Rational behavior is consistent behavior that maximizes an individual’s satisfaction. The notion of rational behavior rests on three assumptions: • First the individual has a preference and can identify, within limits, what he or she wants. • Second, the individual is capable of ordering his or her wants consistently, from most preferred to least preferred. • Third, the individual will choose consistently from these ordered preferences to maximize his or her satisfaction. Even though the individual cannot fully satisfy all her wants, she will always choose more of what she wants rather than less. Furthermore, she will always choose less rather than more of what she does not want. In short, the rational individual always stands ready to further her own interests. Some readers will find these assertions obvious and acceptable. To others, they may seem narrow and uninspiring. Later in the chapter we will examine some possible objections to the concept of rational behavior, but first we must examine its logical consequences. Chapter 3 Principles of Rational Behavior at Work in Society and Business 3 Rational Decisions in a Constrained Environment Several important conclusions flow from the economist’s presumption of rational behavior. First, the individual makes choices from an array of alternatives. Second, in making each choice, a person must forgo one or more things for something else. All rational behavior involves a cost, which is the value of the most preferred alternative forgone. Third, in striving to maximize his or her welfare, the individual will take those actions whose benefits exceed their costs. Choice We assume that the individual can evaluate the available alternatives and select the one that maximizes his utility. Nothing in the economic definition of rational behavior suggests that the individual is completely free to do as he wishes. Whenever we talk about individual choices, we are actually talking about constrained choices—choices that are limited by outside forces. For example, you as a student find yourself in a certain social and physical environment and have certain physical and mental abilities. These environmental and personal factors influence the options open to you. You may have neither the money, the time, nor the stomach to become a surgeon, or your career goal may not allow you the luxury of taking many of the electives listed in your college catalog. Although your range of choices may not be wide, choices do exist. At this moment you could be doing any number of things instead of reading this book. You could be studying some other subject, or going out on a date, or playing with your son or daughter. You could have chosen to go shopping, to engage in intramural spots, or to jog around the block. You may not be capable of playing varsity sports, but you have other choices. Although your options are limited, or constrained—you are not completely free to do as you please—you can still choose what you want to do. In fact, you must choose. Suppose that you have an exam tomorrow in economics and that there are exactly two things you can do within the next 12 hours. You can study economics, or you can play your favorite video game. These two options are represented in Figure 3.1. Suppose you spend the entire 12 hours studying economics. In our example, the most you can study is four chapters, or E 1 . At the other extreme, you could do nothing but play games—but again, there is a limit: eight games or G 1 . Neither extreme is likely to be acceptable. Assuming that you aim both to pass your exam and to have fun, what combination of games and study should you choose? The available options are represented by the straight line E 1 G 1 , the production possibilities curve for study and play and the area underneath it. If you want to maximize your production, you will choose some point on E 1 G 1 , such as a: two chapters of economics and four games. You might yearn for five games and the same amount of study, but that point is above the curve and beyond your capabilities. If you settle for less—say one chapter and three games, or point x—you will be doing less than you are capable of doing and will not be maximizing your utility. The combination you actually choose will depend on your preference. Chapter 3 Principles of Rational Behavior at Work in Society and Business 4 Changes in your environment or your physical capabilities can affect your opportunities and consequently the choices you make. For example, if you improve your study skills, your production rate for chapters studied will rise. You might then be able to study eight units of economics in 12 hours -- in which case your production possibilities curve would expand outward. Even if your ability to play Amazons from Outer space remained the same, your greater proficiency in studying would enable you to increase the number of games played. Your new set of production possibilities would be E 2 G 1 in Figure 3.2. Again, you can choose any point along this curve or in the area below it. You may decide against further games and opt instead for four chapters of economics (point c). You could move to point b, in which case you would still be learning more economics—three chapters instead of two—but would also be playing more games. The important point is that you are able to choose from a range of opportunities. The option you take is not predetermined. FIGURE 3.1 Constrained Choice With a given amount of time and other resources, you can produce any combination of study and games along the curve E 1 G 1 . The particular combination you choose will depend on your personal preferences for those two goods. You will not choose point x, because it represents less than you are capable of achieving—and as a rational person, you will strive to maximize your utility. Because of constraints on your time and resources, you cannot achieve a point above E 1 G 1 . FIGURE 3.2 Change in Constraints If your study skills improve and your ability at the game remains constant, your production possibilities curve will shift from E 1 G 1 to E 2 G .1 . Both the number of chapters you can study and the number of games you can play will increase. On your old curve, E 1 G 1 , you could study two chapters and play four games (point a). On your new curve E 2 G 1 , you can study three chapters and play five games (point b). Chapter 3 Principles of Rational Behavior at Work in Society and Business 5 Cost The fact that choices exist implies that some alternative must be forgone when another is taken. If A and B represent two mutually exclusive opportunities, to choose A is simultaneously to not choose B. In the presence of choice—a situation in which no more than one alternative can be taken at a time—a cost must be incurred. Cost (or more precisely, opportunity cost) is the value of the most highly preferred alternative not taken. Put another way, it is the value the individual places on the most favored alternative not taken at the time the choice is made. For example, suppose that you have decided to spend half an hour watching old television programs. The two programs you most want to watch are M.A.S.H. and Gilligan’s Island. If you choose Gilligan’s Island, the cost is the pleasure you sacrifice by not watching M.A.S.H. Notice that cost is not defined in terms of money. Money is a useful measure because it reduces all costs to one common denominator. Money is only the means of measuring cost, however; it is not cost itself. The shoes you are wearing may have cost you $50 (a money cost), but the real cost (the opportunity cost) is the value of what you could have purchased instead. Money cost is a monetary measure of the benefits forgone when a choice is made. The real cost is the actual benefits given up from the most preferred alternative not taken when a choice is made. When economists use the term cost, they mean real, or opportunity, cost. You could have bought dozens of soft drinks or deposited the $50 in a savings account for future use. Either option would be a legitimate alternative to purchasing shoes. The point is that the cost of the shoes to you is the value of the most attractive option not taken, whether it is the soft drinks or the future use of the money. As long as you have alternative uses for your time and other resources, there is no such thing as a free lunch. Nothing can be free if other opportunities are available. One goal of economics courses is to help you recognize this very simple principle and to train you to search for hidden costs. There is a cost to writing a poem, to watching a sunset, to extending a common courtesy, if only to open a door for someone. Although money is not always involved in choices, the opportunity to do to other things is. A cost is incurred in every choice. Maximizing Satisfaction: Cost-benefit Analysis An individual who behaves rationally will choose an option only when its benefits are greater than or equal to its costs. Furthermore, individuals will try to maximize their satisfaction by choosing the most favorable option available. That is, they will produce or consume those goods and services whose benefits exceed the benefits of the most favored opportunity not taken. This restatement of the maximizing principle, as it is called, explains individual choice in terms of cost. In Figure 3.1, the choices along curve E 1 G 1 represent various Chapter 3 Principles of Rational Behavior at Work in Society and Business 6 cost-benefit tradeoffs. If you choose point a, we must assume that you prefer a to any other combination because it yields the most favorable ratio of benefits to costs. A change in cost will produce a change in behavior. Suppose you and a friend set a date to play checkers, but at the last moment he received a lucrative job offer for the day of the match. Most likely the contest will be rescheduled. The job offer will change your friend’s opportunities in such a way that what otherwise would have been a rational act (playing checkers) becomes one that is no longer rational. The cost of playing checkers will rise significantly, enough to exceed the benefits of most checkers games. Economists see cost-benefit analysis as the basis of much (but certainly not all) of our behavior. Cost-benefit analysis is the careful calculation of all costs and benefits associated with a given course of action. Why do you attend classes, for example? The obvious answer is that at the time you decide to attend class, you expect the benefits to attending the exceed the costs. The principle applies even to classes you dislike. A particular course may have no intrinsic value, but you may fear that by cutting class, you will miss information that would be useful on the examination. Thus the benefits of attending are a higher grade than you would otherwise expect. Besides, other options open to you on Tuesday morning at 10:00 AM may have so little appeal that the cost of going to class is very slight. Take another example. Americans are known for the amount of waste they pile up. Our gross national garbage is estimated to be more valuable than the gross national output of many other nations. We throw away many things that people in other parts of the world would be glad to have. However morally reprehensible, waste may be seen as the result of economically rational behavior. Wastefulness may be beneficial in a limited personal sense. The food wrappings people throw away are “wasted,” but they do add convenience and freshness to the food. In the individual’s narrow cost-benefit analysis, the benefits of the wrapping can exceed the costs. Is life priceless? Although we like to think so, many of us are not willing to bear the cost that must be paid to preserve it. Several million animals—dogs, opossums, squirrels, and birds—are killed on the highways each year. Most of us make some effort to avoid animal highway deaths. If saving lives were all -- important, we could drive less -- but that would bring a significant cost. Even when human beings are involved, we sometimes refuse to bear the cost of preserving life. People avoid helping victims of violent crime, and doctors routinely pass by highway accidents although they might save lives by stopping to help. Indeed, revolutions succeed through people’s willingness to sacrifice lives—both others’ and their one -- to achieve political or economic goals. The behavior of business people is not materially different from that of drivers or consumers. People in business are constantly concerned with cost-benefit calculations, only the comparisons are often (but not always) made in dollar terms: For example, whether the cost of improving the quality of a product is matched by the benefits of the improvement. Will consumers value the added benefits enough to pay for hem? In assessing the safety of their products, business people must consider whether consumers are willing to pay the cost of any improvements. Chapter 3 Principles of Rational Behavior at Work in Society and Business 7 The Effects of Time and Risk on Costs and Benefits When an individual acts, costs are not necessarily incurred immediately, and benefits are not necessarily received immediately. The decision to have a child is a good example. At turn of the century prices, a college -- educated couple’s first child can easily cost more than $500,000, from birth through college. 2 Fortunately this high cost is incurred over a relatively long period of time (or people would rarely become parents!). Benefits received in the future must also be compared with present benefits. If you had a choice between receiving $10,000 now and $10,000 one year from now, you would take $10,000 today. You could put the money in a bank, if nothing else, where it would earn interest, or you could avoid the effects of future inflation by spending the money now. In other words, future benefits must be greater than present benefits to be more attractive than present benefits. To compare future costs and benefits on an equal footing with costs and benefits realized today, we must adjust them to their present value. Present value is the value of future costs and benefits in terms of current dollars. The usual procedure for calculating present value -- a process called discounting -- involves an adjustment for the interest that could be earned (or would have to be paid) if the money were received (or due) today rather than in the future. 3 If there is any uncertainty about whether future benefits or costs will actually be received or paid, further adjustments must be made. Without such adjustments, perfectly rational act may appear to be quite irrational. For example, not all business ventures can be expected to succeed. Some will be less profitable than expected or may collapse altogether. The average fast-food franchise may earn a yearly profit of $1 million, but, but only nine out of ten franchises may survive their first year (because the average profits is distorted by the considerable earnings of one franchise). Thus the estimated profits for such a franchise must be discounted, or multiplied by 0.90. If 10 percent of such ventures can be expected to fail, on average each will earn $900,000 ($1 million x .90). The entrepreneur who starts a single business venture runs the risk that it may be the one out of ten that fails. In that case profit will be zero. To avoid putting all their eggs in one basket, many entrepreneurs prefer to avoid putting all their “eggs” in the 2 For rough estimates of the cost of rearing children by expenditure, see U.S. Department of Commerce, Statistical Abstract of the United States: 1998 (Washington, D.C.: U.S. Government Printing Office, 1998), table 732. To obtain the total cost of childcare, you must then estimate the value of parental time. 3 The mathematical formula for computing the present value of future costs or benefits received one year from now is PV = [1/(1 + r)] f, where PV stands for present value, r for the rater of interest, and f for future costs or benefits. The interest rate used in this formula is the rate at which we discount future costs and benefits. . Office, 199 8), table 732. To obtain the total cost of childcare, you must then estimate the value of parental time. 3 The mathematical formula for computing. f, where PV stands for present value, r for the rater of interest, and f for future costs or benefits. The interest rate used in this formula is the rate