Behavioral economics & game theory in managerial microeconomics - Research Paper Example

? Running Head: Behavioral Economics & Game Theory in Managerial Microeconomics Behavioral Economics & Game Theory in Managerial Microeconomics Institution Behavioral Economics & Game Theory in Managerial Microeconomics Introduction In lay man language, the term economic means home management. It is the study of the system in which mankind systematizes itself to challenge the rudimentary difficulties of insufficiency resources between competing ends. These two explanations define economics as the social science that studies economic activities such as consumption of goods and services, exchange and production (Png, 2002). Managerial economics encompasses unification of economic theory with business rehearses so as to simplify policymaking and forthcoming forecasting by management. Managers are enabled to make rational decisions on obstacles facing an organization. Thus, formulation of logical managerial decision is possible (Hirschey, 2008). These decisions are imperative component in the working wheel of an organization and business success or letdown is liable upon the decisions arrived at by managers. Integrations of economic theories and management discipline is a necessity resulting from increasing complexity in the business world, spewing greater challenges for managers. This study analysis the place of game theory and behavioral theory in managerial economics in isolation, then integrates them together, in applying their arguments in addressing real life situations. Game Theory and Managerial Economics Game theory is complex and involves a lot of difficulties in reasoning (Siddiqui, 2006). A game is any circumstance comprising interdependence amongst players. There are different types of games such as continuous versus discrete pay-offs, simultaneous or sequential games, zero-sum versus non-zero games, and co-operative versus non co-operative games. This study focuses on co-operative versus non-co-operative games because they involve competition among economic entities, challenging cooperate leaders and their management skills. They are characterized by aggressive competition in the business world. The basic concepts of game theory are similar to the setting of a simple game in real life situation (Fisher et al, 2010). All participants in a game have one intention; to win. Consequently, rules are set in a complex manner to ensure a win-win situation for all. This creates difficulties and necessitates systematic analysis prior to the actual occurrence of the situation. In some cases, challenges might arise when a situation is in progress, creating much complexity leading to multiple systems being set up to counter the challenge. In managerial microeconomics, managers face similar situations especially in marketing of products and services. Competitors may keep changing their tactics, in order to keep up with the changing trends in the market. Competitors actions as well as micro and macroeconomic factors beyond the control of firms such as government policies on taxation, social corporate welfare, interest rates, and currency deflation or inflation creates complexity in the business world. In addressing the above challenges among others, managers must thus adopt a game like approach. Representing and Solving Games by Managers in the Business World Assume the following payoff scenario Company a’s actions High price Low price Company B’s action High price 200A 200B 200A -40B Low price -40A -120B 100A 50B Solution If company B has set a high price then A chooses low price, the B high/Ahigh approach can be ignored. If B sets a low price, then A chooses a low price, the Blow/ Ahigh branch will be impractical. Consequently, B is forced to choose between high price (-40) and a low price (50). In these two scenarios, A must follow B price strategy because they are the dominant strategies. The above scenario illustrates a number of key ideas for managers. In decision making, a set of strategies such that each is best for each player, given that the others are playing their own equilibrium is the optimal choice. There are no clean strategies which a manager can apply with certainty (Siddiqui, 2006). Players, in our scenario managers, must employ mixed strategies where their probability for earnings is higher which is an extremely difficult exercise to implement. A problem presented by game theory is an attempt of managers to collide (Fisher, 2010). This is mostly observed in price wars. Either way, price war is not a solution and managers have to find a way around it and exit or escape. Three common techniques are applicable in such a situation, repetition, punishment or rewards and leadership (Hirschey, 2008). With repetition, players in the market observe each other behavior as they continuously collide. As a result of this observation, co-operation may eventually be established, escaping the drama. For instance company A and B can decide to set the market price for their products and services in case they learn each has its own set of customers. This logic is applicable if the numbers of collision are deemed to be infinite by all players. If they are finite, cheating might take place thus there will be no incentive to co-operate. The dilemma will keep re-appearing and solutions to the problem will depend on the last actions taken by the rivals. In real situations, where there are more than two firms involved, these firms might decide to form a central organization to arbitrate. This depends on the co-operation of all the participants. Failure to employ this option will involve continuous collision until the weak manager/firm surrenders to be a price follower or exits the market. Penalties and rewards involve firms punishing themselves in order to set structures to assist collision. For instance, A, might set a low price like B, in a competitive move to produce a pay-off structure in which collision is the outcome. Penalties and rewards will come from the customer, such as failure of clients to purchase Bs product once A lowers its price, or from law, trade associations might punish those who defect from the collision. Leadership to Backing Collision If one firm has larger pay-offs than the other firm, then it can set higher prices even if the competitor sets low price in a bid to create collision (Png, 2002). For example, the market position of A might allow the manager to set a higher price regardless of B actions. Customer loyalty perceived brand quality among other characteristics contributes to a firm owning larger pay-offs. A larger firm may also employ the game technique of paying side-offs to rivals to increase overall profits. Behavioral economics and managerial economics Behavioral economics assimilates psychology and economics by recognizing systematic inconsistencies in decision making (Fisher et al, 2010). These are now recognized to be an essential basis of error in business decisions, and they deliver the underpinning for both marketing and finance. Anomalies, such as status quo, influences people behavior. Thus, at the principal of behavioral economics is the principle that increasing the practicality of the psychological underpinnings of economic exploration will improve economics on its own terms, creating theoretical insights, making better predictions of field phenomena, and signifying better policy (Png, 2002). Most of the ideas of behavioral economics have origin in neoclassical economics. When economics was acknowledged as a field to study, psychology discipline did not exist until Adam smith busted out human psychology in his well-known book, ‘The Theory of Moral Sentiments’. This was the stepping stone in to the emergence of behavioral economics. Psychological research shows that the effect of perspective on decision making is tremendously influential (Hirschey. 2008). Judging possibility of events is dominant in behavioral economics. People will evaluate likelihood of yet to come events based on how easy those events are to envision or regain from the memory (Png, 2002). Events similar to those that occurred in the past are easier to imagine than counterfactual events that did not, humans often misjudge the probability they devoted to events which later transpired. This is referred to as a cure for knowledge, denoting that people who know a lot find it hard to imagine how little others know (Siddiqui, 2006). ‘Representatives’ are another probability judging in behavioral economics. In general economics, representativeness is an economical shortcut that conveys sensible judgments with least cognitive working many cases (Png, 2002). Law of small numbers is a derivative of representativeness where small numbers are inferred in delivering conclusions about a whole. This violates logical reasoning which might lead to some errors. Judging is employed in real life situations in explaining why people behave the way they do (Png, 2002). For instance, people under react to information about the stock market in the short term, but in the long-term they over react. In other words, consider a scenario where a shop attendant asks whether you would like to be given $100 at end month or $110 a day after and a different scenario where you are asked whether you would prefer to be given $100 today or $110 tomorrow. In a study, it was found out a higher percentage of people would prefer $110 a day after end month, but in contrast, they preferred $100 dollar at hand today than tomorrow. These two finding upswing each other. It is difficult to understand what going on here because the difference in days on both offers is equal. Human behavior in organization setting is equivalent to this complex situation. Mankind response to different situations is uncertain, unexpected, and based on behavioral economics, it is a blend portrayed by different level employees, placing managers in compromising situations (Fisher et all, 2010). People divulge inconsistency or subjective inclinations; through this they typically obey normative principles of economic theory when it is crystal clear to do so. They are sensitive to gains or losses they will get from different situations. Another revelation oh this behavior is that true knowledge never exist, economic activities involves uncertainty and risk (Fisher et all, 2010). Consequently, in making managerial decisions, there is a potential risk of applying the intended knowhow inappropriately. For instance, in applying the incremental concept, managers may make basic mistakes. This concept involves measurement of revenues resulting from a new product line. Not only the revenue received from the sale of a new product that need to be considered, but also any change in revenue generated over the remainder of the firm's product line. If a new item takes sales away from other firm’s products, this loss in revenue must be accounted for in measuring the incremental revenue of the new product. But in applying the representativeness judging concept, a manager may fail to consider the whole scenario and concentrate on the representative sample, which is the new product line. Existing product line sales may thus decline but go unnoticed because the company profits are rising. Discussion: Application of Behavioral economics and Game Theory in Managerial microeconomics Managerial economics encompasses the use of economic approaches of thought to scrutinize business condition (Png, 2002). In other words, it is the incorporation of economic theory with business practice for the resolve of aiding decision making and accelerative forecasting by management. All firms operating in the market have to take under consideration the basic of the economic environment for its proper working (Hirschey, 2008). This economic environment is nothing but micro economics elements. Consequently, managerial microeconomics is supposed as managerial economics which combines demand analysis and forecasting, theory of price, theory of revenue and cost, theory of supply and production as the major underpins. It aims at solving issues regarding organization decision making (Siddiqui, 2006). Game theory is essential in analyzing all underpins for managerial microeconomic (Fisher et al, 2010). Behavioral economics relates to the challenge faced by managers in arriving at decisions about these micro economic variables. All managers want to make maximum efficient decisions on all business functions. For this reason, business planning need to be effectively planned and performed with a comprehensive understanding of microeconomic concept and its application. With adequate compliance to these, optimum managerial decisions will be made regardless of market constraints. If a manager wants to increase the price of a product as a result of increase in cost of factor of production, he or she can apply the game theory concept to make the optimum decision (Hirschey, 2008). By applying the basic game theory concept, a manager will be able to effectively analyze the elasticity of demand of such a product, to ensure that price rise will not be followed by substantial fall in demand in the real world situation. Through consideration of possible outcomes of every possible move, he or she will select the optimal strategy, taking under consideration competitor’s retaliation possibilities, and probability of occurrence of a collision situation. On this same situation, behavioral economics will enhance manager judgment on probability of various unintended outcomes thus put I place contingency plans before implementing his or her plans. It is on behavioral economics basis that a manager’s understanding of unpredictable human behavior is enhanced, and as a result, he or she will have various comeback or counter plans in case of consumers refusal to purchase his products. Decisions concerning manufacture and supply of the product in the market, awareness of obtain ability of fixed and flexible factors of production, state of technology to be employed and accessibility of raw materials are crucial in defining the worth of a manager (Fisher et al, 2010). Poor managerial decisions on these core business functions will lead to end of a firm’s life. Careful coordination of the same is vital for success to be achieved. In employing game theory, the complexity of these functions will be clear to managers in real life situations. Using of solution making and implementation game theory technique will guide a manager at arriving at the optimum decision. For instance, employing of repetition technique will present an opportunity for him or her to co-operate with other market players or distinguish him or herself as the market leader. Through the application of game theory statistical methods such as linear programing in real life situations, manager’s decisions are more accurate, especially in budget preparation for various departments of the organization, and capital rationing will be favorable to all. Cost-benefit analysis which is an essential function for any commercial entity is best calculated by use of game theory statistical techniques (Png, 2002). Case study Business environment encompasses negotiations on a daily basis. Game theory is a guide to effective managers’ negotiations (Fisher et al, 2010). Consider the following illustrations where company A and B wants to merge; they want to establish the basis of sharing profit. Each has its strategies, but they have to agree on the optimal strategy which satisfies both of them.A, wants to share on the basis of 6: 5, while B, and wants to share on the basis of 5:5. Staff remuneration is also an issue as each company wants to keep compensating their workers the current salary they offer them. In spite of this, a merger will result to an entirely new entity requiring an appraisal of all employees and restructuring of their salary packages. In the above scenario, an overwhelming majority of employees will start searching for employment in other places due to uncertainty of the future. The merging organizations will not only be facing organization restructuring challenges, but also personnel problems. Application of behavioral economics theories on unpredictable and inconsistent human behavior under different situations will guide the management in establishing ways for retaining the working workforce. Incorporating game theory statistical techniques, the management of both firms will be able to conduct meaningful negotiations by considering all the strategies in determining profit sharing ratios. Game theory will enable them realize the strategic strategies available thus they will not spend time in unnecessary approaches. Conclusion Game theory shows that it is always a good strategy to minimize your opponent maximum payout, even if it requires guaranteeing him a higher minimum (Png, 2002). In the real world situations, it provides the basis for negotiations, as a result, makes a manager aware of when to stop negotiation or in other words when he or she has achieved his or her intended result. It is also advantageous for managers because it makes it possible for them to have information at hand prior to negotiations thus they have pretty strong basis for negotiations. Behavioral economics indicates the difficulties of predicting human action. In spite of the uncontrollable macro and microeconomic variables influencing managerial decisions which are beyond their control, behavioral economics points out the human aspect of an organization to be most complex. Regardless of managerial decisions made for the betterment of an organization, human aspects are capable of implementing the made decisions. Their unpredictability in different situations makes the managerial decision extremely difficult. This study concludes that in attempts to making optimal decisions, managers should be open minded and extremely flexible. This is because regardless of being the market leader or executing their optimal strategies accurately, there is no individual with optimal knowledge. All managerial decisions are made based on theories and these theories might be far from reality especially in the contemporary world where new information can easily be rendered useless by technology. References Hirschey Mark, (2008) Managerial Economics. Cengage Learning Png Ivan, (2002) Study Guide To Accompany Managerial Economics. John Wiley & sons Hirschey Mark, (2008). Fundamentals of Managerial Economics. Cengage Learning Fisher C. G. Timothy., Robert Waschik, Tim F., David Prentice Robert, Robert G. Waschik, (2010). Managerial Economics, Second edition: AsStrategic Approach. Taylor & Francis Siddiqui S.A, (2006) Managerial Economics and Financial Analysis. New Age International. Read More