Chapter 3 Principles of Rational Behavior at Work in Society and Business 8 proverbial one basket by initiating several new ventures, thereby spreading the risk of doing business. In the same way, investors spread their risk by investing in a wide variety of companies, and firms spread their risk by producing a number of products. To give another example, criminal behavior may appear irrational if only the raw costs and benefits are considered. A burglar who nets $1,500 from the sale of stolen property may have to spend a year in jail if caught, prosecuted, and convicted. He could lose the annual income from his legitimate job, perhaps $10,000. That is a high cost to pay for a $1,500 profit on stolen property, but he pays that cost only if he is caught, prosecuted, convicted, and sentenced. The police cannot be everywhere at all times; prosecutors may be reluctant to prosecute; and suspended sentences are commonplace. All in all, even an inept burglar may have no more than a 10 percent chance of spending a year in jail. 4 To estimate the actual cost faced by the burglar who is caught, sentenced, and sent to jail for a year, we might multiply the cost if caught, $10,000, by 0.10. That calculation indicates that to a burglar who is sent to jail for an average of one out of ten burglaries, the cost of any one burglary is only $1,000 ($10,000 x 0.10). Thus the actual cost of the burglary is less than the benefits received, $1,500. Although it may be morally reprehensible, the criminal act can conceivably be a rational one. Surveys of criminal activities and their rewards tend to support such a conclusion. A study of burglary and grand larceny cases in Norfolk, Virginia, showed that for the unusual criminal who committed just one crime and was caught in the act, crime did not pay. The typical criminal, however, convicted the average number of times and sentenced to the average number of years in prison, more than tripled the lifetime income he could have earned from a regular salaried job—even allowing for one or more years of unsalaried incarceration. 5 When this study was replicated in Minnesota, the results were not quite as dramatic, but the criminal’s lifetime income still doubled. 6 For criminals who are never caught, crime pays even more handsomely. The same logical process of discounting can be applied to your life as a student. When you signed up for your MBA program, you actually had limited information on how it would work out for you. (Admit it, it was a gamble!) Similarly, when you sign up for courses, you usually have only a very rough idea of how difficult and time -- 4 This is not an unreasonably low figure. Gregory Krohm “concluded that the chance of an ‘adult’ (seventeen or older) burglar being sent to prison for any single offense is .0024. . . For juveniles. . . the risk was much lower, .0015.” “The Pecuniary Incentives of Property Crime,” in The Economics of Crime and Punishment, ed. Simon Rottenberg (Washington, D.C.: American Enterprise Institute for Public Research, 1973), p. 33. 5 William E. Cobb, “Theft and the Two Hypotheses,” in The Economics of Crime and Punishment, ed. Simon Rottenberg (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1973), pp. 19 -- 30. 6 David L. Johnson, “An Analysis of the Costs and Benefits for Criminals in Theft” (Economics Department, St. Cloud State College, St. Cloud, Minn., May 1974), mimeographed. Chapter 3 Principles of Rational Behavior at Work in Society and Business 9 consuming they will be, and what benefits you will receive from them. In other words, you are rarely certain of their costs and benefits. To make your decision, you will have to discount the raw costs and benefits by the probability of their being realized. Risks are pervasive in human experience, and rational behavior takes those risks into account. What Rational Behavior Does Not Mean The concept of rational behavior often proves bothersome to the noneconomist. Most of the difficulties surrounding this concept arise from a misunderstanding of what rationality means. Common objections include the following: 1. People do many things that do not work out to their benefit. A driver speeds and ends up in the hospital. A student cheats, gets caught, and is expelled from school. Many other examples can be cited. To say that people behave rationally does not mean that they never make mistakes. We can calculate our options with some probability, but we do not have perfect knowledge, nor can we fully control the future. Chances are that we will make a mistake at some point, but as individuals, we base our choices on what we expect to happen, not on what does happen. We speed because we expect not to crash, and we cheat because we expect not to be caught. Both can be rational behaviors. 2. Rational behavior implies that a person is totally self -- centered, doing only things that are of direct personal benefit. Rational behavior need not be selfish. Altruism can be rational; a person can want to be of service to others, just as he can want to own a new car. Most of us get pleasure from seeing others happy—and particularly when their happiness is the result of our actions. Altruism may not always spring from rational cost-benefit calculations; however, it is not always inconsistent with economic rationality. Self -- interest, moreover, does not necessarily stop at the individual. For many actions, “self” includes members of one’s family or friends. When a father spends a weekend building a tree house for his children, economists say that he has been engaged in self -- interested behavior. 3. People’s behavior is subject to psychological quirks, hang -- ups, habits and impulses. Surely such behavior cannot be considered rational. Human actions are governed by the constraints of our physical and mental makeup. Like our intelligence, our inclination toward aberrant or impulsive behavior is one of those constraints. It makes our decision-making less precise and contributes to our mistakes, but it does not prevent our acting rationally. Moreover, what looks like impulsive or habitual behavior may actually be the product of some prior rational choice. The human mind can handle only so much information and make only so many decisions in one day. Consequently, we may attempt to economize on decision making by reducing some behaviors to habit. Smoking may appear to be totally impulsive, and the physical addition that accompanies it may indeed restrict the smoker’s range of choices. Why might a person pull a cigarette from the pack “without Chapter 3 Principles of Rational Behavior at Work in Society and Business 10 thinking”? Perhaps because she has reasoned earlier that contemplating the pros and cons of smoking each and every time she things of cigarettes is too costly. By allowing smoking to become more or less automatic, the smoker probably increases the number of cigarettes she smokes daily, but she sees the tedium of having to make the decision each and every time she smokes. 4. Rational behavior implies that people know what they want, that they know which alternatives are available, and that they know how to act on that information. People cannot assimilate all the information they need to make rational choices, however. People do lack information, and they could make better choices if information were easier to obtain. However, rational behavior does not require perfect information. People will make choices on the basis of the information they have or can rationally acquire. If they have less than perfect information, they may make mistakes in their choices. The success or failure of their choices must be judged within those constraints. 5. People do not necessarily maximize their satisfaction. For instance, many people do not perform to the limit of their abilities. Satisfaction is a question of personal taste. To some individuals, lounging around is an economic good; by consuming it, they increase their welfare. Criticism of such is tinged with normative value judgments. An observer who equates rational behavior with what he or she considers good will have no trouble demonstrating that such behavior is irrational. Irrational behavior is behavior that is inconsistent or clearly not in the individual’s best interests and that the individual recognizes as such at the time of the behavior. 6. But to the economist, the values of the actor, not the observer or the social critic, determine the rationality of an act. Harold, not Jennifer or Max, determines the rationality of Harold’s behavior. Disincentives in Poverty Relief Our discussion of rational behavior can be used to understand one of the biggest policy issues of our time, welfare reform. We can do this by assuming that welfare recipients are tolerably rational. So much of the public discussions about welfare programs, especially cuts in them, assumes that since Congress has the authority to change the programs, it can alter the programs any way it wishes without creating problems. However, as we can easily see, Congress is in something of an economic, if not political, bind on welfare relief, given how incentives change when the program is adjusted. The basic problem is that the practice of scaling down welfare benefits as earned income rises creates an implicit marginal tax on additional earned income that discourages the poor from working. Why not lower the implicit marginal tax rate? Figure 3.3 gives the answer. The 45 -- degree line that extends out from the origin indicates points of equal distance from each axis—that is, points at which spendable Chapter 3 Principles of Rational Behavior at Work in Society and Business 11 income equals earned income. At point y, for example, a poor person earns and can spend $5,000 annually. At points above the line, spendable income exceeds earned income. For instance, at point x, a poor person earns $5,000 annually and can spend $7,500. He receives a subsidy equal to y – x, or $2,500. FIGURE 3.3 Policy Tradeoffs of a Negative Income Tax With a guaranteed income of SI 1 ($5,000) and a break -- even earned income level of EI 1 ($10,000), the implicit marginal tax rate on the poor is 50 percent. If policymakers attempt to reduce the implicit tax rate by raising the break -- even income level, however, the government’s poverty relief budget will rise by the shaded area SI 1 ab. A higher explicit tax burden will fall on a smaller group of taxpaying workers. Suppose the government establishes a negative income tax with a guaranteed annual income level of $5,000, or SI 1 . The break -- even earned income level is $10,000, or EI 1 . A person who earns nothing will receive a subsidy of $5,000 a year. As his earned income rises the subsidy will decline, until it reaches zero at $10,000. Curve SI 1 shows the spendable income of people in this program at various earned income levels. They lose $500 in subsidies for every $1,000 of additional earned income. That is, they face an implicit marginal tax rate of 50 percent. If policy markers want to reduce the implicit marginal tax rate on an earned income of $10,000 to less than 50 percent, they must either reduce the guaranteed spendable income level or raise the break -- even earned income level. If they raise the break -- even earned income level—to $15,000, or EI 2, for example—curve SI 1 a will shift to SI 1 b. But then more people—all those with earned incomes up to EI 2 —will receive benefits. Moreover, all the people covered originally will receive larger subsidies. A person with an income of $5,000 would receive $8,000 instead of $7,000 in spendable income (point z instead of point x), for example. The total increase in the government’s poverty relief expenditures would equal the shaded area in the figure bounded by SI 1 ab. The increase in expenditures would place a greater tax burden on taxpaying workers. Yet because more workers would be covered by the negative income tax, fewer people Chapter 3 Principles of Rational Behavior at Work in Society and Business 12 would share the increased tax burden. Thus the explicit marginal tax rate on high -- income workers rises—lowering their incentive to work and earn additional income. If the government reduces the guaranteed income level, say from SI 1 to SI 0, a different problem will result. On the new curve SI 0 a, the poor will receive less government aid at each earned income level. They may have more incentive to work under such an arrangement, but will they have enough to live on? Policymakers, then, face difficult tradeoffs between the goal of helping the poor and the goal of minimizing the disincentive to work. To provide adequate aid, they may have to raise the breakeven income level high enough that people who are not strictly poor benefit. Yet to reduce aid to people who are not truly poor, they would have to lower the break -- even income level—thus increasing the implicit tax rate on the poor. To keep the implicit marginal tax rate down, they could lower the guaranteed income level— decreasing the benefits that go to the truly poor. Our graphic analysis suggests that there may be economic as well as altruistic limits to the government’s ability to transfer income from the rich to the poor. As more and more income is allocated to the poor, either the guaranteed income or break -- even income level must go up. If only the guaranteed income level is raised, the implicit marginal tax rate facing the poor increases. If that problem is avoided by raising the break -- even income level, poverty relief will cover more people, and the taxes paid by the remaining workers will go up. Increased aid to the poor thus should have three consequences. A higher explicit tax burden will fall on fewer taxpayers. Because of this burden, higher -- income groups will have less incentive to work, and lower -- income groups, because of the higher implicit tax rate, will also be less inclined to work. MANAGER’S CORNER: The Last-Period Problem Much of this chapter has been concerned with how people behave rationally. Here, we introduce “opportunistic behavior” as a form of rational behavior that people in business will want to protect themselves from. We suggest ways different parties to business deals can take advantage of other parties and how managers can structure their organizational and pay policies to minimize what we call “opportunistic behavior.” More specifically, this section is concerned with how an announced end to a business relationship can inspire opportunistic behavior. Its goal is, however, constructive, structuring business deals – and the embedded incentives -- in order to maximize the durability and profitability of the deals. To do that, business relationships must be ongoing, or have no fixed end, to the extent possible. Having a fixed termination date can encourage opportunistic behavior, which can reduce firm revenues and profits. That is to say, a reputation for continuing in business has economic value, which explains why managers work hard to create such a reputation. Chapter 3 Principles of Rational Behavior at Work in Society and Business 13 Problems with the End of Contracts A terrific advantage of dealing with outside suppliers is that the relationship is constantly up for renewal and can easily be terminated if it is not satisfactory to both parties. But therein lies an important disadvantage of dealing with outside suppliers: the relationship lacks permanence or confidence that any given buyer/supplier relationship will be renewed. The supplier must attribute some probability that the end of the contract will be the end of the relationship, given that he or she might not be the next low bidder, a deduction that can have profound effects on the relationship that the astute manager must recognize. Without much question, firms have begun to develop relationships with suppliers that approximate partnerships because of the “last-period” problems inherent in relationships that are totally grounded in the low -- bidder status of the suppliers. The basic problem is that during the last period of any business relationship, there is no penalty for cheating, which implies maximum incentive to cheat. As a consequence, cheating on deals in the last period is more likely than at any other time in the relationship. Consider a simple business deal. Suppose that you want a thousand widgets of a given quality delivered every month, starting with January and continuing through December, and that you have agreed to make a fixed payment to the supplier when the delivery is made. If you discover after you have made payment that your supplier sent fewer than a thousand units or sent the requisite thousand units but of inferior quality, you can simply withhold future checks until the supplier makes good on his or her end of the bargain. Indeed, you can terminate the yearlong contract, which can impose a substantial penalty for any cheating early in the contract. Knowing that, the supplier will tend to have a strong incentive early on in the contract period to do what he or she has agreed to do. However, the supplier’s incentive to uphold his or her end of the bargain begins to fade as the year unfolds, for the simple reason that there is less of a penalty -- in terms of what is lost from your ending the working relationship -- that you can impose. The supplier might go so far as to reason that during the last period (December), the penalty is very low, if not zero. The supplier can cut the quantity or quality of the widgets delivered during December and then can take the check before you know what has been done. The biggest fear the supplier has is that you might inspect the shipment before handing over the final check. You may be able to get the supplier to increase the quantity or quality somewhat with inspection, but you should expect him or her to be somewhat more difficult to deal with. And you should not expect the same level of performance or quality. The problem is that you have lost a great deal of your bargaining power during that last month, and that is the source of what we call and mean by the last-period (or end -- period) problem, meaning the costs that can be expected to be incurred from opportunistic behavior when the end of a working relationship approaches. It is a problem, however, that can be mitigated in several ways. The simplest and perhaps most common way is by maintaining continuing relationships. If you constantly jump from one supplier to another, you might save a few bucks in terms of the quoted prices, but Chapter 3 Principles of Rational Behavior at Work in Society and Business 14 you might also raise your costs in terms of unfulfilled promises by suppliers during the last period of their association with you. “Working relationships,” in other words, have an economic value apart from what the relationship actually involves, for example, the delivery of so many widgets. This is one important reason businesses spend so much time cultivating and maintaining their relationships and why they may stick with suppliers and customers through temporary difficulties. Solutions to the Last-Period Problem Nothing works to solve the last-period problem, however, like success. The more successful a firm is -- the greater the rate of growth for the firm and its industry -- the more likely others will recognize that the firm will continue in business for sometime into the future. The opposite is also true -- failure can feed on itself as suppliers, buyers, and workers begin to think that the last period is near. Firms understand these facts of business life. As a consequence, executives tend to stress their successes and downplay their failures. Their intent may not be totally unethical, given how bad business news can cause the news to get worse. Outsiders understand these tendencies. As a consequence, many investors pay special attention to whether executives are buying or selling their stock in their companies. The executives may have access to (accurate) insider information that is not being distributed to the public. Another simple way of dealing with the last-period problem in new relationships is to leave open the prospect of future business, in which case the potential penalty is elevated (in a probabilistic sense) in the mind of the supplier. When there is no prospect of future business, the expected cost from cheating is what can be lost during the last period. When there is some prospect of future business, the cost is greater, equal to the cost that can be imposed during the last period plus the cost (discounted by the probability that it will be incurred) incorporated in the loss of future business. When dealing with remodeling or advertising firms, for instance, you can devise a contract for a specified period, but you can suggest, or intimate, in a variety of creative ways, that if the work is done as promised and there are no problems, you might extend the contract or expand the scope of the relationship. In the case of the remodeling firm, you might point out other repairs in the office that you are thinking of having done. In the case of the advertising firm, you might suggest that there are other ad campaigns for other products and services that you are considering. You should, therefore, be able to secure somewhat better compliance with your supplier during the last period of the contract, and how much the compliance is improved can be related to just how well you can convince your supplier that you mean business (and a lot of it) for some time into the future. However, we are not suggesting that you should outright lie about uncertain future business. The problem with lying is that it can, when discovered, undercut the value of your suggestions of further business and bring back to life the last-period problem. You need, in other words, to be prepared to extend, from time to time (if not always), working relationships when in fact they work the way you want them to work. Chapter 3 Principles of Rational Behavior at Work in Society and Business 15 However, if you are not able to develop that impression, the last period can come sooner than you might think (or sooner than December in our earlier example). That is, the contractual relationship can unravel because of the way you and the supplier begin to think about what the other is thinking and how the other might act as a consequence. If both you and your supplier are inclined to cheat on the contract, and you have already figured that your supplier will cheat to the maximum (send nothing) during the last period, then December becomes irrelevant and November becomes the last period. Your incentive then is to cheat on the supplier in November. Well, with November now the last period, you can imagine what your supplier is thinking. He is contemplating cheating in November before you get a chance to cheat. Ah, but you can bet the supplier by cheating in October. That thought suggests that when contemplating the contract before it is signed and sealed, you and the supplier can reach the conclusion that January is the (relevant) last period -- which means that the deal will never be consummated. In this way, the last-period problem becomes a first -- period problem, actually one of setting the terms of the contract. This way of thinking about it can make the signing problematic, and more costly than it need be, assuming there are ways around the problem. This line of argument reminds us of an old joke about a prisoner condemned to death. As it happened, the prisoner was told on Sunday that he would be hung between Monday and Saturday, but the day of his hanging would be a total surprise. He reasoned, “They can’t hang me on Saturday because it wouldn’t be a surprise. So, Friday is the last day of the relevant period.” Therefore, he reasoned, “They can’t hang me on Friday because if they wait until then, it won’t be a surprise.” Continuing this line of reasoning, Friday gave way to Thursday being the last day, and so forth. He eventually concluded that they couldn’t hang him. Of course, when they hung him on Wednesday, he was really surprised! This joke suggests that the last period problem doesn’t always lead to an unraveling in which the last period becomes the first. But the last period problem is potentially serious and is one reason that firms exist: firms are collections of departments (and people) who have continuing relationships that are not always up for re -- bidding, which means that the parties can figure that they will be continued, with there being no clear last period. The last-period problem is also a significant reason why the corporation is such an important form of doing business. The corporation is a legal entity whose existence is independent of the life of the owner or owners; the corporation typically lives on beyond the death of the owners. Given that ownership is in shares, the corporation makes for relatively easy and seamless transfer of ownership, which means the life of the company is, in an expectational sense, longer as a corporation than as a partnership or proprietorship, two organizational forms that die with the owners. This means that the corporate charter should be prized simply because it adds value to the company by muting (though not always eliminating) the last-period problem. The last-period problem extends beyond buyer -- supplier relationships of the sort we described above involving the purchase of widgets. There is clearly a last-period problem for military personnel. When officers or enlisted men and women are given Chapter 3 Principles of Rational Behavior at Work in Society and Business 16 their transfer orders, they can sit back and relax, given that the penalties that can then be imposed on them have been severely limited by the orders to move on. The problem becomes especially severe when personnel are about to leave the military altogether. Military people have a favorite expression for what we call shirking during the last period. They call it “FIGMO”: “F -- -- k you, I’ve got my orders.” We are sure that the military has devised a variety of ways to mute the impact of FIGMO, but it is equally clear that the problem of shirking as military men and women approach the ends of their assignments remains a pressing one. Sometimes you just have to accept some costs of shirking (otherwise you might end up concluding that people should be fired the moment they enlist, which can be more costly than the shirking). The last-period problem can surface with a vengeance when an employee who has access to easily destroyed records and equipment is fired. The firm doing the firing must worry that the employee will use his or her remaining time in the plant or office to impose costs on the firm, to “get back” at the firm. As a consequence, firings are often a surprise, done quickly, with the employee given little more time than to collect his or her personal things in the office – all to minimize damage. The firm may even hand the employee a paycheck for hours of work not done, simply to make the break as quickly as possible and discourage fired workers from imposing even greater costs through damage to records and equipment. Indeed, when the potential for serious damage is present and likely, firms may hire a security guard to be with the fired employee until he or she is escorted to the door for the last time. The last-period problem can also show up in the greater incentives people have to shirk as they approach retirement. To prevent workers from shirking, deferred compensation can be used with some of the compensation withdrawn if shirking ever does occur. A variation of this type of solution for executives is to tie their compensation to stock. If executives shirk toward the ends of their careers, causing their companies to do poorly, then the executives lose more than any remaining salary they are due for the duration of their tenure; they lose the value of the stock, which approximated the discounted value of the company’s lost earnings attributable to the executives’ shirking while still on the job. Apparently, corporations’ executive compensation committees are aware of the last-period problem. Economists Robert Gibbons and Kevin Murphy have found from their econometric studies that as CEOs get closer to retirement age, their compensation tends to become more closely tied to their firm’s stock market performance. 7 Another way of solving the last-period problem is through performance payments, which means that payments are made as a project is completed. For example, separate payments can be made for constructing a house when the house is framed, when it is under roof, and when wiring is in and the interior walls have been finished. However, a significant portion of the total amount due is withheld until after the entire project is 7 Robert Gibbons and Kevin J. Murphy, “Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence,” Journal of Political Economy, vol. 100, n3 (June 1992), pp. 468 -- 506. Chapter 3 Principles of Rational Behavior at Work in Society and Business 17 completed and the results approved. For example, 20 percent of the entire construction cost is not paid until after the final inspection. Business critics often decry the extent to which many pension plans are not fully “funded” -- that is, not enough has been set aside by the firm in investment accounts to meet the retirees’ scheduled benefits. The under -- funded pension plans can be a way by which firms seek to solve a form of the last-period problem of retired workers, especially unionized workers, whose concern for the financial stability of the firm may stop when they get their gold watch. Unions often negotiate the retirement payments and fringe benefits for unionized retirees at the same time they negotiate the pay packages for the current workers. Even when retirement benefits are fixed for retirees’ lives, the retirees have an interest in the continuation of the firm, but only when the pension plans are not fully funded. When they are fully funded the retirees don’t have as much of a stake in the continuation of the firms. They can reason, “Who cares what the workers get paid, we’ve got ours!” When the retirement plans are not fully funded, the retirees must worry that excessive wage demands by current workers can decrease the ability of the firm to fund the retirement benefits in the future and thereby meet the scheduled benefit payments. Hence, under -- funded pension plans can be a way of tempering union wage demands by giving retirees a stake in wage rates than are lower than otherwise. The very fact that an “old” owner of a business can sell to a “young” owner also enhances the incentive of the old owner to maintain the reputation of the firm. However, once the firm is sold, there is an incentive for the old owner to allow the firm’s reputation to decline, a prospect that encourages a speedy transfer of a business when the deal is closed. If the new owner can’t take over the business in a timely fashion, then he or she might overcome the last-period problem simply by insuring that the old owner retains stock in the business. Of course, the new owner might prefer to have complete control of the business once it is acquired. However, the value of the share he or she controls might be greater if the old owner retains some incentive to keep the reputation and material and human resources of the business intact between the time the sale is completed and the transfer of ownership is finalized. Otherwise, the old owner may have an incentive not only to relax on the job, but also to set up a totally new business and then raid the old company of its key employees and customers. If the old owner retains some interest in the firm, then he or she also has an incentive to work with the new owners, giving them time to develop the required reputation for honest dealing with employees and customers and to take control of one of the more elusive business assets -- the network of contacts. The practice of keeping the old owner on after the sale of the business is common among businesses such as medical offices. Doctors first form a firm that looks and operates like a partnership, after which they finalize the sale. In all of these cases, the old owners will want to work with the new owners to make the transfer as “seamless” as possible, simply because the sale price will be higher, and the greater the chance the new owner has to establish a reputation for honest dealing and to take charge of the contacts. . for your MBA program, you actually had limited information on how it would work out for you. (Admit it, it was a gamble!) Similarly, when you sign up for. might multiply the cost if caught, $10, 000, by 0 .10. That calculation indicates that to a burglar who is sent to jail for an average of one out of ten burglaries,