CHAPTER 4 Conceptual framework for selection of materials for structural frame
4.2 Firm‘s decision on economic matters
4.2.1 The theory of the firm
The period of First World War saw a change of emphasis in economic theory away from industry-level analysis which mainly included analyzing markets to analysis at the level of the firm, as it became increasingly clear that perfect competition was no longer an adequate model of how firms behaved.
Economic theory till then had focused on trying to understand markets alone and there had been little study on understanding why firms or organizations exist (Spulber, 2009).
The main tasks of the theory of the firm are to answer these questions (Spulber, 2009):
Why do firms exist? The theory of the firm shows that firms exist only when they improve the efficiency of economic transactions.
How are firms established? Individual consumers can choose to become entrepreneurs and establish firms. The theory of the firm thus makes the entrepreneur endogenous in microeconomics.
What do firms contribute to the economics? Firms are institutions that coordinate transactions by acting as intermediaries.
84
The theory of the firm incorporates advances in the study of firms from industrial organization, contract theory, game theory, law and economics, institutional economics, the economics of organizations, and finance (Spulber, 2009). Therefore, the theory of the firm helps to clarify management decision making. However, Hall and Hitch (1939) found that executives made decisions by the rule of thumb rather than in a marginalist way.
Transaction cost theory is the foundation of the theory of the firm. Coase (1937) raised the question of why firms exist as functions that are more complex than the firm of conventional pricing theory, as indicated in the traditional theory of the firm. Coase‘s (1937) contribution to the modern theory of the firm inspired researchers to investigate the existence of the firms by categorizing organizations into specific market problems. Williamson (1975, 1985) expanded Coase‘s contribution and developed transaction cost theory, where the existence of firms is analyzed in economic terms – the transaction costs. To put it succinctly, both Coase (1937) and Williamson (1975, 1985) believed that a firm is an instrument for reducing transaction costs (Schmidt, 2000). The second element in the modern theory of the firm is the theory of agency, which was described by Jesen and Meckling (1976). The agency theory implies that in firms and enterprises, ownership is not always equal to management control. The firm is a legal entity which is at the center of a nexus of contracts (Jesen and Meckling, 1976). These contracts are the agency between ownership and management control. The third building block in the modern theory of the firm is the theory of incomplete contracts. Based on the theory, Grossman and Hart (1986) analyzed the economic factors that have an influence on the decision-making process but do not belong to the category of contracts.
Neoclassical economics is employed to analyze the actions of firms. Newer versions of neoclassical theory often incorporated human awareness of economic criteria changes. Neoclassical economics is therefore still widely used with the following assumptions (Spulber, 2009):
People have rational preferences among outcomes that can be identified and associated with a value;
85
Individuals maximize utility and firms maximize profits.
People act independently on the basis of full and relevant information.
One characteristic of firms is that firms separate the decision makers of buyers from sellers. As a seller in building development business, a building developer has to consider the consumers‘ profit and their requirements when planning the building. The relationship between developers and designers is that of buyers and sellers. If design firms aim to sell their design work to developer firms, they have to consider the profit of developer firms and their requirements.
According to the theory of the firm, the following conclusions may be drawn:
The firm is an efficient organizational form for minimizing transaction costs in building business.
Both development firms and design firms should consider consumers‘
utilities.
The firm is regarded as a profit-maximizing entity whose aims are to react to the changes of inputs and outputs of the market and achieve optimal production (Schmidt, 2000).
4.2.2 Rational choice theory
Rational choice theory, also known as rational action theory, is a framework for understanding and often formally modeling social and economic behavior (Hedstrửm & Stern, 2008). It is the dominant theoretical paradigm in microeconomics. It is also central to modern political science and is used by scholars in other disciplines such as sociology and philosophy.
The 'rationality' described by rational choice theory is different from the colloquial and most philosophical uses of the term. 'Rationality' means in colloquial language 'sane' or 'in a thoughtful clear headed manner'. In Rational Choice Theory 'rationality' simply means that a person reasons before taking an action. In rational choice theory, all decisions are arrived at by a 'rational'
86 process of weighing costs against benefits.
a) Principle
The basic idea of rational choice theory is that patterns of behavior in societies reflect the choices made by individuals as they try to maximize their benefits and minimize their costs (Hedstrửm & Stern, 2008). In other words, people make decisions about how they should act by comparing the costs and benefits of different courses of action. As a result, patterns of behavior will develop within the society as a result of those choices.
The idea of rational choice, where people compare the costs and benefits of certain actions, is easy to see in economic theory. Since people want to get the most useful products at the lowest price, they will judge the benefits of a certain object (for example, how useful is it or how attractive is it) compared to similar objects. Then they will compare prices (or costs). In general, people will choose the object that provides the greatest reward at the lowest cost.
According to Hedstrửm and Stern (2008), rational decision making entails choosing an action given one's preferences, the actions one could take, and expectations about the outcomes of those actions. Actions are often expressed as a set, for example a set of j exhaustive and exclusive actions:
………..…... (Eq. 4.1) b) Assumptions
Although models used in rational choice theory are diverse, all assume that individuals choose the best action according to stable preference functions and constraints facing them. Most models have additional assumptions. Proponents of rational choice models do not claim that a model's assumptions are a full description of reality, but that good models can aid reasoning and provide help in formulating falsifiable hypotheses, whether intuitive or not. Successful hypotheses are those that survive empirical tests.
Rational choice theory makes two assumptions about individuals' preferences
87 for actions:
Completeness – all actions can be ranked in an order of preference (indifference between two or more is possible).
Transitivity – if action a1 is preferred to a2, and action a2 is preferred to a3, then a1 is preferred to a3.
These assumptions underpin the concept that given a set of exhaustive and exclusive actions to choose from, an individual can rank them in terms of his preferences, and that his preferences are consistent.
Often, to simplify calculation and facilitate testing, some possibly unrealistic assumptions are made about the world. These include:
An individual has full or perfect information about exactly what will occur under any choice made. More complex models rely on probability to describe outcomes.
An individual has the cognitive ability and time to weigh every choice against every other choice. Studies about the limitations of this assumption are included in theories of bounded rationality.
Other assumptions are often incorporated in more complex models, such as the assumption of independence axiom. Also, with dynamic models that include decision-making over time, time inconsistency may affect an individual's preferences.
c) Application
Becker (1978) was an early proponent of applying rational actor models more widely. He won the 1992 Nobel Prize in Economics for his studies of discrimination, crime, and education.
Rationality is widely used as an assumption of the behaviour of individuals in microeconomic models and analysis. Although rationality cannot be directly empirically tested, empirical tests can be conducted on some of the results
88
derived from the models. Over the last decades, rational choice theory has also become increasingly employed in social sciences other than economics, such as sociology and political science (Scott, 1997). It has had far-reaching effects on the study of political science, especially in fields like the study of interest groups, elections, behaviour in legislatures, coalitions, and bureaucracy (Dunleavy, 1991).
4.2.3 Application of theories to economic sustainability
According to the theory of the firm, firms pursue maximum profits. In addition, rational choice theory supports the idea that people will choose the object that provides the greatest reward at the lowest cost. The two theories might explain why economic indicators have to be considered when managers making decisions.
The two theories could be applied in any industry including the construction industry. Firms (developers and construction firms) will pursue economic sustainability when decision makers are selecting building materials.
Therefore, the structural frame that provides the greatest benefit at the lowest life cycle cost will be preferred.