Bounded Rationality

1
Welcome

• Strategies of Network Organizations
• Jonathan D. Wareham
• wareham_at_acm.org

2
What are Networked Companies?

• Supply chains
• Procurement systems
• Sales channels
• Out sourcing
• Off shoring
• Inter-Organizational Systems
• E-Lance and Free-Lance
• Web Sevices
• New constructions of transacting entities that do
  business in fundamentally new ways.

3
Where technology affects transactions
4
Why study them?

• New methods of transacting offer new challenges
  for management
• Understand what they are
• Understand the problems and conflicts
• Find and use the right tools to analyze problems
  and recommend solutions.

5
The basic phenomenon

• Advances in Information and Communication
  Technology have enabled new methods of
  interacting and transacting.
• Buying, selling, contracting, supplier
  relationships, vendor relationships, price
  setting, etc

6
Where the Tools meet the Technology
Economics Sociology Management
7
Core Issues

• Transacting
• In-house or out-source?
• Boundary of the firm
• Sourcing agreements
• Contract management
• Employees personnel management in networks
• Intermediaries
• Pricing

8
Economics as a Discipline

• Assumes that people have endogenous utility
  functions and they pursue them
• Largely a problem of optimization
• Must make certain assumptions about people/firms
  to solve optimization problems
• Defines generic roles and structures for
  agents/firms calculates equilibrium point
• If you can live with the assumptions and logic,
  it can be very powerful!!!!
• Base discipline for Strategy, Finance, Marketing,
  Accounting..

9
Sociology

• Sociology is a science which attempts the
  interpretive understanding of social action in
  order thereby to arrive at a causal explanation
  of its course and effects.... Action is social
  when it takes into account the behavior of others
  and is thereby oriented in its course (Weber,
  1947).
• Preferences and actions are exogenously
  determined.The big sponge view

10
Road Map
11
Life Insurance Suicide
12
Information Asymmetry

• Differences among individuals in their
  information, especially when this information is
  relevant to determining an efficient plan or
  determining individual performance.
• In simple terms a situation that exists when
  some people have better information than others.
• Example Insider trading

13
2 types of Information Asymmetry

• Hidden characteristics
• Things one party to a transaction knows about
  itself, but which are unknown by the other party.
• Hidden actions
• Actions taken by one party in a relationship that
  cannot be observed by the other party.

14
Scenarios

• You rent a car, youre young, beautiful a free
  spirited, wind in your hair. Go ahead, trash the
  car, drive it hard, Why Not????
• Youve been working hard all day. The boss leaves
  for a few hours. Go ahead, kick back, relax,
  drink a beer, surf the net.Why Not???

15
Moral Hazard

• Originally from the tendency of people with
  insurance to reduce the care they take to avoid
  losses or reduce insured losses. Now the term
  refers to a form of post-contractual opportunism
  that arises when actions desired or required
  under the contract are not freely observable.
• Situation where one party to a contract takes a
  hidden action that benefits him or her at the
  expense of another party.That is.. you do not
  directly bear the consequences of your actions.
• potential divergence of interest
• basis of gainful exchange or transaction
• difficulties in monitoring and enforcing

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Solutions I

• Signaling
• Attempt by an informed party to send an
  observable indicator of his or her hidden
  characteristics to an uninformed party.
• To work, the signal must not be easily mimicked
  by other types.
• Example Education ESADE MBA

17
Solutions II

• Improve monitoring
• Competing sources of information
• Monitoring by markets
• Explicit incentive contracts. Linking pay to some
  operational output
• Achieving goal congruence
• Sources of social governance eg. reputation, peer
  approval, morals, religion, culture,
• Corporate culture Workable principles or
  routines of shared expectations that guide
  behavior in the face of uncertainty.

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Problem

• Characteristics of population have specific mean
  and distribution, but those buying insurance have
  different profile. Why?
• Examples
• Choice of medical plans
• High-interest loans
• Auto insurance for drivers with bad records
• USAA

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Adverse Selection

• pre-contractual opportunism that arises when one
  party to a bargain has private information about
  something that affects the other's net benefit,
  implying that it would be dis -advantageous for
  another party to enter the contract
• Situation where individuals have hidden
  characteristics and in which a selection process
  results in a pool of individuals with undesirable
  characteristics

20
Solutions

• Screening
• Attempt by an uninformed party to sort
  individuals according to their characteristics.
• Often accomplished through a self-selection
  device
• A mechanism in which informed parties are
  presented with a set of options, and the options
  they choose reveals their hidden characteristics
  to an uninformed party.
• Example Price discrimination

21
Opportunism degrees

• Self interested behavior
• Self interested behavior unconstrained by
  morality
• Opportunism with guile you may actually not
  mind, or even enjoy - doing something at someone
  else's expense!

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Opportunism Debate!!!

• Is it soooo bad????
• Just how prevalent is it?
• How to we mitigate or protect ourselves against
  it?
• If we consciously choose not to be opportunistic,
  is it because we are simply good people, or is
  it because we believe there will be long term
  benefits?

23
Buying a Car
Price 11,000 Nom. Value 100 Distance
12mi. Value(dist).1.89
You are here!
Price 15,000 Nom. Value 95 Distance
15mi. Value(dist.)1.05
Price 10,000 Nom. Value 140 Distance
18mi. Value(dist.)1.94
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Bounded Rationality

• The limitations of human mental abilities that
  prevent people from foreseeing all possible
  contingencies and calculating their optimal
  behavior.
• Also includes limitations of human language that
  prevent people from communicating things that are
  known.
• We assume agents are rational, but only sort of
  rational
• Theoretical garbage can

25
Fairness - Retaliation

• Negative Reciprocity Envy You hurt me, I will
  hurt you back! I will even take pleasure in it
  making you suffer loose something at my expense.
• Explanations Comes from survival instincts in
  nature
• Only in very simple societies do we find less
  negative reciprocity (people are happy with
  relatively small shares of money).

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Altruism Fariness

• Economist world view based on self interested
  behavior.
• I help you, even when I get nothing back for it..
• How do we explain it?
• Why dont companies reduce salaries in hard
  times? The fire people instead

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An experiment

• Imagine you are stranded on a beach on a
  sweltering day and that someone offers to go for
  their favorite brand of beer. How much would they
  be willing to pay?
• Subjects agree to pay more if they are told that
  the beer is being purchased from an exclusive
  hotel rather than from a rundown grocery. It
  strikes them as unfair to pay the same.
• But a beer is a beer and should be worth the
  same???
• Social preference I accept prices that I feel
  are fair to you

28
Buying a house

• I am selling my house for 350,000
• If you knew I bought it 3 years ago for 320,000,
  would you think it is a good deal?
• If you new I bought it 3 years ago for 150,000,
  would you think it is a good deal?

29
What is the average rainfall of New Zealand?

• 45cm
• 55cm
• 63cm
• 79cm
• 114cm
• 123cm
• 156cm

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The Law of Small Numbers Weber law (people are
petty)

1. You are buying a glass of orange juice. You can
   buy it here for 4 Euro, or walk across the street
   and buy it for 3 Euro. What do you do?
2. You are buying a big screen TV. You can buy it
   here for 800 Euro, or walk across the street and
   buy it for 799 Euro. What do you do?
3. the impact of a change in intensity of a stimulus
   is proportional to the absolute level of the
   original stimulus. In financial terms, a 500
   gain on a 100 investment is greater
   psychologically than a 500 gain on a 1000
   investment.

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Investors

• Alex invested 100,000 Euro and gained 27,000 for
  a total of 127,000 Euro.
• Anne invested 300,000 Euro and lost 39,000 for a
  total of 261,000 Euro.
• Who is happier? Why?

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Prospect Theory
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Prospect Theory Says

• 1 unit of loss hurts about twice as much as 1
  unit of gain. So.We are loss averse
• What would you rather have 10 Euro today, or 5
  Euro today and 5 Euro next week? Changes are more
  important than absolute levels
• What is better you crash your car once and it
  costs you 1000 Euro. You crash your car twice and
  it costs you 400 and 600 Euro respectively.

34
Changes..

• What is happiness?
• Are rich people really happier? (Of course they
  are)
• We anchor everything to our current status.
• Sooo What Combine losses, spread out gains
• We tend to hold onto loosing stocks..

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...Decisions Are Not Always Rational
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Price Perception Issues are Complex...

• More Acceptable Pricing
• Product-Based
• Open
• Discretionary
• Discounts and Promotions
• Rewards

• Less Acceptable Pricing
• Customer-Based
• Hidden
• Imposed
• Surcharges
• Penalties

37
Time

• You are going to order a new BMW for 60,000 Euro.
• The car dealer A tells you that you can get the
  car delivered in 7 days.
• Car dealer B, who is 4 blocks away, tells you the
  car can be delivered in 3 days.
• Do you walk down the street to the other car
  dealer price and other options being equal?

38
Time

• You are going to order a special BMW for 140,000
  Euro.
• The car dealer A tells you that you can get the
  car delivered in 94 days
• Car dealer B, who is 4 blocks away, tells you the
  car can be delivered in 90 days.
• Do you walk down the street to the other car
  dealer price and other options being equal?

39
Procrastination

• Scenario A
• May 1 Work 7 hours
• May 2 Relax
• Scenario B
• May 1 Relax
• May 2 Work 7.7 hours
• Today is April 30th - which option would you
  choose?

40
Procrastination

• Scenario A
• August 1 Work 7 hours
• August 2 Relax
• Scenario B
• August 1 Relax
• August 2 Work 8 hours
• Today is April 30th - which option would you
  choose?

41
What is the average rainfall of New Zealand?

• 63cm
• 79cm
• 114cm
• 123cm
• 156cm
• 164cm
• 178cm

42
Framing Effects

• People base their decisions on the references
  given
• Extremes aversion
• 2nd cheapest wine most expensive

43
Endowment Effects

• What would you pay for this chair?
• 10.00 Euro fine
• How much will you sell this chair for?
• 10.01 Euro???

44
What are market transactions?

• They are defined by
• Moral hazard
• Adverse selection
• Information asymmetry
• Bounded rationality
• Opportunism

Uncertainty