Transcript Bounded Rationality - Information Systems Department

Welcome
Strategies of Network Companies
Jonathan D. Wareham
[email protected]
What are Networked Companies?
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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.
Where technology affects transactions
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.
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…
Where the Tools meet the Technology
Economics
Sociology
Management
Core Issues
Transacting
In-house or out-source?
Boundary of the firm
Sourcing agreements
Contract management
Employees & personnel management
in networks
 Intermediaries
 Pricing
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Economics as a Discipline
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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…..
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
Road Map
Life Insurance & Suicide
Suicide Frequencies
1.2
0.8
0.6
0.4
0.2
Months after life insurance policy issued
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27
25
23
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15
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11
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3
0
1
Frequency
1
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
2 types of Information Asymmetry
1. Hidden characteristics
 Things one party to a transaction knows
about itself, but which are unknown by
the other party.
2. Hidden actions
 Actions taken by one party in a
relationship that cannot be observed by
the other party.
Scenarios
 You rent a car, you’re young, beautiful
a free spirited, wind in your hair. Go
ahead, trash the car, drive it hard,
Why Not????
 You’ve 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???
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.
1. potential divergence of interest
2. basis of gainful exchange or transaction
3. difficulties in monitoring and enforcing
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
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
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shared expectations that guide behavior in the face of
uncertainty.
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
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
Solutions
Screening
 Attempt by an uninformed party to sort
individuals according to their
characteristics.
 Often accomplished through a selfselection 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
Opportunism: degrees
1. Self interested behavior
2. Self interested behavior
unconstrained by morality
3. Opportunism with guile: you may
actually not mind, or even enjoy doing something at someone else's
expense!
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?
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
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
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).
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 don’t companies reduce salaries
in hard times? The fire people instead
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…
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?
What is the average rainfall of New
Zealand?
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45cm
55cm
63cm
79cm
114cm
123cm
156cm
The Law of Small Numbers –
Weber’ law (people are petty…)
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III.
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?
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?
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.
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?
Prospect Theory
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.
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..
...Decisions Are Not Always
“Rational”
Tickets; $7.95
Tickets; $6.95
$1.00 Discount
for Children &
Seniors
$1.00 Extra
for Middle Aged
People
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
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?
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?
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?
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?
What is the average rainfall of New
Zealand?
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63cm
79cm
114cm
123cm
156cm
164cm
178cm
Framing Effects
 People base their decisions on the
references given
 Extremes aversion
 2nd cheapest wine most expensive
Endowment Effects
 What would you
pay for this
chair?
 10.00 Euro fine
 How much will
you sell this
chair for?
 10.01 Euro???
What are institutions?
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They are a response to:
Moral hazard
Adverse selection
Information asymmetry
Uncertainty
Bounded rationality
Opportunism
Prisoner’s Dilemma
A
Tell
Don't Tell
B
Tell
7, 7
10, 2
Don't Tell
2, 10
2, 2
Key Insights of Game theory
Put yourself in your rival’s shoes
Use analysis to identify dominant strategies
Not all games are games of conflict.
Communication can help solve coordination
problems.
 Sequential moves can help solve
coordination problems.
 Collusion can be sustained as a Nash
equilibrium when there is no certain “end”
to a game.
 Doing so requires:
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 Ability to monitor actions of rivals
 Ability (and reputation for) punishing defectors
 Low interest rate
OPEC
OPEC’s Demise
40
Low Interest
Rates
35
High Interest
Rates
30
25
20
15
10
5
0
1970
-5
1972
1974
1976
1978
Real Interest Rate
1980
1982
1984
Price of Oil
1986
Economics & Rational Choice
 Individualism: only individuals make social
actions, and social actions cause the macro
social outcomes one wishes to explain.
 Optimality: individual actions are social
actions optimally chosen given the
individual’s transitive preferences across
opportunities he or she perceives.
 Self-Regard: individuals’ actions and social
actions are entirely concerned with their
own welfare
 We are but isolated, atomized, self-serving,
algorithms
The Manager’s role
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Procure inputs in the
least cost manner
Provide incentives for
workers to put forth
effort
Failure to accomplish
this results in a point
like A
Costs
C(Q)
A
$100
80
B
Output
0
$10
Methods of Procuring Inputs
 Spot Exchange
 When the buyer and seller of an input
meet, exchange, and then go their
separate ways.
 Contracts
 A legal document that creates an
extended relationship between a buyer
and a seller.
 Vertical Integration
 When a firm shuns other suppliers and
chooses to produce an input internally.
Knight (1921) & Coase (1937)
Coase (1937) Why do we have firms?
Knight (1921) Why don’t we have one
big firm?
possibility of monopoly rents motivates
continuous and unlimited expansion
of firms, But we do not always see it.
There must be offsetting
mechanisms.
Ronald Coase (1937)
Why do we have firms?
there must be some cost in using the price
mechanism.
• Price discovery/search costs
• Contract negotiation
• Long term stability of supply sources
(uncertainty)
Ergo, operation of the market costs something, and by forming
and organization and letting some authority to allocate
resources, some costs are saved
Coase’s Argument
 Transactions vary in nature and
dimension, and will align themselves
with the governance mechanisms
which manages these transactions
most efficiently.
 Size of firm increases until additional
rent gained by bringing transaction in
house is superceded by cost of
bringing it in. That is, it has to be
more costly on the market
 Coase theorem: Efficiency determines
Coordination Costs
 Price determination
 Details of transaction
 Disclose existence of buyers and
sellers to execute transactions
 Search prices or quality control
 Compiling and transferring
information
Basic attributes of transactions
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Specificity
Frequency
Duration
Complexity
Uncertainty
Difficulty of measuring performance
Connectedness
Asset Specificity
 Investments made to allow two
parties to exchange but has little or
no value outside of the exchange
relationship
 Site specificity
 Physical-asset specificity
 Dedicated assets
 Human capital
 Lead to higher transaction costs and
the problem of “hold-up”
Rule of thumb
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
Internal Vs External
Coordination
 Internal: cost of communication and
coordination “reduced returns to
management”
 External: Costs of using market
 Balance:
 Internal
 External
 Economies of scale - keep firms at given
size,
Discussion
 Your firm is considering outsourcing
its IT function. Use Transaction Cost
Economics to help you evaluate this
decision.
 What important factors are not
addressed in a Transaction cost
perspective?