Microeconomic Assumptions: Are They Valid?

Microeconomic Assumptions: Are They Valid?

Sam Choon Yin (2003)

 

I received a message the other day with an attached ‘IQ’ question that read like this:

 

Rich man needs ______

Poor man has _______

Eat ______ and you’ll die.

 

The question requires the readers to fill in the three blanks using a same word. While I would not reveal my answer to you here (the answer was subjective anyway), it surprised me when the ‘official’ answer that came back to me read ‘NOTHING’. It surprises me because the answer does not seem to be true at least for the first and second blanks. To understand why, one needs to know what Economics is about.

Economics is the science of choice. It studies individuals’ decision-making. Generally, a person needs to make choices because he or she does not have sufficient resources to satisfy all the needs. In short, we face the economic problem of scarcity. Scarcity is a relative concept meaning that the problem exists only when the needs outweigh the amount of resources available to satisfy them. So, if ‘needs’ is represented as (x) and resources availability is measured as (y), then scarcity exists when x > y. Scarcity does not exist when x y. This brings me to the IQ question that was posed earlier. The point is everybody encounters the scarcity problem. Even the rich man does. He may be rich, but that does not mean he can satisfy all his needs. There are definitely some wishes that he wants to be granted but not possible because of insufficient resources. A very good example is time. Rich or poor, all of us have 24 hours to spend per day. They are only so many things we may want to do in a given day. If they are so many things to do than what the amount of time permits, then some of these things must be done on other days. Of course, the poor man faces the same problem. There are needs that he cannot satisfy. The point is, every individual encounters scarcity problem.

Because choices are made, it must imply that some choices are sacrificed while some gains are reaped. In Economics, the cost of making choices is known as opportunity cost. Consider an example. Say you have $10 to spend. There are two items which you want to purchase; a compact disc and a pair of slippers. For simplicity, assume that both items cost $10 each. Clearly, you could not have both. You are encountering the scarcity problem. The resource ($10) is not sufficient to satisfy all the needs (which in this case amounts to $20). You have to make a choice. Assume that you choose to purchase the compact disc. The choice brings to you both benefit and cost. The benefit is in the form of enjoyment that you reap from listening to the compact disc. The cost amounts to the ‘benefits’ sacrificed if you have purchased the pair of slippers instead. The latter is known as opportunity cost.

There are two branches of economics; microeconomics and macroeconomics. The former tries to study behaviors of individuals that made up the country’s economy. Known as economic agents, the individuals are decision-makers in households, firms and government. Macroeconomics is more concerned with workings of the whole country’s economy. It concentrates on aggregate matters like aggregate consumption, aggregate investment and total output (or gross domestic output). This essay focuses on microeconomics. More specifically, I am interested to examine the main microeconomic assumptions about human behavior, and assess whether the assumptions make sense practically.

Let us first consider the individuals’ behavior in households. The economic assumption links to the notion of utility maximization as a motivator directing the choices made. Each individual is said to have utility functions comprising independent variables which define his or her utilities. What goes into the function is subjective and depends on the individual. Only the person will be able to say what makes him more happy or satisfied. An outsider does not know simply because the information is usually hidden and personal. However, we can predict the thinking process of individuals. The most sought after model describing individuals’ thinking process is rationality.

A person is considered rationale if he assesses the benefits and costs of each alternative available to address a concern and chooses the option which yields the highest net benefits. Each utility function essentially defines an alternative with a set of independent variables combination. It is up to the person to choose the alternative which enables him to enjoy the highest utility. A common perception is that a rational person is synonymously linked to an egoistic person. This implies that among the alternatives that he can choose from, typically the alternative that yields the highest benefits to the person himself will be chosen. This is not entirely true. As was mentioned earlier, what goes into the utility function is unknown to an outsider. This implies that the form of utility is also unknown to outsiders. Only the person under consideration will be able to tell. It is possible that being altruistic or utilitarian satisfies the person. That is, the utility function can be in the forms: Uegoistic = f(x11, x12, …., x1n); Ualtrustic = f(x21, x22, ……, x2n) or Ucommunitarian = f(x31, x32, ….., x3n). For altruistic and communitarian individuals, the alternative that yields benefits to others is more likely to be chosen. It is a common mistake to assume individuals being egoistic.

Consider tax payments. Why would anyone be paying taxes willingly  despite knowing that his contributions is insignificant in anyway to contribute to the society’s well being? Why would he pay taxes if his contributions were so small that the kind of services provided will not be affected much with or without his contributions? The answer is, a person may decide to taxes instead of evading them because the benefits of doing so outweighs the costs. Being moral responsible to the society and minimizing risks be being caught are some benefits. The person follows the communitarian principle of moral. What this essentially tells us is that alternatives containing inside the individuals’ utility function can be influenced somewhat through incentives and disincentives inducement and/or appeal to moral consciousness. The term ‘somewhat’ is used because of the possibility that someone may be less responsive to the inducements than others rendering the policy initiatives less ineffective. However, this does not imply that this person is irrational. But just that the weights placed on other alternatives are on a high side. In this case, more effort to influence the positive behaviors must be forthcoming. To sum up, the microeconomic assumption of utility maximization, which drives behavior of individuals representing household is valid. It is not possible though to know for sure the form of utility one possesses. He could be egoistic, altruistic or communitarian, and the form may differ depending on circumstances. What we can predict is the thinking process of the person and rationality appears a very appealing concept to carry out the prediction task.

The economic assumption on behavior of individuals representing the firms is profit maximization. The drive to maximize profits essentially directs choices they make. Note that the focus here is on economic institutions rather than social institutions or non-profit organizations. Generally, entrepreneurs sacrifice some of their capital to postpone today’s consumption. They undertake the risk to venture into businesses without the guarantee of success. They face the possibility of having lower purchasing power in the future due to inflation. Profits after tax and other expenses, to them, are essential to act as rewards or compensation. 

In the past, the entrepreneurs managed their own firms. Perhaps began in late 19th century with Standard Oil Trust where the notion of owners as managers had become less distinct. Instead, more concentration was placed on another group of individuals – professional managers – to carry out the essential tasks of maximizing profits of the firms. It is possible for the owners and managers to be separate persons. Owners (more commonly known as shareholders nowadays) engage the help of professional managers to manage the firms on their behalf. The latter essentially have the discretionary power to control the usage of resources and how the profits are to be distributed. Contracts are signed with managers to try and align their interest with those of the shareholders. But contracts are usually incomplete. It is possible that managers carry out tasks to benefit themselves rather than doing things in the interests of shareholders. The problem is known as the principal-agent problem. The problem basically resulted from the separation of managers (agents) and owners (principals) (more about this later).

Nevertheless, the idea of profit maximization remains generally valid. It can be argued that even firms, which engaged in community and philanthropic efforts had in mind the objective of maximizing profit. The efforts may be exploited to build up their reputation (media coverage is usually extensive) and savings in taxes. There is nothing wrong with this. The firms are merely pursing activities that in tandem with their objective. The difference here is that the community benefits in the process. Likewise, the attempts to care for stakeholders (other than shareholders) are directed towards profit maximization. Treating suppliers as part of the family, working closely together with creditors and maximize customers’ satisfaction are strategies adopted.

There is a problem though. It is not known for sure if the decisions made are directed towards the economic objective. The professional managers engaged by shareholders may deliberately engaged in community and philanthropic efforts to raise their own reputations so that they become more popular among their peers and potential employers. This essentially raises their employability. Managers may also deliberately hold on to excess cash rather than paying them to shareholders in the form of dividends. The cash may instead be used to furnish the managers’ offices or spend lavishly on business trips. This is part of the principal-agent problem as mentioned earlier. They are several attempts which can be used to address the problem. Assigning independent board members, design a well-structured board of directors, signing incentive contracts with managers (for example offering stock options plan) and increase participation of institutional investors, are some of the initiatives commonly cited in corporate governance literature. After considering four requirements (information, motivation, empowerment and independence), Robert Monks argued that, of all the participants, institutional investors appear to be the best as far as monitoring performance of executive managers is concerned (Monks, 1998, p. 63-68).

To sum up, while the profit maximization assumption appears valid, the principal-agent problem may roughen the road to success. To tackle the problem requires high standards of corporate governance. Corporate governance is indeed a lively subject which gains importance in recent years perhaps beginning from the outset of Asian crises in 1997 and recent corporate failures in US (like Tyco, Enron and WorldCom).

Let us consider the individuals representing the government. The economic assumption regarding the behavior of individuals is maximization of society’s net benefit. Politicians and civil servants in general have a fiduciary responsibility to the society in making sure that the public’s interest is met. In Richard Musgrave classic book on public finance, the government has roles relating to allocation of resources, distribution of income and stabilization of the economy (to attain reasonable economic growth with low unemployment and inflation rates) (Musgrave, 1959). However, the term ‘public’s interest’ here is rather difficult to define. What constitutes public’s interest is not easy to ascertain. The public comprises different groups of individuals whose interests may be conflicting. This renders the term public’s interest rather meaningless. Perhaps, what is important to determine is the question of who have the strongest influential power directing how things are done in the society. Their decisions and interest would ultimately define what public’s interest is. In Singapore, the core executives of the government have the greatest influence on society’s standards (Worthington, 2003). This essentially calls for good public sector governance.

While the economic assumption about government’s role is generally accepted, its overall success depends on integrity of public sector officials. Bribery, extortions and nepotism may weigh strongly on the behavior of public officials. They bring private benefits to them at the expense of the society. In this case, the economic assumption of maximizing society’s interest is violated. So, like the case of private sector institutions, the economic assumption of maximizing society’s interest is generally valid to describe choices made by public sector agents. However, recognition must exist to acknowledge the fact that corruption problem may render the assumption invalid.

 

Reference

1.         Monks, Robert (1998) The Emperor’s Nightingale: Restoring the Integrity of the Corporation in the Age of Shareholder Activism. Addison-Wesley (United States).

2.         Musgrave, Richard. A. (1959) The Theory of Public Finance: A Study in Public Economy. McGraw Hill (New York).

3.        Worthington, Ross (2003) Governance in Singapore. RoutledgeCurzon (USA and Canada).