Rational Decision Making in Business Organizations

Introduction

Alfred Marshall defined economics as a psychological science focused on mankind's behavior in everyday life, particularly concerning wealth attainment and use. He also stated that man's character is molded by his every-day work.
Economic science has largely concentrated on reason, especially in resource allocation under scarcity.
Modern definitions of economics include allocating scarce resources and rational decision-making.
Economists have begun exploring areas traditionally belonging to political science, sociology, and psychology.

Decision Theory as Economic Science

The study of economics is unevenly distributed with normative studies of international and national economies being the heartland and decision theory being an important colonial territory.
Political economy focuses on full employment, efficient resource allocation, and equitable distribution.
Economic sciences encompasses the entire domain, including decision theory.
Normative economics is supported by descriptive theory, exemplified by Walrasian general equilibrium theories.
Theories by Arrow, Hurwicz, Debreu, and Malinvaud demonstrate the equivalence of competitive equilibrium and Pareto optimality under specific conditions.
The real-world relevance of these refined theories has been questioned.
Positive political economy is influenced by economic policy demands.

Decision Theory in the Service of Political Economy

Fundamental inquiry is valuable, even without immediate policy relevance.
Descriptive theory of decision making, including the theory of the firm, is underdeveloped and often investigated by those outside economics.
Some economists, like Edward Mason, Fritz Machlup, and Milton Friedman, have questioned the close relationship of behavioral theory with economic inquiry.
Mason questioned the contribution of behavioral theory of the firm to economic analysis.
Friedman argued that a theory's realism is determined by its predictive accuracy for its intended purpose.
The prevailing purpose is providing decision-theoretic foundations for positive and normative political economy.
Fundamental inquiry into rational human behavior in business organizations is considered outside political economy unless it significantly contributes to that purpose.
Economic theories of decision making are sometimes not considered falsified by incompatible micro-level empirical predictions if they align with aggregate observations of political economy.
Economists may demand maximization from economic actors but settle for satisficing in evaluating their own theories.
The application of satisficing is sometimes defended by Occam's Razor, advocating for the simplest effective theory.
Occam's Razor suggests that we should accept the theory that makes no more assumptions than necessary to account for the phenomena (Essentia non sunt multiplicanda praeter necessitatem).
Parsimony should be secondary to predictive accuracy.
Positive decision theory should handle both microscopic and aggregative phenomena.

Decision Theory Pursued for its Intrinsic Interest

The definition of economics is flexible; however, the training and concerns of economists are important.
Focusing solely on aggregative phenomena neglects a rich domain of rational human behavior.
Behavioral theory of the firm is relevant to political economy.
Human behavior in business firms requires explanation, and practical applications will likely emerge with further understanding.
Friedman implied that the correctness of rational behavior assumptions in classical theory is not empirically testable directly, but only through macroscopic predictions.
Micro-level behavior is directly observable through various techniques.
Economic theories can be tested via concrete behavior of decision-making agents, not only aggregate time-series data.

Aggregative Tests of Decision Theory: Marginalism

Aggregate phenomena are relevant to testing decision theory.
The classical theory of omniscient rationality is simple and allows prediction without observation.
Predictive power comes from characterizing the environment.
Behavioral theories of bounded rationality are less simple but have weaker assumptions about human capabilities.
Behavioral theories make modest demand on knowledge and computational abilities.
Behavioral theories don't predict that agents will equate costs and returns at the margin.

Have the Marginalist Predictions Been Tested?

Empirical observations cited as support for the classical theory of the firm are not direct observations.
Most empirically verified consequences of classical theory are weaker than equating marginal costs and revenues.
Four important examples: negatively sloping demand curves, first-degree homogeneity of fitted Cobb-Douglas functions, decreasing returns to scale, and executive salaries varying with the logarithm of company size.

Negatively Sloping Demand Curves

Evidence of consumers maximizing utilities and equating marginal utilities is nonexistent.
Empirical data confirms that demand curves generally have negative slopes.
Negatively sloping demand curves can arise from various behaviors satisfying bounded rationality assumptions.
Gary Becker argues that negatively inclined demand curves result from changes in opportunities, largely independent of the decision rule.

First-Degree Homogeneity of Production Functions

Observed phenomenon that classical assumptions provide sufficient, but not necessary, conditions is the equality between labor's share of product and the exponent of the labor factor in fitted Cobb-Douglas production functions.
Fitted Cobb-Douglas functions are homogeneous, generally of degree close to unity, with a labor exponent of about the right magnitude.
These findings can be produced by mistakenly fitting a Cobb-Douglas function to data generated by a linear accounting identity.

The Long-Run Cost Curve

Classical theory requires the firm's long-run cost curve to be U-shaped for competitive equilibrium to be stable.
Theories of bounded rationality do not predict this.
Observed data make it doubtful that cost curves are generally U-shaped.
Evidence shows costs at the high-scale ends of the curves to be essentially constant or even declining.
This finding is compatible with stochastic models of business firm growth and size, but not with the static equilibrium model of classical theory.

Executive Salaries

Average salaries of top corporate executives grow with the logarithm of corporate size.
This finding has been derived from the assumptions of the classical theory of profit maximization only with the help of very particular ad hoc assumptions about the distribution of managerial ability.
The observed relation is implied by a simple behavioral theory that assumes only that there is a single, culturally determined, parameter which fixes the average ratio of the salaries of managers to the salaries of their immediate subordinates.
The behavioral model is more parsimonious than the classical model.

Summary: Phenomena that Fail to Discriminate

Specific phenomena requiring a theory of utility or profit maximization for their explanation rather than a theory of bounded rationality simply have not been observed in aggregate data.
Classical theory faces difficulties in handling some empirical observations.

Failures of Classical Theory

Classical theory can be adapted to handle stable economies near competitive equilibrium.
A strong case for replacing the classical theory with a model of bounded rationality emerges when examining decision making under uncertainty and imperfect competition.
Classical theory was not designed to handle these situations.
Statistical decision theory and game theory have contributed conceptual clarification but lack satisfactory descriptions of human behavior and usable normative theories.

Normative Decision Theory

Decision theory is pursued for building foundations for political economy, understanding phenomena, and offering advice to decision makers.
Prior to World War II, this area was sparsely settled.
During World War II, operations research or operations analysis was rediscovered by scientists, mathematicians, and statisticians.
Economists established management science as their own colony.
Optimization techniques were transported into management science from economics, and new optimization techniques were invented and developed.
Decision tools in management science must be capable of making or recommending decisions using available empirical data and feasible computations.
Idealized models of optimizing entrepreneurs are of little use.
Models must be computationally practical, even with approximations and simplifications.
Two directions: optimization with simplification and satisfying models.
Decision makers can satisfice by finding optimum solutions for a simplified world or satisfactory solutions for a more realistic world.
Theory in management science shares with descriptive decision theory a concern with how decisions are made, not just outcomes.
These are theories of how to decide rather than theories of what to decide.

In Search of a Descriptive Theory

There will be a close relationship between normative and descriptive decision theory.
Both areas are concerned with procedural rather than substantive rationality.
As new mathematical tools and computers evolve, normative decision theory and actual decision-making practices in business firms will change, possibly with macro-economic consequences.

Characterizing Bounded Rationality

Institutionalism

The principal forerunner of a behavioral theory of the firm is the tradition usually called Institutionalism.
Institutionalism seeks to reformulate economic theory to account for social and legal structures.
John R. Commons is a prominent figure among American Institutionalists.
Commons' writings borrow heavily from the law and use the transaction as the basic unit of behavior.
Commons' ideas provided insights into organizational decision making.
Commons influenced Chester I. Barnard, who proposed original theories on authority and motivation in organizations.
Barnard provided a realistic description of organizational decision making, characterized as opportunistic.

Subgoal Identification

Observed disagreement and tension within organizations regarding resource allocation despite shared objectives.
Decision-makers didn't equate expenditures at the margin because, intellectually, they couldn't.
This phenomenon is referred to as subgoal identification.
Decisions are judged against subordinate goals that can be connected operationally.
The formulation of subordinate goals depends on the decision maker's knowledge, experience, and organizational environment.
Subgoal identification is a central research interest of cognitive psychology.

Administrative Behavior

Administrative Behavior represented a shift in understanding organizational decision-making, emphasizing the limits of rationality and the importance of psychological and social factors. It provided a framework for analyzing how decisions are actually made in organizations, rather than how they should be made according to purely rational models.
Herbert Simon's work explored the concept of bounded rationality, which posits that individuals make decisions based on simplified models of the world due to cognitive limitations, incomplete information, and time constraints. Instead of optimizing, decision-makers satisfice, seeking satisfactory rather than optimal solutions.
Key themes of Administrative Behavior:

Bounded Rationality: Decision-makers have cognitive limitations that prevent them from making fully rational choices.
Satisficing: Decision-makers seek satisfactory solutions rather than optimal ones.
Organizational Structure: The structure of an organization influences decision-making processes.
Information Processing: How information is processed