MICROECONOMICS
Q40. How does the behavioural theory of the business explain how businesses work?
Many descriptions of the business focus on its need to extract the greatest profit (the difference between its revenue and its costs). Other descriptions of business behaviour focus on decisions made under uncertainty, where people possess limited cognitive ability and so can exercise only bounded rationality when making decisions. Individuals and groups working in businesses will tend to 'satisfice' -to attempt to attain realistic goals, instead of trying to extract maximum profit.
In the real world, businesses do not just try to maximise their profits. Every business exists in a sea of uncertainty - they simply do not know what will come next. Their information about their world is limited and, even if that information were unlimited, their ability to process all of the relevant information is extremely limited. The business does not exist to clear market prices, but in fact exists merely to continue existing. Unlike the story presented above, businesses are not interested in market clearing prices, nor will their actions, at least in most markets, lead to an equilibrating solution in other markets.
The first goal of any business is to survive until the next year. The second goal is to accumulate power. Power over its customers, its suppliers, its rivals, potential new entrants, the government, the legal and regulatory environment, the natural environment, even the future. The business seeks this power in order to continue to improve its odds of survival into the future. The best way to ensure survival is to grow. The business is therefore incentivised to grow as fast as it can: to be a growth-maximiser.
The benefits of business size growth are pretty obvious: higher salaries, job security, prestige, company planes and cars, and high social status. Importantly, the larger a business is relative to other businesses in its sector (or market), the larger its influence on prices and costs, as well as commuters and communities.
Under conditions of uncertainty, with imperfect market structure, it makes sense to think of the business as searching for a set of cost curves which (it thinks) will guarantee its survival into tomorrow. The fact is that, in any period, any one business can only borrow a finite amount of money, and this amount is usually based on the amount of internal funds the business has accumulated in previous periods. So, retained earnings become important to model for a realistic description of the business. The principle of increasing risk holds that the higher the gearing or leverage ratio (externally generated funds/internally generated funds), the larger the potential volatility of earnings net of interest payments. Businesses, in normal times, are free to borrow what they like at the current rate as a multiple of their previous retained earnings. In crisis periods, this reverses, and the multiple becomes a divisor, perhaps driving businesses out of business (no pun intended).
Q41. How does a business decide how much to produce?
Despite many, many variations across time, across countries, and even across regions, every one producing anything commercially must follow the logic of this simple, stark, equation:
Every business needs to get its raw materials, labour, and machinery at the lowest price it can, and use the best available technology to combine these elements somehow into a product it can sell to the markets at a price high enough to compensate its employees with wages, and pay the rent on its plant and machinery, as well as other overhead costs.
From the point of view of the economy as a whole, there is no difference between workers and machinery. Labour sometimes is thought of as a substitute for capital, the economist's shorthand for machinery and raw materials. This means that, if a better production technology is available, which produces the product at a lower cost but uses more machinery and fewer workers, then the employer will let workers go as the new machines are bought and come online. And when production lines become expensive to run, they can be switched off, and the workers laid off.
However, the cost to the organisation is different to the cost to society. Workers who become unemployed represent a direct cost to the State through increased claims of unemployment benefit but also, indirectly, through the negative effects unemployment can have on individuals and their families. Notice the difference: production lines, when switched off, do not have these extra costs. Labour does. Labour is special as a result. Which is why unions, employment legislation, and training agencies exist: to help ease and facilitate the transition from one job to another. This distinction is important, because it can sometimes be tempting to think of labour as a good substitute for capital.
There are several stories describing how much a business decides to produce. Most run like this: Businesses know their cost base, and, in the presence of lots of competition, they vary the proportion of capital and labour until they get the lowest cost combination possible with a given level of technology. This is called marginal analysis.
Other stories focus on the business attempting first, just to survive, and second, when the business is making some money, to expand itself. The benefits of business size growth include higher salaries, job security, prestige, company planes and cars, and high social status. Importantly, the larger a business is relative to other businesses in its sector (or market), the larger its influence on prices and costs, as well as on communities.
