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CHAPTER 3

Principles of Rational Behavior at
Work in Society and Business

We are not ready to suspect any person of being defective in selfishness.
Adam Smith

ith this chapter we begin a detailed examination of key issues in
microeconomics, namely the study of how prices are determined in individual
markets. Prices are important – or, rather, should be important – to managers
because of their unavoidable impact on the decisions of managers within individual
firms. We have already seen how the forces of supply and demand determine prices
(Chapter 2). Now we will explore the determinants of the supply and demand for goods,
services, and resources.
Microeconomics rests on certain assumptions about individual behavior. One is
that people are capable of envisioning various ways of improving their position in life.
This chapter reviews and extends the discussion begun in Chapter 1 of how people –
business people included go about choosing among those alternatives. According to
microeconomic theory, consumers and producers make choices rationally, so as to
maximize their own welfare and their firms’ profits. This seemingly innocuous basic
premise about human behavior will allow us to deduce an amazing variety of
implications for business and every other area of human endeavor.


Rationality: A Basis for Exploring Human Behavior
People’s wants are ever expanding. We can never satisfy all our wants because we will
always conceive of new ones. The best we can do is to maximize our satisfaction, or
utility, in the face of scarcity. Utility is the satisfaction a person receives from the
consumption of a good or service or from participation in an activity. Happiness, joy,
contentment, or pleasure might all be substituted for satisfaction in the definition of

utility. Economists attempt to capture in one word—utility—the many contributions
made to our well being when we wear, drink, eat, or play something.
The ultimate assumption behind this theory is that people act with a purpose. In
the words of von Mises, they act because they are “dissatisfied with the state of affairs as
it prevails.”
1


1
Ludwig von Mises, The Ultimate Foundations of Economic Science: An Essay on Method (Princeton,
N.J.: D. Van Nostrad, 1962), pp. 2—3.
W

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The Acting Individual
If people act in order to satisfy their consciously perceived wants, their behavior must be
self directed rather than externally controlled. However, there is no way to prove this
assertion. Economists simply presume that individuals, as opposed to groups, perform
actions. It is the individual who has wants and desires, and looks for the means to fulfill
them. It is the individual who attempts to render his or her state “less unsatisfactory.”
Group action, when it occurs, results from the actions of the individuals in the
group. Social values, for instance, draw their meaning from the values held collectively

by individuals. Economists would even say that group action cannot be distinguished
from individual action. Although economists do not deny the existence of group
psychology, they leave the study of social groups to others. Thus to understand group
behavior, the economist looks to the individual.
Of course individuals in a group affect one another’s behavior. In fact, the size
and structure of a group can have a dramatic effect on individual behavior. When
economists speak of a competitive market, they are actually talking about the influence
that other competitors have on the individual consumer or firm.

Rational Behavior
When individuals act to satisfy their wants, they behave rationally. Rational behavior is
consistent behavior that maximizes an individual’s satisfaction. The notion of rational
behavior rests on three assumptions:
• First the individual has a preference and can identify, within limits, what he or
she wants.
• Second, the individual is capable of ordering his or her wants consistently,
from most preferred to least preferred.
• Third, the individual will choose consistently from these ordered preferences
to maximize his or her satisfaction.
Even though the individual cannot fully satisfy all her wants, she will always choose
more of what she wants rather than less. Furthermore, she will always choose less rather
than more of what she does not want. In short, the rational individual always stands
ready to further her own interests.
Some readers will find these assertions obvious and acceptable. To others, they
may seem narrow and uninspiring. Later in the chapter we will examine some possible
objections to the concept of rational behavior, but first we must examine its logical
consequences.

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Rational Decisions in a Constrained Environment
Several important conclusions flow from the economist’s presumption of rational
behavior. First, the individual makes choices from an array of alternatives. Second, in
making each choice, a person must forgo one or more things for something else. All
rational behavior involves a cost, which is the value of the most preferred alternative
forgone. Third, in striving to maximize his or her welfare, the individual will take those
actions whose benefits exceed their costs.

Choice
We assume that the individual can evaluate the available alternatives and select the one
that maximizes his utility. Nothing in the economic definition of rational behavior
suggests that the individual is completely free to do as he wishes. Whenever we talk
about individual choices, we are actually talking about constrained choices—choices that
are limited by outside forces. For example, you as a student find yourself in a certain
social and physical environment and have certain physical and mental abilities. These
environmental and personal factors influence the options open to you. You may have
neither the money, the time, nor the stomach to become a surgeon, or your career goal
may not allow you the luxury of taking many of the electives listed in your college
catalog.
Although your range of choices may not be wide, choices do exist. At this

moment you could be doing any number of things instead of reading this book. You
could be studying some other subject, or going out on a date, or playing with your son or
daughter. You could have chosen to go shopping, to engage in intramural spots, or to jog
around the block. You may not be capable of playing varsity sports, but you have other
choices. Although your options are limited, or constrained—you are not completely free
to do as you please—you can still choose what you want to do. In fact, you must choose.
Suppose that you have an exam tomorrow in economics and that there are exactly
two things you can do within the next 12 hours. You can study economics, or you can
play your favorite video game. These two options are represented in Figure 3.1. Suppose
you spend the entire 12 hours studying economics. In our example, the most you can
study is four chapters, or E
1
. At the other extreme, you could do nothing but play
games—but again, there is a limit: eight games or G
1
.
Neither extreme is likely to be acceptable. Assuming that you aim both to pass
your exam and to have fun, what combination of games and study should you choose?
The available options are represented by the straight line E
1
G
1
, the production
possibilities curve for study and play and the area underneath it. If you want to maximize
your production, you will choose some point on E
1
G
1
, such as a: two chapters of
economics and four games. You might yearn for five games and the same amount of

study, but that point is above the curve and beyond your capabilities. If you settle for
less—say one chapter and three games, or point x—you will be doing less than you are
capable of doing and will not be maximizing your utility. The combination you actually
choose will depend on your preference.
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Changes in your environment or your physical capabilities can affect your
opportunities and consequently the choices you make. For example, if you improve your
study skills, your production rate for chapters studied will rise. You might then be able to
study eight units of economics in 12 hours in which case your production possibilities
curve would expand outward. Even if your ability to play Amazons from Outer space
remained the same, your greater proficiency in studying would enable you to increase the
number of games played. Your new set of production possibilities would be E
2
G
1
in
Figure 3.2.
Again, you can choose any point along this curve or in the area below it. You
may decide against further games and opt instead for four chapters of economics (point
c). You could move to point b, in which case you would still be learning more
economics—three chapters instead of two—but would also be playing more games. The
important point is that you are able to choose from a range of opportunities. The option

you take is not predetermined.













FIGURE 3.1 Constrained Choice
With a given amount of time and other resources,
you can produce any combination of study and
games along the curve E
1
G
1
. The particular
combination you choose will depend on your
personal preferences for those two goods. You
will not choose point x, because it represents less
than you are capable of achieving—and as a
rational person, you will strive to maximize your
utility. Because of constraints on your time and
resources, you cannot achieve a point above
E

1
G
1
.


FIGURE 3.2 Change in Constraints
If your study skills improve and your ability at
the game remains constant, your production
possibilities curve will shift from E
1
G
1
to E
2
G
.1 .

Both the number of chapters you can study and
the number of games you can play will increase.
On your old curve, E
1
G
1
, you could study two
chapters and play four games (point a). On your
new curve E
2
G
1

, you can study three chapters
and play five games (point b).


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Cost
The fact that choices exist implies that some alternative must be forgone when another is
taken. If A and B represent two mutually exclusive opportunities, to choose A is
simultaneously to not choose B. In the presence of choice—a situation in which no more
than one alternative can be taken at a time—a cost must be incurred. Cost (or more
precisely, opportunity cost) is the value of the most highly preferred alternative not taken.
Put another way, it is the value the individual places on the most favored alternative not
taken at the time the choice is made. For example, suppose that you have decided to
spend half an hour watching old television programs. The two programs you most want
to watch are M.A.S.H. and Gilligan’s Island. If you choose Gilligan’s Island, the cost is
the pleasure you sacrifice by not watching M.A.S.H.
Notice that cost is not defined in terms of money. Money is a useful measure
because it reduces all costs to one common denominator. Money is only the means of
measuring cost, however; it is not cost itself. The shoes you are wearing may have cost
you $50 (a money cost), but the real cost (the opportunity cost) is the value of what you
could have purchased instead. Money cost is a monetary measure of the benefits forgone

when a choice is made. The real cost is the actual benefits given up from the most
preferred alternative not taken when a choice is made. When economists use the term
cost, they mean real, or opportunity, cost. You could have bought dozens of soft drinks
or deposited the $50 in a savings account for future use. Either option would be a
legitimate alternative to purchasing shoes. The point is that the cost of the shoes to you is
the value of the most attractive option not taken, whether it is the soft drinks or the future
use of the money.
As long as you have alternative uses for your time and other resources, there is no
such thing as a free lunch. Nothing can be free if other opportunities are available. One
goal of economics courses is to help you recognize this very simple principle and to train
you to search for hidden costs. There is a cost to writing a poem, to watching a sunset, to
extending a common courtesy, if only to open a door for someone. Although money is
not always involved in choices, the opportunity to do to other things is. A cost is
incurred in every choice.

Maximizing Satisfaction: Cost-benefit Analysis
An individual who behaves rationally will choose an option only when its benefits are
greater than or equal to its costs. Furthermore, individuals will try to maximize their
satisfaction by choosing the most favorable option available. That is, they will produce
or consume those goods and services whose benefits exceed the benefits of the most
favored opportunity not taken.
This restatement of the maximizing principle, as it is called, explains individual
choice in terms of cost. In Figure 3.1, the choices along curve E
1
G
1
represent various
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cost-benefit tradeoffs. If you choose point a, we must assume that you prefer a to any
other combination because it yields the most favorable ratio of benefits to costs.
A change in cost will produce a change in behavior. Suppose you and a friend set
a date to play checkers, but at the last moment he received a lucrative job offer for the
day of the match. Most likely the contest will be rescheduled. The job offer will change
your friend’s opportunities in such a way that what otherwise would have been a rational
act (playing checkers) becomes one that is no longer rational. The cost of playing
checkers will rise significantly, enough to exceed the benefits of most checkers games.
Economists see cost-benefit analysis as the basis of much (but certainly not all) of
our behavior. Cost-benefit analysis is the careful calculation of all costs and benefits
associated with a given course of action. Why do you attend classes, for example? The
obvious answer is that at the time you decide to attend class, you expect the benefits to
attending the exceed the costs. The principle applies even to classes you dislike. A
particular course may have no intrinsic value, but you may fear that by cutting class, you
will miss information that would be useful on the examination. Thus the benefits of
attending are a higher grade than you would otherwise expect. Besides, other options
open to you on Tuesday morning at 10:00 AM may have so little appeal that the cost of
going to class is very slight.
Take another example. Americans are known for the amount of waste they pile
up. Our gross national garbage is estimated to be more valuable than the gross national
output of many other nations. We throw away many things that people in other parts of
the world would be glad to have. However morally reprehensible, waste may be seen as
the result of economically rational behavior. Wastefulness may be beneficial in a limited
personal sense. The food wrappings people throw away are “wasted,” but they do add

convenience and freshness to the food. In the individual’s narrow cost-benefit analysis,
the benefits of the wrapping can exceed the costs.
Is life priceless? Although we like to think so, many of us are not willing to bear
the cost that must be paid to preserve it. Several million animals—dogs, opossums,
squirrels, and birds—are killed on the highways each year. Most of us make some effort
to avoid animal highway deaths. If saving lives were all important, we could drive less
but that would bring a significant cost. Even when human beings are involved, we
sometimes refuse to bear the cost of preserving life. People avoid helping victims of
violent crime, and doctors routinely pass by highway accidents although they might save
lives by stopping to help. Indeed, revolutions succeed through people’s willingness to
sacrifice lives—both others’ and their one to achieve political or economic goals.
The behavior of business people is not materially different from that of drivers or
consumers. People in business are constantly concerned with cost-benefit calculations,
only the comparisons are often (but not always) made in dollar terms: For example,
whether the cost of improving the quality of a product is matched by the benefits of the
improvement. Will consumers value the added benefits enough to pay for hem? In
assessing the safety of their products, business people must consider whether consumers
are willing to pay the cost of any improvements.
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The Effects of Time and Risk on

Costs and Benefits
When an individual acts, costs are not necessarily incurred immediately, and benefits are
not necessarily received immediately. The decision to have a child is a good example.
At turn of the century prices, a college educated couple’s first child can easily cost
more than $500,000, from birth through college.
2
Fortunately this high cost is incurred
over a relatively long period of time (or people would rarely become parents!).
Benefits received in the future must also be compared with present benefits. If
you had a choice between receiving $10,000 now and $10,000 one year from now, you
would take $10,000 today. You could put the money in a bank, if nothing else, where it
would earn interest, or you could avoid the effects of future inflation by spending the
money now. In other words, future benefits must be greater than present benefits to be
more attractive than present benefits.
To compare future costs and benefits on an equal footing with costs and benefits
realized today, we must adjust them to their present value. Present value is the value of
future costs and benefits in terms of current dollars. The usual procedure for calculating
present value a process called discounting involves an adjustment for the interest that
could be earned (or would have to be paid) if the money were received (or due) today
rather than in the future.
3

If there is any uncertainty about whether future benefits or costs will actually be
received or paid, further adjustments must be made. Without such adjustments, perfectly
rational act may appear to be quite irrational. For example, not all business ventures can
be expected to succeed. Some will be less profitable than expected or may collapse
altogether. The average fast-food franchise may earn a yearly profit of $1 million, but,
but only nine out of ten franchises may survive their first year (because the average
profits is distorted by the considerable earnings of one franchise). Thus the estimated
profits for such a franchise must be discounted, or multiplied by 0.90. If 10 percent of

such ventures can be expected to fail, on average each will earn $900,000 ($1 million x
.90).
The entrepreneur who starts a single business venture runs the risk that it may be
the one out of ten that fails. In that case profit will be zero. To avoid putting all their
eggs in one basket, many entrepreneurs prefer to avoid putting all their “eggs” in the

2
For rough estimates of the cost of rearing children by expenditure, see U.S. Department of Commerce,
Statistical Abstract of the United States: 1998 (Washington, D.C.: U.S. Government Printing Office, 1998),
table 732. To obtain the total cost of childcare, you must then estimate the value of parental time.

3
The mathematical formula for computing the present value of future costs or benefits received one year
from now is PV = [1/(1 + r)] f, where PV stands for present value, r for the rater of interest, and f for future
costs or benefits. The interest rate used in this formula is the rate at which we discount future costs and
benefits.

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proverbial one basket by initiating several new ventures, thereby spreading the risk of
doing business. In the same way, investors spread their risk by investing in a wide
variety of companies, and firms spread their risk by producing a number of products.
To give another example, criminal behavior may appear irrational if only the raw

costs and benefits are considered. A burglar who nets $1,500 from the sale of stolen
property may have to spend a year in jail if caught, prosecuted, and convicted. He could
lose the annual income from his legitimate job, perhaps $10,000. That is a high cost to
pay for a $1,500 profit on stolen property, but he pays that cost only if he is caught,
prosecuted, convicted, and sentenced. The police cannot be everywhere at all times;
prosecutors may be reluctant to prosecute; and suspended sentences are commonplace.
All in all, even an inept burglar may have no more than a 10 percent chance of spending a
year in jail.
4

To estimate the actual cost faced by the burglar who is caught, sentenced, and sent
to jail for a year, we might multiply the cost if caught, $10,000, by 0.10. That calculation
indicates that to a burglar who is sent to jail for an average of one out of ten burglaries,
the cost of any one burglary is only $1,000 ($10,000 x 0.10). Thus the actual cost of the
burglary is less than the benefits received, $1,500. Although it may be morally
reprehensible, the criminal act can conceivably be a rational one.
Surveys of criminal activities and their rewards tend to support such a conclusion.
A study of burglary and grand larceny cases in Norfolk, Virginia, showed that for the
unusual criminal who committed just one crime and was caught in the act, crime did not
pay. The typical criminal, however, convicted the average number of times and
sentenced to the average number of years in prison, more than tripled the lifetime income
he could have earned from a regular salaried job—even allowing for one or more years of
unsalaried incarceration.
5
When this study was replicated in Minnesota, the results were
not quite as dramatic, but the criminal’s lifetime income still doubled.
6
For criminals who
are never caught, crime pays even more handsomely.
The same logical process of discounting can be applied to your life as a student.

When you signed up for your MBA program, you actually had limited information on
how it would work out for you. (Admit it, it was a gamble!) Similarly, when you sign up
for courses, you usually have only a very rough idea of how difficult and time

4
This is not an unreasonably low figure. Gregory Krohm “concluded that the chance of an ‘adult’
(seventeen or older) burglar being sent to prison for any single offense is .0024. . . For juveniles. . . the risk
was much lower, .0015.” “The Pecuniary Incentives of Property Crime,” in The Economics of Crime and
Punishment, ed. Simon Rottenberg (Washington, D.C.: American Enterprise Institute for Public Research,
1973), p. 33.

5
William E. Cobb, “Theft and the Two Hypotheses,” in The Economics of Crime and Punishment, ed.
Simon Rottenberg (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1973), pp.
19 30.

6
David L. Johnson, “An Analysis of the Costs and Benefits for Criminals in Theft” (Economics
Department, St. Cloud State College, St. Cloud, Minn., May 1974), mimeographed.

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consuming they will be, and what benefits you will receive from them. In other words,

you are rarely certain of their costs and benefits. To make your decision, you will have to
discount the raw costs and benefits by the probability of their being realized. Risks are
pervasive in human experience, and rational behavior takes those risks into account.

What Rational Behavior Does Not Mean
The concept of rational behavior often proves bothersome to the noneconomist. Most of
the difficulties surrounding this concept arise from a misunderstanding of what rationality
means. Common objections include the following:
1. People do many things that do not work out to their benefit. A driver speeds
and ends up in the hospital. A student cheats, gets caught, and is expelled
from school. Many other examples can be cited. To say that people behave
rationally does not mean that they never make mistakes. We can calculate our
options with some probability, but we do not have perfect knowledge, nor can
we fully control the future. Chances are that we will make a mistake at some
point, but as individuals, we base our choices on what we expect to happen,
not on what does happen. We speed because we expect not to crash, and we
cheat because we expect not to be caught. Both can be rational behaviors.
2. Rational behavior implies that a person is totally self centered, doing only
things that are of direct personal benefit. Rational behavior need not be
selfish. Altruism can be rational; a person can want to be of service to others,
just as he can want to own a new car. Most of us get pleasure from seeing
others happy—and particularly when their happiness is the result of our
actions. Altruism may not always spring from rational cost-benefit
calculations; however, it is not always inconsistent with economic rationality.
Self interest, moreover, does not necessarily stop at the individual. For
many actions, “self” includes members of one’s family or friends. When a
father spends a weekend building a tree house for his children, economists say
that he has been engaged in self interested behavior.
3. People’s behavior is subject to psychological quirks, hang ups, habits and
impulses. Surely such behavior cannot be considered rational. Human

actions are governed by the constraints of our physical and mental makeup.
Like our intelligence, our inclination toward aberrant or impulsive behavior is
one of those constraints. It makes our decision-making less precise and
contributes to our mistakes, but it does not prevent our acting rationally.
Moreover, what looks like impulsive or habitual behavior may actually be the
product of some prior rational choice. The human mind can handle only so
much information and make only so many decisions in one day.
Consequently, we may attempt to economize on decision making by reducing
some behaviors to habit. Smoking may appear to be totally impulsive, and the
physical addition that accompanies it may indeed restrict the smoker’s range
of choices. Why might a person pull a cigarette from the pack “without
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thinking”? Perhaps because she has reasoned earlier that contemplating the
pros and cons of smoking each and every time she things of cigarettes is too
costly. By allowing smoking to become more or less automatic, the smoker
probably increases the number of cigarettes she smokes daily, but she sees the
tedium of having to make the decision each and every time she smokes.
4. Rational behavior implies that people know what they want, that they know
which alternatives are available, and that they know how to act on that
information. People cannot assimilate all the information they need to make
rational choices, however. People do lack information, and they could make
better choices if information were easier to obtain. However, rational

behavior does not require perfect information. People will make choices on
the basis of the information they have or can rationally acquire. If they have
less than perfect information, they may make mistakes in their choices. The
success or failure of their choices must be judged within those constraints.
5. People do not necessarily maximize their satisfaction. For instance, many
people do not perform to the limit of their abilities. Satisfaction is a question
of personal taste. To some individuals, lounging around is an economic good;
by consuming it, they increase their welfare. Criticism of such is tinged with
normative value judgments. An observer who equates rational behavior with
what he or she considers good will have no trouble demonstrating that such
behavior is irrational. Irrational behavior is behavior that is inconsistent or
clearly not in the individual’s best interests and that the individual recognizes
as such at the time of the behavior.
6. But to the economist, the values of the actor, not the observer or the social
critic, determine the rationality of an act. Harold, not Jennifer or Max,
determines the rationality of Harold’s behavior.

Disincentives in Poverty Relief
Our discussion of rational behavior can be used to understand one of the biggest policy
issues of our time, welfare reform. We can do this by assuming that welfare recipients
are tolerably rational.
So much of the public discussions about welfare programs, especially cuts in
them, assumes that since Congress has the authority to change the programs, it can alter
the programs any way it wishes without creating problems. However, as we can easily
see, Congress is in something of an economic, if not political, bind on welfare relief,
given how incentives change when the program is adjusted. The basic problem is that the
practice of scaling down welfare benefits as earned income rises creates an implicit
marginal tax on additional earned income that discourages the poor from working. Why
not lower the implicit marginal tax rate?
Figure 3.3 gives the answer. The 45 degree line that extends out from the origin

indicates points of equal distance from each axis—that is, points at which spendable
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income equals earned income. At point y, for example, a poor person earns and can
spend $5,000 annually. At points above the line, spendable income exceeds earned
income. For instance, at point x, a poor person earns $5,000 annually and can spend
$7,500. He receives a subsidy equal to y – x, or $2,500.



FIGURE 3.3 Policy Tradeoffs of a Negative
Income Tax
With a guaranteed income of SI
1
($5,000) and a
break even earned income level of EI
1
($10,000),
the implicit marginal tax rate on the poor is 50
percent. If policymakers attempt to reduce the
implicit tax rate by raising the break even income
level, however, the government’s poverty relief
budget will rise by the shaded area SI

1
ab. A higher
explicit tax burden will fall on a smaller group of
taxpaying workers.




Suppose the government establishes a negative income tax with a guaranteed annual
income level of $5,000, or SI
1
. The break even earned income level is $10,000, or EI
1
.
A person who earns nothing will receive a subsidy of $5,000 a year. As his earned
income rises the subsidy will decline, until it reaches zero at $10,000. Curve SI
1
shows
the spendable income of people in this program at various earned income levels. They
lose $500 in subsidies for every $1,000 of additional earned income. That is, they face an
implicit marginal tax rate of 50 percent.
If policy markers want to reduce the implicit marginal tax rate on an earned income of
$10,000 to less than 50 percent, they must either reduce the guaranteed spendable income
level or raise the break even earned income level. If they raise the break even earned
income level—to $15,000, or EI
2,
for example—curve SI
1
a will shift to SI
1

b. But then
more people—all those with earned incomes up to EI
2
—will receive benefits. Moreover,
all the people covered originally will receive larger subsidies. A person with an income
of $5,000 would receive $8,000 instead of $7,000 in spendable income (point z instead of
point x), for example. The total increase in the government’s poverty relief expenditures
would equal the shaded area in the figure bounded by SI
1
ab.
The increase in expenditures would place a greater tax burden on taxpaying workers.
Yet because more workers would be covered by the negative income tax, fewer people
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would share the increased tax burden. Thus the explicit marginal tax rate on high
income workers rises—lowering their incentive to work and earn additional income.
If the government reduces the guaranteed income level, say from SI
1
to SI
0,
a different
problem will result. On the new curve SI
0

a, the poor will receive less government aid at
each earned income level. They may have more incentive to work under such an
arrangement, but will they have enough to live on?
Policymakers, then, face difficult tradeoffs between the goal of helping the poor and
the goal of minimizing the disincentive to work. To provide adequate aid, they may have
to raise the breakeven income level high enough that people who are not strictly poor
benefit. Yet to reduce aid to people who are not truly poor, they would have to lower the
break even income level—thus increasing the implicit tax rate on the poor. To keep
the implicit marginal tax rate down, they could lower the guaranteed income level—
decreasing the benefits that go to the truly poor.
Our graphic analysis suggests that there may be economic as well as altruistic
limits to the government’s ability to transfer income from the rich to the poor. As more
and more income is allocated to the poor, either the guaranteed income or break even
income level must go up. If only the guaranteed income level is raised, the implicit
marginal tax rate facing the poor increases. If that problem is avoided by raising the
break even income level, poverty relief will cover more people, and the taxes paid by
the remaining workers will go up. Increased aid to the poor thus should have three
consequences. A higher explicit tax burden will fall on fewer taxpayers. Because of this
burden, higher income groups will have less incentive to work, and lower income
groups, because of the higher implicit tax rate, will also be less inclined to work.

MANAGER’S CORNER: The Last-Period Problem
Much of this chapter has been concerned with how people behave rationally. Here, we
introduce “opportunistic behavior” as a form of rational behavior that people in business
will want to protect themselves from. We suggest ways different parties to business deals
can take advantage of other parties and how managers can structure their organizational
and pay policies to minimize what we call “opportunistic behavior.” More specifically,
this section is concerned with how an announced end to a business relationship can
inspire opportunistic behavior. Its goal is, however, constructive, structuring business
deals – and the embedded incentives in order to maximize the durability and

profitability of the deals. To do that, business relationships must be ongoing, or have no
fixed end, to the extent possible. Having a fixed termination date can encourage
opportunistic behavior, which can reduce firm revenues and profits. That is to say, a
reputation for continuing in business has economic value, which explains why managers
work hard to create such a reputation.

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Problems with the End of Contracts
A terrific advantage of dealing with outside suppliers is that the relationship is constantly
up for renewal and can easily be terminated if it is not satisfactory to both parties. But
therein lies an important disadvantage of dealing with outside suppliers: the relationship
lacks permanence or confidence that any given buyer/supplier relationship will be
renewed. The supplier must attribute some probability that the end of the contract will be
the end of the relationship, given that he or she might not be the next low bidder, a
deduction that can have profound effects on the relationship that the astute manager must
recognize. Without much question, firms have begun to develop relationships with
suppliers that approximate partnerships because of the “last-period” problems inherent in
relationships that are totally grounded in the low bidder status of the suppliers.
The basic problem is that during the last period of any business relationship, there
is no penalty for cheating, which implies maximum incentive to cheat. As a
consequence, cheating on deals in the last period is more likely than at any other time in
the relationship.

Consider a simple business deal. Suppose that you want a thousand widgets of a
given quality delivered every month, starting with January and continuing through
December, and that you have agreed to make a fixed payment to the supplier when the
delivery is made. If you discover after you have made payment that your supplier sent
fewer than a thousand units or sent the requisite thousand units but of inferior quality,
you can simply withhold future checks until the supplier makes good on his or her end of
the bargain. Indeed, you can terminate the yearlong contract, which can impose a
substantial penalty for any cheating early in the contract. Knowing that, the supplier will
tend to have a strong incentive early on in the contract period to do what he or she has
agreed to do.
However, the supplier’s incentive to uphold his or her end of the bargain begins to
fade as the year unfolds, for the simple reason that there is less of a penalty in terms of
what is lost from your ending the working relationship that you can impose. The
supplier might go so far as to reason that during the last period (December), the penalty is
very low, if not zero. The supplier can cut the quantity or quality of the widgets
delivered during December and then can take the check before you know what has been
done. The biggest fear the supplier has is that you might inspect the shipment before
handing over the final check. You may be able to get the supplier to increase the quantity
or quality somewhat with inspection, but you should expect him or her to be somewhat
more difficult to deal with. And you should not expect the same level of performance or
quality.
The problem is that you have lost a great deal of your bargaining power during
that last month, and that is the source of what we call and mean by the last-period (or
end period) problem, meaning the costs that can be expected to be incurred from
opportunistic behavior when the end of a working relationship approaches. It is a
problem, however, that can be mitigated in several ways. The simplest and perhaps most
common way is by maintaining continuing relationships. If you constantly jump from
one supplier to another, you might save a few bucks in terms of the quoted prices, but
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you might also raise your costs in terms of unfulfilled promises by suppliers during the
last period of their association with you. “Working relationships,” in other words, have
an economic value apart from what the relationship actually involves, for example, the
delivery of so many widgets. This is one important reason businesses spend so much
time cultivating and maintaining their relationships and why they may stick with
suppliers and customers through temporary difficulties.

Solutions to the Last-Period Problem
Nothing works to solve the last-period problem, however, like success. The more
successful a firm is the greater the rate of growth for the firm and its industry the
more likely others will recognize that the firm will continue in business for sometime into
the future. The opposite is also true failure can feed on itself as suppliers, buyers, and
workers begin to think that the last period is near. Firms understand these facts of
business life. As a consequence, executives tend to stress their successes and downplay
their failures. Their intent may not be totally unethical, given how bad business news can
cause the news to get worse. Outsiders understand these tendencies. As a consequence,
many investors pay special attention to whether executives are buying or selling their
stock in their companies. The executives may have access to (accurate) insider
information that is not being distributed to the public.
Another simple way of dealing with the last-period problem in new relationships
is to leave open the prospect of future business, in which case the potential penalty is
elevated (in a probabilistic sense) in the mind of the supplier. When there is no prospect
of future business, the expected cost from cheating is what can be lost during the last

period. When there is some prospect of future business, the cost is greater, equal to the
cost that can be imposed during the last period plus the cost (discounted by the
probability that it will be incurred) incorporated in the loss of future business.
When dealing with remodeling or advertising firms, for instance, you can devise a
contract for a specified period, but you can suggest, or intimate, in a variety of creative
ways, that if the work is done as promised and there are no problems, you might extend
the contract or expand the scope of the relationship. In the case of the remodeling firm,
you might point out other repairs in the office that you are thinking of having done. In
the case of the advertising firm, you might suggest that there are other ad campaigns for
other products and services that you are considering.
You should, therefore, be able to secure somewhat better compliance with your
supplier during the last period of the contract, and how much the compliance is improved
can be related to just how well you can convince your supplier that you mean business
(and a lot of it) for some time into the future. However, we are not suggesting that you
should outright lie about uncertain future business. The problem with lying is that it can,
when discovered, undercut the value of your suggestions of further business and bring
back to life the last-period problem. You need, in other words, to be prepared to extend,
from time to time (if not always), working relationships when in fact they work the way
you want them to work.
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However, if you are not able to develop that impression, the last period can come
sooner than you might think (or sooner than December in our earlier example). That is,

the contractual relationship can unravel because of the way you and the supplier begin to
think about what the other is thinking and how the other might act as a consequence.
If both you and your supplier are inclined to cheat on the contract, and you have
already figured that your supplier will cheat to the maximum (send nothing) during the
last period, then December becomes irrelevant and November becomes the last period.
Your incentive then is to cheat on the supplier in November. Well, with November now
the last period, you can imagine what your supplier is thinking. He is contemplating
cheating in November before you get a chance to cheat. Ah, but you can bet the supplier
by cheating in October. That thought suggests that when contemplating the contract
before it is signed and sealed, you and the supplier can reach the conclusion that January
is the (relevant) last period which means that the deal will never be consummated. In
this way, the last-period problem becomes a first period problem, actually one of
setting the terms of the contract. This way of thinking about it can make the signing
problematic, and more costly than it need be, assuming there are ways around the
problem.
This line of argument reminds us of an old joke about a prisoner condemned to
death. As it happened, the prisoner was told on Sunday that he would be hung between
Monday and Saturday, but the day of his hanging would be a total surprise. He reasoned,
“They can’t hang me on Saturday because it wouldn’t be a surprise. So, Friday is the last
day of the relevant period.” Therefore, he reasoned, “They can’t hang me on Friday
because if they wait until then, it won’t be a surprise.” Continuing this line of reasoning,
Friday gave way to Thursday being the last day, and so forth. He eventually concluded
that they couldn’t hang him. Of course, when they hung him on Wednesday, he was
really surprised!
This joke suggests that the last period problem doesn’t always lead to an
unraveling in which the last period becomes the first. But the last period problem is
potentially serious and is one reason that firms exist: firms are collections of departments
(and people) who have continuing relationships that are not always up for re bidding,
which means that the parties can figure that they will be continued, with there being no
clear last period. The last-period problem is also a significant reason why the

corporation is such an important form of doing business. The corporation is a legal
entity whose existence is independent of the life of the owner or owners; the corporation
typically lives on beyond the death of the owners. Given that ownership is in shares, the
corporation makes for relatively easy and seamless transfer of ownership, which means
the life of the company is, in an expectational sense, longer as a corporation than as a
partnership or proprietorship, two organizational forms that die with the owners. This
means that the corporate charter should be prized simply because it adds value to the
company by muting (though not always eliminating) the last-period problem.
The last-period problem extends beyond buyer supplier relationships of the sort
we described above involving the purchase of widgets. There is clearly a last-period
problem for military personnel. When officers or enlisted men and women are given
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their transfer orders, they can sit back and relax, given that the penalties that can then be
imposed on them have been severely limited by the orders to move on. The problem
becomes especially severe when personnel are about to leave the military altogether.
Military people have a favorite expression for what we call shirking during the last
period. They call it “FIGMO”: “F k you, I’ve got my orders.” We are sure that the
military has devised a variety of ways to mute the impact of FIGMO, but it is equally
clear that the problem of shirking as military men and women approach the ends of their
assignments remains a pressing one. Sometimes you just have to accept some costs of
shirking (otherwise you might end up concluding that people should be fired the moment
they enlist, which can be more costly than the shirking).

The last-period problem can surface with a vengeance when an employee who has
access to easily destroyed records and equipment is fired. The firm doing the firing must
worry that the employee will use his or her remaining time in the plant or office to
impose costs on the firm, to “get back” at the firm. As a consequence, firings are often a
surprise, done quickly, with the employee given little more time than to collect his or her
personal things in the office – all to minimize damage. The firm may even hand the
employee a paycheck for hours of work not done, simply to make the break as quickly as
possible and discourage fired workers from imposing even greater costs through damage
to records and equipment. Indeed, when the potential for serious damage is present and
likely, firms may hire a security guard to be with the fired employee until he or she is
escorted to the door for the last time.
The last-period problem can also show up in the greater incentives people have to
shirk as they approach retirement. To prevent workers from shirking, deferred
compensation can be used with some of the compensation withdrawn if shirking ever
does occur. A variation of this type of solution for executives is to tie their compensation
to stock. If executives shirk toward the ends of their careers, causing their companies to
do poorly, then the executives lose more than any remaining salary they are due for the
duration of their tenure; they lose the value of the stock, which approximated the
discounted value of the company’s lost earnings attributable to the executives’ shirking
while still on the job.
Apparently, corporations’ executive compensation committees are aware of the
last-period problem. Economists Robert Gibbons and Kevin Murphy have found from
their econometric studies that as CEOs get closer to retirement age, their compensation
tends to become more closely tied to their firm’s stock market performance.
7

Another way of solving the last-period problem is through performance payments,
which means that payments are made as a project is completed. For example, separate
payments can be made for constructing a house when the house is framed, when it is
under roof, and when wiring is in and the interior walls have been finished. However, a

significant portion of the total amount due is withheld until after the entire project is

7
Robert Gibbons and Kevin J. Murphy, “Optimal Incentive Contracts in the Presence of Career Concerns:
Theory and Evidence,” Journal of Political Economy, vol. 100, n3 (June 1992), pp. 468 506.
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completed and the results approved. For example, 20 percent of the entire construction
cost is not paid until after the final inspection.
Business critics often decry the extent to which many pension plans are not fully
“funded” that is, not enough has been set aside by the firm in investment accounts to
meet the retirees’ scheduled benefits. The under funded pension plans can be a way by
which firms seek to solve a form of the last-period problem of retired workers, especially
unionized workers, whose concern for the financial stability of the firm may stop when
they get their gold watch. Unions often negotiate the retirement payments and fringe
benefits for unionized retirees at the same time they negotiate the pay packages for the
current workers. Even when retirement benefits are fixed for retirees’ lives, the retirees
have an interest in the continuation of the firm, but only when the pension plans are not
fully funded. When they are fully funded the retirees don’t have as much of a stake in the
continuation of the firms. They can reason, “Who cares what the workers get paid, we’ve
got ours!” When the retirement plans are not fully funded, the retirees must worry that
excessive wage demands by current workers can decrease the ability of the firm to fund
the retirement benefits in the future and thereby meet the scheduled benefit payments.

Hence, under funded pension plans can be a way of tempering union wage demands by
giving retirees a stake in wage rates than are lower than otherwise.
The very fact that an “old” owner of a business can sell to a “young” owner also
enhances the incentive of the old owner to maintain the reputation of the firm. However,
once the firm is sold, there is an incentive for the old owner to allow the firm’s reputation
to decline, a prospect that encourages a speedy transfer of a business when the deal is
closed. If the new owner can’t take over the business in a timely fashion, then he or she
might overcome the last-period problem simply by insuring that the old owner retains
stock in the business.
Of course, the new owner might prefer to have complete control of the business
once it is acquired. However, the value of the share he or she controls might be greater if
the old owner retains some incentive to keep the reputation and material and human
resources of the business intact between the time the sale is completed and the transfer of
ownership is finalized. Otherwise, the old owner may have an incentive not only to relax
on the job, but also to set up a totally new business and then raid the old company of its
key employees and customers.
If the old owner retains some interest in the firm, then he or she also has an
incentive to work with the new owners, giving them time to develop the required
reputation for honest dealing with employees and customers and to take control of one of
the more elusive business assets the network of contacts. The practice of keeping the
old owner on after the sale of the business is common among businesses such as medical
offices. Doctors first form a firm that looks and operates like a partnership, after which
they finalize the sale. In all of these cases, the old owners will want to work with the new
owners to make the transfer as “seamless” as possible, simply because the sale price will
be higher, and the greater the chance the new owner has to establish a reputation for
honest dealing and to take charge of the contacts.
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Scott Cook, who in 1983 developed the widely used home-finance software
package called “Quicken,” the major product of Cook’s firm, Intuit, Inc., which was
courted for a buyout in 1994 by Microsoft. Cook eventually agreed to sell Intuit to
Microsoft for $1.5 billion in Microsoft stock, 40 percent above Intuit’s market price at the
time. Microsoft agreed to pay a premium price for a couple of reasons. First, Bill Gates,
CEO of Microsoft, saw a need to have a dominant personal finance program that could be
integrated into his Microsoft Office line and that would allow him to pursue his goal of
transforming the way people manage their money. The value of Intuit was greater as an
integrated part of Microsoft than by itself. Second, and more importantly for the
purposes of this chapter, Cook agreed to become a vice president of Microsoft and to
retain an interest in the future development and use of Quicken, if Microsoft bought
Intuit. This way Cook could minimize the impact of the last-period problem, and the sale
of Intuit would mean that Quicken might continue to develop. The proposed buyout of
Intuit eventually was terminated by the Justice Department, which threatened to sue
Microsoft for antitrust violation. However, the example is still a good one not only
because it involves prominent business personalities and their successful firms, but also
because of the moral it illuminates: Sometimes, by selling only a part of the company, an
owner can increase the value of the part that is sold, enhancing the combined value of the
part that is sold and the part that is retained.
The last-period problem also helps to explain why fathers (or mothers) are so
anxious for one of their sons (or daughters) to go into their business as retirement age
approaches. This not only extends the life of the business, but it also increases the
amount of business that can be done as the retirement age is approached, given that with
the elevation of the son or daughter, the last period is then put off until some time in the
future.

Why do signs on business establishments sometimes read, for example, “Sampson
& Sons” or “Delilah & Daughter”? The usual answer is that the parent is proud to
announce that a daughter (or son) has joined the business. That is probably often the
case, but we also think it has a lot to do with the parent seeking to assure customers and
suppliers that the original owner, the parent, will not soon begin to take advantage of
them.
Economists David Laband and Bernard Lentz have found that the rate of
occupational following within families with a self employed proprietor is three times
greater than within other families, which suggests that proprietors have good reason
measured in continuing the value of their companies to bring their children into the
business that other people don’t have.
8
Caterpillar, the manufacturer of farm equipment
and heavy machinery, depends on its dealers to maintain customer trust and goodwill.
One way Caterpillar has attempted to enhance customer trust is to set up a school to help
children of dealers learn about and pursue careers in Caterpillar dealerships.
9


8
David N. Laband and Bernard F. Lentz, “Entrepreneurial Success and Occupational Inheritance Among
Proprietors,” Canadian Journal of Economics, Vol. 23, No. 3 (August 1990), pp. 101 117.
9
William Davidow and Michael Malone, The Virtual Corporation, (New York: Harper Collins Publishers,
1992), p. 234.
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Firms commonly complain that goods delivered in the last days of the supplier’s
operation are of inferior quality. The problem? It may be one of the incentives, or lack
thereof, that people have to deliver goods of waning quality during their last days.
Bankruptcy laws can be explained in part as a means of reducing these end period
problems.
10
They extend the potential end of the firm, and can give the firm a new lease
on life and set back the last-period problem indefinitely.
Also, a firm in financial trouble can be pressed into liquidation by nervous
bondholders, a fact that can exacerbate the last-period problem, given that suppliers
would have to worry that nervous bondholders will encourage firms to deliver shoddy
merchandise, which can make customers more nervous about dealing with the financially
strapped firm. By allowing firms in financial trouble to continue operating, bankruptcy
laws make it more likely that the bankrupt firms will keep up the quality of the products,
and provide more motivation for suppliers to keep up honest dealing.

The Keiretsu As a Solution to the Last-period Problem
Japanese firms are renown for organizing themselves into groups of firms called
keiretsus. Keiretsu members buy from one another, share information, and organize
joint ventures to produce goods and services in concert with one another. The largest and
best-known keiretsu is Mitsubishi, which has 28 core member firms and hundreds of
other firms that are loosely tied to the core firms. They integrate their activities in a
number of ways, not the least of which is having their headquarters close together, having
the CEOs of the various firms meet regularly to exchange information, and organizing
social and business clubs that are open to employees of the keiretsu member firms. The
members often own stock in one another.

In the United States, many of the activities of any keiretsu would likely worry the
antitrust authorities because the organization would be construed as monopolistic. No
doubt, some keiretsu activities might indeed restrain competition in some markets,
causing prices of Japanese goods to be higher than they otherwise would be (especially in
the domestic market where competition from other producers from around the world
might be impaired by import restrictions). The keiretsu might also be seen as a highly
efficient means by which Japanese firms are able to make use of new technologies,
quickly incorporating them into products. The Japanese have demonstrated a knack for
bringing new products to market quickly.
However, we mention the keiretsu organizational form here only because of one
of its more unheralded benefits: it is a form of business organization that seeks to solve
the last-period problem. The integration of the member firms’ purchases and sales and
strategic plans for the future is a means by which members can assure one another that
their business relationship will be enduring or that the member employees have
minimum incentive to behave opportunistically in the short run and have maximum

10
Gibbons and Murphy, “Optimal Incentive Contracts in the Presence of Career Concerns.”
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incentive to work with their joint future income stream in mind.
11
Being ousted from the

keiretsu can inflict substantial costs on the opportunistic firms and their employees. Even
the social gatherings of keiretsu employees can be construed as a means by which the
employees can “bond.” Here, we are not so much concerned with the “warm and fuzzy”
feelings people might have from integrating their lives. Instead, we mean that by
integrating their lives at the social level, employees can provide each other mutual
assurance that they will live up to expectations in their business dealings, that they will
not act opportunistically. The employees can lose the long term benefits of their social
and business relationships.
12

In short, the keiretsu is a clever means by which opportunistic behavior is made
more costly. It seeks to reduce some of the shirking and monitoring costs of doing
business, when business is done at arm’s length.
Indeed, one of the more unrecognized benefits of the firm in general is that it
does, under one “roof,” what is attempted under a keiretsu. The firm seeks to bring
people together and have them associate and work together on a continuing basis for the
purpose of minimizing the last-period problem. As we noted early in the book, it’s quite
possible for all departments within a firm and all stages of an assembly line to be
operated on a market basis, with every department and every stage of the assembly line
buying from one another. However, you can imagine that such an organization of
economic activity would give rise to a multitude of last-period problems, especially if
there were no attempt to ensure that everyone “worked together” as something
approximating a keiretsu.
The Japanese relatively greater use of formal and informal long term buyer
supplier relationships – sometimes cited as “strategic industrial sourcing” combined with
so called “relational contracting” may be partially explained by the fact that the
Japanese, as commonly argued, have the required business culture, one grounded in a
long term, future oriented business perspective that prescribes long term contracts.
The Japanese may, to a greater degree than Americans and Europeans, have a pervasive
sense of duty that insures that the parties will abide by any contracts that have been

consummated, and the Japanese may have a greater aversion than others to ongoing
contentious bargaining relationships that would be required if contracts were always up
for grab by the low cost bidders.
13
The long term business relationships may also be
a consequence of the growing affluence in Japan, which has elevated the importance of
quality over price that, in turn, has induced large Japanese firms to work with their
suppliers in an effort to enhance product quality.
14
The long term contracting can also
be explained partially by the encouragement the Japanese government gave to the

11
For an interesting discussion of the keiretsu, see Clyde V. Prestowitz, Jr., Trading Places: How We
Allowed Japan to Take the Lead (New York: Basic Books, Inc., 1988), pp. 156 166.
12
As Clyde Prestowitz notes, “Thus the Keiretsu system reduces risks for the Nippon Electric Company
and the other Japanese companies through the accumulation of relationships that can be counted upon to
cushion shock in time and trouble” (ibid., p. 164).
13
This explanation for long term contracting has been argued at length by Ronald P. Dore, Taking Japan
Seriously (Stanford, Calif.: Stanford University Press, 1987).
14
Ibid., p. 188.
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creation of long term buyer supplier relationships in the past (especially during
World War II) and the existing laws and legal sanctions against abusive treatment of
subcontractors by their customers.
15

But it seems to us altogether reasonable that long term contracting must be
grounded in factors other than culture and affluence. One economic explanation may
start with a recognition of the extent to which firms are integrated in Japan. The fact of
the matter is that in some industries Japanese production is far less integrated into
identified “firms” than, say, in the United States and other countries. In the United States
and Western Europe, for example, 50 to 60 percent of the automobile manufacturing
costs are incurred “in house.” In Japanese firms, on the other hand, only 25 to 30
percent of the automobile production costs are typically incurred “in house,” or inside
Japanese firms.
16
Only 20 percent of Honda’s production costs are incurred inside, which
means it buys 80 percent, or $6 billion, of its inputs from outside suppliers.
17
Because of
the lack of integration, Japanese firms may need to develop long term buyer supplier
relationships to a much greater degree than more highly integrated firms do just to
overcome the potential last-period problems, if nothing else.
Put another way, Japanese firms are able to engage in what is called strategic
outsourcing, and do so competitively, because they are willing and able to develop long -
- term working relationships. If they didn’t, they would have to endure the added costs
associated with the ever present closing of those relationships. It doesn’t surprise us
that many buyer supplier relationships in Japan give the “look and feel” of integrated

firms with buyers and suppliers helping each other and investing in each other (which is
what happens, to more or less degree, within unified firms).
When Honda signs a contract with a supplier, it expects the working relationship
to continue for 25 to 50 years, which effectively means that the last-period problem is set
back considerably.
18
Moreover, the permanence of the buyer supplier relationship is
two way, with commitments on the parts of both buyers and suppliers. Buyers agree to
stay with the suppliers, and vice versa, through ups and downs (at least up to a point).
Hence, Honda can justify incurring the costs associated with helping its suppliers
increase productivity, even provide the needed technology and specialized equipment.
Moreover, such expenditures, plus investments in the specific assets of the suppliers, by
Honda have the added advantage of being a bond, the value of which is forgone if Honda
does not abide by its agreement. Managers at Honda are basically saying to suppliers,
“Look at what we are doing. We are serious in our commitment. If we renege, our up
front investment will be worth very little. We will lose our projected income stream from
the investment. Because of those costs, you can count us in for the long run.” Such tie
ins aid in making the contracts self enforcing and durable; they help to make the long
run a viable perspective.

15
Ibid.
16
As reported in Toshihiro Nishiguchi and Masayoshi Ikeda, “Suppliers’ Process Innovation: Understated
Aspects of Japanese Industrial Sourcing,” in Managing Product Development, edited by Toshihiro
Nishiguchi (New York: Oxford University Press, 1996), pp. 206 230.
17
As reported in Lisa H. Harrington, “Buying Better,” Industry Week, July 21, 1997, pp. 74 80.
18
Ibid.

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The Role of Markets
Should production be rigidly integrated as in American firms or more loosely integrated
as in Japanese business consortiums? We surely cannot answer that question with the
certitude that many readers will want. Japanese firms obviously gain the benefits of
keeping their suppliers in a position that is marginally more tenuous and, maybe, more
competitive with other potential suppliers, but they have to deal with the marginally more
severe last-period problems. Many factors, which are offsetting and subject to change
with the costs associated with contracting and with principal/agency problems we have
discussed, are involved. We suspect that different organizational forms will suit different
situations and eras (as has obviously been the case in Japan where relational contracting
has not always been prevalent
19
).
Answers will come from real world experimentation in the marketplace. We
suspect that competition will press firms to adjust their organization forms, and the
inherent incentive structures, as some variation of organizational form is relatively more
successful. Many American firms have had to seriously consider and, to a degree,
duplicate the added organizational flexibility of Japanese firms. Why? Their
management methods have obviously worked in some industries, most notably the
automobile industry. It takes 17 hours to assemble a car in Japan and 25 to 37 hours to

assemble a comparable car in the United States and Europe. Japanese firms can develop
a new car in 43 months, whereas it takes American and European firms over 60 months,
and Japanese cars come off the production lines with 30 percent fewer defects. The worst
American made air conditioning units have a thousand defects for every defect in the
best Japanese made units.
20

Firm integration and relational contracting are hardly the only means of
moderating last-period problems. Joint ventures, which more often than not require up
front investments by the firms involved, can also be seen as extensions of firm efforts to
reduce last-period problems, with the potential of enhancing the quality of the goods and
services produced and lowering production costs. Joint ventures might lower production
costs because they give rise to economies of scale and scope through the application of
technology, but they also can lower production costs by lowering the potential costs
associated with opportunistic behavior and monitoring. They make the future income
streams of each party a function of the continuation of the relationship.
* * * * *
The “last-period” problem is nothing more than what we have tagged it, a
“problem” that businesses must consider and handle. It implies costs. At the same time,
firms can make money by coming up with creative ways of making customers and
suppliers believe that the “last period” is some reasonable distance into the future.
Failing firms have a tough time doing that, which is one explanation why the pace of

19
See Toshihiro Nishiguchi, Strategic Industrial Sourcing: The Japanese Advantage (New York: Oxford
University Press, 1994), chap. 2.
20
As reported with citations to other sources by Nishiguchi, Strategic Industrial Sourcing, pp. 5 6.
Chapter 3 Principles of Rational Behavior at
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failure quickens when the prospects are recognized, given that customers and suppliers
can be expected to withdraw their dealings as the expected date of closing approaches.
Firms that want to continue to exist have an obvious interest in making sure there
is a resale market for their firm, not just the assets that might be sold separately. The
owners and workers can then capture the long run value of their efforts to build the
firm. By highlighting the last-period problem, we are suggesting that the firm resale
market can boost the long term value of those assets simply by alerting people to the
fact that the firm can continue for some time into the future. This means that those firms
brokers who make a market for the sale of firms add value in a way not commonly
recognized, by giving firms the prospect of longevity.
The “hollow corporation,” in which everything is “outsourced,” or nothing is
produced directly, is sometimes viewed as the organizational ideal, given that the firm
owners can rely on competitive forces to keep the prices of what they sell as low as
possible. We doubt that the “hollow corporation” will ever dominate the economic
landscape of any country for a simple reason that comes out of the analysis of this
“Manager’s Corner”: The absence of the continuing association of employees under one
roof would mean that the last-period problems would arise in spades. This is because the
direct association of people under one roof has an unappreciated benefit: as in the
keiretsu in Japan, the firm permits the creation of abiding relationships that reduce the
incentive individuals have to behave opportunistically in the short run and enhance their
incentives to work with their long term goals in mind. “Bonding” is something that
firms do.

Concluding Comments
The concept of rational behavior means that the individual has alternatives, can order
those alternatives on the basis of preference, and can act consistently on that basis. The
rational individual will also chose those alternatives whose expected benefits exceed their
expected costs.
Traditionally economics has focused on the activities of business firms, and much
of this book is devoted to exploring human behavior in a market setting. The concept of
rational behavior can be applied to other activities, however, from politics and
government to family life and leisure pursuits. No matter what the activity, we all tend to
maximize our well being. Any differences in our behavior can be ascribed to
differences in our preferences and in the institutional settings, or constraints, within
which we operate.
Institutional settings affect people’s range of alternatives and thus the choices
they make. It makes sense to examine the constraints of institutional settings. In this part
of the book we will investigate the specific characteristics of the market system, the
subject of microeconomic theory. Later we will look at the constraints of government.
In both cases the range of choices open to individuals affects the ability of the system to
produce the results expected of it.
Chapter 3 Principles of Rational Behavior at
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24


We have also indicated in this chapter how individual rationality can give rise to a
nontrivial problem for managers, the last-period problem, which can make deals costly.
At the same time, we have indicated how thinking in terms of rational precepts can

suggest ways managers can deal with their last-period problems to lower firm costs and
raise firm profitability.


Review Questions
1. What are the costs and benefits of taking this course in microeconomics? Develop a
theory of how much a student can be expected to study for this course. How might
the student’s current employment status affect his or her studying time?
2. Some psychologists see people’s behavior as determined largely by family history
and external environmental conditions. How would “cost” fit into their explanations?
3. Why not base a course on an assumption of widespread “irrational” behavior?
4. Okay, so no one is totally rational. Does that undermine the use of “rational
behavior” as a means of thinking about markets and management problems?
5. How could drug use and suicide be considered “rational”?
6. If your firm were consistently dealing with “irrational behavior” among the owners
and workers, what would happen to correct the problem? More to the point, what
might you do to correct the problem?
7. Develop an economic explanation for why professors give examinations at the end of
their courses. Would you expect final examinations to more necessary in
undergraduate courses or MBA courses? In which classes – undergraduate or MBA –
would you expect more cheating?