Economic Decision Making and Optimality Concepts

Ex Ante and Ex Post Optimality

• Optimality under certainty (full information) means a decision today is equally optimal tomorrow.
• Uncertainty reverses this; a decision optimal today might not be optimal tomorrow.
• A decision made under uncertainty can be regrettable later.
• Ex ante rational decisions (optimal before the information is revealed) may be ex post suboptimal (after the information is revealed).

Examples

• Post-education decisions (choosing a job or continuing study).
• Job suitability is assessed ex ante, but circumstances and information revealed may change ex post.
• Optimal choice in the present is not always the best one for the future.

Approaches to Economic Analysis

• Economic analysis borrows techniques from physics.
• Unlike physics, parameters in economics are often unknown or based on best guesses.
• Decisions today are not guaranteed to be optimal in the future due to the unknown parameters.

A Stylised Education Model with Stigma

• Higher future wages are a benefit to remaining in education.
• If leaving school early is the social norm, staying in education may be viewed negatively—resulting in a "stigma".
• Utility to staying in school is balanced against the direct and stigma costs of staying.

A Stylised Education Model with Stigma - More Detail

• Wage associated with leaving school is known.
• This income stream is discounted.
• Utility to staying in school includes costs, and a stigma cost (S) .
• Stigma cost is positive (if the social norm is to leave school) or negative (if the social norm is to stay on).

The Random Utility Function Model

• If keeping on studying: there’s a random utility associated with continuing your education path.
• Based on the known utility associated with leaving education.

If Staying On is Chosen

• Considering all aspects; the individual decides whether to stay on with their education.
• This depends on expectations and the subjective expectations of the education premium.
• The impact can be positive or negative; expectations below average can reduce staying on likely, above average increase it.

Risk Averse Individuals and Uncertainty

• The variance in return is a significant factor, particularly for risk-averse individuals.
• Individuals avoid risk, more so if the uncertainty of the return is higher.

Ex Post and Ex Ante Optimality

• Optimality under perfect certainty leads to early education investment.
• Population returning to education after an initial leave is evidence of ex ante/ex post optimality divergence.

The Role of Peers and Externalities

• Peer influence and externalities are important factors in decision-making.
• Worker’s efforts and productivity are affected by others’ efforts and output; it is sometimes worth the effort (or not, see other workers' effort).
• Peer effects can cause suboptimal outcomes due to reduced individual incentives for effort and/or investment.

An Example of Externalities

• Production function as a result of the effort of two workers.
• Utility function for each worker, given by:
• Decentralized outcome; each worker maximizes utility, independently.

Centralised Outcome (Internalised Externality)

• Solution incorporates the interconnected interests of both workers.
• Constraints and objective functions to represent the problem, leading to an optimal solution.

FOCS

• First-order conditions; represent the maximum of utility given the externality constraints.
• The outcome is to provide the optimal effort level for each member that maximizes utility.

Decentralised Welfare

• Value plugging in utility functions leads to a calculation of decentralized welfare.

More General

• The optimal effort choice is dependent on other individuals' choices.
• There are stable and unstable equilibrium points, and one has to consider these in an analysis of the problem.

Real-World Examples

• The Big Push concept—as an example of externalities and co-ordination problems associated with initiating an industry.
• Investment is made more likely when there are other similar investments.

Multiple Equilibria

• Externalities can lead to multiple equilibria: the original decision is based on other’s actions .
• Profitability depends on the decisions of other producers and individuals.

Key Concept

• Strategic behaviour is possible.
• Returns to scale, multiple equilibria, and complementarities are all significant in industries.

Student Group Work

• Coordination costs, motivation costs, and intellectual costs can be significant in group work.
• Free-riding and social loafing harm the group.
• Conflict and groupthink also reduce efficiency.

Opportunities for Strategic Behaviour

• The return to effort calculation gives a net of 3, 3.75 or 4.
• The students have the choice whether or not to exert effort.
• Depending on the level of effort students 2 and 3 exert, student 1 can get a higher net return by setting their effort to zero.

Summary

• Examples are given of the externalities of decisions.
• The issues described are important in groups of all sizes.