Mergers and Acquisition

Mergers and Acquisition Defined

Mergers and acquisitions fall under the broad category of business combinations. A business combination is defined as the union of two or more enterprises as one entity, accompanied by changes in the corporate ownership structure in one or more of the enterprise or the uniting of statutory interests of two or more enterprises.

Section 76 of the Corporation Code of the Philippines (CCP) defines a merger as the union of two or more corporations where one company survives and continues to operate while the others are absorbed by the surviving entity. Larsen calls this a statutory merger. An example of this type of business combination is the merger between Union Bank of the Philippines (Unionbank) and the International Corporate Bank, Inc. (Interbank) in May 1994. As a result of the business combination, Interbank was dissolved while Unionbank became the surviving company.

Section 76 of the CCP also defines a consolidation as the union of two or more companies resulting in the formation of a new corporation and the absorption of all the constituent companies by the new company. Larsen calls this type of business combination a statutory consolidation. The business combination of Brown Chemical Corp. and Brown Chemical Sales Corp. in June 1993 is an example of a statutory consolidation. The two companies were dissolved and a new corporation, Epic Holdings Corporation, was formed. The name of the corporation was later changed to A. Brown Company, Inc. which was listed in the stock market in February 1994.

Acquisition may be only slightly different from a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies, and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another--there is no exchanging of stock or consolidating as a new company. Acquisitions are often congenial, with all parties feeling satisfied with the deal. Other times, acquisitions are more hostile.

In an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash, with stock, or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.

Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares.

REASONS FOR MERGERS AND ACQUISITIONS

There are many possible reasons why companies desire to combine with other entities. Operational and/or financial synergy, an increase in or protection of market share and market power, diversification and the economies of vertical integration are some of the possible reasons. Other more pragmatic reasons such as the compression of the time required to list a company have been in vogue in the country recently.

Operational and/or Financial Synergy
Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:
• Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.
• Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can keep or develop a competitive edge.
• Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies--when placing larger orders, companies have a greater ability to negotiate price with their suppliers.

Increase in or Protection of Market Share
Companies buy companies to improved market share and industry visibility, to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones. For instance, some institutions would not want to deal with small banks because small banks may be considered ‘high risk.” One way of addressing the competitive disadvantage of small banks is through mergers. Unionbanks’ growth accelerated after its merger with Interbank was consummated.

Diversification
One way of minimizing the risks of the company’s operations and/or stabilizing the flow of a firm’s earnings and its cash flows is through diversification. Diversification lessens the dependence of the company’s current and future income on any industry and mitigates the impact of troughs of the business cycles in one industry by acquiring an entity in another industry with a different business cycle.

Diversification is often used to justify mergers and acquisitions. Many holding companies see opportunities in industries such as telecommunications which is perceived to have good prospects for sustained growth. The telecommunications business thus offers the potential for a steady flow of income, in contrast to the cyclical behavior of other consumer products.
Economies of Vertical Integration

A vertical merger results when a company merges with its suppliers or customers. A merger with a supplier is referred to as backward integration while a merger with a customer is forward integration. There is a vertical merger (backward integration) when foe example, a company that produces cement acquires another company that produces cement bags. Vertical integration with the supplier can be a motive for acquiring a company to ensure the quality and the supply of inputs for production. A merger with a customer generally seeks to improve the distribution and the marketing of a company’s products.

VALUATION OF THE TARGET FIRM

The valuation of the target firm requires a deep appreciation of the factors that affect not only the post-merger operations of the target firm, but also the combined operations of the target firm and the acquiring firm. While in theory, value may be created by the merger, e.g., synergy, such value will depend on the implementation of the merger plans. The acquiring firm is also not assured of extracting the theoretical gain if it ends up paying too high a price for the target firm. This makes the valuation of the target firm one of the most critical issues in the exercise.

There are essentially two approaches to the valuation problem:

a. the existing assets can be valued at their current values and the net value of the firm determined by deducting all liabilities; or

b. the future cash earnings of the target firm are projected and discounted at an appropriate rate.

In practice, a combination of the two is usually arrived at during the final negotiations.

The Audit Process

In determining the value of the target firm, the acquiring firm conducts a “due diligence audit of its accounts and operations. The audit team is usually composed of finance, accounting, technical and legal staff chosen by the acquiring company and an independent appraisal firm acceptable to both parties. The review is designed to give the acquiring firm a reasonable basis for determining the soundness of the target firm’s financial statements and the reasonableness of projections of its future cash earnings. Given these objectives, the audit should at least cover the following:

1. assessment of realizable values of current assets such as receivables, inventories and repayments;
2. appraisal of fixed assets, a listing of the nature of encumbrance on such properties, the efficiency and capacities of equipment and plant facilities and adequacy of operating systems;
3. review of pension fund and tax liabilities;
4. review of Board minutes and major contracts such as loan documents, collective bargaining agreements, if any, etc., which may affect the merger/future operations or indicate the existence of unrecorded/contingent liabilities;
5. review of regular audit findings and the adequacy of accounting records, internal control and information systems;
6. review of market trends and competition, and marketing and distribution systems, where applicable; and
7. review of labor-management relationships and overall employee morale.
Valuation Process

To determine the net asset value (NAV) of the company, an independent appraiser may be hired to determine the fair market values of the various assets and liabilities of the target firm. After determining the net asset value of the company, qualitative factors may have to be considered, which could result in a discount or premium over the NAV of the target firm. For instance, the potential effects of the firm on the acquiring company’s present operations must be considered.

The other way of setting the price for a target firm is through the use of capital budgeting. Under this method, the incremental cash flows from the target firm must be estimated and discounted at the appropriate cost of capital.

In determining the incremental cash flows, factors such as the potential effect of the acquisition on the acquiring firm’s own operations must be considered. The acquisition of a target firm may result in operating synergies that increase revenues and lower operating costs, e.g., because of economies of sale. Such effects must be considered in determining the incremental cash flows from the target firm. Again, similar to the qualitative factors previously mentioned, the opportunity cost of not acquiring the target firm must be considered.

The nature of the business of the target firm, the objectives of the acquiring company, and the number of other potential acquirers and their competitive strengths will be critical considerations in setting the price. Sensitivity analysis should give the management of the acquiring company some idea as to maximum offer the competitors can give and the maximum price the acquiring company can offer to ensure a successful bid. It is at this point where the proper appreciation of the issues at hand by the management of the acquiring company is most critical. Failure to do so can lead to far reaching consequences that may be hard to reverse.

Both NAV and capital budgeting methods can be used in setting the price for the target firm. However, for acquiring companies whose main objective is just to acquire a listed firm, the net asset value method may not apply. In this case, the acquiring company’s primary interest is a backdoor listing, and not the net asset value of the target firm. The capital budgeting technique for this type of acquisition is generally applicable since the savings on registration and listing costs are readily identifiable and quantifiable.

FINANCING SCHEMES FOR ACQUIRING THE FIRM

There are different ways of carrying out mergers and acquisitions. Some mergers and acquisitions are carried out through a cash purchase, an exchange of assets, or through leveraged buyouts. Many mergers and acquisitions in the Philippines however, are carried out through stock swaps. Some involve combinations of cash and an equity swap. Convertible bonds can also be used to finance mergers and acquisitions.

Cash Purchase
Under this method, the acquiring firm simply pays the existing stockholders cash in exchange for the shares of the company. This is the case for subsidiary mergers.

Leveraged Buyouts
A leveraged buyout (LBO), as the term implies, involves the heavy use of debt to finance an acquisition. The management-led group borrows heavily against the firm’s assets, using so-called “junk bonds”. These are high risk (below investment grade) but high yield bonds issued to finance the buyout.

Equity Swap
This is one of the most common mean of carrying out mergers and acquisitions in the Philippines. Under this scheme, the acquiring company issues its own shares in exchange for the shares of the companies being acquired. Sometimes, the acquiring company’s shares of other companies are used to carry out the merger or acquisition.

Combination of Cash and Equity
Some mergers and acquisition are carried out through a combination of cash purchase and equity swap.

Issuance of Convertible Notes
Some companies finance mergers and acquisitions through the issuance of convertible notes. These notes may be converted to equity shares at some time in the future.

LEGAL AND TAX CONSTRAINTS ON THE MERGER STRUCTURE

The structure of a business combination sometimes depends on two factors: (a) the length of time within which the combination can be affected, and (b) tax implications.

A true merger usually entails an arduous process which may take a year or more to complete. The two corporations involved are required by the SEC to submit documents for its review. These documents range from minutes of the Board of Directors’ and stockholders’ meetings approving the merger plan to a long-form audit report of both companies. Because delays in the merger process cost time and money in terms of exploiting the business synergy and in terms of reduced employee morale, most corporations opt for the acquisition of shares method.

The exchange for shares of stock of the acquiring firm is non-taxable and results in a de facto merger. Alternatively, the acquisition by one firm of substantially all of the properties of another firm solely for stock is also a tax exempt transaction. Where the exchange is not solely for stock, the transaction becomes taxable on the part of the target firm and its shareholders. It is therefore advantageous for the latter to deal with a listed company whose shares can offer liquidity rather than require payment other than stock.

ACCOUNTING FOR MERGERS AND ACQUISITIONS

There are two accounting methods used for business combinations. These are the purchase method and the pooling of interest method. Based on the Statement of Financial Accounting Standards No. 20, the purchase method accounts for the business combination is the acquisition of one enterprise by another. Hence, the acquiring company records at cost the assets and liabilities acquired. If the cost of the acquiring company is higher than the fair market values of the tangible and intangible assets acquired less liabilities, the difference is charged to goodwill.
The pooling of interest method accounts for a business combination as the union of the ownership interests of two or more companies through an exchange of equity shares. Under this method, the assets and liabilities of the companies acquired are recorded at their historical cost, in contrast to the purchase method which records assets and liabilities at their fair market values. In the case of subsidiary mergers where the acquired company is not dissolved, the assets and liabilities are still recorded at cost. However, when financial statements are consolidated, these assets and liabilities are adjusted to approximate their fair market values at the time the business combination was consummated. These adjustments do not have any tax effects.

FINANCIAL MANAGEMENT

Capital Budgeting

A capital investment problem is essentially one of determining whether the anticipated cash inflows from a proposed project are sufficiently attractive to warrant risking the investment of funds in the project.

In the net present value method the basic decision rule is that a proposal is acceptable if the present value of the cash inflows expected to be derived from it equals or exceeds the present value of the investment. To use this from it equals or exceeds the present value of the investment. To use this rule, one must estimate:
(1) the required rate of return
(2) the economic life
(3) the amount of cash inflow in each year
(4) the amount of investment, and
(5) the terminal value.

The internal rate of return method finds the rate of return that equates the present value of cash inflows to the present value of the investment- the rate that gives the project an NPV of zero. The simple payback method finds the number of years of cash inflows that are required to equal the amount of investment. The discounted payback method finds the number of years required for the discounted cash inflows to equal the initial investment. The unadjusted return on investment method computes a project’s net income according to the principles of accrual accounting and expresses this profit as a percentage of either the initial investment or the average investment. The simple payback and unadjusted return methods are conceptually weak because they ignore the time value of money.

In preference problems the task is to rank two or more investment proposals in order of their desirability. The profitability index – the ratio of the present value of cash inflows to the investment – is the most valid way of making such a ranking.

The foregoing are monetary considerations. Non-monetary considerations are often as important as the monetary considerations and in some cases are so important that no economic analysis is worthwhile. In some instances a manager’s aversion to risk may cause a project with an acceptable return to be rejected or not even proposed.

ANALYTICAL PROCESS IN USING NET PRESENT VALUE METHOD:

1. Select a required rate of return. This rate applies to projects deemed to be of average risk and may be adjusted for a specific proposal whose risk is felt to be above or below average.
2. Estimate the economic life of the proposed project.
3. Estimate the differential cash inflows for each year during the economic life, being careful that the base case is properly defined and quantified.
4. Find the net investment, which includes the additional outlays made at Time Zero, less the proceeds (adjusted for tax effects) from disposal of existing equipment and the investment tax credit, if any.
5. Estimate the terminal value at the end of the economic life, including the residual value of equipment and current assets that will be liquidated.
6. Find the present value of all the inflows identified in steps 3 and 5 by discounting them at the required rate of return, using Table A (for single annual amounts) or Table B (for a series of equal annual flows).
7. Find the net present value of the inflows. If the net present value is zero or positive, decide that the proposal is acceptable insofar as the monetary factors are concerned.
8. Taking into account the non-monetary factors, reach a final decision. (This part of the process is at least as important as all the other parts put together, but there is no way of generalizing about it.)

INTERNAL RATE OF RETURN METHOD (IRR)

When the NPV method is used, the required rate of return must be selected in advance of making the calculations because this rate is used to discount the cash inflows in each year. As already pointed out, the choice of an appropriate rate of return is a difficult matter. The IRR method avoids this difficulty. It computes the rate of return that equates the present value of the cash inflows with the present value of the investment - the rate that makes the NPV equal zero. This rate is called IRR, or the discounted cash flow (DCF) rate of return. (The IRR method is sometimes called the DCF method.)

If the management is satisfied with the internal rate of return, then the project is acceptable. If the IRR is not high enough, then the project is unacceptable. In deciding what rate of return is high enough, the same considerations apply as those in selecting a required rate of return.

PREFERENCE PROBLEMS

There are two classes of investment problems: screening problems and preference problems. In a screening problem the question is whether or not to accept a proposed investment. The discussion so far has been limited to this class of problem. Many individual proposals come to management’s attention; by the techniques described above, those that are worthwhile can be screened out from the others.

In preference problems (also called ranking, or capital rationing problems), a more difficult question is asked: Of a number of proposals, each of which has an adequate return, how do they rank in terms of preference? If not all the proposals can be accepted, which ones are preferable? The decision may merely involve a choice between two competing proposals, or it may require that a series of proposals be ranked in order of their attractiveness. Such a ranking of projects is necessary when there are more worthwhile proposals than funds available to finance them, which is often the case.

Criteria for Preference Problems

Both the IRR and NPV methods are used for preference problems. If the IRR method is used, the preference rule is as follows: the higher the IRR, the better the project. A project with a return of 20% is said to be preferable to a project with a return of 18%, provided that the projects are of equal risk. If the projects entail different degrees of risk, then judgment must be used to decide how much higher the IRR of the more risky project should be.

If the net present value method is used. The present value of the cash inflows of one project cannot be compared directly with the present value of the cash inflows of another unless the investments are of the same size. Most people would agree that a $1,000 investment that produced cash inflows with a present value of $2,000 is better than a $1,000,000 investment that produces cash inflows with a present value of $1,001,000, even though they each have an NPV of $1,000. In order to compare two proposals under the NPV method, therefore, we must relate the size of the discounted cash inflows to the amount of money risked. This is done simply by dividing the present value of the cash inflows by the amount of investment, to give a ratio that is called the probability index. Thus, a project with an NPV of zero has a probability index of 1.0. The preference rule is: the higher the probability index, the better the project.

Application Problem:

Suppose you are in the real estate business. You are considering construction of an office block. The land would cost P50,000 and construction would cost further P300,000. You foresee a shortage of office space and predict that a year from now you will be able to sell the building for P400,000. Thus you would be investing P350,000 now in the expectation of realizing P400,000 at the end of the year. You should go ahead if the present value of the P400,000 payoff is greater than the investment of P350,000.

Assume for the moment that the P400,000 payoff is a sure thing. The office building is not the only way to obtain P400,000 a year from now. You could invest in a 1-year US Treasury bill. Suppose the T-bill offers interest of 7%. How much would you have to invest in it in order to receive P400,000 at the end of the year? That’s easy: you would have to invest

P400,000 x 1/1.07 = P400,000 x .935 = P373,832

Therefore, at an interest rate of 7%, the present value of the P400,000 payoff from the office building is P373,832.



Net present value

Q. It's been a while since I bought anything except by seat-of-the-pants intuition. Can someone bring me up to speed on Net Present Value calculations for machinery?
Forum Responses It would seem to me that what you paid for it, less what you have depreciated it on your taxes, would equal what its net present value is. That's presuming you don't still owe on it. Am I close?
From contributor Q: Here is what I know about NPV. It is the value today of a future payment. (Present value of revenues - Present value of costs). The equation for present value is Revenue or Cost/(1+interest rate) to the power of years. Most industry uses 7-8% interest or hurdle rate, I am pretty sure. You will have to figure out annual costs and incomes from the machine. Sometimes this can get pretty detailed. The purchase of the machine is in year 0 so there is no calculation for that.
Contributor Q, with the highest respect, you lost me totally. Why would a woodworker need to make such a wild calculation?
From the original questioner: If you can show a positive NPV to your banker, she might just give you the loan for that overpriced profile grinder.
If I remember correctly, the calculation requires that you set a reasonable desired return on investment, market value of the equipment after x years, increase in productivity, increase or decrease in labour inputs, and so on. The idea of using the NPV evaluation is that it takes into consideration that money now is worth more than money later. (More sophisticated tool than other evaluation models.)
I work in the finance field (Chartered Accountant).
NPV is the value of a project, expressed in today's dollars. Value is defined as increased earnings (or decreased cost) net of expenses incurred to implement the project - including the interest to finance the project's acquisition and the tax break that writing off the project affords.
Unfortunately, sometimes there's no way to simplify an idea without losing important information.
Seems to me the present value of a machine is what you can sell it for. Too simple?
From contributor G: If you bought a machine today and tomorrow it did its job and the money you got for the job it did was greater than the cost of the machine, you would make the investment. That is, there would be a profit. The *net* profit would be the gross receipt minus the machine expense. But you probably also had labor costs, maybe some energy, etc., so often these operating costs are subtracted from the profit. You may also want to subtract taxes. You may wish to sell the machine immediately and add this back into the value. When you are done, you have the *net present value after taxes*. If the number is positive, then it is a good investment - it is profitable; if the NPV is negative, then it is not a good investment.
Now here is the hard part. When you buy a machine, it does not pay back everything tomorrow, but it will pay you (or generate profit) over a long period of time - say three years. So, if it will generate $3000 for me in three years, what is such money worth today? Well, it depends on the interest rate. (One suggested change from the previous postings: Use an interest rate for a small business that is the rate at which you can borrow money. Maybe 12% interest rate today. Sometimes this is called the discount rate.) So, $3000 three years from now needs to be reduced (discounted) by 12% for every year to get a true value of that money in today's dollars. So, for year three, we calculate that the value is $360 less, or $2640. For year two, we again reduce the new value of $2640 by 12%, or $317. So, for year two it is worth $2327. And finally for year one, we reduce the value by 12% again, giving us $2048.
Stated another way, if you had $2048 that you put in a CD bearing 12% annually in interest and left the interest to accumulate and earn additional interest, you would have $3000 in three years. So, the *present value* in my example is $2048. Now, if I had to invest $2000 in order to get a machine that would pay me the $3000 in three years, then I subtract the machine cost from the present value ($2048 - $2000), giving me the *net present value* of $48. Another way to look at this is that the investment of $2000 in a machine that will give me $3000 in three years will be returning a little more than 12% on my investment - $48 more.
Some people like to figure out what interest rate (discount rate) will give a 0 NPV. In my example, this is about 12.6%. (If you got a loan for the $2000 and the interest was over 12.6%, you would lose money!) The value of 12.6% is called the Internal Rate of Return (IRR). (As mentioned, you may wish to make several subtractions and additions to your numbers.)
From the original questioner: Thank you so much! Your description brought me back to the example used when I first heard of NPV. In that case, the contemplated acquisition was a chop optimizer vs. 4 or 5 guys chained to upcut saws.
I get the impression that NPV analysis is more relevant as you move towards commodity production and less relevant as you move toward specialized products where strategic purchases and company image are more important to price premiums. Or is it just that these things are harder to quantify for the arithmetic?
A former employer of mine (video equipment rentals) recently had to decide if he was going to buy 25 digital VTRs worth over $1,000,000 when he was assured of only one rental on them (World's Track & Field). He did, and had trouble sleeping until they were booked for the SLC games. If he didn't buy them, though, a competitor may have done so and he could have lost a regular customer.
I can also imagine that changing technology like CNC could not only change the throughput, but also demand for product and market price if others invested in it too. Some tools are so versatile that you know darn well that in a year's time you'll be making something you could never have forecast.
Still, I think I'm going to make use of NPV for my next programme. I think using it will force me to evaluate all the ins and outs of doing something.
From contributor C: Net present value, return on capital and rate of return are all methods used to justify projects or purchases. They are mostly used by large corporations to put a ranking on all capital projects so they can get the most from their available capital or to determine if some borrowing is necessary. The ranking is of course especially necessary when the decision-makers are far removed from the projects and don't know (or want to know) the details of every project.
For everyone else, it's usually obvious if there is enough potential profit to justify the purchase. The real danger is in underestimating the total cost of everything needed to get the job done and then your calculations are for naught. One of the deliberate abuses of the method (in the large companies) is to not include everything that will eventually be necessary and then after you start, you create justification for the rest of the project.
From contributor G: Contributor C, the problem I see most often is that the NPV or IRR is very good, but the cash flow is terrible. Small firms use their capital to purchase equipment rather than borrow and use the cash for slow weeks/months.
From contributor C: Contributor G, I wish I could say that I have never done that, but it would not be the truth.
The large corporations usually have a very formal system for capital expenditures and they have a set amount of retained earnings that is set aside for that purpose. All the projects compete for those funds through the rate of return method and yes, the returns are very high - typically 20% minimum and a good benchmark would be $1 back every year for every $2 you spend. If there is not enough money to fund the best projects, they are either not approved, delayed, or they release more stock, sell bonds, or borrow money for the best projects. These companies even have people to watch the cash balance on an hourly basis and borrow or loan money for days at a time to maximize return on cash balances.
The big hazard in this system, other than spending the money for daily operations, is underfunding projects. This is usually caused by: 1. Trying to beat the rate of return system for a favorite project. After you start the project, you create justification for the additional capital needed. 2. Underestimating all the equipment, tooling, space, etc. needed to fully complete the project. It's never ignorance, just being overly optimistic. 3. Unforseen problems. There is usually contingency money for the small problems, but it never is enough for big problems. There is sometimes a "risk factor" added to the rate of return system to account for this and new technology projects naturally carry the highest risk.

Production Management

· Benchmarking is a method for organizations to compare their processes, practices and performance with others.

· Benchmarking is the process of determining who is the very best, who sets the standard, and what that standard is. It is a process of re-engineering or Quality Improvement Initiative.

· There are two major approaches to Benchmarking these are performance and process benchmarking.

Performance Benchmarking is the collection of (generally numerical) performance information and making comparisons with other compatible organizations. It answers the question: What are the most important performance yardsticks and where do we rank, compared with others in our industry and other analogous industries?

Total Quality Management (TQM)

TQM is a form of management that focuses on the customers, an environment of trust and openness, working in teams, breaking down internal organizational barriers, team leadership and coaching, shared power, and continuous improvement; use of this approach often involves fundamental changes in the organization’s culture.

It is a set of management pratices throughout the organization consistently meets or exceeds customer requirements.



Process Benchmarking is the comparison of practices, procedures and performance, with specially selected benchmarking partners, studying one business process at a time. It answers the question: What is the best practice in this topic, where are the best practitioners and what can we learn from them?

Introduction to Organizational Behavior

ORGANIZATIONAL BEHAVIOR

An organization is a complex, competitive world. It reflects the image of its people. Their relationship should be built on trust and confidence. On the other hand, behavior is a manner of reaction, deportment, the expression of habits or tendencies of people.

As a concept, human behavior in organizations is not new. There is, however, a problem in understanding it. Some people put emphasis on human behavior, while others on organization.

According to Ramon J. Aldag and Arthur P. Brief, “organizational behavior is a branch of social sciences that seeks to build theories that can be applied to predicting, understanding and influencing behavior in work organization.”

Organizational behavior appears to be a simple subject. After all everyone has learned something about human behavior from his or her own unique experiences with people.

Diagram below could help us in visualizing what is organizational behavior is all about.



Organizational Behavior discusses about individuals in an organization as well as group and organizational process. Individuals are unique in terms of their attitudes, perception, personalities and motivation. These are oftentimes influenced by heredity and environment. Common goals and interests bind individual to form a group. Group may be formal or informal in form. Formal group includes task and command group which performs specific task and functional reporting relationships. Informal group includes friendship and interest group. Organizational processes include organizational culture, values, structure and politics. Organizational culture is a pattern of basic assumptions that are considered valid and are taught to new members as the way to perceive, think and feel in the organization.

Elements of Organizational Behavior

The organization's base rests on management's philosophy, values, vision and goals. This in turn drives the organizational culture which is composed of the formal organization, informal organization, and the social environment. The culture determines the type of leadership, communication, and group dynamics within the organization. The workers perceive this as the quality of work life which directs their degree of motivation. The final outcome are performance, individual satisfaction, and personal growth and development. All these elements combine to build the model or framework that the organization operates from.

Models of Organizational Behavior

There are four major models or frameworks that organizations operate out of:

Autocratic - The basis of this model is power with a managerial orientation of authority. The employees in turn are oriented towards obedience and dependence on the boss. The employee need that is met is subsistence. The performance result is minimal.

Custodial - The basis of this model is economic resources with a managerial orientation of money. The employees in turn are oriented towards security and benefits and dependence on the organization. The employee need that is met is security. The performance result is passive cooperation.

Supportive - The basis of this model is leadership with a managerial orientation of support. The employees in turn are oriented towards job performance and participation. The employee need that is met is status and recognition. The performance result is awakened drives.

Collegial - The basis of this model is partnership with a managerial orientation of teamwork. The employees in turn are oriented towards responsible behavior and self-discipline. The employee need that is met is self-actualization. The performance result is moderate enthusiasm.

Although there are four separate models, almost no organization operates exclusively in one. There will usually be a predominate one, with one or more areas over-lapping in the other models.

The first model, autocratic, had its roots in the industrial revolution. The managers of this type of organization operate out of McGregor's Theory X. The next three models begin to build on McGregor's Theory Y. They have each evolved over a period of time and there is no one "best" model. The collegial model should not be thought as the last or best model, but the beginning of a new model or paradigm.

WHY INDIVIDUAL DIFFERENCES ARE IMPORTANT

Individual differences are important in studying organizational behavior and management for a very important reason: Individual differences have a direct effect on behavior. Every person is unique because of their background, individual characteristics, needs, and how they perceive the world and other individuals.

HUMAN MOTIVATION

Human behavior in organizations may be affected by the individual’s motivation. There are five motives for working as identified by James W. Kalat. They are as follows:

People work for a variety of motives one is money. A second is status. Many jobs provide prestige and even the lowliest job is more prestigious than no job at all. A third motive is social interaction. Most workers enjoy their dealings with co-workers, clients and supervisors. A fourth motive is pride of accomplishment. Most people believe their work contributes in some way to the betterment of society. A fifth motive is physical activity. Although people dislike jobs that drain their energies, many workers welcome a moderate amount of physical exertion on the job.

Motivation has been defined in many ways. It is defined as drives, urges, wishes or desires that initiate the sequence of events known as behavior. It is also the force which leads a person to act in a particular way in response to a need. Need is a deprivation felt when physical or emotional balance is disturbed. Needs are either primary or secondary. Primary needs are the inborn or physiological needs for food, water, rest, sleep, air to breath and sex. Secondary needs arise from individual’s interaction with the environment, and are not inborn but develop with maturity. Secondary needs include those for safety and security, belongingness and social relations and self-esteem and self respect.

In the theory of human needs, Abraham H. Maslow, psychologist, presented three specific assumptions:

1. Human beings are never satisfied. Their wants are determined by what they have.

2. A satisfied need does not cause behavior. Once people satisfy their need for safety, they are motivated by as yet unsatisfied needs, not ones that are satisfied.

3. Human needs are arranged in hierarchy of importance.

HUMAN NEEDS

Abraham Maslow is known for establishing the theory of a hierarchy of needs, writing that human beings are motivated by unsatisfied needs, and that certain lower needs need to be satisfied before higher needs can be satisfied.



According to Maslow, there are general types of needs (physiological, safety, love, and esteem) that must be satisfied before a person can act unselfishly. He called these needs "deficiency needs." As long as we are motivated to satisfy these cravings, we are moving towards growth, toward self-actualization. Satisfying needs is healthy; blocking gratification makes us sick or evil. In other words, we are all "needs junkies" with cravings that must be satisfied and should be satisfied. Else, we become sick.

At once other (and higher) needs emerge, and these, rather than physiological hungers, dominate the organism. And when these in turn are satisfied, again new (and still higher) needs emerge, and so on. As one desire is satisfied, another pops up to take its place.

Physiological Needs are the very basic needs such as air, water, food, sleep, sex, etc. When these are not satisfied we may feel sickness, irritation, pain, discomfort, etc. These feelings motivate us to alleviate them as soon as possible to establish homeostasis. Once they are alleviated, we may think about other things.

Safety Needs
If the physiological needs are relatively well gratified, there then emerges a new set of needs, which we may categorize roughly as the safety needs.
Safety needs have to do with establishing stability and consistency in a chaotic world. These needs are mostly psychological in nature. We need the security of a home and family. However, if a family is dysfunction, i.e., an abusive husband, the wife cannot move to the next level because she is constantly concerned for her safety. Love and belongingness have to wait until she is no longer cringing in fear. Many in our society cry out for law and order because they do not feel safe enough to go for a walk in their neighborhood. Many people, particularly those in the inner cities, unfortunately, are stuck at this level. In addition, safety needs sometimes motivate people to be religious. Religions comfort us with the promise of a safe secure place after we die and leave the insecurity of this world.

Social Needs
If both the physiological and the safety needs are fairly well gratified, then there will emerge the love, affection and belongingness needs or what we call social needs.
Humans have a desire to belong to groups: clubs, work groups, religious groups, family, gangs, etc. We need to feel loved (non-sexual) by others, to be accepted by others. Performers appreciate applause. We need to be needed.
One thing that must be stressed at this point is that love is not synonymous with sex. Sex may be studied as s purely physiological need. Ordinarily sexual behavior is multi-determined, that is to say, determined not only by sexual but also by other needs, chief among which are the love and affection needs. Also not to be overlooked is the fact that love needs involve both giving and receiving love.

Esteem Needs
All people in our society have a need or desire for a stable, firmly based, high evaluation of themselves, for self-respect or self-esteem, and for the esteem of others. By firmly based self-esteem, this means that which is soundly based upon real capacity, achievement and respect from others. These needs may be classified into two subsidiary sets. These are, first, the desire for strength, for achievement, for adequacy, for confidence in the face of the world, and for independence and freedom. Secondly, we have what we may call the desire for reputation or prestige, recognition, attention, importance or appreciation.
This is similar to the belongingness level; however, wanting admiration has to do with the need for power. People, who have all of their lower needs satisfied, often drive very expensive cars because doing so raises their level of esteem.

Self-Actualization
Even if all these needs are satisfied, we may still often expect that a new discontent and restlessness will soon develop, unless the individual is doing what he is fitted for.

People who have everything can maximize their potential. A musician must make music, an artist must paint, a poet must write, if he is to be ultimately happy. What a man can be, he must be. This need we may call self-actualization. The need for self-actualization is "the desire to become more and more what one is, to become everything that one is capable of becoming."
The clear emergence of these needs rests upon prior satisfaction of the physiological, safety, social or love, and esteem needs.

Maslow’s hierarchy model reveals that humans generally have different level of needs at the same time. When this happens, the needs at the lower level take precedence. An example will be a situation wherein you would prefer to render overtime to earn extra for the fence of your house (safety need level) rather than join your friend in their “drinking session” (social need level).

OTHER THEORIES OF MOTIVATION

McGREGOR’S THEORY OF X AND THEORY OF Y
Mayo’s “Rabble Hypothesis” may have paved the way for the development of Douglas McGregor’s Theory X and Theory Y. Mayo’s Rabble Hypothesis stated that management operated and organized work on the basic assumption that workers were contemptible lot. From Hawthorne Studies, Mayo found certain negative assumptions about nature of people that management hold, like: (1) Society is composed of horde or unorganized individuals whose only concern was self-preservation or self-interest; (2) people were dominated by physiological and safety needs; (3) humans want to make as much money for as little work as possible.

Theory X assumes that most people prefer to avoid responsibility and are motivated by money, fringe benefits, and the threat of punishment. If you are a manager with these assumptions, your attitude is to structure, control, and closely supervise your employees. You will think that your employees are unreliable, immature and irresponsible.

Theory Y assumes that people are not by nature, lazy and unreliable. This theory postulates that people have the potential to be self-motivated and mature. Thus, if you have Theory Y assumptions, your task is to unleash the potentials in individuals to achieve their own goals by guiding their efforts toward exposing them to progressively less external control and allowing them to assume more self control.

FREDERICK HERZBERG’S TWO-FACTOR THEORY
Herzberg’s motivation-hygiene theory resulted from hundreds of interviews in Pittsburgh area. He concluded that people have two different categories of needs that are essentially independent of each other and affect behavior in different ways. He found that when people felt dissatisfied with their jobs, they were concerned about the environment (extrinsic) in which they were working (hygiene/maintenance factors). However, when people felt good about their jobs, this had to do with the work (intrinsic) itself (motivators).

Maslow’s hierarchy of needs identified the needs or motives of humans, whereas, Herzberg’s two-factor theory provided direction on the type of goals or incentives needed to satisfy an individual need once pinpointed.

ALDERFER’S ERG THEORY
Clayton P. Alderfer reworked Maslow’s hierarchy of need from five to three and labeled the groups of core needs as: Existence, Relatedness, and Growth needs.
•Existence is concerned with basic material existence requirements and included Maslow’s physiological and safety needs.
•Relatedness is the desire for maintaining important interpersonal relationships. This includes the social need and partial of the esteem need of Maslow’s need hierarchy.
•Growth is an intrinsic desire for personal development and included the other part of Maslow’s esteem need and the self-actualization need.
Unlike Maslow’s step like progression need, ERG theory states that (1) more than one need may be operative at the same time, and (2) if the higher level need is unsatisfied, the desire to satisfy a lower-level need increases – frustration regression dimension. This theory recognizes individual differences among people. Education, family background, and cultural environment are variables that can change the importance or intensity that a group of needs holds for a person.

McCLELLAND’S THEORY OF NEEDS
David C. McClelland and his associates developed a theory of needs, with the aid of the Thematic Apperception Test (TAT) that focuses on:
•Achievement need (nAch) – The drive to do better, to excel, to succeed, or to master complex tasks.
•Affiliation need (nAff) – The drive to establish close interpersonal relationships
•Power need (nPower) – The drive to control, to influence people’s behavior and to change situations.

ADAM’S EQUITY THEORY
The writings of J. Stacy Adams concluded that when people gauge the fairness work outcomes with others, felt inequity is a motivating state of mind. Inequities exist whenever people feel that the rewards or inducements received for their work inputs or contributions are unequal to the rewards other persons appear to have received for their inputs. This theory predicts that people who feel under-rewarded or over-rewarded for their work will act to restore a sense of equity. Adams et.al., concluded that people are less comfortable when under-rewarded than when over-rewarded.

VROOMS’ EXPECTANCY THEORY
Expectancy theory seeks to predict the reason/s of an individual’s willingness to exert personal effort to work. Furthermore, Vroom suggested that as a manager, you must know the:
•Person’s belief that working hard will enable various levels of task performance to be achieved.
•Person’s belief that various work outcomes or rewards will result from the achievement of the various levels of work performance.
•Value the individual assigns to these work outcomes.

Market Structure

Monopolies, Oligopolies and Perfect Competition

A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra.

In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well.

There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits.

Supply and Demand

Supply and demand analysis tries to explain how prices and quantities work in markets.

Supply and Demand Equilibruim

Suppliers - those who sell goods in a market

Demanders - those who buy goods in a market

Market Equilibruim - a situation in which demanders can buy the quantities they want and suppliers can sell the quantities they want at the prevailing price. This price is the equilibruim price, and the total quantity bought and sold at that price is the equilibruim quantity.

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

A. The Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.



A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.



A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.


C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.



As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

Strategic and Tactical Decision Making

Strategic management is concerned with the fundamental direction of the organization's activity, i.e., the businesses that the organization intends to pursue and desired levels of achievement in those lines of business. Such decisions, by their very natures, must be made at the highest policy making level of the organization. The time frame is from the present to as far into the future as the organization's time horizon. The organization's time horizon is limited to that of its least visionary policy maker who constrains the enthusiasm of its would-be innovators.

By virtue of the fact that such directional decision making covers the long run and is laden with risk, it should be understood to be entrepreneurial rather than managerial in nature. Although the language of the business administration literature stresses strategic management, it should be more properly understood to be stragetic entrepreneurship. In the late twentieth century, the term "entrepreneurship" has come to be associated with new, small, "start-up" business ventures that are highly risky. Entrepreneurship often is not perceived to occur in established or "going" concerns, especially if they have attained large size in terms of assets, employment, market share, or volume of sales.

Strategic entrepreneurship may occur at any level in any organization, whether a new local venture or a well-established multinational enterprise. In a new venture, entrepreneurship is exercised by the founder of the firm. To the extent that fundamental change is initiated at the board room level of an established enterprise, the function of the governing board is almost purely entrepreneurial since the board must assume the risks of its innovational decisions. If proposals for change are devised at lower levels in the administrative organization and only submitted to the governing board for approval, it is the site of the innovative proposal that is the true locus of entrepreneurship. However, in its approval the governing board assumes a substantial portion of the risk of the proposed innovation, and in effect shares risk with the proposer of the strategic change.

There is some confusion over the meanings of the terms "goals" and "objectives." We shall take the term goal to refer to an ultimate end that the organization at its highest policy making level determines to try to achieve. The term objective is taken to refer to desirable intermediate situations or levels of performance to be achieved in pursuit of the ultimate goals of the organization. By their nature then, goals are long-term and strategic in orientation, whereas objectives are more short-term, immediate, and partial in nature.

In military parlance, the term "tactic" is usually juxtaposed to "strategy" in referring to an action that is taken "in the field" by a specific unit to accomplish a limited objective in pursuit of a strategic goal of the organization. The term "tactic" and its various derivative forms are rarely used in discussions of strategic management. However, decisions taken at various levels in the administrative organization to implement an approved strategic change are oriented toward specific objectives (such as a target volume of sales or share of the market) rather than ultimate goals (such as a required return on investment in a particular line of business), and are thus essentially tactical in nature. In a new venture, goals and objectives may coincide, and strategic and tactical decision making may converge in the mind of the founding entrepreneur.

In the established enterprise, tactical decision making at various administrative levels must confront choices that involve risks. A modicum of entrepreneurship may therefore be exercised by the mid-level manager in the tactical decisions that must be made. However, tactical decisions that involve simply deciding upon increases or decreases in activities already in progress belong to the realm of managerial decision making. It is possible that nearly all of the decisions that must be made in a new business venture are strategic and entrepreneurial rather than tactical and managerial.

A prime example of strategic decision making is found in the international business arena. It is not uncommon for corporations to engage in international transactions or operations, but proprietorships and partnerships may do so as well. By its very nature, much of the business decision making concerning the international realm is entrepreneurial because of the inherent risks attendant upon extending operations into other countries. But once international operations have become established, tactical managerial decision making is required to adjust levels and rates of operations.

The Nature of the Decision Problem
Managers may make a myriad of decisions every day. Some of the decisions are trivial in the sense that the consequences of them do not matter very much. The consequences of other decisions, for example, what employee health insurance plan to adopt or whether to add or drop a product line from the company's product mix, may be monumental.

We shall assume as an operating premise that human beings are basically interested in their own welfare. Rational human behavior consists of trying to maximize the value of some positive quantity, or to minimize the value of something perceived as having negative connotations. Although human nature is culturally influenced, we shall also presume that human beings are more-or-less materialistic, i.e., more is better than less, and hedonistic, i.e., that pain and displeasure are to be avoided or minimized. We consider in Chapter A2 whether these behavior premises truly are viable foundations upon which to erect models of managerial decision making.

Human approaches to decisions may be categorized as capriciousness, conditioned response, and deliberate, reasoned choice. The more trivial the consequences of the decision, the less time and effort are devoted to the decision process. Sometimes people seem to act without engaging in any apparent decision-making process. The choices underlying such actions may have been nearly automatic, based upon an implicit summing-up of the current circumstance compared with the decision maker's accumulated stock of past experiences under similar circumstances. Occasionally, however, human beings indulge themselves in a capricious action (an act without deliberate choice), even when the consequences may be non-trivial. If a capricious action constitutes a "bad" decision, the actor must suffer the consequences.


Dimensions of the Decision Problem

Multiple Goals. The decision maker may be confronted with a multiplicity of goals. Since it is technically not possible to try to maximize simultaneously the values of multiple conflicting goals, the decision maker has to choose one of the goals for primary pursuit. The other goals, expressed as minimum or maximum acceptable values, can then be regarded as constraints on the pursuit of the primary goal. The object of the decision is to maximize the value of the primary goal, subject to realization of satisfactory levels of subordinate goals. The mathematical modeling problems and possibilities with respect to multiple goals are elaborated in Chapter B2.

Multiple Strategies. With respect to any single goal, a decision involves multiple possible courses of action, or strategies. If there were no alternatives, no decision would be required other than selecting the goal for pursuit. The deliberate approach to decision making involves the identification of all possible courses of action and the benefits and costs likely to result from each of the alternatives. The rational choice is the alternative that yields the greatest relative positives or the largest sum of net benefits (positives less negatives), given the decision maker's set of preferences.

Marginal Changes. In many cases, the choices are not mutually-exclusive alternative courses of action; rather they involve more or less of the same course of action. The range of possible alternatives includes larger or smaller quantities to be selected. Typically, the decision problem is to select some quantity that is an alternative to the present one. Assuming that the alternative quantities are arrayed from smallest to largest, or vice-versa, choosing to shift from one to another involves additions to or subtractions from benefits or costs. Economists speak of such additions and subtractions as incremental changes, or marginal changes if they are the smallest possible changes that can be made. The rational choice in such cases is to make a quantitative change that will yield the greatest marginal benefit relative to marginal cost. The application of the calculus to marginal analysis is the subject of Chapter B2.

Multiple Outcomes. Often the possible alternative courses of action can be identified, but each decision alternative may have several outcome possibilities. If the decision maker can in some meaningful sense assess the probability, p, of the occurrence of each possible outcome, V, for each of the alternative courses of action, he may then compute the expected value of each alternative. The expected value is a probability-weighted average of the possible outcomes for each decision alternative,

(1) EV = p1V1 + p2V2 + ... + pkVk,

or

(1') EV = Sj=1,k (pjVj),

where EV is the expected value of the alternative, p is the probability of the outcome V for each of the k possible outcomes of the alternative. The presumption here is that the sum of the probabilities of the possible outcomes is 1.0. Each outcome may itself be a net difference between benefit (b) and cost (c), or V = b - c. Other things remaining the same, the rational decision then is the choice of the alternative that promises the largest expected value of possible outcomes.


An extension of the expected value concept may be employed in decision situations that unfold in stages such that subsequent stages depend upon what happens in previous stages. In such cases, the probability of occurrence of an ultimate outcome is a conditional probability, i.e., the product of the probabilities of the final outcome and all prior stages. Such a situation can best be visualized with a "decision tree," an example of which is illustrated in Figure A1-1. In this hypothetical situation the decision maker has to decide whether to develop a major shopping center anchored by two department stores, or a small strip shopping center with no department stores. In Figure A1-1, the decision point is represented by the box on the left side of the tree. The circles in the diagram indicate non-decision outcome branches. There is a 60 percent chance that if a major center is built, the county will construct a 4-lane approach road to the center, but a 40 percent chance that the existing 2-lane road will have to do. But if a small strip is constructed, there is only a 20 percent chance of construction of a 4-lane. Beyond the estimated completion of the project, there is a 20 percent chance that the economy will boom, a 50 percent chance of normal economic conditions, and a 30 percent chance of recession.

Introduction to Economics and Managerial Decision Making

THE ECONOMIC NATURE OF DECISION MAKING

Managerial economics is about the criteria for rational decision making by managers of business enterprises. The criteria elaborated here for business enterprises can also be applied to non-commercial decision settings, including government agencies, eleemosynary institutions, the home, and one's personal life. Before we proceed to an examination of these decision criteria, we shall review the essential economic nature of decision making in order to establish the fundamental principles upon which decision criteria may be based.

As noted in a first Principles of Economics course, the world is characterized by scarcity rather than abundance. Human beings need certain things for survival, and they want to possess or consume a much larger variety of amenities. If all of these things were abundantly available, each person could simply gather as much as he or she wished, and still leave enough for everyone else to do likewise. Managerial decision making would require little more than determining the time sequence of acquisition.

In regard to most of the things that humans consume, scarcity is the rule and abundance is the exception. A scarcity of something means that the total of human wants for it exceeds the quantity of it available for human consumption. As a result, one person simply cannot take all that he or she might want without consequences for other persons. Something may be said to be scarce when its price exceeds zero (P greater than 0). The price may be expressed and paid in non-pecuniary terms as well as in money. There are a few things that have essentially zero prices, e.g., common air and the water available from a water fountain.