b) MBA students sometimes criticize utility theory as being not relevant to management training. Explain the link between utility theory and prospect theory/loss aversion, and show how prospect theory can contribute to the following management challenges:
Utility theory and prospect theory are linked because they both address the consumer’s behavior when choosing a product or service based on the level of satisfaction and benefit it would bring to them and/or their families.
Utility theory refers to the level of satisfaction a customer would receive from consuming a product and as such customers aim to maximize their satisfaction when deciding how to spend their money and what to buy.
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Prospect theory suggests that decision-making may not be entirely rational. According to research, how you make decisions varies according to possible gains and losses relative to the precise position you are in at the moment.
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Motivation in the management of people or organization behavior. (7 marks)
Prospect theory can contribute to management challenges such as motivation of people or organizational behavior in the following ways:
Employees may be resistant to motivation with regards to making changes or advancements in the organization because they may have grown comfortable in certain instances such as the way they complete tasks.
Employees may be averse to taking risks depending on the climate of the organization. For instance, a company may be experiencing financial trials which can act as motivation for the employees to seek employment elsewhere in order to gain the possible benefit of job security. However, the employee may decide to remain in the uncertain climate where apparent job stability has decreased because of current ties and benefits, although there may be more promising opportunities elsewhere.
Helping policy makers to understand or predict the reactions of the public to changes in public policy. (8 marks)
Prospect theory is founded on the belief that people do not always act rationally. As such, using the theory for predictions can provide challenges of high speculation. When the public feels that they might gain, they prefer certainty but when they feel they might lose, they are more willing to take risks to reduce the losses. Therefore, as far as policy goes, if they feel that there is much to be lost, they would be more inclined to take extreme measures to avoid signing of the policy such as protests, sabotage etc. However, if the public feels that they would gain, they would encourage their peers to do the like and support the policy. Policy makers now have to be proactive and prepare for any sway of reactions to the policy that would make predictions quite difficult.
Question 2:
a) Illustrate and explain the relationship between marginal product and average product. (10 marks)
Marginal Product is the extra product gained by employing an additional factor of production (i.e. the change in output that arises from an additional unit of input) whereas Average Product is the output per factor or production (i.e. output per employee/output produced per unit).
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As long as the marginal product of a worker is greater than the average product (which is computed by taking the total product divided by the number of workers), the average product will rise. Thus the marginal product will always intersect the average product at the maximum average product.
The point of intersection between the marginal product and average product curves is also the peak of the average product curve. If the productivity of the marginal worker is equal to the average productivity of the existing workers, then the averageproduct does not change.
Q (Labour)
TP (Output)
MP
AP
1
2
2
2
2
5
3
2.5
3
9
4
3
4
12
3
3
5
14
2
2.8
6
14
0
2.333333
7
12
-2
1.714286
Table 1 – Bag Manufacturing
Table 1 shows the production of bags on a short-run cost where the quantity of labour is increased.
As the quantity of labour increases from 1-3, the Marginal Product increases, thereby automatically pulling the Average Product upward. This is where the increasing marginal returns are experienced.
At quantity 4, employing one other employee reduces Marginal Product to 3. At this point, Average Product is maximizing and intersects the Marginal Product. Marginal Product intersects Average product at its highest point (always).
At quantity 5, Marginal Product is less than Average Product thereby reducing Average Product.
Diminishing Returns is experienced when the labour force is between 5 -6 workers.
Negative marginal returns are experienced at 7 workers.
Marginal Product is the benefit gained when hiring one more additional worker.
If this worker enables the team to produce more per individual, then this directly affects an upward movement of Average Product.
If hiring an additional worker creates a dip in production as shown from Q (Labour) 4 to 5, then the Average Product is lowered.
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Bag Manufacturing Graph – Marginal Product and Average Product
b) Compare and contrast this relationship with the one between marginal cost and average cost. (15 marks)
Marginal Cost is the change in total cost when another unit is produced.
Average Cost is the total cost divided by the number of goods produced.
Q(Labour)
TC
MC
AC
1
6
-
6.00
2
7
1
3.50
3
7.5
0.5
2.50
4
9
1.5
2.25
5
11
2
2.20
6
14
3
2.33
7
18
4
2.57
Table 2 – Bag Production
Table 2 shows the costing of Bag Production.
As labour increases from Q 1-5, there is an increased marginal return because the price per unit gets cheaper. Average Cost reduces from $6 to $2.20.
As the company hires more staff, the Marginal Cost tends to exceed the Average Cost.
Marginal Cost intersects Average Cost at the point where Average Cost is the lowest, which can be referred to as Minimum Cost Output. This implies that as the company hires more staff, Average Cost per unit reduces.
The (MC, AC) intersection is the most efficient point of production since after this, the Marginal Cost increases and thereby Average Cost will also increase. This implies that the cost per unit will increase, at which point there will be diminishing marginal returns.
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Bag Manufacturing Graph – Marginal Cost and Average Cost
