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					   Managerial Economics

Economic Decision Making (2)

          Applying the tools

        Paul Kerin & Sam Wylie
          MBS: Term 3, 2004
Topic 1- Economic Decision Making

Decision making and value creation:
non-strategic decisions



                                      2
Decisions

   Non-strategic – if the decision only depends on your
    actions and not how your actions interact with other
    peoples‟ actions

    Strategic – your best action depends on other
    peoples‟ actions and vice-versa

   Under certainty – if there is no uncertainty or risk
    associated with your actions

    Under uncertainty – if there is uncertainty or risk
    associated with your actions

                                                           3
Example (non-strategic under
certainty)


                          open in the city   $120,000
         open a restaurant
                                in Brunswick $150,000
Flavio
           don’t     0

How do you solve? By rollback
= first solve the decision that is furthest to the right;
  eliminate the choice(s) you don’t want. Now move left.
                                                            4
Decision trees are made of:
   a. Nodes: at a square node, a person has to
    make a decision (tree should say which
    person); at a circular node, we say “Nature”
    makes a decision.

   b. Branches: each branch represents a choice
    available to a person at a node.

   c. Payoffs: each line of nodes and branches
    must end with a payoff.

                                                   5
Solving decision trees

 USE ROLL-BACK:

 To solve a decision tree, start at the end of
 the tree and work backwards, eliminating
 actions that you do not want to make and
 leaving only the best actions




                                                 6
Example (non-strategic under
certainty)


                          open in the city   $120,000
         open a restaurant
                                in Brunswick $150,000
Flavio
           don’t     0

How do you solve? By roll-back
= first solve the decision that is furthest to the right;
  eliminate the choice(s) you don’t want. Now move left.
                                                            7
Using roll-back…

… is somewhat useful when it’s only you
 involved (= non-strategic with certainty)
    The idea = explore what happens after you make
     a choice.

…is very useful when others are involved
    when “Nature” is playing = uncertainty
    when other firms are playing = strategic choice



                                                       8
Solving decision trees

 Uncertainty – calculate expected value

 If you roll-back to a move by nature then you
 can calculate the „value‟ of that node by
 calculating the expected value of the payoffs
 from that node




                                                 9
Example (non-strategic under
uncertainty)

 A firm can spend $1m to develop a new product. If
 there is a boom, the product will earn $2 Million; if there
 is a recession, the product will earn $200,000. There is a
 40% chance of a recession.

            Don‟t Develop
                              $0
 Firm

                       Boom (0.6)       $2m - $1m

        Develop

                      Recession (0.4)   $200,000 - $1m

                                                          10
Example (non-strategic under
uncertainty)

 A firm can spend $1m to develop a new product. If
 there is a boom, the product will earn $2 Million; if there
 is a recession, the product will earn $200,000. There is a
 40% chance of a recession.

            Don‟t Develop
                               $0
 Firm


        Develop        Expected value = $280,000
                        = (0.6×$1m) – (0.4×$0.8m)
                                                          11
Why use decision trees?

    For more complex decisions, decision trees
    help us to carefully consider all options and to
    evaluate those options

   avoid mistakes due to omission
   avoid mistakes due to complexity of options
    and alternatives



                                                   12
Using decision trees to avoid common
mistakes in decision making
a)   Confusion – taking irrelevant information
     into account
b)   Sunk Costs – an example of irrelevant
     information
c)   Fixed costs and the correct time frame
d)   Marginal and lumpy decisions
e)   Exclusive and non-exclusive choices
f)   Consider all the alternatives

Economic profit = a measure of the benefits of
   good decision-making
                                                 13
(a) Getting the right information and
avoiding confusion
   A common mistake in decision making is to
    include too much information – the decision
    becomes confused by extraneous detail
   You need to focus on the correct information
    and ignore the rest!




                                                   14
Example: Spilt milk
Suppose that you have run out of milk. But guests are coming and
might want a cup of coffee with milk. Your guests are due in half an
hour but there is a 50% chance that they may only come in an hour.
You could go to the local shop or the supermarket. Both are equal
distance from your house but the supermarket may have a long queue.
So the local shop will only take ten minutes and the supermarket might
take either ten or fifteen minutes depending on the queue. You would
rather pay an extra $2 rather than stand in the long queue. However,
milk is cheaper at the supermarket – it is only $2 rather than $3. The
probability of a long queue at the supermarket is only 20 percent. Also
you are not sure if your partner has taken the car. If she has taken the
car then you cannot go to either shop and there is a 10% chance of
her taking the car. You have everything ready for your guests but the
milk!


  Let‟s draw the tree – with only the relevant information!           15
(b) Sunk costs

   A particular form of irrelevant information is a
    „sunk cost‟. This is something that you pay
    and nothing you do will change the amount
    that you pay
   As there is nothing you can do to avoid the
    cost, the sunk cost should be ignored




                                                   16
An example of sunk costs
  Mita runs petrol stations and express stores at several
  highway exits. Until recently, she didn’t sell any drinks.
  She brought in a new line of drinks, Fizzies, which
  have proved unpopular
  She has 10,000 Fizzies left. She thinks she can sell half
  of the remaining drinks for $1.00, but only 15% of the
  drinks at the standard price of $2.50. If she paid $0.30
  per drink, how much should she charge? What about if
  she paid $1.05 per drink?
  Mita cannot return unsold stock of Fizzies, but must
  throw it out


                                                           17
  If she cannot return unsold Fizzies, then
  the purchase price is irrelevant – it is a
  sunk cost
                            Sell at $1
Mita‟s
decision if she Mita
paid 30 cents
per Fizzie               Sell at $2.50



                             Sell at $1
Mita‟s
decision if she   Mita
paid $1.05 per
Fizzie                     Sell at $2.50

                                               18
Question

How would your answer to „Mita‟s problem‟
   alter if she could return unsold Fizzies at the
   wholesale price?
If your answer does not change, why doesn‟t it
   change?
If your answer does change, why does it
   change?



                                                     19
(c) Fixed costs and the time-frame for a
decision
 Rosetta runs a pizza shop in Lygon street. In
 January a new „super pizza‟ opens and she
 loses half of her customers forever. She
 makes $5 on every pizza she sells and
 expects to sell 1000 pizza per week. But her
 rent is $4500 per week and even minimum
 staff costs $800 per week. She can dismiss
 her staff with 6 weeks notice. The lease on
 her shop expires in 20 weeks. What should
 Rosetta do?

                                                 20
                  Close today             -(6×800) – (20×4500) = - $94,800


Rosetta
                                Close in six weeks

                                                   (6×5000) – (6×800) – (20×4500)
                                                   = - $64,800
               Close in
          twenty weeks

                                     (20×5000) – (20×800) – (20×4500)
                                      = - $6,000


  So the best thing Rosetta can do is to keep operating in the short term even
  though she is making a loss. This is because she has fixed costs that she
  cannot avoid even if she shuts down

                                                                                 21
Fixed Costs and Variable Costs
   Fixed Costs: Costs that are the same, no matter
    how much you produce (even if you produce
    nothing)
   Variable Costs: Costs that change, depending on
    how much you produce.

    So for Rosetta the wages were a fixed cost for six
    weeks and the rent was a fixed cost for twenty
    weeks

   All sunk costs are fixed costs
                                                         22
Identifying the right decision in each
time frame
   First identify fixed and variable costs
   If you are not covering your variable costs then you
    should produce nothing (shut down now!)
   If you are covering your variable costs but not
    covering your fixed costs consider each point in time
    when a fixed cost becomes variable
   Then choose the optimal point to make your decision

    e.g. For Rosetta, what is her optimal decision if rent is
    $800 per week and minimum staff costs are $5,500
    per week (keeping everything else the same)?
                                                                23
                  Close today             -(6×5500) – (20×800) = - $49,000


Rosetta
                                Close in six weeks

                                                (6×5000) – (6×5500) – (20×800)
                                                = - $19,000
               Close in
          twenty weeks

                                     (20×5000) – (20×5,500) – (20×800)
                                      = - $26,000


  The alternative case – shut down in 6 weeks and leave the shop empty until
  the lease expires


                                                                               24
(d) Marginal and lumpy decisions

   “Marginal” decisions= decisions involving
    the smallest possible units.
    (e.g. produce one more pizza, stay open
    one more hour)

   “Lumpy” decisions = decisions that have to
    be made about a group of small units,
    together
    (e.g. shut down business)

                                                25
e) Exclusive versus non-exclusive choices

Reminder - Rosetta makes $5 on every pizza she sells
  and expects to sell 1000 pizza per week. But her rent is
  $4500 per week and even minimum staff costs $800 per
  week. She can dismiss her staff with 6 weeks notice.
  The lease on her shop expires in 20 weeks. What should
  Rosetta do?


  But suppose she can sublet her store until
  the lease expires for $4300 per week


                                                         26
                  Close today             -(6×800) – (20×4500) = - $94,800


Rosetta
                                Close in six weeks

                                                   (6×5000) – (6×800) – (20×4500)
                                                   = - $64,800
               Close in
          twenty weeks

                                     (20×5000) – (20×800) – (20×4500)
                                      = - $6,000



  If we forget to include the ability to sublet she will
  keep operating for the next twenty weeks
                                                                                27
                  Close today             -(6×800) – (20×4500) + (20×4300)
                                           = - $8800
Rosetta
                                Close in six weeks

                                                   (6×5000) – (6×800) – (20×4500)
                                                   + (14×4300) = - $4,600
               Close in
          twenty weeks

                                     (20×5000) – (20×800) – (20×4500)
                                      = - $6,000



  But if we include the ability to sublet, she will
  close her shop in six weeks
                                                                                28
We say that the money that Rosetta would gain from
subletting the store is an opportunity cost of keeping
the store open.

After six weeks keeping the store open means she
gains $4200 (after wages) towards the (fixed cost)
rent. But closing the store and subletting she gains
$4300 towards the rent.

The opportunity cost of keeping the store open
exceeds the money from selling pizza



                                                       29
Exclusive versus non-exclusive choices

   Suppose you have 2 investment opportunities
   Key question:
       Do I want to take both investment opportunities, or
        just one?
       Can I take both investment opportunities?

   Often the hidden cost of a choice is giving up
    on another choice
       Example: What is the cost of doing an MBA?


                                                          30
(f) Consider all the alternatives
   One of the most common problems with
    decision making is not considering all the
    alternatives
       Can you make a small change (marginal) or only
        a big change (lumpy)?
       Have you included all relevant time frames (e.g.
        when fixed costs become variable)?
       Have you included all of the relevant alternatives
        and options? Creative thinking is required here:
        Co-opetition will give some suggestions on how
        to think “outside the box.”

                                                         31
Consider all the alternatives
If you are using multiple resources then you can
    ask three types of questions:

1.   Could the firm stop using those resources, and put
     each one to its best alternative use?
2.   Could the firm pursue another business
     opportunity with those resources?
3.   Could the firm combine its resources with more
     outside resources to do something else?


                                                      32
            *** Economic Profit ***
   The economic profit of a decision is the accounting
    profits you earn from one decision, minus the accounting
    profits you earn from making the best alternative
    decision.
    (It‟s the payoff from the branch you choose, minus the
    payoff on the next best branch.)

    sell at $2.50     $3750 - cost
Mita
   sell at $1.00      $5000 - cost

Whatever the sunk costs, the economic profit of charging
 $1 rather than $2.50 is $1250

                                                           33
 One implication: choose a baseline to start from
   It doesn‟t matter where you start, but you have to be consistent!



                           Sell at $1
Starting from                             $5,000 + $372,999
Mita‟s current   Mita
accounting
position                                  $3750 + $372,999
                        Sell at $2.50



                            Sell at $1
                                          $5,000
Starting from
zero =
choosing her     Mita
current                                     $3750
                          Sell at $2.50
position as a
baseline
                                                                       34
Example – the dismal science!

 Suppose you had $10,000 to invest in 1998.
 You put it in the stock market, right near the
 end of the bubble. Your share portfolio is
 currently worth $11,000. Have you made
 $1,000 profit?




                                                  35
In accounting terms – yes! You have made
10% on your $10,000 investment.
But an economist would want to know the
opportunity cost. Suppose you could have
bought government bonds with a return of 4%
rather than invest in shares. If you had
bought bonds, you would now have $11,700.

So to an economist, you have made $700
less than your next best alternative. You have
made an economic loss of $700!

                                             36
“Utility” and consumer choice
    Firms want to buy goods to make profits from
     them (by reselling them, or using them in
     production)
    Consumers want to buy goods for the
     pleasure/use they derive from them; economists
     call this utility
    We‟ll assume that utility is something we can
     specify in money terms:
    If I buy a coffee that gives me $10 of utility, and I
     pay $2.60, I end up with ($10 – $2.60) net surplus

    This is only applicable to relatively small
     purchases (that don‟t have a big impact on my
     budget set) and simple situations

                                                         37

				
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