# Managerial Economics

Document Sample

```					   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

Under uncertainty – if there is uncertainty or risk

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
   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

alter if she could return unsold Fizzies at the
wholesale price?
change?
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
together

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

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
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

```
DOCUMENT INFO
Shared By:
Categories:
Stats:
 views: 16 posted: 7/9/2011 language: English pages: 37