Managerial Economics A

1
Managerial Economics (A) (B)

• Topic 1 Economic Decision Making
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Outline for today

• Subject organisation
• Framing economic decisions
• Solving decision trees

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Why economics?

• Economics provides basic tools to analyse ...
• production and exchange (both in markets and
  other organisations)
• prices
• competition
• investments
• Changes in markets over time
• strategic interaction between firms customers
• ? Provides a toolkit that can be applied to a
  huge range of management tasks.

4
Course objectives

• Specific objectives are to understand
• Pricing and value creation what determines how
  much you pay or are paid?
• Changing price what actions can you take that
  alter pricing outcomes?
• General objective
• Be able to apply the tools of economics to help
  your managerial decision making

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Background for subject

• Logical and intuitive thinking
• Interpretation of graphs
• Mathematics
• But Ive done economics before
• Housekeeping

Models simplifying the real world to improve
focus and understanding
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Subject organisation

• Classes mix of
• Theory practice
• Working through examples
• Web Site
• Textbook
• Preparation
• Problem Sets

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Overview for today

• Topic One Economic Decision Making
• Decision trees the basic analytical tool of
  decision making
• Non-strategic decisions (this week)
• Strategic decisions (later )
• Decisions to buy and sell we start with the
  most basic decision facing a firm or an
  individual in a market interaction

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Types of decisions
High
Market entry
How hard to study
What to bid
Interdependence with others actions
Which MBA
What to wear
Whether to do an MBA
Extreme sports
What to have for lunch
Low
Low
High
Degree of Uncertainty
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Basic tool - decision trees

• The basic tool for decision making is a decision
  tree
• Idea a traveller comes to a fork in the road.
  She must make a decision whether to go right or
  left

L
R
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Plan

• Illustration of how to use decision trees
• Using decision trees to illustrate basic
  principles of good decision-making

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Decision-making

• Product development

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Changs dilemma

• Sarah Chang is the owner of a small electronics
  company. There is a proposal for the provision of
  an electronic timing system for the 2004 Olympic
  Games. For several years, Changs company has
  been developing a new microprocessor, a critical
  component in a timing system that would be
  superior to any product currently on the market.
• Progress has been slow and Chang is unsure about
  whether the new product will be developed on
  time. If the RD succeeds, then there is an
  excellent chance her company will win the 1m
  Olympic contract awarded solely on the basis of
  quality. If it does not succeed, they might still
  win the contract with their original, but
  inferior, system for which there are closer
  substitutes.
• The costs involved in continuing RD are
  200,000. Developing a proposal itself will cost
  Changs company 50,000. Finally, the costs of
  producing the product should they win the
  contract will be 150,000.
• Should Chang continue RD or not?

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Framing the decision I

• Changs decision is between two alternatives to
  continue RD or to abandon the project

Take risk on developing the new technology at an
additional cost of 200,000 and reconsider
proposal
Continue
Abandon
Perhaps make proposal with inferior technology at
an additional cost of 50,000
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Framing the decision II

• What additional information does Chang need to
  make this decision?

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Building the tree
Continue
Expend 50,000 and perhaps win
Proposal
Abandon
Not
0
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Building the tree (cont)
Continue
800,000
Win
0.05
Proposal
0.95
Lose
Abandon
-50,000
Not
0
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Building the tree
Expend 50,000 and have a good chance of winning
Succeed
0.5
0.5
Fail
Expend 50,000 and perhaps win
Continue
800,000
Win
0.05
Proposal
Abandon
0.95
Lose
-50,000
Not
0
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Building the tree
600,000
Win
0.9
Proposal
0.1
Not
Lose
-250,000
Succeed
0.5
-200,000
600,000
Win
0.05
0.5
Proposal
Fail
Continue
0.95
Not
Lose
-250,000
-200,000
800,000
Win
0.05
Proposal
Abandon
0.95
Lose
-50,000
Not
0
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Solving the tree roll-back

• While we built the tree by adding branches
• the way to solve a tree is to fold back
• Looking forward and working backwards is a key
  skill in economic decision-making

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Solving the tree
Expected monetary value 0.05 (800,000) 0.95
(-50,000) -7,500
?
Continue
800,000
Win
0.05
Proposal
0.95
Lose
Abandon
-50,000
Not
0
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Solving the tree
Choose the branch with the better payoff
?
Continue
-7,500
Proposal
Abandon
Not
0
22
Solving the tree
600,000
Win
0.9
Proposal
0.1
Not
Lose
-250,000
Succeed
0.5
-200,000
600,000
Win
0.05
Continue
0.5
Proposal
Fail
0.95
Not
Lose
-250,000
-200,000
Abandon
0
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Solving the tree
600,000
Win
0.9
Proposal
0.1
Not
Lose
-250,000
Succeed
0.5
-200,000
Continue
0.5
Proposal
-207,500
Fail
Not
-200,000
Abandon
0
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Solving the tree
Proposal
515,000
Not
Succeed
0.5
-200,000
Continue
0.5
Fail
-200,000
Abandon
0
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Solving the tree
515,000
Succeed
0.5
Continue
0.5
Fail
-200,000
Abandon
0
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Solving the tree

• Never make proposal if dont have newer
  technology
• Choose to take risk and continue RD

157,500
Continue
Abandon
0
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Indys choice

• Example (from Dixit Nalebuff) Indiana Jones in
  the climax of the movie Indiana Jones and the
  Last Crusade
• Indiana Jones, his father, and the Nazis have all
  converged at the site of the Holy Grail. The two
  Joneses refuse to help the Nazis reach the last
  step. So the Nazis shoot Indianas dad. Only
  the healing power of the Holy Grail can save the
  senior Dr. Jones from his mortal wound. Suitably
  motivated, Indiana leads the way to the Holy
  Grail. But there is one final challenge. He
  must choose between literally scores of chalices,
  only one of which is the cup of Christ. While
  the right cup brings eternal life, the wrong
  choice is fatal. The Nazi leader impatiently
  chooses a beautiful gold chalice, drinks the holy
  water, and dies from the sudden death that
  follows from the wrong choice. Indiana picks a
  wooden chalice, the cup of a carpenter.
  Exclaiming Theres only one way to find out he
  dips the chalice into the font and drinks what he
  hopes is the cup of life. Upon discovering that
  he has chosen wisely, Indiana brings the cup to
  his father and the water heals the mortal wound.

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Framing Indys decision

• What alternatives does Indy have?

Drink himself
Give drink to Snr
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Framing Indys decision

• Do you need more information?

Jnr Snr Live
Right
Drink himself
Wrong
Jnr Snr Die
Jnr Snr Live
Right
Give drink to Snr
Wrong
Snr Dies but Jnr Lives
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Uses of decision trees

• Decision trees are used in situations that may be
  too complex to think through in your mind
• Examples of these situations are
• High uncertainties
• Multiple decisions
• Non-obvious/complex payoffs
• Non-obvious alternative choices
• Several players making choices
• Being systematic helps you to see though
  complexity and to remember all your alternative
  choices