Managerial Economics

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Managerial Economics

• Individual Decision Making

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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 firm decisions.

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Course Objectives

• Specific objectives are to understand
• Value creation appropriation
• What is the economic value of your productive
  activities?
• How much of that value do you get?
• Prices
• Prices allocate value
• What actions can you take to alter pricing
  outcomes?
• General objective learn to apply the tools of
  economics to improve your managerial decision
  making

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Review of subject structure
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Skills required for subject

• Logical and intuitive thinking
• Interpretation of graphs
• Mathematics

The main thinking tool MODELS Reduce
complex situations to their fundamentals to
develop general principles
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Subject Organisation

• Textbook
• Problem Sets
• Aplia
• Additional problems
• Additional online materials

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Topic 1

• Individual decision making non-strategic
  decisions

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Overview

• Decision Trees
• Basic analytical tool of decision making
• Non-strategic decisions (this week)
• Strategic decisions (later)
• Decision rules follow from decision trees
• The concept of economic profit

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Decisions

• Degree of interdependence
• Non-strategic Direct consequences of your
  decision depend only upon your own behavior, not
  that of others
• Strategic Agents actions interact to determine
  direct consequences for all
• Uncertainty
• Low Linkages between actions and consequences are
  well understood and completely specified
• High Linkages are partially understood and/or
  incompletely specified

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Types of Decisions
High
Market entry
How hard to study
What to bid
Degree of 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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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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Example (non-strategic under certainty)
Decision Node indicates a point at which an
action must be taken (one path for each possible
action)
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Changs Dilemma in 2003

• 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 Step 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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Step II
Continue
Expend 50,000 and perhaps win
Proposal
Abandon
Not
0
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Uncertainty in a decision tree

• Chang must assess the probability of success
• Objective based upon data or specific knowledge
• Subjective based upon experience judgement
• Suppose the probability of winning the contract
  with the old product is only 5 0.05
• This implies probability of losing is 95

Random Event Node point at which Nature
takes an action of her own (one path for each
possible outcome)
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Step III
Continue
800,000
Win
0.05
Proposal
0.95
Lose
Abandon
-50,000
Not
0
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Step IV
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Step V
Prop
No
Prop
No
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Optimal decision plan

• While we built the tree by adding branches
• the way to solve it is to start at the end and
  roll back.
• Looking forward and working backwards is a key
  skill in economic decision-making

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Example (non-strategic under certainty)

• First, solve a node furthest to the right
• Decision node Pick the best choice
• Nature node Calculate the average value
• Solve next node to the left
• Continue

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Solving at a node with uncertainty Expected
value

• Chang wants to know, is RD a risk worth taking?
• Easy to solve, so long as Chang is risk-neutral
• Risk-neutral agents prefer decisions with highest
  average payoff
• Good assumption when agent is a firm, poor for
  individuals(investors can diversify their own
  portfolios)
• Example Flip a coin,
• Heads you get 2.10
• Tails you lose 1.00
• 1000 flips roughly 500 heads, 500 tails ?
  an average of ? per flip.
• Expected value
• (Probability of heads)?(Payoff if heads)
  (Prob of tails)?(Payoff if tails)
• ½ x 2.1 ½ x (-1.00)
• ½ x (2.1 1.00)
• 0.55

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Solving the Tree
Expected 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 best payoff
?
Continue
-7,500
Proposal
Abandon
Not
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
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 the Decision

• What alternatives does Indy have?

Drink himself
Give drink to Snr
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Framing the 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
• In Decision Analysis used in situations where
  there is uncertainty, multiple decisions
• In Managerial Economics used in situations
  where
• The payoffs are not so obvious
• The alternative choices are not so obvious
• Several players have to make choices
• Being systematic helps you to see though
  complexity and to remember all your alternative
  choices

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Economic Cost opportunity foregone

• The true cost of one choice is giving up the
  benefits associated with your next-best choice
• Example What is the cost of doing an MBA?
• Besides the price, there is an opportunity cost
  what you would have earned, using the resource
  (your time) for another opportunity
• Costs that do not change with your decision are
  irrelevant

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Consider this situation

• Mita runs petrol stations and express stores at
  several highway exits. Until recently, she didnt
  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 the stock out.

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Definition Sunk Cost

• A cost is considered sunk with respect to a
  specific decision if, no matter what you decide,
  that cost does not change
• On a decision tree, a sunk cost appears on all
  leaves (payoffs)
• sell at 2.50 3750 - cost
• Mita
• sell at 1.00 5000 - cost
• Economic benefit of charging 1 rather than 2.5
  is 1,250
• (cost is the same in all cases it is sunk
  irrelevant)

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Definition Economic Profit

• The economic profit of a decision is the cash you
  earn from one decision, minus that from the best
  alternative decision
• Decision tree from best choice, minus from
  next best choice
• sell at 2.50 3750 - cost
• Mita
• sell at 1.00 5000 - cost
• Economic profit 1,250