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Managerial Economics

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Title: Managerial Economics


1
Managerial Economics
  • Individual Decision Making

2
Outline for Today
  • Subject organisation
  • Framing economic decisions
  • Solving decision trees

3
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.

4
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

5
Review of subject structure
6
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
7
Subject Organisation
  • Textbook
  • Problem Sets
  • Aplia
  • Additional problems
  • Additional online materials

8
Topic 1
  • Individual decision making non-strategic
    decisions

9
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

10
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

11
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
12
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
13
Example (non-strategic under certainty)
Decision Node indicates a point at which an
action must be taken (one path for each possible
action)
14
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?

15
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
16
Step II
Continue
Expend 50,000 and perhaps win
Proposal
Abandon
Not
0
17
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)
18
Step III
Continue
800,000
Win
0.05
Proposal
0.95
Lose
Abandon
-50,000
Not
0
19
Step IV
20
Step V
Prop
No
Prop
No
21
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

22
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

23
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

24
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
25
Solving the Tree
Choose the branch with the best payoff
?
Continue
-7,500
Proposal
Abandon
Not
0
26
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
27
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
28
Solving the Tree
Proposal
515,000
Not
Succeed
0.5
-200,000
Continue
0.5
Fail
-200,000
Abandon
0
29
Solving the Tree
515,000
Succeed
0.5
Continue
0.5
Fail
-200,000
Abandon
0
30
Solving the Tree
  • Never make proposal if dont have newer
    technology
  • Choose to take risk and continue RD

157,500
Continue
Abandon
0
31
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.

32
Framing the Decision
  • What alternatives does Indy have?

Drink himself
Give drink to Snr
33
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
34
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

35
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

36
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.

37
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)

38
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
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