Managerial Economics Economic Decision Making 2

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Managerial EconomicsEconomic Decision Making (2)

• Applying the tools
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Topic 1- Economic Decision MakingDecision
making and value creation non-strategic
decisions
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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

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Example (non-strategic under certainty)

• open in the city 120,000
• open a restaurant
• in Brunswick 150,000
• Flavio
• dont 0
• How do you solve? By rollback
• first solve the decision that is furthest to
  the right eliminate the choice(s) you dont
  want. Now move left.

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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.

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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

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Example (non-strategic under certainty)

• open in the city 120,000
• open a restaurant
• in Brunswick 150,000
• Flavio
• dont 0
• How do you solve? By roll-back
• first solve the decision that is furthest to
  the right eliminate the choice(s) you dont
  want. Now move left.

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Using roll-back

• is somewhat useful when its 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

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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

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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.

Dont Develop
0
Firm
2m - 1m
Boom (0.6)
Develop
200,000 - 1m
Recession (0.4)
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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.

Dont Develop
0
Firm
Develop
Expected value 280,000 (0.61m)
(0.40.8m)
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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

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Using decision trees to avoid common mistakes in
decision making

• Confusion taking irrelevant information into
  account
• Sunk Costs an example of irrelevant information
• Fixed costs and the correct time frame
• Marginal and lumpy decisions
• Exclusive and non-exclusive choices
• Consider all the alternatives
• Economic profit a measure of the benefits of
  good decision-making

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(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!

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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!
Lets draw the tree with only the relevant
information!
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(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

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An example of sunk costs

• 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 it out

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If she cannot return unsold Fizzies, then the
purchase price is irrelevant it is a sunk cost
Sell at 1
Mitas decision if she paid 30 cents per Fizzie
Mita
Sell at 2.50
Sell at 1
Mitas decision if she paid 1.05 per Fizzie
Mita
Sell at 2.50
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Question

• How would your answer to Mitas problem alter
  if she could return unsold Fizzies at the
  wholesale price?
• If your answer does not change, why doesnt it
  change?
• If your answer does change, why does it change?

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(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?

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-(6800) (204500) - 94,800
Close today
Rosetta
Close in six weeks
(65000) (6800) (204500) - 64,800
Close in twenty weeks
(205000) (20800) (204500) - 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
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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

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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)?

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-(65500) (20800) - 49,000
Close today
Rosetta
Close in six weeks
(65000) (65500) (20800) - 19,000
Close in twenty weeks
(205000) (205,500) (20800) - 26,000
The alternative case shut down in 6 weeks and
leave the shop empty until the lease expires
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(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)

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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

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-(6800) (204500) - 94,800
Close today
Rosetta
Close in six weeks
(65000) (6800) (204500) - 64,800
Close in twenty weeks
(205000) (20800) (204500) - 6,000
If we forget to include the ability to sublet she
will keep operating for the next twenty weeks
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-(6800) (204500) (204300) - 8800
Close today
Rosetta
Close in six weeks
(65000) (6800) (204500) (144300) -
4,600
Close in twenty weeks
(205000) (20800) (204500) - 6,000
But if we include the ability to sublet, she will
close her shop in six weeks
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• 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

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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?

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(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.

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Consider all the alternatives

• If you are using multiple resources then you can
  ask three types of questions
• Could the firm stop using those resources, and
  put each one to its best alternative use?
• Could the firm pursue another business
  opportunity with those resources?
• Could the firm combine its resources with more
  outside resources to do something else?

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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.
• (Its 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

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One implication choose a baseline to start from
It doesnt matter where you start, but you have
to be consistent!
Sell at 1
5,000 372,999
Starting from Mitas current accounting position
Mita
3750 372,999
Sell at 2.50
Sell at 1
5,000
Starting from zero choosing her current
position as a baseline
Mita
3750
Sell at 2.50
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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?

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• 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!

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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
• Well 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 dont have a big impact on my
  budget set) and simple situations