1.
Individual Decision Making

2.
Outline for Today <ul><li>Subject organisation </li></ul><ul><li>Framing economic decisions </li></ul><ul><li>Solving decision trees </li></ul>

3.
Why economics? <ul><li>Economics provides basic tools to analyse ... </li></ul><ul><li>production and exchange (both in markets and other organisations) </li></ul><ul><li>prices </li></ul><ul><li>competition </li></ul><ul><li>investments </li></ul><ul><li>changes in markets over time </li></ul><ul><li>strategic interaction between firms & customers </li></ul><ul><li>Provides a ‘toolkit’ that can be applied to a huge range of firm decisions. </li></ul>

4.
Course Objectives <ul><li>Specific objectives are to understand: </li></ul><ul><ul><li>Value creation & appropriation: </li></ul></ul><ul><ul><ul><li>What is the economic value of your productive activities? </li></ul></ul></ul><ul><ul><ul><li>How much of that value do you get? </li></ul></ul></ul><ul><ul><li>Prices: </li></ul></ul><ul><ul><ul><li>Prices allocate value </li></ul></ul></ul><ul><ul><ul><li>What actions can you take to alter pricing outcomes? </li></ul></ul></ul><ul><li>General objective: learn to apply the tools of economics to improve your managerial decision making </li></ul>

5.
Review of subject structure Subject Situation Description Tool Analysis Individual Decision-Making Single-agent decision One agent must make an optimal decision. The actions of others have no direct influence. Uncertainty and the time-value of money may be concerns. Decision tree Roll-back Strategic Decision-Making Simultaneous moves Both agents know everything about the game and each other. Decisions happen simultaneously. Matrix Game Nash Equilibrium Sequential moves Both agents know everything about the game and each other. Decisions happen sequentially. Sequential Game Roll-back Negotiations Bilateral Two agents who are active negotiations. Try to maximise value and appropriate their share Bargaining Theory Nash bargaining Monopoly One seller versus many buyers. All agents are active negotiators. Bargain over value split. VAUC (Value-Appropriation Under Competition) CDV & added value Many sellers Many sellers versus many buyers. All agents are active negotiators. Bargain over value split. VAUC CDV, added value, Market-clearing prices Mass-Market Pricing Monopoly One seller versus many buyers. Firm sets price. Supply (cost) & Demand (revenue) Functions MC = MR Oligopoly Many sellers vs. many buyers. Firms set prices. Bertrand, Cournot Nash, undercut-proofness

6.
Skills required for subject <ul><li>Logical and intuitive thinking </li></ul><ul><li>Interpretation of graphs </li></ul><ul><li>Mathematics </li></ul>The main thinking tool = MODELS Reduce complex situations to their fundamentals to develop general principles

7.
Subject Organisation <ul><li>Textbook </li></ul><ul><li>Problem Sets </li></ul><ul><ul><li>Aplia </li></ul></ul><ul><ul><li>Additional problems </li></ul></ul><ul><ul><li>Additional online materials </li></ul></ul>

8.
Individual decision making: “non-strategic” decisions Topic 1

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Overview <ul><li>Decision Trees </li></ul><ul><ul><li>Basic analytical tool of decision making </li></ul></ul><ul><ul><li>Non-strategic decisions (this week) </li></ul></ul><ul><ul><li>Strategic decisions (later) </li></ul></ul><ul><li>Decision rules follow from decision trees </li></ul><ul><li>The concept of economic profit </li></ul>

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

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Types of Decisions Degree of Uncertainty Low High Degree of Interdependence with others’ actions High Low Market entry Extreme sports What to wear What to have for lunch How hard to study Whether to do an MBA Which MBA What to bid

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Decision Trees <ul><li>The basic tool for decision making is a decision tree </li></ul><ul><li>Idea: a traveller comes to a fork in the road. She must make a decision whether to go right or left. </li></ul>R L

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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) CBD $120,000 $150,000 Brunswick open a restaurant don’t $0 Entry decision Location decision

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Chang’s Dilemma in 2003 <ul><li>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, Chang’s 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. </li></ul><ul><li>Progress has been slow and Chang is unsure about whether the new product will be developed on time. If the R&D 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 . </li></ul><ul><li>The costs involved in continuing R&D are $200,000 . Developing a proposal itself will cost Chang’s company $50,000 . Finally, the costs of producing the product – should they win the contract – will be $150,000 . </li></ul><ul><li>Should Chang continue R&D or not? </li></ul>

15.
Framing the Decision: Step I <ul><li>Chang’s decision is between two alternatives – to continue R&D or to abandon the project </li></ul>Abandon Continue Perhaps make proposal with inferior technology at an additional cost of $50,000 Take risk on developing the new technology at an additional cost of $200,000 and reconsider proposal

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Step II Abandon Continue Not Proposal $0 Expend $50,000 and perhaps win

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Uncertainty in a decision tree <ul><li>Chang must assess the probability of success </li></ul><ul><ul><li>Objective based upon data or specific knowledge </li></ul></ul><ul><ul><li>Subjective based upon experience & judgement </li></ul></ul><ul><li>Suppose the probability of winning the contract with the old product is only 5% = 0.05 </li></ul><ul><li>This implies probability of losing is 95% </li></ul>= 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 Abandon Continue Not Proposal $0 Win Lose 0.05 0.95 $800,000 -$50,000

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Step IV Abandon Continue Not Proposal $0 Win Lose 0.05 0.95 -$50,000 Succeed Fail 0.5 0.5 $800,000 Expend $50,000 and perhaps win Expend $50,000 and have a good chance of winning

20.
Step V No Prop No Prop Abandon Continue $0 W L 0.05 0.95 -$50,000 Succeed Fail 0.5 0.5 $800,000 No Prop -$200,000 W L 0.9 0.1 -$250,000 $600,000 -$200,000 W L 0.05 0.95 -$250,000 $600,000

21.
Optimal decision plan <ul><li>While we built the tree by adding branches … </li></ul><ul><li>the way to “solve” it is to start at the end and ‘roll back.’ </li></ul><ul><li>Looking forward and working backwards is a key skill in economic decision-making </li></ul>

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Example (non-strategic under certainty) <ul><li>First, solve a node furthest to the right </li></ul><ul><ul><li>Decision node: Pick the best choice </li></ul></ul><ul><ul><li>Nature node: Calculate the average value </li></ul></ul><ul><li>Solve next node to the left </li></ul><ul><li>Continue … </li></ul>CBD $120,000 $150,000 Brunswick open a restaurant don’t $0

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Solving at a node with uncertainty: Expected value <ul><li>Chang wants to know, is R&D a risk worth taking? </li></ul><ul><li>Easy to solve, so long as Chang is risk-neutral; </li></ul><ul><ul><li>Risk-neutral agents prefer decisions with highest average payoff </li></ul></ul><ul><ul><li>Good assumption when agent is a firm, poor for individuals (investors can diversify their own portfolios) </li></ul></ul><ul><li>Example: Flip a coin, </li></ul><ul><ul><li>Heads you get $2.10 </li></ul></ul><ul><ul><li>Tails you lose $1.00 </li></ul></ul><ul><li> 1000 flips: roughly 500 heads, 500 tails  an average of ? per flip. </li></ul><ul><li>Expected value : </li></ul><ul><li>= (Probability of heads)  (Payoff if heads) + (Prob of tails)  (Payoff if tails) </li></ul><ul><li>= ½ x 2.1 + ½ x (-1.00) </li></ul><ul><li>= ½ x (2.1 – 1.00) </li></ul><ul><li>= $ 0.55 </li></ul>

24.
Solving the Tree Abandon Continue Not Proposal $0 Win Lose 0.05 0.95 $800,000 -$50,000 ? Expected value = 0.05 ($800,000) + 0.95 (-$50,000) = - $7,500

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Solving the Tree Abandon Continue Not Proposal $0 -$7,500 ? Choose the branch with the best payoff

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Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 Not Proposal -$200,000 Win Lose 0.9 0.1 -$250,000 $600,000 Not Proposal -$200,000 Win Lose 0.05 0.95 -$250,000 $600,000

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Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 Not Proposal -$200,000 Win Lose 0.9 0.1 -$250,000 $600,000 Not Proposal -$200,000 -$207,500

28.
Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 Not Proposal -$200,000 $515,000 -$200,000

29.
Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 $515,000 -$200,000

30.
Solving the Tree Abandon Continue $0 $157,500 <ul><li>Never make proposal if don’t have newer technology </li></ul><ul><li>Choose to take risk and continue R&D </li></ul>

31.
Indy’s Choice <ul><li>Example (from Dixit & Nalebuff): Indiana Jones in the climax of the movie Indiana Jones and the Last Crusade . </li></ul><ul><li>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 Indiana’s 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 “There’s 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. </li></ul>

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Framing the Decision <ul><li>What alternatives does Indy have? </li></ul>Give drink to Snr Drink himself

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Framing the Decision <ul><li>Do you need more information? </li></ul>Give drink to Snr Drink himself Right Wrong Jnr & Snr Live Jnr & Snr Die Right Wrong Jnr & Snr Live Snr Dies but Jnr Lives

34.
Uses of Decision Trees <ul><li>Decision Trees are used in situations that may be too complex to think through in your mind </li></ul><ul><li>In Decision Analysis: used in situations where there is uncertainty, multiple decisions </li></ul><ul><li>In “Managerial Economics”: used in situations where </li></ul><ul><ul><ul><li>The payoffs are not so obvious </li></ul></ul></ul><ul><ul><ul><li>The alternative choices are not so obvious </li></ul></ul></ul><ul><ul><ul><li>Several players have to make choices </li></ul></ul></ul><ul><li>Being systematic helps you to see though complexity and to remember all your alternative choices </li></ul>

35.
Economic Cost = opportunity foregone <ul><li>The true cost of one choice is giving up the benefits associated with your next-best choice </li></ul><ul><ul><li>Example: What is the cost of doing an MBA? </li></ul></ul><ul><ul><li>Besides the price, there is an opportunity cost = what you would have earned, using the resource (your time) for another opportunity </li></ul></ul><ul><ul><li>Costs that do not change with your decision are irrelevant </li></ul></ul>

36.
Consider this situation <ul><li>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. </li></ul><ul><li>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? </li></ul><ul><li>Mita cannot return unsold stock of Fizzies, but must throw the stock out. </li></ul>

37.
Definition: Sunk Cost <ul><li>A cost is considered sunk with respect to a specific decision if, no matter what you decide, that cost does not change </li></ul><ul><li>On a decision tree, a sunk cost appears on all leaves (payoffs) </li></ul><ul><li>sell at $2.50 $3750 - cost </li></ul><ul><li>Mita </li></ul><ul><li>sell at $1.00 $5000 - cost </li></ul><ul><li>Economic benefit of charging $1 rather than $2.5 is $1,250 </li></ul><ul><li>(cost is the same in all cases … it is sunk & irrelevant ) </li></ul>

38.
Definition: *** Economic Profit *** <ul><li>The economic profit of a decision is the cash you earn from one decision, minus that from the best alternative decision </li></ul><ul><li>Decision tree: $ from best choice, minus $ from next best choice </li></ul><ul><li>sell at $2.50 $3750 - cost </li></ul><ul><li>Mita </li></ul><ul><li>sell at $1.00 $5000 - cost </li></ul><ul><li>Economic profit = $1,250 </li></ul>