Individual Decision Making

Outline for Today

 Subject organisation  Framing economic decisions  Solving decision trees

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
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Provides a toolkit that can be applied to a huge range of firm decisions.

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

Review of subject structure

Subject
Individual Decision-Making

Situation
Single-agent decision Simultaneous moves Sequential moves Bilateral

Description
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. Both agents know everything about the game and each other. Decisions happen simultaneously. Both agents know everything about the game and each other. Decisions happen sequentially. Two agents who are active negotiations. Try to maximise value and appropriate their share One seller versus many buyers. All agents are active negotiators. Bargain over value split. Many sellers versus many buyers. All agents are active negotiators. Bargain over value split.

Tool
Decision tree

Analysis
Roll-back

Matrix Game Sequential Game Bargaining Theory VAUC (Value-Appropriation Under Competition) VAUC Supply (cost) & Demand (revenue) Functions Bertrand, Cournot

Nash Equilibrium Roll-back

Strategic Decision-Making

Nash bargaining

Negotiations

Monopoly

CDV & added value CDV, added value, Market-clearing prices MC = MR Nash, undercutproofness

Many sellers

Monopoly Mass-Market Pricing Oligopoly

One seller versus many buyers. Firm sets price.

Many sellers vs. many buyers. Firms set prices.

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

Subject Organisation
 Textbook  Problem Sets
 Aplia  Additional problems  Additional online materials

Topic 1
Individual decision making: non-strategic decisions

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

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

Types of Decisions
Degree of Interdependence with others actions
High How hard to study What to bid Market entry

Which MBA What to wear Whether to do an MBA Extreme sports High

Low

What to have for lunch Low

Degree of Uncertainty

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

Example (non-strategic under certainty)

= Decision Node: indicates a point at which an action must be taken (one path for each possible action)

Entry decision

$120,000

$150,000

$0 Location decision

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 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. The costs involved in continuing R&D 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 R&D or not?

Framing the Decision: Step I

 Changs decision is between two alternatives to continue R&D or to abandon the project

Continue

Take risk on developing the new technology at an additional cost of $200,000 and reconsider proposal

Abandon

Perhaps make proposal with inferior technology at an additional cost of $50,000

Step II

Continue Proposal Abandon Not

$0 Expend $50,000 and perhaps win

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)

Step III

Continue Proposal Abandon Not

$0

Win 0.05 0.95 Lose

$800,000

-$50,000

Step IV
Expend $50,000 and have a good chance of winning Succeed 0.5

0.5

Continue

Fail

Expend $50,000 and perhaps win

Win 0.05

$800,000

Proposal Abandon
Lose 0.95 -$50,000

Not

$0

Step V
$600,000 W

Prop
L -$200,000 W 0.5 Fail

0.9 0.1

Succeed

0.5

No

-$250,000 $600,000 0.05

Prop
0.95 L -$200,000 $800,000 W 0.05 0.95 L -$50,000 -$250,000

Continue

No

Abandon

Prop

No

$0

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

Example (non-strategic under certainty)

$120,000

$150,000

$0

 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

Solving at a node with uncertainty: Expected value

  Chang wants to know, is R&D 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)v(Payoff if heads) + (Prob of tails)v(Payoff if tails) = x 2.1 + x (-1.00) = x (2.1 1.00) = $ 0.55

Solving the Tree

Expected value = 0.05 ($800,000) + 0.95 (-$50,000) = - $7,500

Continue

?
Win 0.05 $800,000

Proposal Abandon Not

$0 Lose

0.95 -$50,000

Solving the Tree

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

Continue

Solving the Tree

Win $600,000 0.9 0.1 Succeed 0.5

Proposal Not
Lose -$200,000 Win

-$250,000 $600,000 0.05 0.95

Continue
Fail

0.5

Proposal Not
Lose -$200,000

-$250,000

Abandon

$0

Solving the Tree

Win $600,000 0.9 0.1 Succeed 0.5

Proposal Not
Lose -$200,000

-$250,000

Continue
Fail

0.5

Proposal Not

-$207,500

-$200,000

Abandon

$0

Solving the Tree

Proposal Not
-$200,000

$515,000

Succeed

0.5

Continue
Fail

0.5 -$200,000

Abandon

$0

Solving the Tree

$515,000 Succeed 0.5

Continue
Fail

0.5 -$200,000

Abandon

$0

Solving the Tree

1. Never make proposal if dont have newer technology 2. Choose to take risk and continue R&D
$157,500

Continue

Abandon

$0

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.

Framing the Decision

 What alternatives does Indy have?

Drink himself

Give drink to Snr

Framing the Decision

 Do you need more information?
Right Jnr & Snr Live

Drink himself
Wrong Right Jnr & Snr Die Jnr & Snr Live

Give drink to Snr

Wrong

Snr Dies but Jnr Lives

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

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

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.

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 Mita sell at $1.00 $3750 - cost $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)

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 Mita sell at $1.00 $3750 - cost $5000 - cost

Economic profit = $1,250