What is meant by Economic decision making

what does economic decision making involve,what is the economic decision making process, what are examples of economic decision making, what are the steps in economic decision making
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c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 1 CHAPTER 1 Introduction to Economic Decision Making The crucial step in tackling almost all important business and government decisions begins with a single question: What is the alternative? ANONYMOUS Decision making lies at the heart of most important business and government problems. The range of business decisions is vast: Should a high-tech company undertake a promising but expensive research and development program? Should a petrochemical manufacturer cut the price of its best-selling industrial chemical in response to a new competitor’s entry into the market? What bid should company management submit to win a government telecommunications contract? Should management of a food products company launch a new prod- uct after mixed test-marketing results? Likewise, government decisions range far and wide: Should the Department of Transportation impose stricter rollover standards for sports utility vehicles? Should a city allocate funds for construction of a harbor tunnel to provide easy airport and commuter access? These are all interesting, important, and timely questions—with no easy answers. They are also all economic decisions. In each case, a sensible analysis of what decision to make requires a careful comparison of the advantages and disadvantages (often, but not always, measured in dollars) of alternative courses of action. As the term suggests, managerial economics is the analysis of major man- agement decisions using the tools of economics. Managerial economics applies many familiar concepts from economics—demand and cost, monopoly and competition, the allocation of resources, and economic trade-offs—to aid man- agers in making better decisions. This book provides the framework and the economic tools needed to fulfill this goal. 1c01IntroductiontoEconomicDecisionMaking.qxd 9/28/11 11:10 AM Page 2 2 Chapter 1 Introduction to Economic Decision Making In this chapter, we begin our study of managerial economics by stressing decision-making applications. In the first section, we introduce seven decision examples, all of which we will analyze in detail later in the text. Although these examples cover only some applications of economic analysis, they represent the breadth of managerial economics and are intended to whet the reader’s appetite. Next, we present a basic model of the decision-making process as a framework in which to apply economic analysis. This model proposes six steps to help structure complicated decisions so that they may be clearly analyzed. After presenting the six steps, we outline a basic theory of the firm and of government decisions and objectives. In the concluding section, we present a brief overview of the topics covered in the chapters to come. SEVEN EXAMPLES OF MANAGERIAL DECISIONS The best way to become acquainted with managerial economics is to come face to face with real-world decision-making problems. The seven examples that fol- low represent the different kinds of decisions that private- and public-sector man- agers face. All of them are revisited and examined in detail in later chapters. The examples follow a logical progression. In the first example, a global carmaker faces the most basic problem in managerial economics: determining prices and outputs to maximize profit. As we shall see in Chapters 2 through 6, making decisions requires a careful analysis of revenues and costs. The second example highlights competition between firms, the subject of Chapters 7 through 10. Here, two large bookstore chains are battling for market share in a multitude of regional markets. Each is trying to secure a monopoly, but when both build superstores in the same city, they frequently become trapped in price wars. The next two examples illustrate public-sector decisions: The first concerns funding a public project, the second is a regulatory decision. Here, a shift occurs both in the decision maker—from private to public manager—and in the objectives. As we argue in Chapter 11, government decisions are guided by the criterion of benefit-cost analysis rather than by profit considerations. The final three examples involve decision making under uncertainty. In the fifth example, the failure of BP to identify and manage exploration risks cul- minated in the 2010 explosion of its Deepwater Horizon drilling rig in the Gulf of Mexico and the resulting massive oil spill in the gulf that took so long to stop. In the next example, a pharmaceutical company is poised between alter- native risky research and development (R&D) programs. Decision making under uncertainty is the focus of Chapters 12 and 13. In the final example, David Letterman and two rival television networks are locked in a high-stakes negotiation as to which company will land his profitable late-night show. Competitive risk in the contexts of negotiation and competitive bidding is taken up in Chapters 15 and 16.c01IntroductiontoEconomicDecisionMaking.qxd 9/29/11 8:45 PM Page 3 Seven Examples of Managerial Decisions 3 Almost all firms face the problem of pricing their products. Consider a U.S. Multinational Production and multinational carmaker that produces and sells its output in two geographic Pricing regions. It can produce cars in its home plant or in its foreign subsidiary. It sells cars in the domestic market and in the foreign market. For the next year, it must determine the prices to set at home and abroad, estimate sales for each market, and establish production quantities in each facility to supply those sales. It rec- ognizes that the markets for vehicles at home and abroad differ with respect to demand (that is, how many cars can be sold at different prices). Also, the pro- duction facilities have different costs and capacities. Finally, at a cost, it can ship vehicles from the home facility to help supply the foreign market, or vice versa. Based on the available information, how can the company determine a profit- maximizing pricing and production plan for the coming year? For 20 years, the two giants of the book business—Barnes & Noble and Borders Market Entry Group—engaged in a cutthroat retail battle. In major city after major city, the rivals opened superstores, often within sight of each other. By the mid-1990s, more books were sold via chain stores than by independent stores, and both com- panies continued to open new stores at dizzying rates. The ongoing competition raises a number of questions: How did either chain assess the profitability of new markets? Where and when should each enter new markets? What if a region’s book-buying demand is sufficient to sup- port only one superstore? What measures might be taken by an incumbent to erect entry barriers to a would-be entrant? On what dimensions—number of titles, pricing, personal service—did the companies most vigorously compete? In view of accelerating book sales via the Internet and the emerging e-book market, can mega “bricks and mortar” bookstores survive? As chief city planner of a rapidly growing Sun Belt city, you face the single Building a New Bridge biggest decision of your tenure: whether to recommend the construction of a new harbor bridge to connect downtown with the surrounding suburbs located on a northern peninsula. Currently, suburban residents commute to the city via a ferry or by driving a long-distance circular route. Preliminary studies have shown that there is considerable need and demand for the bridge. Indeed, the bridge is expected to spur economic activity in the region as a whole. The pro- jected cost of the bridge is 75 million to 100 million. Part of the money would be financed with an issue of municipal bonds, and the remainder would be contributed by the state. Toll charges on commuting automobiles and partic- ularly on trucks would be instituted to recoup a portion of the bridge’s costs. But, if bridge use falls short of projections, the city will be saddled with a very expensive white elephant. What would you recommend? Environmental regulations have a significant effect on business decisions A Regulatory Problem and consumer behavior. Charles Schultze, former chairperson of the President’s Council of Economic Advisers, describes the myriad problemsc01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 4 4 Chapter 1 Introduction to Economic Decision Making associated with the regulations requiring electric utilities to convert from oil to coal. Petroleum imports can be conserved by switching utilities from oil- fired to coal-fired generation. But barring other measures, burning high- sulfur Eastern coal substantially increases pollution. Sulfur can be “scrubbed” from coal smoke in the stack, but at a heavy cost, with devices that turn out huge volumes of sulfur wastes that must be disposed of and about whose reliability there is some question. Intermittent control tech- niques (installing high smoke stacks and turning off burners when mete- orological conditions are adverse) can, at a lower cost, reduce local concentrations of sulfur oxides in the air, but cannot cope with the grow- ing problem of sulphates and widespread acid rainfall. Use of low-sulfur Western coal would avoid many of these problems, but this coal is obtained by strip mining. Strip-mine reclamation is possible but sub- stantially hindered in large areas of the West by lack of rainfall. More- over, in some coal-rich areas the coal beds form the underlying aquifer, and their removal could wreck adjacent farming or ranching economies. Large coal-burning plants might be located in remote areas far from highly populated urban centers in order to minimize the human effects of pollution. But such areas are among the few left that are unspoiled by pollution, and both environmentalists and the residents (relatively few in number compared to those in metropolitan localities but large among the voting populations in the particular states) strongly object to this policy. Fears, realistic or imaginary, about safety and accumulation of 1 radioactive waste have increasingly hampered the nuclear option. Schultze’s points apply directly to today’s energy and environmental trade- offs. Actually, he penned this discussion in 1977 Important questions persist. How, when, and where should the government intervene to achieve and bal- ance its energy and environmental objectives? How would one go about quan- tifying the benefits and costs of a particular program of intervention? BP and Oil BP (known as British Petroleum prior to 2001) is in the business of taking risks. Exploration Risks As the third largest energy company in the world, its main operations involve oil exploration, refining, and sale. The risks it faces begin with the uncertainty about where to find oil deposits (including drilling offshore more than a mile under the ocean floor), mastering the complex, risky methods of extracting petroleum, cost-effectively refining that oil, and selling those refined products at wildly fluctuating world prices. In short, the company runs the whole gamut of risk: geological, technological, safety, regulatory, legal, and market related. 1 C. L. Schultze, The Public Use of Private Interest (Washington, DC: The Brookings Institution, 1977), 9–10.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 5 Seven Examples of Managerial Decisions 5 Priding itself on 17 straight years of 100 percent oil reserve replacement, BP is an aggressive and successful oil discoverer. But the dark side of its strategic aspi- rations is its troubling safety and environmental record, culminating in the explo- sion of its Deepwater Horizon drilling rig in the Gulf of Mexico in April 2010. This raises the question: What types of decisions should oil companies like BP take to identify, quantify, manage, and hedge against the inevitable risks they face? A five-year-old pharmaceutical company faces a major research and develop- An R&D Decision ment decision. It already has spent a year of preliminary research toward pro- ducing a protein that dissolves blood clots. Such a drug would be of tremendous value in the treatment of heart attacks, some 80 percent of which are caused by clots. The primary method the company has been pursuing relies on conventional, state-of-the-art biochemistry. Continuing this approach will require an estimated 10 million additional investment and should lead to a commercially successful product, although the exact profit is highly uncertain. Two of the company’s most brilliant research scientists are aggressively advo- cating a second R&D approach. This new biogenetic method relies on gene splicing to create a version of the human body’s own anticlotting agent and is considerably riskier than the biochemical alternative. It will require a 20 mil- lion investment and has only a 20 percent chance of commercial success. However, if the company accomplishes the necessary breakthroughs, the anti- clotting agent will represent the first blockbuster, genetically engineered drug. If successful, the method will entail minimal production costs and generate annual profits two to five times greater than a biochemically based drug would. Which method should the firm choose for its R&D investment? In January 1993, David Letterman made it official—he would be leaving Late Wooing David Letterman Night on NBC for a new 11:30 P.M. show on CBS beginning in the fall. A tangled web of negotiations preceded the move. In 1992 NBC chose the comedian Jay Leno, instead of Letterman, to succeed Johnny Carson as the host of The Tonight Show in an effort to keep its lock on late-night programming. Accordingly, CBS, a nonentity in late-night television, saw its chance to woo David Letterman. After extensive negotiations, CBS offered Letterman a 14 million salary to do the new show (a 10 million raise over his salary at NBC). In addition, Letterman’s own production company would be paid 25 million annually to produce the show. However, NBC was unwilling to surrender Letterman to CBS without a fight. The network entered into secret negotiations with Letterman’s representative, Michael Ovitz, exploring the possibility of dumping Leno and giving The Tonight Show to Letterman. One group of NBC executives stood firmly behind Leno. Another group preferred replacing Leno to losing Letterman to CBS. In the end, NBC offered The Tonight Show to Letterman—but with the condition that he wait a year until Leno’s current contract was up. David Letterman faced the most difficult decision of his life. Should he make up and stay with NBC or take a new path with CBS? In the end, he chosec01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 6 6 Chapter 1 Introduction to Economic Decision Making to leave. The Letterman negotiations raise a number of questions. How well did Michael Ovitz do in squeezing the most out of CBS on behalf of Letterman? In its negotiations, what (if anything) could NBC have done dif- ferently to keep its star? SIX STEPS TO DECISION MAKING The examples just given represent the breadth of the decisions in managerial economics. Different as they may seem, each decision can be framed and ana- lyzed using a common approach based on six steps, as Figure 1.1 indicates. With the examples as a backdrop, we will briefly outline each step. Later in the text, we will refer to these steps when analyzing managerial decisions. Step 1: Define the Problem What is the problem the manager faces? Who is the decision maker? What is the decision setting or context, and how does it influence managerial objectives or options? FIGURE 1.1 The Basic Steps in Decision Making 1. Define the Problem The process of decision making can be broken Determine the 2. down into six basic Objective steps. 3. Explore the Alternatives 4. Predict the Consequences 5. Make a Choice 6. Perform Sensitivity Analysisc01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 7 Six Steps to Decision Making 7 Decisions do not occur in a vacuum. Many come about as part of the firm’s planning process. Others are prompted by new opportunities or new problems. It is natural to ask, what brought about the need for the decision? What is the decision all about? In each of the examples given earlier, the decision prob- lem is stated and is reasonably well defined. In practice, however, managerial decisions do not come so neatly packaged; rather, they are messy and poorly defined. Thus, problem definition is a prerequisite for problem management. In fact, the decision in the fourth example—the conversion of utilities to coal— raises interesting issues concerning problem definition. How narrowly does one define the problem? Is the crux of the problem minimizing pollution from utilities? Presumably cost is also important. Thus, the problem involves deter- mining how much pollution to clean up, by what means, and at what cost. Or is the problem much broader: reducing U.S. dependence on foreign energy sources? If so, which domestic energy initiatives (besides or instead of utility conversion to coal) should be undertaken? A key part of problem definition involves identifying the context. The majority of the decisions we study take place in the private sector. Managers representing their respective firms are responsible for the decisions made in five of the examples. By contrast, the third and fourth examples occur in the public sector, where decisions are made at all levels of government: local, state, and national. The recommendation concerning construction of a new bridge is made by a city agency and must be approved by the state govern- ment. Similarly, the chain of decisions accompanying the conversion of util- ities from oil to coal involves a surprising number of public-sector authorities, including the Department of Energy, the Environmental Protection Agency, state and local agencies, the Department of the Interior, and possibly the Nuclear Regulatory Commission. As one might imagine, the larger the num- ber of bodies that share policy responsibility and the pursuit of different goals, the greater is the likelihood that decision-making problems and con- flicts will occur. Step 2: Determine the Objective What is the decision maker’s goal? How should the decision maker value out- comes with respect to this goal? What if he or she is pursuing multiple, con- flicting objectives? When it comes to economic decisions, it is a truism that “you can’t always 2 get what you want.” But to make any progress at all in your choice, you have to know what you want. In most private-sector decisions, profit is the principal 2 Many readers will recognize this quote as a lyric penned by Mick Jagger of the Rolling Stones. What many may not know is that Jagger briefly attended the London School of Economics before pur- suing the path to rock stardom.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 8 8 Chapter 1 Introduction to Economic Decision Making objective of the firm and the usual barometer of its performance. Thus, among alternative courses of action, the manager will select the one that will maximize the profit of the firm. Attainment of maximum profit worldwide is the natural objective of the multinational carmaker, the drug company, and the management and shareholders of Barnes & Noble, Borders Group, BP, NBC, and CBS. The objective in a public-sector decision, whether it be building a bridge or regulating a utility, is broader than the private-sector profit standard. The government decision maker should weigh all benefits and costs, not solely rev- enues and expenses. According to this benefit-cost criterion, the bridge in the third example may be worth building even if it fails to generate a profit for the government authority. In turn, the optimal means of regulating the produc- tion decisions of the utility depend on a careful comparison of benefits (mainly in the form of energy conservation and independence) and costs (in dollar and environmental terms). In practice, profit maximization and benefit-cost analysis are not always unambiguous guides to decision making. One difficulty is posed by the timing of benefits and costs. Should a firm (the drug company, for example) make an investment (sacrifice profits today) for greater profits 5 or 10 years from now? Are the future benefits to commuters worth the present capital expense of building the bridge? Both private and public investments involve trade-offs between present and future benefits and costs. Uncertainty poses a second difficulty. In some economic decisions, risks are minimal. For instance, a fast-food chain may know that it can construct a new outlet in 45 days at a cost of 75 per square foot. The cost and timing of construction are not entirely certain, but the margin of error is small enough to be safely ignored. In contrast, the cost and date of completing a nuclear power plant are highly uncertain (due to unanticipated design changes, cost overruns, schedule delays, and the like). At best, the utilities that share own- ership of the plant may be able to estimate a range of cost outcomes and com- pletion dates and assess probabilities for these possible outcomes. The presence of risk and uncertainty has a direct bearing on the way the decision maker thinks about his or her objective. Both BP and the phar- maceutical company seek to maximize company profit, but there is no sim- ple way to apply the profit criterion to determine their best actions and strategies. BP might pay 50 million to acquire a promising site it believes is worth 150 million and find, after thorough drilling and exploration, that the site is devoid of oil or natural gas. Similarly, the drug company cannot use the simple rule “choose the method that will yield the greater profit,” because the ultimate profit from either method cannot be pinned down ahead of time. There are no profit guarantees; rather, the drug company faces a choice between two risky research options. Similarly, public programs and regulatory policies generate future benefits and costs that cannot be predicted with certainty.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 9 Six Steps to Decision Making 9 Step 3: Explore the Alternatives What are the alternative courses of action? What are the variables under the decision maker’s control? What constraints limit the choice of options? After addressing the question “What do we want?” it is natural to ask, “What are our options?” Given human limitations, decision makers cannot hope to identify and evaluate all possible options. Still, one would hope that attractive options would not be overlooked or, if discovered, not mistakenly dismissed. Moreover, a sound decision framework should be able to uncover options in the course of the analysis. In our examples, the main work of problem definition has already been carried out, greatly simplifying the identification of decision options. In the first example, the carmaker is free to set prices at home and abroad. These prices will largely determine the numbers of vehicles the firm can expect to sell in each market. It still remains for the firm to determine a production plan to supply its total projected sales; that is, the firm’s other two decision variables are the quantities to produce in each facility. The firm’s task is to find optimal values of these four decision variables—values that will generate a maximum level of profit. In the other examples, the decision maker faces a choice from a relatively small number of alternatives. But even when the choices are limited, there may be more alternatives than first meet the eye. BP faces a myriad of choices as to how and where to explore for oil, how to manage its wells and refineries, and how to sell its petroleum products. Similarly, the utilities example illustrates the way in which options can multiply. There, the limitations and repercussions of the “obvious” alternatives lead to a wider consideration of other choices, which, unfortunately, have their own side effects. The drug company might appear to have a simple either/or choice: pur- sue the biochemical R&D program or proceed with the biogenetic program. But there are other alternatives. For instance, the company could pursue both programs simultaneously. This strategy means investing resources and money in both but allows the firm to commercialize the superior program that emerges from the R&D competition. Alternatively, the company could pursue the two R&D options in sequence. After observing the outcome of an initial R&D program, the company could choose to develop it or to reject it. After terminating the first program, the company could then pursue the second R&D approach. The question raised by the sequential option is, which approach, the safer biochemical method or the riskier biogenetic alternative, should the company pursue first? Most managerial decisions involve more than a once-and-for-all choice from among a set of options. Typically, the manager faces a sequence of deci- sions from among alternatives. For instance, in the battle for David Letterman, each side had to formulate its current negotiation stance (in light of how much value it might expect to get out of alternative deals). How aggressive orc01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 10 10 Chapter 1 Introduction to Economic Decision Making conciliatory an offer should it make? How much can it expect the other side to concede? Thus, a commonly acknowledged fact about negotiation is that the main purpose of an opening offer is not to have the offer accepted (if it were, the offer probably was far too generous); rather, the offer should direct the course of the offers to follow. To sum up, in view of the myriad uncer- tainties facing managers, most ongoing decisions should best be viewed as con- tingent plans. Step 4: Predict the Consequences What are the consequences of each alternative action? Should conditions change, how would this affect outcomes? If outcomes are uncertain, what is the likelihood of each? Can better information be acquired to predict outcomes? Depending on the situation, the task of predicting the consequences may be straightforward or formidable. Sometimes elementary arithmetic suffices. For instance, the simplest profit calculation requires only subtracting costs from revenues. The choice between two safety programs might be made according to which saves the greater number of lives per dollar expended. Here the use of arithmetic division is the key to identifying the preferred alternative. MODELS In more complicated situations, however, the decision maker often must rely on a model to describe how options translate into outcomes. A model is a simplified description of a process, relationship, or other phenomenon. By deliberate intent, a model focuses on a few key features of a problem to examine carefully how they work while ignoring other complicating and less important factors. The main purposes of models are to explain and to pre- dict—to account for past outcomes and to forecast future ones. The kinds of predictive models are as varied as the decision problems to which they are applied. Many models rest on economic relationships. Suppose the multinational carmaker predicts that a 10 percent price cut will increase unit sales by 15 percent in the foreign market. The basis for this prediction is the most fundamental relationship in economics: the demand curve. Borders’ decision of when and how to enter a new market depends on predictions of demand and cost and of how Barnes & Noble might be expected to respond. These elements may be captured with a model of competitive behavior among oligopolists. Indeed, Chapters 3 through 6 survey the key economic models of demand and cost used in making managerial decisions. Other models rest on statistical, legal, and scientific relationships. The construction and configuration of the new bridge (and its likely environ- mental impact) and the plan to convert utilities to coal depend in large part on engineering predictions. Evaluations of test-marketing results rely heavily on statistical models. Legal models, interpretations of statutes, precedents, and the like are pertinent to predictions of a firm’s potential patent liability and to the outcome in other legal disputes. Finally, the drug company’sc01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 11 Six Steps to Decision Making 11 assessment of the relative merits of competing R&D methods rests on scientific and biological models. A key distinction can be drawn between deterministic and probabilistic models. A deterministic model is one in which the outcome is certain (or close enough to a sure thing that it can be taken as certain). For instance, a soft-drink manufacturer may wish to predict the numbers of individuals in the 10-to-25 age group over the next five years. There are ample demographic statistics with which to make this prediction. Obviously, the numbers in this age group five years from now will consist of those who today are between ages 5 and 20, minus a predictable small number of deaths. Thus, a simple deterministic model suffices for the prediction. However, the forecast becomes much less certain when it comes to estimating the total consump- tion of soft drinks by this age group or the market share of a particular prod- uct brand. The market share of a particular drink will depend on many unpredictable factors, including the advertising, promotion, and price deci- sions of the firm and its competitors as well as consumer tastes. As the term suggests, a probabilistic model accounts for a range of possible future out- comes, each with a probability attached. Step 5: Make a Choice After all the analysis is done, what is the preferred course of action? For obvi- ous reasons, this step (along with step 4) occupies the lion’s share of the analy- sis and discussion in this book. Once the decision maker has put the problem in context, formalized key objectives, and identified available alternatives, how does he or she go about finding a preferred course of action? In the majority of decisions we take up, the objectives and outcomes are directly quantifiable. Thus, a private firm (such as the carmaker) can compute the profit results of alternative price and output plans. Analogously, a govern- ment decision maker may know the computed net benefits (benefits minus costs) of different program options. The decision maker could determine a preferred course of action by enumeration, that is, by testing a number of alter- natives and selecting the one that best meets the objective. This is fine for deci- sions involving a small number of choices, but it is impractical for more complex problems. For instance, what if the car company drew up a list of two dozen different pricing and production plans, computed the profits of each, and settled on the best of the lot? How could management be sure this choice is truly the best of all possible plans? What if a more profitable plan, say, the twenty-fifth candidate, was overlooked? Expanding the enumerated list could reduce this risk, but at considerable cost. Fortunately, the decision maker need not rely on the painstaking method of enumeration to solve such problems. A variety of methods can identify and cut directly to the best, or optimal, decision. These methods rely to varyingc01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 12 12 Chapter 1 Introduction to Economic Decision Making extents on marginal analysis, decision trees, game theory, benefit-cost analysis, and linear programming, all of which we take up later in this book. These approaches are important not only for computing optimal decisions but also for checking why they are optimal. Step 6: Perform Sensitivity Analysis What features of the problem determine the optimal choice of action? How does the optimal decision change if conditions in the problem are altered? Is the choice sensitive to key economic variables about which the decision maker is uncertain? In tackling and solving a decision problem, it is important to understand and be able to explain to others the “why” of your decision. The solution, after all, did not come out of thin air. It depended on your stated objectives, the way you structured the problem (including the set of options you considered), and your method of predicting outcomes. Thus, sensitivity analysis considers how an optimal decision is affected if key economic facts or conditions vary. Here is a simple example of the use of sensitivity analysis. Senior manage- ment of a consumer products firm is conducting a third-year review of one of its new products. Two of the firm’s business economists have prepared an exten- sive report that projects significant profits from the product over the next two years. These profit estimates suggest a clear course of action: Continue market- ing the product. As a member of senior management, would you accept this recommendation uncritically? Probably not. After all, you may be well aware that the product has not yet earned a profit in its first two years. (Although it sold reasonably well, it also had high advertising and promotion costs and a low intro- ductory price.) What lies behind the new profit projection? Greater sales, a higher price, or both? A significant cost reduction? The process of tracking down the basic determinants of profit is one aspect of sensitivity analysis. As one would expect, the product’s future revenues and costs may be highly uncertain. Management should recognize that the revenue and cost projec- tions come with a significant margin of error attached and should investigate the profit effects if outcomes differ from the report’s forecasts. What if sales are 12 percent lower than expected? What if projected cost reductions are not real- ized? What if the price of a competing product is slashed? By answering these what-if questions, management can determine the degree to which its profit projections, and therefore its marketing decisions, are sensitive to the uncer- 3 tain outcomes of key economic variables. 3 Sensitivity analysis might also include assessing the implementation of the chosen decision to see whether it achieved the desired solution. If so, management may be satisfied that it has made a sound choice. If not, why not? Has the decision setting been accurately described? Is the appro- priate objective being pursued? Have all alternatives been considered? In light of an after-the-fact assessment, should the firm modify its original strategy?c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 13 Private and Public Decisions: An Economic View 13 PRIVATE AND PUBLIC DECISIONS: AN ECONOMIC VIEW Our approach to managerial economics is based on a model of the firm: how firms behave and what objectives they pursue. The main tenet of this model, or theory of the firm, is that management strives to maximize the firm’s prof- its. This objective is unambiguous for decisions involving predictable revenues and costs occurring during the same period of time. However, a more precise profit criterion is needed when a firm’s revenues and costs are uncertain and accrue at different times in the future. The most general theory of the firm states that Management’s primary goal is to maximize the value of the firm. Here, the firm’s value is defined as the present value of its expected future profits. Thus, in making any decision, the manager must attempt to predict its impact on future profit flows and determine whether, indeed, it will add to the value of the firm. Value maximization is a compelling prescription concerning how managerial Business Behavior: Maximizing Value decisions should be made. Although this tenet is a useful norm in describing actual managerial behavior, it is not a perfect yardstick. After all, large-scale firms consist of many levels of authority and myriad decision makers. Even if value maximization is the ultimate corporate goal, actual decision making within this complex organization may look quite different. There are several reasons for this: 1. Managers may have individual incentives (such as job security, career advancement, increasing a division’s budget, resources, power) that are at odds with value maximization of the total firm. For instance, it sometimes is claimed that company executives are apt to focus on short-term value maximization (increasing next year’s earnings) at the expense of long-run firm value. 2. Managers may lack the information (or fail to carry out the analysis) necessary for value-maximizing decisions. 3. Managers may formulate but fail to implement optimal decisions. Although value maximization is the standard assumption in managerial economics, three other decision models should be noted. The model of satis- ficing behavior posits that the typical firm strives for a satisfactory level of per- formance rather than attempting to maximize its objective. Thus, a firm might aspire to a level of annual profit, say 40 million, and be satisfied with policies that achieve this benchmark. More generally, the firm may seek to achievec01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 14 14 Chapter 1 Introduction to Economic Decision Making acceptable levels of performance with respect to multiple objectives (prof- itability being only one such objective). A second behavioral model posits that the firm attempts to maximize total sales subject to achieving an acceptable level of profit. Total dollar sales are a visible benchmark of managerial success. For instance, the business press puts 4 particular emphasis on the firm’s market share. In addition, a variety of stud- ies show a close link between executive compensation and company sales. Thus, top management’s self-interest may lie as much in sales maximization as in value maximization. A third issue centers on the social responsibility of business. In modern capitalist economies, business firms contribute significantly to economic wel- fare. Within free markets, firms compete to supply the goods and services that consumers demand. Pursuing the profit motive, they constantly strive to pro- duce goods of higher quality at lower costs. By investing in research and devel- opment and pursuing technological innovation, they endeavor to create new and improved goods and services. In the large majority of cases, the economic actions of firms (spurred by the profit motive) promote social welfare as well: business production contributes to economic growth, provides widespread employment, and raises standards of living. The objective of value maximization implies that management’s primary responsibility is to the firm’s shareholders. But the firm has other stakeholders as well: its customers, its workers, even the local community to which it might pay taxes. This observation raises an important question: To what extent might management decisions be influenced by the likely effects of its actions on these parties? For instance, suppose management believes that downsizing its work- force is necessary to increase profitability. Should it uncompromisingly pursue maximum profits even if this significantly increases unemployment? Alternatively, suppose that because of weakened international competition, the firm has the opportunity to profit by significantly raising prices. Should it do so? Finally, suppose that the firm could dramatically cut its production costs with the side effect of generating a modest amount of pollution. Should it ignore such adverse environmental side effects? All of these examples suggest potential trade-offs between value maxi- mization and other possible objectives and social values. Although the cus- tomary goal of management is value maximization, there are circumstances in which business leaders choose to pursue other objectives at the expense of some foregone profits. For instance, management might decide that retaining 100 jobs at a regional factory is worth a modest reduction in profit. To sum up, 4 It is fashionable to argue that raising the firm’s current market share is the best prescription for increasing long-run profitability. In particular circumstances (for instance, when learning-curve effects are important), share increases may indeed promote profitability. But this does not mean that the firm’s ultimate objective is gaining market share. Rather, gaining market share remains a means toward the firm’s ultimate end: maximum value. (Moreover, in other circumstances, the goals of gaining market share and profitability will be in conflict.)c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 15 Private and Public Decisions: An Economic View 15 value maximization is not the only model of managerial behavior. Nonetheless, the available evidence suggests that it offers the best description of a private firm’s ultimate objectives and actions. Since 2001, in response to growing international outcries, major American and Lower Drug Prices in Africa European pharmaceutical companies have dramatically reduced the prices of AIDS drugs in Africa. Drug companies such as Abbott Laboratories, Bristol- Myers Squibb Co., GlaxoSmithKline PLC, and Merck & Co. have variously pledged to cut prices by 50 percent or more, sell the drugs at or below cost, or 5 in some cases even supply the drugs for free. In 2005, Glaxo offered its pow- erful cocktail of AIDS drugs at a price of 1,300 per year in Africa (whereas the price was greater than 11,000 in the United States). Since then, there have been two further rounds of price cuts. The problem of health and disease in the developing world presents a stark conflict between the private profit motive and social welfare. The outbreak of disease in sub-Saharan Africa is considered to be the world’s number one health problem. Some 30 million African inhabitants are infected with HIV, the virus that causes AIDS. Millions of others suffer from a host of tropical dis- eases including malaria, river blindness, and sleeping sickness. However, global pharmaceutical companies have little profit incentive to invest in drugs for tropical diseases since those afflicted are too poor to pay for the drugs. Given the enormous R&D costs (not to mention marketing costs) of commercializing new drugs, multinational companies maximize their profits by selling drugs at high prices to high-income nations. Over the last decade, such groups as the World Health Organization, Doctors without Borders, and national govern- ments of developing countries have argued for low drug prices and abundant drug supplies to deliver the greatest possible health benefits. For many years, multinational drug companies made some price concessions but otherwise dragged their feet. What accounts for the dramatic change in the drug companies’ position since the turn of the millennium? Pharmaceutical executives professed their willingness to cut prices and therefore sacrifice profit only after being con- vinced of the magnitude of Africa’s health problem. In addition, the “volun- tary” cuts in drug prices were spurred by two other factors. First was the competitive threat of two Indian companies that already were promoting and selling generic (copycat) versions of a host of AIDS drugs and other drugs in Africa. Second, several national governments, notably South Africa, threatened to revoke or ignore drug patents. (From the 1970s to the present, the Indian 5 This account is based on many published reports including, “Glaxo Cuts Price of HIV Drugs for World’s Poorest Countries,” The Wall Street Journal, February 20, 2008, p. D7; “A Gathering Storm,” The Economist, June 9, 2007, p. 71; “AIDS: The End of the Beginning?” The Economist, July 17, 2004, p. 76; and M. Schoofs and M. Waldholz, “AIDS-Drug Price War Breaks Out in Africa, Goaded by Generics,” The Wall Street Journal, March 7, 2001, p. A1.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 16 16 Chapter 1 Introduction to Economic Decision Making government has refused to acknowledge international drug patents.) In return for the companies’ recent price concessions, the World Health Organization has reaffirmed the validity of the companies’ patents. In addition, recognizing the severity of the AIDS epidemic, the World Trade Organization extended until 2016 the transition period during which developing countries could be exempt from patent requirements of certain pharmaceuticals. In short, the major multinational drug companies seem willing to make selective price cuts (they are unwilling to cut prices for the poor in industrial economies) in return for patent assurances. In recent years, however, conflicts have reemerged as “middle-income” countries such as Thailand and Brazil have said they would overrule pharmaceutical patents for a number of AIDS drugs. Dramatic cuts in drug prices are but a first step. For instance, cutting the cost per patient per year from 1,000 to 200 for a combination dose of anti- AIDS medication is a strong achievement. But to be truly affordable in the poorest nations, the cost would need to be reduced to about 50 per person per year. In addition, the ultimate solution for the health crisis in developing nations will require additional initiatives such as (1) resources for more doctors and hospitals as well as for disease prevention and drug distribution, (2) improved economic conditions, education, and in many regions the end of civil war, and (3) monetary aid from world health organizations and foreign governments. Public Decisions In government decisions, the question of objectives is much broader than sim- ply an assessment of profit. Most observers would agree that the prupose of public decisions is to promote the welfare of society, where the term society is meant to include all the people whose interests are affected when a particular decision is made. The difficulty in applying the social welfare criterion in such a general form is that public decisions inevitably carry different benefits and costs to the many groups they affect. Some groups will gain and others will lose from any public decision. In our earlier example of the bridge, businesses and commuters in the region can expect to gain, but nearby neighbors who suffer extra traffic, noise, and exhaust emissions will lose. The program to convert utilities from oil to coal will benefit the nation by reducing our dependence on foreign oil. However, it will increase many utilities’ costs of producing elec- tricity, which will mean higher electric bills for many residents. The accompa- nying air pollution will bring adverse health and aesthetic effects in urban areas. Strip mining has its own economic and environmental costs, as does nuclear power. In short, any significant government program will bring a vari- ety of new benefits and costs to different affected groups. The important question is: How do we weight these benefits and costs to make a decision that is best for society as a whole? One answer is provided byc01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 17 Private and Public Decisions: An Economic View 17 benefit-cost analysis, the principal analytical framework used in guiding public decisions. Benefit-cost analysis begins with the systematic enumeration of all of the potential benefits and costs of a particular public decision. It goes on to measure or estimate the dollar magnitudes of these benefits and costs. Finally, it follows the decision rule: Undertake the project or program if and only if its total benefits exceed its total costs. Benefit-cost analysis is similar to the profit calculation of the private firm with one key difference: Whereas the firm con- siders only the revenue it accrues and the cost it incurs, public decisions account for all benefits, whether or not recipients pay for them (that is, regard- less of whether revenue is generated) and all costs (direct and indirect). Much of economic analysis is built on a description of ultrarational self- Behavioral Economics interested individuals and profit-maximizing businesses. While this framework does an admirable job of describing buyers and sellers in markets, workers interacting in organizations, and individuals grappling with major life-time decisions, we all know that real-world human behavior is much more compli- cated than this. The ultrarational analyzer and calculator (Mr. Spock of Star Trek) is an extreme type, a caricature. Over the last 25 years, research in behavioral economics has shown that beyond economic motives, human actions are shaped by psychological factors, 6 cognitive constraints, and altruistic and cooperative motives. For instance, credit card use encourages extra spending because it is psychologically less painful to pay on credit than to part with cold cash. Many of us, whether age 5 or 45, lack the foresight, self-control, and financial acumen to plan for and save enough for retirement. And not all our actions are governed by dollars and cents. I’m happy to snow-blow the driveway of the elderly widow next door (because it is the right thing to do), and she is happy to look after my kids in a pinch. Neighbors help neighbors; altruism and reciprocity are the norm alongside everyday monetary transactions. Similarly, nonprofit businesses, charitable organizations, and cooperative ventures coexist with profit-maximizing firms. Each of these organizations must pass its own benefit-cost test. Though it is not seeking a profit, the nonprofit entity must be able to deliver goods or services that fulfill a real need, while cov- ering its costs so as to break even. If not well run, a charitable organization will see its mission compromised and, indeed, may fail altogether. Twin lessons emerge from behavioral economics. On the one hand, per- sonal and business decisions are frequently marked by biases, mistakes, and pitfalls. We’re not as smart or as efficient as we think we are. On the other, deci- sion makers are capable of learning from their mistakes. Indeed, new meth- ods and organizations—distinct from the traditional managerial functions of 6 For a discussion of behavioral economics, see D. Kahnman, “Maps of Bounded Rationality: Psychology for Behavioral Economics,” The American Economic Review (September 2003): p. 1,449–1,475; and D. Brooks, “The Behavioral Revolution,” The New York Times, October 28, 2008, p. A23.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 18 18 Chapter 1 Introduction to Economic Decision Making private firms or the policy initiatives of government institutions—are emerging all the time. Philanthropic organizations with financial clout (the largest being the Bill and Melinda Gates Foundation with 36 billion in assets) play an influ- ential role in social programs. Organizations that promote and support open- source research insist that scientists make their data and findings available to all. When it comes to targeted social innovations (whether in the areas of poverty, obesity, delinquency, or educational attainment), governments are increasingly likely to partner with profit and nonprofit enterprises to seek more efficient 7 solutions. THINGS TO COME Figure 1.2 presents a schematic diagram of the topics and decision settings to come. As the figure indicates, the central focus of managerial economics is the private firm and how it should go about maximizing its profit. Chapters 2 and 3 begin the analysis by presenting a basic model of the firm and considering the case of profit maximization under certainty, that is, under the assumption that revenues and costs can be predicted perfectly. Specifically, the chapters show how the firm can apply the logic of marginal analysis to determine optimal out- puts and prices. Chapters 3 and 4 present an in-depth study of demand analy- sis and forecasting. Chapters 5 and 6 present analogous treatments of production and cost. The firm’s strategy for resource allocation using linear programming is deferred to Chapter 17. Chapters 7 through 11 focus on market structure and competitive analysis and constitute the second major section of the text. This discussion stresses a key point: The firm does not maximize profit in a vacuum; rather, the market environment it inhabits has a profound influence on its output, pricing, and profitability. Chapters 7 and 8 present overviews of perfect competition and pure monopoly, while Chapter 9 examines the case of oligopoly and provides a rich treatment of competitive strategy. Chapter 10 applies the discipline of game theory to the analysis of strategic behavior. Chapter 11 considers the regulation of private markets and government provision of goods and services. These topics are particularly important in light of the divergent views of government held by the “person on the street.” Some see government as the essential engine to promote social welfare and to check private greed. Others call for “less” government, insisting that “for every action, there is an equal and opposite government regulation.” Our discus- sion does not settle this dispute. But it does introduce the discipline of bene- fit-cost analysis to help evaluate how well government programs and regulations function. 7 Social innovation is discussed by L. Lenkowsky, “The Do-Good Marketplace,” The Wall Street Journal, January 2, 2009, p. A13; and “Social Innovation,” The Economist, August 14, 2010, pp. 55–57.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 19 Things to Come 19 FIGURE 1.2 Topics in Managerial Economics Demand Analysis and Forecasting This flow chart shows Competitive Analysis (Chapters 3 and 4) the relationship and Market Structure among the main topics (Game Theory) Cost Analysis in managerial econom- (Chapters 7, 8, 9, and 10) (Chapters 5 and 6) ics: decisions of the firm, market structure, decisions under uncer- tainty, and govern- ment decisions. The Firm (Profit Analysis) (Chapters 2, 3, and 17) Regulation Decision Making under Uncertainty Government (Chapters 12 and 13) Decisions: Public Goods and Special Topics: Regulation Asymmetric Information, (Benefit-Cost Analysis) Negotiation, and (Chapter 11) Competitive Bidding (Chapters 14, 15, and 16) Chapters 12 and 13 extend the core study of management decisions by incorporating risk and uncertainty. Managerial success, whether measured by a particular firm’s long-run profitability or by the international competitive- ness of our nation’s businesses as a whole, increasingly depends on making decisions involving risk and uncertainty. Managers must strive to envision the future outcomes of today’s decisions, measure and weigh competing risks, and determine which risks are acceptable. Chapter 12 shows how decision trees can be used to structure decisions in high-risk environments. Chapter 13 examines the value of acquiring information about relevant risks prior to making impor- tant decisions. Chapters 14, 15, and 16 present thorough analyses of four top- ics that are on the cutting edge of managerial economics and are of increasing importance to managers: asymmetric information, organizational design, nego- tiation, and competitive bidding.c01IntroductiontoEconomicDecisionMaking.qxd 8/18/11 6:46 PM Page 20 20 Chapter 1 Introduction to Economic Decision Making The Aim of This Book This book takes a prescriptive approach to managerial decisions; that is, it focuses on how managers can use economic analysis to arrive at optimal decisions. The aim of the prescriptive approach is to aid in solving important and difficult real-world decisions. One often hears the complaint, “That’s fine in theory, but 8 it wouldn’t work in practice.” There is some validity to this objection; yet, in our view, the criticism misses the main point. To be useful, decision-making principles must be applicable to actual business behavior. In the course of our discussion, we will make frequent reference to the actual practice of managerial decision making—the customary methods by which business and government decisions are made. We need hardly point out that managerial practices frequently differ from our prescriptions. After all, if managers (and future managers like yourself) were always able to analyze per- fectly the complex choices they face, there would be little need for texts like this one. Actual managerial practice changes slowly. Many methods and practices accepted as essential by today’s managers were unknown or untried by man- agers of earlier generations. These include many of the core decision methods of this book: optimal pricing and market segmentation, econometric forecast- ing, competitive analysis using game theory, benefit-cost analysis, and resource allocation via linear programming. The challenge of the prescriptive approach is to improve current and future practices. The value of a careful decision analysis is especially clear when one con- siders the alternatives. Individuals and managers have a host of informal ways of making decisions: relying on intuitive judgments, common sense, company policies, rules of thumb, or past experience, to name a few. In many cases these informal approaches lead to sound decisions, but in others they do not. For instance, one’s intuitive judgments frequently are misleading or unfounded. A company’s traditional rules of thumb may be inappropriate for many of the problems the firm currently faces. Often an optimal decision requires uncom- mon sense. For some managers (a small group, we hope), 10 years of experience may be equivalent to making first-year mistakes 10 times over. A choice inspired by company policy or past experience should be checked against the logic of a careful analysis. Has the manager kept clear sight of the essentials—the objec- tives and alternative courses of action? Has he or she evenhandedly considered all the economic factors, pro and con? How would the manager explain and jus- tify his or her decision to others? A careful analysis that relies on the six steps defined earlier will provide the answers to just such questions. A final advantage of the prescriptive approach is its emphasis on keeping things simple. A decision maker cannot consider everything. If he or she tried 8 In many cases, the prescriptive approach turns this criticism on its head by asking, “That’s fine in practice, but does it make sense in theory?” In other words, is current practice the best way of mak- ing decisions, or could it be improved?

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