CHAPTER ONE
INTRODUCTION TO ECONOMIC
DECISION MAKING
OBJECTIVES
1. To introduce Managerial Economics and provide concrete examples of
managerial decisions
2. To provide a framework for analyzing decisions (Six Steps to Decision
Making)
4. To compare decisions of the private firm (where maximum profit is the
objective) to public sector decisions (where maximum societal net
benefit is the objective). (Private and Public Decisions)
5. To introduce the student to the book and its organization. (Things to
Come)
TEACHING SUGGESTIONS
I. Introduction and Motivation
The chapter begins by stressing concrete applications of managerial
economics (the eight examples) rather than speaking generally about topics
and methods. Our practice in class is to lead a brief discussion of some of
the text examples (the three we like best) augmented with additional
representative examples from the current business press.
A. Additional questions on text examples:
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1. Multinational Production and Pricing (Revisited in Chapter 3 and in
Problem S2 (global production of microchips) of Chapter 6). Why
might the company want to charge different prices home and abroad?
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(What if the company had to charge the same price because of
anti-dumping restrictions?) Why might it want to ship output overseas?
2. Market Entry (Revisited in Chapter 10). In a market that can support
only one store, is there an advantage to being the first in? Are there
strategic advantages to commitment? (Here you might tell the story of
the game of chicken. Any advantage if one driver pulls off the steering
wheel and throws it out the window?) How might an office supply
store commit? What if both commit? (Both throw their steering wheels
out the window?)
3. Building a New Bridge. (Revisited in Chapter 11). Building a bridge is
usually a public responsibility (paid for out of public funds raised via
taxes). Why is this the case? How might a public planner determine the
need for a new bridge? How should tolls (if any) be set?
4. A Regulatory Problem (Revisited in Chapter 11). Does regulation put
too great a cost burden on business? How should the benefits of
environmental regulation be weighed against the costs?
5. BP and the Risks of Oil Exploration (Revisited in Chapter 12.) How
can BP identify and quantify crucial risk factors? What measures (and
at what cost) can it take to reduce or manage key risks?
6. An R&D Decision (Revisited in Chapter 12). Might the
pharmaceutical company be wise to pursue both R&D methods
simultaneously?
7. Wooing David Letterman (Revisited in Chapter 15). What bargaining
strategy should Letterman adopt to get the best deal? How can a
value-maximizing deal be achieved?
B. Additional Vignettes. A good way to spice up the discussion is to
(1) preview decision examples from later chapters or (2) take examples
from chapters that are not assigned. Here are some suggestions.
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• Airline price discrimination (Chapter Three)
• Introducing New Coke (Chapter Four)
• Euro Disney (Chapter Four)
• The OPEC Cartel (Chapter Eight)
• Battle for Air Passengers (Chapter Ten)
• Regulating AZT (Chapter Eleven)
• An Oil Wildcatter (Chapter Twelve)
• Predicting Credit Risks (Chapter Thirteen)
• Constructing an Optimal Portfolio (Chapter Sixteen)
I. Teaching the “Nuts and Bolts”
A. Issues deserving extra emphasis
1. The meaning of economic tradeoffs:
• benefits versus costs.
• short-term profit versus long-term profit.
• risk versus return.
• tradeoffs among multiple objectives (For example in auto
regulation: safety vs. emission reduction vs. fuel economy
2. The virtues of simple models (predictive models, the model of the
firm)
3. Coming to grips with uncertainty
B. The six decision steps mostly speak for themselves. (In our
experience,
students find them relatively easy to grasp.) The instructor may wish to
reemphasize them by discussing some of the steps in class.
Alternatively, the six steps can be applied by discussing the decision
vignettes in question 4 at the end of the chapter. In each instance, did
the individual make a faulty decision? If so, in what step(s) did he or
she go wrong? (See answers below).
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C. Guinea Pig Questions. One way of previewing a number of upcoming
topics in the course is to present a number of short, so-called “guinea
pig” questions. Students meet these questions “cold” without any
advanced background or preparation. The main idea is to challenge
them to think about possible solutions. By necessity, they usually rely
on their general judgment or intuition rather than on any systematic
analysis. (It’s a good idea for the teacher to tell the students that the
questions are in some sense “unfair”; students don’t have enough
information find the best solution. But neither do managers in real-life
business decisions.)
1. Locating a Shopping Mall. (Instructor’s online site, Chapter Two).
2. Finding the Best Item (Instructor’s online site, Chapter Thirteen).
Suppose that you will be shown three “prizes” in order. Ahead of time,
you know absolutely nothing about how valuable the prizes might be.
Only after viewing all three can you determine which you like best.
You are shown the prizes in order and are allowed to select one.
However, there is no “going back.” You must select a prize
immediately after seeing it, and before seeing any subsequent prize.
a) Your sole objective is to obtain the best of the three prizes. (Second
best doesn’t count.) A random selection provides a one-third chance
of getting the best prize. Find a strategy that provides a strictly
greater chance (and compute the actual chance).
b) What if there are a large number of prizes (say 10, 50, or 100)?
Describe in general terms the kind of strategy you might use.
3. Let’s make a Deal (Chapter Thirteen, Problem 6). Consider the
following simplified version of the game “Let’s Make a Deal.” There is
a grand prize behind one of three curtains. The other two curtains are
empty. As the contestant, you get to choose a curtain at random. Let’s
say you choose curtain three. Before revealing what’s behind the
curtain, the game show host offers to show you what’s behind one of the
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other curtains. Suppose he shows you that curtain two is empty. In
fact, he always shows you an empty curtain. (You know that’s how the
game works, the audience knows it, everybody knows it.) Now you
must decide: do you stick with your original choice, curtain three, or
switch to curtain one? Which action gives you the better chance of
finding the grand prize?
4. A Competitive Decision. Consider the following game involving two
players. The players will alternate choosing the nine integers: 1, 2, 3, 4,
5, 6, 7, 8, 9. If the first player picks 4 (let’s say), the second player can
choose any one of the remaining digits, and so on. The first player that
obtains three digits that add up to exactly 15 wins. For instance, the
first player wins with the digits, 2, 3, 6, and 7 since 2 + 6 + 7 = 15. He
would not win with 6, 7, 8, and 9 since no three of them add up to 15.
Ask for two volunteers to play this game (with the rest of the class free
to kibitz). Questions to think about: How would you play? Is it an
advantage to move first? What well-known game does this number
game resemble?
D. Discussion of Guinea Pig Questions. Though these questions are
deliberately set in non-business situations, almost all have interesting
business counterparts. Question 1 demonstrates marginal analysis.
Questions 2 and 3 involve decisions under uncertainty. Question 4 is a
competitive decision.
1. Siting a Shopping Mall. For discussion, see Instructor’s Manual,
Chapter Two, also the Instructor’s Online Site, Chapter Two.
2. Finding the Best Item. For an arbitrary number of items (not only
three), this is variously called the “secretary problem” (interviewing
and selecting the best secretary), the “hotel problem” (deciding to stop
at one of three hotels situated hours apart along a cross-country route),
or the “art gallery problem” (in the gallery you are allowed to view
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paintings one at a time and choose only one, without going back). Your
best strategy is as follows:
Observe the first item but bypass it. Then, select the second item only if
it is better than the first. If it isn’t, go on to the third item and select it.
This plan delivers the best item with probability 1/2, the second-best
item with probability 1/3, and the worst item with probability 1/6. Here
are the six equally likely orders in which the items might appear:
First Item: best best 2nd best 2nd best worst worst
Second Item: 2nd best worst best worst best 2nd best
Third Item: worst 2nd best worst best 2nd best best
The bold-faced outcomes show the result of using the “wait and see”
strategy. As shown, the strategy delivers three bests, two 2nd bests, and
one worst. For more on generalizations of this example, see Chapter
Thirteen of this instructor’s manual.
3. Let’s make a Deal. Almost all students (if they have not seen the
problem before) believe that either curtain offers a 50-50 chance of
having the prize. This is incorrect. In fact, the chance is one-third that
the grand prize is behind your chosen curtain and two-thirds that it’s
behind the other curtain. After all, choosing your original curtain at
random offers a one-third winning chance. The fact that you are shown
an empty curtain does not change this prior probability (although it does
eliminate one curtain from consideration). Since your winning chances
are 1/3 if you “stick”, you should switch and gain a 2/3 winning chance.
Many students will still be unconvinced by this argument. One
response is to challenge students (in pairs) to simulate the setup for
themselves. The simulation could mean shuffling 2 black playing cards
and one red card (the prize), and playing 60 times. Always “sticking”
with one’s original card after a black card has been revealed will
produce only 20 wins on average. A second argument is to imagine
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that there are 100 curtains and one prize. After a curtain is chosen (say,
curtain 1), the host reveals 98 empty curtains (all but curtain 71). Most
students will easily see that the odds are 99 to 1 in favor of curtain 71
over curtain 1.
This classic problem has been discussed among social scientists
since the mid 1970s and has even made it to the front page of The New
York Times: “Behind Monty Hall’s Doors: Puzzle, Debate, and Answer,”
NYT, July 21, 1991, p. 1. The discussion and analysis are recommended.
Even in the 21st century, the riddle is still going strong.
4. A Competitive Decision. This is a tough game because it involves
mental arithmetic and keeping track of many possibilities. The
“sneaky” way to play this game is by using the following magic square:
816
357
492
In a magic square, all rows, columns, and diagonals add up to the same
number (in this case 15). Using the magic square, we see that the
number game is strategically equivalent to tic tac toe. The ways you
can win in the number game are identical to the ways you can win in tic
tac toe. There are many ways to play either game optimally — block
your opponent whenever he has a potential winning move and never let
him set up two ways to win. The result of optimal play is a draw.
When students play, the first mover often wins because the second
mover is apt to make the first mistake. A typical play of the game might
be: 6, 9, 8, 1, 4, 3, 5, the first player wins with 6 + 4 + 5 = 15.
You can use this game to make two points: (1) Optimal competitive
strategies (see Chapter Ten) often require looking ahead to anticipate
competitors’ moves and counter moves. (2) Often the best way to solve
a new decision problem is to see that it is similar to a problem you
already know how to solve.
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ADDITIONAL MATERIALS
I. Recommended Readings
D. Kahneman, Thinking Fast and Slow, Farrar, Straus, and Giroux
Publishing, New York, 2011.
M. Bazerman and D. Moore, Judgment in Managerial Decision Making,
John Wiley & Sons, 7th edition, 2008 (especially chapters 1, 2 and 9).
J. E. Russo, M. Hittleman, and P. J. Schoemaker. Winning Decisions. New
York: Bantam Dell Publishers, 2001.
J. E. Russo and P. J. Schoemaker, Decision Traps, Fireside Publishing, New
York, 1990.
G. Belsky and T. Gilovich. Why Smart People Make Big Money Mistakes
and How to Correct Them. New York: Simon and Schuster, 2000.
N.R. Augustine, Augustine’s Laws, Penguin Books, 1987. (A nice
commentary on the foibles of managerial decision making)
II. Short Readings
Robert Shiller, “The Rationality Debate, Simmering in Stockholm, The New
York Times, January 19, 2014, p. BU6.
Gardiner Harris and Katie Thomas, “Low-Cost Drugs in Poor Nations Get a
Lift in Indian Court,” The New York Times, April 2, 2013, p. A1.
Carolyn Preston, “Getting Back More than a Warm Feeling,” The New York
Times, November 9, 2012, F1.
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G. Mankiw, “A Course Load in the Game of Life,” The New York Times,
September 5, 2010, p. BU5.
“Let’s Hear those Ideas,” The Economist, August 14, 2010, pp. 55-57.
(This article discusses “social entrepreneurs.”)
R. Frank, “Flaw in Free Markets: Humans,” The New York Times, September
13, 2009, p. BU4.
D. Brooks, “The Behavioral Revolution,” The New York Times, October 28,
2008, p. A23.
R. Trudel and J. Cotte, “Does being Ethical Pay?” The Wall Street Journal,
May 12, 2008, p. R1.
D. A. Garvin and M. A. Roberto, “What You Don’t Know about Making
Decisions,” Harvard Business Review, September 2001, pp. 108-116.
III. Cases
Fighting Aids and Pricing Drugs (9-502-061), Harvard Business School,
2002.
Decision Making at the Top (9-398-061), Harvard Business School, 1997.
Canonical Decision Problems (9-396-308), Harvard Business School, 1997.
Teaching Note (5-396-313)
IV. Quips and Quotes
General maxims about decision making:
There are three valid answers to making a decision: yes, no, or no decision
right now. Only 20% of the answers should be an immediate yes or no.
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Find two good reasons to do something. (You can always find one good
reason.)
When making a decision of minor importance, I have always found it
advantageous to consider all the pros and cons. In vital matters, however,
such as the choice of a mate or a profession, the decisions should come from
the unconscious, from somewhere within ourselves. (Sigmund Freud)
Never, never use intuition (General Omar Bradley)
When asked what he’d done during the terror of the French revolution, Abbe
Sieyes replied, “I survived.” (An example of satisficing?)
If you don’t know where you’re going, chances are you won’t get there.
We never make the same mistake twice. All our blunders are different.
I’d like to rush for 1500 or 2000 yards, whichever comes first. (Former
Washington Redskin running back George Rodgers)
In a choice between two evils, I make it my general rule to choose the one I
haven’t tried yet. (Mae West).
If the only tool you have is a hammer, you tend to see every problem as a
nail.
The real objective of a committee is not to reach a decision but to avoid it.
It is better to know nothing than to know what ain’t so.
A decision is always a choice among alternative perceived images of the
future. (Kenneth E. Boulding)
Economic activity is rational activity . . . it consists firstly in valuation of
ends, and then in the valuation of the means leading to these ends.
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(Ludwig von Mises)
Here is a slightly exaggerated example from an Ann Landers column:
Dear Ann, Our marriage was once so beautiful but things have changed.
My spouse treats me like a slave, never shows any affection, comes home
drunk every night, slaps me around, and may be having an affair with my
best friend. I alternate between loneliness and fear. I have gained weight
and am severely depressed. My life is a living hell and I pray to get
through the next day. Ann, what should I do?
(Ann Landers responded with a question. Are you better off with him or
without him? That is, what are the outcomes associated with each
alternative? Additional query: are these the only alternatives?)
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