Managerial Economics

CHAPTER 2: ECONOMIC DECISION MAKING

ECONOMIC DECISION
MAKING Step 2. Determine the Objective
The best way to become acquainted with What is the decision maker’s goal?
managerial economics is to come face to face How should the decision maker value
with real-world decision-making problems. outcomes with respect to this goal? What if
Every decision can be framed and analyzed he or she is pursuing multiple, conflicting
using a common approach based on six objectives? When it comes to economic
steps, as Figure below indicates. decisions, it is a truism that “you can’t
The Basic Steps in Decision Making always get what you want.” But to make any
The process of decision making can be progress at all in your choice, you have to
broken down into six basic steps know what you want. In most private-sector
decisions, profit is the principal 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.

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. 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. The presence of risk and uncertainty
has a direct bearing on the way the decision
maker thinks about his or her objective.

Step 1. Define the Problem Step 3. Explore the Alternatives

What is the problem the manager What are the alternative courses of
faces? Who is the decision maker? What is action? What are the variables under the
the decision setting or context, and how does decision maker’s control? What constraints
it influence managerial objectives or options? limit the choice of options? After addressing
the question “What do we want?” it is natural
Decisions do not occur in a vacuum. to ask, “What are our options?” Given human
Many come about as part of the firm’s limitations, decision makers cannot hope to
planning process. Others are prompted by identify and evaluate all possible options.
new opportunities or new problems. It is Still, one would hope that attractive options
natural to ask, what brought about the need would not be overlooked or, if discovered, not
for the decision? What is the decision all mistakenly dismissed. Moreover, a sound
about? A key part of problem definition decision framework should be able to
involves identifying the context. Most of the uncover options in the course of the analysis.
decisions we study take place in the private
sector. Managers representing their Most managerial decisions involve
respective firms are responsible for the more than a once-and-for-all choice from
decisions made. among a set of options. Typically, the
manager faces a sequence of decisions from
among alternatives. In view of the myriad
uncertainties facing managers, most ongoing
decisions should best be viewed as
contingent plans.
Step 4. Predict the Consequences Step 6: Perform Sensitivity Analysis
What are the consequences of each What features of the problem
alternative action? Should conditions change, determine the optimal choice of action? How
how would this affect outcomes? If outcomes does the optimal decision change if
are uncertain, what is the likelihood of each? conditions in the problem are altered? Is the
Can better information be acquired to predict choice sensitive to key economic variables
outcomes? Depending on the situation, the about which the decision maker is uncertain?
task of predicting the consequences may be
straightforward or formidable. Sometimes In tackling and solving a decision
elementary arithmetic suffices. For instance, problem, it is important to understand and be
the simplest profit calculation requires only able to explain to others the “why” of your
subtracting costs from revenues. The choice decision. The solution, after all, did not come
between two safety programs might be made out of thin air. It depended on your stated
according to which saves the greater number objectives, the way you structured the
of lives per dollar expended. Here the use of problem (including the set of options you
arithmetic division is the key to identifying considered), and your method of predicting
the preferred alternative. outcomes. Thus, sensitivity analysis
considers how an optimal decision is affected
if key economic facts or conditions vary.
Step 5. Make a Choice
After all the analysis is done, what is
the preferred course of action? Once the MODELS
decision maker has put the problem in In more complicated situations,
context, formalized key objectives, and however, the decision maker often must rely
identified available alternatives, how does he on a model to describe how options translate
or she go about finding a preferred course of into outcomes. A model is a simplified
action? description of a process, relationship, or
other phenomenon. By deliberate intent, a
In most decisions, the objectives and model focuses on a few key features of a
outcomes are directly quantifiable. Thus, a problem to examine carefully how they work
private firm (such as the carmaker) can while ignoring other complicating and less
compute the profit results alternative price important factors. The main purposes of
and output plans. Analogously, a government models are to explain and to predict—to
decision maker may know the computed net account for past outcomes and to forecast
benefits (benefits minus costs) of different future ones.
program options. The decision maker could
determine a preferred course of action by Other models rest on statistical, legal,
enumeration, that is, by testing several and scientific relationships. The construction
alternatives and selecting the one that best and configuration of the new bridge (and its
meets the objective. This is fine for decisions likely environmental impact) and the plan to
involving a small number of choices, but it is convert utilities to coal depend in large part
impractical for more complex problems. on engineering predictions. Evaluations of
Expanding the enumerated list could reduce test-marketing results rely heavily on
this risk, but at considerable cost. statistical models. Legal models,
interpretations of statutes, precedents, and
Fortunately, the decision maker need the like are pertinent to predictions of a
not rely on the painstaking method of firm’s potential patent liability and to the
enumeration to solve such problems. A outcome in other legal disputes.
variety of methods can identify and cut
directly to the best, or optimal, decision. Key distinction can be drawn between
These methods rely to varying extents on deterministic and probabilistic models. A
marginal analysis, decision trees, game deterministic model is one in which the
theory, benefit-cost analysis, and linear outcome is certain (or close enough to a sure
programming. These approaches are thing that it can be taken as certain) while a
important not only for computing optimal probabilistic model accounts for a range of
decisions but also for checking why they are possible future outcomes, each with a
optimal. probability attached.
 of describing buyers and sellers in markets,
workers interacting in organizations, and
2.1 Public Decisions: individuals grappling with major life-time
decisions, we all know that real-world human
Economic View behavior is much more complicated than this.
In government decisions, the question
of objectives is much broader than simply an Twin lessons emerge from behavioral
assessment of profit. Most observers would economics. On the one hand, personal and
agree that the purpose of public decisions is business decisions are frequently marked by
to promote the welfare of society, where the biases, mistakes, and pitfalls. We are not as
term society is meant to include all the smart or as efficient as we think we are. On
people whose interests are affected when a the other, decision makers are capable of
particular decision is made. The difficulty in learning from their mistakes. Indeed, new
applying the social welfare criterion in such a methods and organizations—distinct from the
general form is that public decisions traditional managerial functions of private
inevitably carry different benefits and costs firms or the policy initiatives of government
to the many groups they affect. Some groups institutions—are emerging all the time.
will gain, and others will lose from any public Philanthropic organizations with financial
decision. In our earlier example of the bridge, clout play an influential role in social
businesses and commuters in the region can programs. Organizations that promote and
expect to gain, but nearby neighbors who support opensource research insist that
suffer extra traffic, noise, and exhaust scientists make their data and findings
emissions will lose. The program to convert available to all. When it comes to targeted
utilities from oil to coal will benefit the nation social innovations (whether in the areas of
by reducing our dependence on foreign oil. poverty, obesity, delinquency, or educational
However, it will increase many utilities’ costs attainment), governments are increasingly
of producing electricity, which will mean likely to partner with profit and nonprofit
higher electric bills for many residents. The enterprises to seek more efficient solutions.
accompanying 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.
Decision within Firms:
In short, any significant government program Profit-Maximization
will bring a variety of new benefits and costs The main goal of a firm’s managers is
to different affected groups. to maximize the enterprise’s profit – either
for its private owners or for its shareholders.
The important question is: How do we This goal implies that decisions that increase
weigh these benefits and costs to make a revenues to be more than costs or reduce
decision that is best for society as a whole? costs to be less than revenues, should be
One answer is provided by benefit-cost selected. This goal will be analyzed using
analysis, the principal analytical framework demand forecasting techniques, marginal
used in guiding public decisions. Benefit-cost analysis, cost analysis, and pricing
analysis begins with the systematic techniques which will be discussed on the
enumeration of all the potential benefits and following chapters.
costs of a particular public decision. It goes
on to measure or estimate the dollar Managerial economics is based on a
magnitudes of these benefits and costs. model of the firm: how firms behave and
Finally, it follows the decision rule: Undertake what objectives they pursue. The main
the project or program if and only if its total principle of this model, or theory of the firm,
benefits exceed its total costs. Benefit-cost is that management strives to maximize the
analysis is similar to the profit calculation of firm’s profits. This objective is unambiguous
the private firm with one key difference: for decisions involving predictable revenues
Whereas the firm considers only the revenue and costs occurring during the same period
it accrues and the cost it incurs, public of time. However, a more precise profit
decisions account for all benefits, whether or criterion is needed when a firm’s revenues
not recipients pay for them (that is, and costs are uncertain and
regardless of whether revenue is generated) accrue at different times in the future. The
and all costs (direct and indirect). most general theory of the firm states that
“Management’s primary goal is to maximize
Much of economic analysis is built on a the value of the firm”.
description of ultrarational self-interested
individuals and profit-maximizing businesses. The firm’s value is defined as the
While this framework does an admirable job present value of its expected future profits.
Thus, in making any decision, the manager pursue maximum profits even if this
must attempt to predict its impact on future significantly increases unemployment?
profit flows and determine whether, indeed, it Alternatively, suppose that because of
will add to the value of the firm. Although weakened international competition, the firm
value maximization is the standard has the opportunity to profit by significantly
assumption in managerial economics, three raising prices. Should it do so? Finally,
other decision models should be noted. The suppose that the firm could dramatically cut
model of satisficing behavior posits that its production costs with the side effect of
the typical firm strives for a satisfactory level generating a modest amount of pollution.
of performance rather than attempting to Should it ignore such adverse environmental
maximize its objective. Thus, a firm might side effects?
aspire to a level of annual profit, say $40
million, and be satisfied with policies that All of these examples suggest potential
achieve this benchmark. More generally, the trade-offs between value maximization and
firm may seek to achieve acceptable levels of other possible objectives and social values.
performance with respect to multiple Although the customary goal of management
objectives (profitability being only one such is value maximization, there are
objective). circumstances in which business leaders
A second behavioral model posits that choose to pursue other objectives at the
the firm attempts to maximize total sales expense of some foregone profits. For
subject to achieving an acceptable level of instance, management might decide that
profit. Total dollar sales are a visible retaining 100 jobs at a regional factory is
benchmark of managerial success. For worth a modest reduction in profit. To sum
instance, the business press puts particular up, value maximization is not the only model
emphasis on the firm’s market share. In of managerial behavior. Nonetheless, the
addition, a variety of studies show a close available evidence suggests that it offers the
link between executive compensation and best description of a private firm’s ultimate
company sales. Thus, top management’s self- objectives and actions.
interest may lie as much in sales
maximization as in value maximization.
Optimal Decision using
A third issue centers on the social
responsibility of business. In modern Marginal Analysis
capitalist economies, business firms Marginal analysis is a method used to
contribute significantly to economic welfare. determine the optimal output level that will
Within free markets, firms compete to supply maximize the firm’s profit. looks at the
the goods and services that consumers change in profit that results from making a
demand. Pursuing the profit motive, they small change in a decision variable. We will
constantly strive to produce goods of higher look once again at the two components of
quality at lower costs. By investing in profit, revenue, and cost, and highlight the
research and development and pursuing key features of marginal revenue and
technological innovation, they endeavor to marginal cost. These marginal
create new and improved goods and services. measurements not only provide a numerical
In the large majority of cases, the economic value to the responsiveness of the function to
actions of firms (spurred by the profit motive) changes in the quantity but also can indicate
promote social welfare as well: business whether the business would benefit from
production contributes to economic growth, increasing or decreasing the planned
provides widespread employment, and raises production volume and in some cases can
standards of living. even help determine the optimal level of
planned production. The marginal revenue
The objective of value maximization measures the change in revenue in response
implies that management’s primary to a unit increase in production level or
responsibility is to the firm’s shareholders. quantity. The marginal cost measures the
But the firm has other stakeholders as well: change in cost corresponding to a unit
its customers, its workers, even the local increase in the production level. The marginal
community to which it might pay taxes. This profit measures the change in profit resulting
observation raises an important question: To from a unit increase in the quantity. Marginal
what extent might management decisions be measures for economic functions are related
influenced by the likely effects of its actions to the operating volume and may change if
on these parties? For instance, suppose assessed at a different operating volume
management believes that downsizing its level.
workforce is necessary to increase
profitability. Should it uncompromisingly Marginal revenue (MR) is the extra
 revenue that an additional unit of product will The firm also expects an
bring to the firm. It can also be described as increase in the demand for
the change in total revenue over the change grilled chicken considering that
in the number of units sold (from Q0 to Q1). many households also use an
This can be expressed as: electric powered stove and
buying cooked meat will be their
Change∈Revenue ∆ R alternative.
Marginal Revenue = = =
Change∈Output ∆Q
R 1−R0 Define the
Q1−Q0 Problem

Marginal cost (MC) is the additional cost of

producing an extra unit of output. The algebraic
definition is: Determine the
Objective
Change∈Cost ∆ C C 1−C 0
Marginal Cost = = =
Change∈Output ∆ Q Q1−Q0
Explore the
In general terms, marginal cost at each level
Alternatives
of production includes any additional costs required
to produce next time. For instance, if producing
additional vehicle requires building new factory, the
marginal cost of those extra vehicles includes the
cost of the new factory. In practice, the analysis is Predict the
segregated into short-run and long-run cases where Consequences
marginal costs include all costs which vary with the
level of production and other costs are considered
fixed costs. This concept will be discussed further in
Chapter 6. Make a Choice

Profit maximization of the firms will be

realized when optimal output is determined. Profit
maximization assumes that there is some output Perform
level that is most profitable. A firm might sell huge Sensitivity
amount at very low prices but discover that profits Analysis
are low or negative. To avoid this, a firm should sell
output and charge price at MR = MC. This condition
is called MR=MC rule. At this quantity, the slopes of
the revenue and cost functions are equal; the 2. How do you see the partnership between
revenue tangent is parallel to the cost line. But this government and private firms in producing public
simply says that marginal revenue equals marginal goods? Does it convert to efficiency of the government
cost. At this optimal output, the gap between programs? Justify your answer.
revenue and cost is neither widening nor narrowing.
Thus, maximum profit is attained. ___________________________________________
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Assessment 2
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1. Complete the chart below by using the steps of the ___________________________________________
economic decision making. ___________________________________________
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The ABCD Grill House is
selling an average of 200 units
of grilled whole chicken per day
using the electric griller but
Situation there will be an electric
interruption within the area
during their operating hours and
so, it will affect their grilled
chicken production for that day.