CHAPTER 1 INTRODUCTION TO ECONOMIC DECISION MAKING The following table shows the four topic sections of this chapter and the associated study guide problems that pertain to each topic section. Section Topic 1 Introduction Problems M1-M2, S1. 2 Seven Examples of Managerial Decisions Problems M3-M6, L1. 3 Six Steps to Decision Making Problems M7-M11, S2-S5, L2-L4. 4 Private and Public Decisions Problems M12-M15, S6-S8, L5-L7. Multiple Choice M1 The common element in almost all business problems is a. Short-term profit maximization. b. Competitive strategy. c. Market analysis. d. Complete and reliable information. e. Decision making. M2 Managerial economics can best be defined as the a. Analysis of major management decisions using economic tools. b. Economic analysis of internal management functions. c. Comparison of different management styles using economic tools. d. Impact of global economic factors on business. e. Study of economic incentives for managers within organizations. M3 The crux of the pharmaceutical company’s decision involved a. Mutually exclusive R&D programs. b. Choosing one or both of two risky R&D programs. c. Predicting the response of government regulators. d. Beating a close competitor to market. e. Answers b, c, and d are all correct. Managerial Economics Study Guide M4 The decision to build a new bridge illustrates a a. Purely private profit-maximizing decision. b. Setting in which benefit-cost analysis is appropriate. c. Public-sector decision involving little or no uncertainty. d. Public-sector decision involving multiple benefits and costs. e. Answers b and d are both correct. M5 The decision of utilities to convert from oil to coal a. Was nearly impossible due to so many conflicting objectives. b. Was expensive but involved relatively few side effects. c. Involved hard tradeoffs between energy conservation and environmental concerns. d. Was properly left to the utilities themselves. e. Showed that the costs of government regulation can often be greater than the benefits. M6 BP’s oil exploration decisions a. Were largely unsuccessful because new discoveries are few and far between. b. Acknowledged the sizeable underlying risks and put safety first. c. Came under close government scrutiny and regulation. d. Were motivated to increase the firm’s value by expanding its oil reserves. e. Answers c and d are both correct.. M7 Which of the following is not one of the suggested steps in decision making? a. Predicting the consequences. b. Exploring the alternatives. c. Implementing the decision. d. Determining the objective. e. Defining the problem. M8 In public-sector decisions, a government program should be undertaken a. Provided it generates a positive profit. b. Provided its return is worth the risk. c. If both its profit is positive and if total benefits exceed total costs. d. If total benefits exceed total costs, even if the government earns no profit. e. If it provides broad public and social benefits. M9 A sound approach for dealing with risk and uncertainty is to a. Always choose the less risky course of action. b. Envision the possible outcomes and assess their likelihoods. c. Simplify the problem by ruling out very low probability events. d. Postpone decisions until the risks are resolved. e. Insure against most risks Introduction to Economic Decision Making Chapter 1 M10 Sensitivity analysis can best be defined as a. Examining how a decision would change if key facts were altered. b. Being sensitive to the impact of decisions on other variables. c. Measuring results against objectives. d. Judging the margin of error for key data used to make a decision. e. Analyzing tradeoffs among multiple objectives. M11 The findings of behavioral economics indicate that decisions are a. Predominantly ultra-rational. b. Often cooperative... c. Marked by biases and mistakes d. Are mainly governed by monetary considerations. e. Answers b and c are both correct. M12 According to the theory of the firm, the objective of top management a. Is managing the firm’s earnings growth. b. Sometimes involves tradeoffs between profit and other social goals. c. Is primarily maximizing the value of the firm. d. Is maximizing the firm’s long-run sales revenues. e. Answers b and c are both correct. M13 Which of the following is a leading alternative model of managerial behavior? a. Managing the firm’s short-term stock price. b. Maximizing total sales and market share. c. Increasing top management’s compensation. d. Maximizing firm growth organically and by acquisitions. e. Answers b and d are both correct. M14 The example of AIDS drugs in Africa shows that a. Private firms can fashion an effective response to a global problem. b. AIDS deaths stem from poverty and poor medical care. c. Fighting AIDS require both low-cost medicines from drug producers and health resources from government. d. A combination of “carrots and sticks” is necessary to induce drug producers to offer low-priced AIDS drugs. e. Answers b, c, and d are all correct. M15 Making decisions based on experience and intuition a. Offers a sound alternative to analytical decision making. b. Is mainly suitable for devising long-term corporate strategy. c. Is the overwhelming norm for most top executives. d. Is problematic because the “logic” of one’s intuition is largely uncheckable. e. Answers a and b are both correct. Short Problems and Questions S1 Define managerial economics and explain how it is useful in decision making. Managerial Economics Study Guide S2 Carefully define sensitivity analysis and explain why it is important in decision making. S3 What are the two main difficulties that may make profit maximization an ambiguous guide to decision making? Explain why they complicate the analysis. S4 “Most managerial decisions involve more than a once-and-for-all choice from among a set of options.” What does this mean, and how does it affect managerial decision-making? S5 What are the main types of models used in managerial economics? How do they differ? How does management use them in decision making? S6 Briefly explain why the profit maximization goal might be at odds with public sector goals. S7 Compare and contrast the objectives of decision-makers in the private sector and the public sector. S8 Current environmental legislation relating to endangered species is phrased so as to emphasize preserving a species regardless of economic impact or cost. Is this approach likely to result in optimal policy decisions? Explain. Longer Problems and Discussion Questions L1 Put yourself in David Letterman’s shoes. How would you decide whether to stay with NBC or switch to CBS? Is it simply a question of dollars and cents? L2 Although rules of thumb and maxims do not constitute systematic guides to decision making, they can provide some wisdom and advice. Explain how each of the following might contribute to making a decision. a. If you don’t know where you’re going, chances are you won’t get there. b. Look before you leap. c. Don’t count your chickens before they hatch. d. Always get a second opinion. e. Don’t put all your eggs in one basket. f. If it ain’t broke, don’t fix it. L3 As the president of Cmart (a Canadian chain of stores), you are facing entry into your markets by an American competitor. You anticipate that your competitor can produce its wares at somewhat lower cost than you can and will maintain its warehouses in the United States. Assess Cmart’s possible reactions to this new rival. Would you recommend trying to deter entry by reducing your prices? Should you do nothing? Outline various alternative courses of actions, considering their strengths and weaknesses. What is your recommendation and why? L4 A company is considering an “expansion” decision such as enlarging an existing plant, increasing advertising expenditures, or launching a new product line. What factors would it consider in making such a decision? What might be useful sources of information for determining the net profit of the expansion plan? Introduction to Economic Decision Making Chapter 1 L5 A public project should be undertaken if and only if its total benefits (to all affected parties) exceed its total costs. What are some possible sources of data for a public agency to use to develop measures of benefits and costs? L6 You are the chairperson of an agency responsible for deciding whether to build a new airport for your city. Though conveniently located, the existing airport is too small to accommodate larger jets. The city could use its power of eminent domain to acquire land for airport expansion but this would be very expensive. In the last decade, there has been strong growth in suburban areas, and this seems likely to continue. Business interests have indicated a desire to see a new airport to “showcase” the city. Land is cheapest in a rural area 25 miles outside the city. What airport options should your agency consider? Outline the major advantages and disadvantages of each. L7 A state economic development agency is concerned that a major employer within the state might close down. The company, a meatpacker, has had several years in which profits have been low and now faces some stiff environmental regulations. Cleaning up production to meet the regulations is expensive. The plant buys animals for slaughter from a wide region of the state. Some of its employees live in outlying communities and in adjacent counties. The city in which the plant is located has experienced rapid economic growth in the service sector, but manufacturing job growth has been slow. In addition, the city has increased taxes to fund improved schools. Outline the major options facing the state, including a list of the affected parties. How would each party be affected by a possible choice? List some major data sources that could be used to weigh these benefits and costs. SOLUTIONS Multiple Choice M1 e M2 a See the second paragraph of the text. M3 b M4 e M5 c Conflicting goals make decisions difficult, but not impossible. M6 d M7 c M8 d The public program need not make a profit. Tax revenues can pay for it. M9 b M10 a M11 e M12 e Value maximization is the primary goal but sometimes tradeoffs are made. M13 b M14 e M15 d Managerial Economics Study Guide Short Problems and Questions S1 Managerial economics is the analysis of major management decisions using the tools of economics. It applies familiar concepts such as demand, cost, monopoly, resource allocation, and so on. By emphasizing the theory of the firm, managerial economics seeks to identify decisions that maximize the firm’s value. This approach uses a variety of models to quantify important economic relationships. S2 Sensitivity analysis considers how an optimal decision would change if key economic facts or conditions were altered. Sensitivity analysis is important because any decision is based on a set of assumptions about uncertain future conditions. Different conditions will, obviously, affect the outcome of a decision. Sensitivity analysis can help management anticipate different outcomes and identify appropriate courses of action. S3 The two difficulties are: (1) the timing of benefits and costs, and (2) uncertainty. Generally speaking, a decision-maker must pay a cost “up front” when making an investment in order to obtain benefits or profits in the future. This requires the decisionmaker to develop comparable measures of present and future monetary values. Uncertainty reminds us that some outcomes are not known with complete confidence. Costs may prove to be far larger than expected, benefits far smaller, and delays in completing initiatives may erode profits. S4 Management strategies typically require considering a series of decisions (not simply making a single decision). For instance, whether a firm should attempt to develop and ultimately launch a new product depends on subsequent decisions concerning pricing and advertising. As decisions are made and the future unfolds, choices should be reassessed. For instance, the firm might decide to drop a once-promising research and development plan after spending $50 million on it. S5 Models are used to simplify analysis and to focus on a small number of most important variables. (Models do not purport to describe all aspects of a decision, but are aids in helping managers focus on the most important issues.) There are two main types of models: deterministic and probabilistic. In a deterministic model, the outcome of a decision is certain (or close enough that it doesn’t matter). For instance, a production manager might be able to estimate with near certainty the total cost of producing different quantities of output. By contrast, probabilistic models list a range of possible outcomes with a probability attached to each. S6 The public sector is different than the private sector. The private firm’s goal is profit and value maximization. The role of the government is to maximize social welfare. Sometimes, these private and public goals are in conflict. For instance, a firm might maximize profit by producing pollution, thus harming the environment. Conversely, the government might undertake a worthy public investment even though its revenues are insufficient to cover its costs. (General tax revenues finance the difference.) Introduction to Economic Decision Making Chapter 1 S7 In the private sector, management seeks maximum profit and value for the firm. (Recall, however, this is not always an accurate description of actual decision making.) With an eye to profit, managers will not generally take into account the impacts (benefits and costs) on other parties. In making a public-sector decision, the responsible manager considers the resulting benefits and costs to all affected parties. Thus, the manager is concerned with all benefits and costs, not just the program’s own revenues and expenses. Benefit-cost analysis is the main tool for guiding public sector decisions. Of course, many parties might be involved in public-sector decisions – often with different goals. These conflicting interests lead to more difficult (and sometimes inefficient) decisions. S8 Preserving endangered species regardless of economic costs is unlikely to lead to sound public decisions. An analysis of actions to preserve endangered species should weigh the benefits against the costs (ignoring neither one). Such a policy should preserve particular species where the benefits are great and the costs (to industry) are small. It would also look for the most cost-effective ways of doing so. Longer Problems and Discussion Questions L1 Concepts raised in Chapter 1 suggest a number of criterion by which Dave might decide. (1) He could regard it purely as a financial decision. Which network offer delivers the greater monetary value? (Of course, this might require quantifying future cash payments.) (2) However, it’s likely that money is not the only thing. Presumably, Dave puts a very high value on getting the chance to perform for a broader 11:30 PM audience, rather than staying at 12:30 AM. So, even if NBC offered him the most money to stay in his current time slot, he might well leave for CBS. (3) Dave might feel loyal to other stakeholders. On the one hand, he might feel loyal to NBC who originally gave him his big break. On the other, he might feel that he should pursue the best interests of his production company on behalf of the large staff that depend on him. In short, multiple objectives might inform his ultimate decision. L2 a. b. c. d. e f. L3 This advice emphasizes the importance of clearly defining objectives and goals before charting a course of action. This adage underscores the importance of predicting and anticipating outcomes before committing to a risky all-or-nothing decision. This saying emphasizes the uncertainty of outcomes and the fact that plans may not turn out as hoped. In any decision under uncertainty, the manager should seek to acquire additional information about the relevant risks before committing to a course of action. Getting a second opinion (or a third or fourth) is a valuable source of information. Diversification – in the form of a financial portfolio, use of multiple input suppliers, or in ensuring that “back up” options are available – is a prudent response to risk and uncertainty. This maxim suggests the importance of knowing when not to take an unnecessary action. Your competitor will face transportation costs as well as taxes on imports to Canada. This is likely to counter-balance its cost advantage. However, you definitely need more information (data) in order to know if you should reduce your prices to try to preclude Managerial Economics Study Guide entry by the American rival. On the other hand, doing nothing means that you have total confidence in your customers and their attachment to your stores. This might be a mistake if you have underestimated the new chain’s power of attraction. Also, you should not underestimate your rival’s ability to market its stores. Besides price cuts, you could try a campaign of advertising emphasizing the pride of Cmart as a Canadian chain. This last option could be promising, but you still need more information (quantitative and qualitative) in order to take such an important decision. L4 The most important variables are the initial investment cost, increased sales revenues, and profits over time, and the interest rate applicable for discounting future profits. Information on sales revenue would include current price and quantity data and the past growth rate of sales. Information on costs would include the current cost of production, the cost of new facilities and equipment, and potential cost decreases due to new technology. L5 A public agency might use many different sources of data on benefits and costs. These include: market data (for instance, to measure business profits or property values), survey data (to measure public interest and willingness to pay), demographic data (to measure population growth), scientific and engineering data (to measure safety and environmental risks and costs), and so on. L6 There are at least three main options to consider: 1. Expand the existing airport. This would allow use of existing facilities. The airport would remain near the city’s current population and business centers. But, expansion would probably be the most expensive in terms of land acquisition and could be of limited appeal to business leaders who want a new airport. 2. Build a new airport in a suburban area. This would be near the population and business centers (though not as near as the existing airport) and land would be cheaper. However, a significant “cost” of this option would be the noise experienced by local residents. 3. Build a new airport in a rural area. Here, the land cost is lowest, and there is the least problem with noise. However, this location increases the cost (in terms of time, money, and convenience) of travel to the airport, and may be inconvenient for the business community and residents. L7 This public sector problem illustrates the complexity of decisions when there are competing goals. The major options include: allowing the plant to close, assistance in the form of tax relief, assistance in direct subsidies for environmental cleanup, subsidies for job creation, and assistance in finding a buyer to operate the plant. The major affected parties include the state, and adjacent states; local city and/or county; neighboring cities; employees of the plant; stockholders of the corporation; and animal breeders in the area. Allowing the plant to close adversely affects every party, although it does limit the out-of-pocket expenses of government. Tax relief may strain local budgets, so that the city may be reluctant to make the concession. Similarly, the state may be unable to reduce taxes in a time of tight budgets. Subsidies for environmental cleanup may allow the plant to continue in operation, though the firm may not choose a cost-efficient form of cleanup. Subsidies for job creation may generate some jobs, but the jobs may be low paying and the cost per job high.