Module 1: Part 1

General Decision-Making Framework:

A trick to understanding a wide variety of economic models/concepts is to realize that

they all have the same basic structure.

We begin by assuming that decision-makers are rational. Essentially this implies that
people try to do the best they can with what they have.

More specifically, we begin an model by explicitly stating the goal of the decision-maker
– what is the objective.

In business, this can often be difficult – as there are many individuals within a firm or
market and they may have competing objectives.

The default goal we typically use is that a firm attempts to maximize profits.

It is important to define carefully profits, and economists use the term differently than
accountants.

An economist includes opportunity costs when calculating profits, whereas an accountant

only measures explicit costs.

For example, if I own a wine store that takes in $40k in revenue and has $20k in explicit
costs, the accountant would report that I earned $20k in profits.

The economist would ask me what my next best alternative would be aside from running
a wine store. If this alternative is being a stock broker making $100k a year, the
economist would tell me that my economic profits are actually -$80k a year and I should
close down the wine store (assuming profits are my goal).

As you can see, for decision-making examining economic profits is the prudent way to
go…

In a market-based economy, profits are an invaluable signal to resource managers – they

let them know where to direct their resources.

Managers move their resources to their most highly valued use – which is measured by
economic profit.

Land use is a great example – consider suburban sprawl – the old timers wish they could
keep their open country living, but developers often invade their space and build condos,
strip malls, and managed communities. Why does this happen? Because the land is more
profitable if used in this way as opposed to open country.

Decisions are difficult for three reasons:

1) resources are scarce: there is a goal to reach, but we face constraints (time
constraints, technology constraints, input price constraints, demand constraints,
ect.)
2) Information regarding constraints is often not known perfectly. This is
particularly true for demand constraints – exactly how much will I relax the
demand constraint by improving the quality of my product as opposed to
improving service?
3) Many constraints depend critically in the interaction between active decision-
makers. We do not operate in a vacuum, and must consider that our choices
impact the choices of others and vice versa. Understanding this interdependence
is critical to effective decision-making.

To address issues effectively, we first must frame the question: develop a way to
organize all the complexities inherent in the problem into a manageable form. To
illustrate, let’s consider an optimization problem away from business first…

Suppose I am deciding how many children to have – how would I go about doing this?

[Note: this may seem like a very strange decision for an economics class to work on, but
I use it to highlight the generality of our approach]

Well, all decisions are made in order to reach some objective. In this case, I (and most
others) decide the number of children to have in order to maximize their total happiness
or well-being.

So, we have the following so far: Choose x (number of children) to maximize H

(happiness).

Now, here is the tough part facing all decisions – decisions are made with constraints.
For example, I may choose to have 500 children, but it would be impossible.

So, the easy answer to the question would simply be “parents decide on a number of
children that they think will make them happiest. But, ofcourse, this ignores the real
question: what influences the impact of an additional child on the happiness of a couple?