RMI2302 Exam 2 Slides

Recognize the difficulties in modeling government/societal decision making

• To understand how/why/what type of decisions government entities make, you need to understand the government’s role in society. 

• While we look at the role of local, state and the US Federal governments, it is important to remember that the roles played by governments in other countries may be vastly different.

Recall the three components of the economy:

• Households

• Businesses

• Government

Define the role of government in society including:

• Legal & Societal Framework

• Maintain Competition

• Stabilize the Economy

• Redistributing Income

• Reallocating Resources

Government’s Role: Legal Structure

•Providing legal structure

•Sets legal statuses of business enterprises

•Ensures rights of private ownership

•Allows making and enforcement of contracts

•Establish “rules of the game” controlling relationships between businesses, suppliers and consumers

•Also social framework: marriage, alcohol consumption, driving, etc…

• Intervention of government is presumed to improve allocation of resources, but intervention may be too little or too much as measured by marginal cost and marginal benefit

Government’s Role: Maintain Competition

•Maintaining Competition

•In nearly all markets, efficient production is best attained with a high degree of competition.

•A monopoly (single seller) controls an industry by controlling supply.

•Monopolists charge higher-than-competitive prices

• Regulated monopolies include local electricity, telephone and transportation services.

Government’s Role: Promote Stability

•Promoting Stability

•When total spending matches economy’s production capacity, prices are stable. Stability is achieved by addressing two problems:

•Unemployment – occurs when private sector spending is too low, common actions taken are an increase in government spending or lowering taxes

•Inflation – occurs when spenders try to buy more then the economy’s capacity to produce, common actions taken are raising taxes or government reducing their total spending

Government’s Role: Redistributing Income

•Redistributing Income

•Transfer payments

•Provide relief to the destitute, the dependent, disabled and older citizens. (welfare checks, food stamps, etc.)

•Market intervention

•Government modifies prices that are/would be established by the market. (paying above-market prices to farmers, requiring minimum wage, etc.)

•Taxation

•Government uses personal income tax to take larger portions from the rich than from the poor to narrow after-tax income differences.

Government’s Role: Reallocating Resources

•Reallocating Resources

•Externality – occurs when some of the cost or the benefits of a good are passed on to someone other than the immediate buyer or seller.

•Negative externality – Production or consumption costs inflicted on a third party without compensation

•Correcting negative externalities

•Legislation 

•Specific taxes – tax confined to a particular product

Recognize the shortcomings of relying solely on economic measures of government decision making

•The free market fails to protect consumer interests, requiring the government to find appropriate ways to protect us from ourselves

•In a world dominated by rational behavior, the government could focus on externalities and focus less on consumers

•However, the world is not always dominated by rational behavior

•Government is balancing competing goals

Contrast the risk/reward trade-off at the individual, organizational, and societal levels

•If you take anything from this class, make sure it is that you understand the relationship between risk and reward

•Employers want employees who can make critical decisions

•Understanding this relationship goes a long way toward that skill

Risk/Reward Individuals

•Individuals

•Measured using expected utility

•How much reward is necessary to induce you to take risk?

•Similarly, how much are you willing to pay to avoid risk?  This is actually the entire basis of insurance, people willing to pay to avoid risk

Risk/Reward Organizations

•Organizations

•Orgs. use expected value, not expected utility

•No natural risk aversion

•Opportunity cost or cost of capital

•Most organizations project future cash flows from investments/opportunities

•Discount those cash flows back to present value based on cost of capital

•Cost of capital is commensurate with riskiness of firm

Risk/Reward: Government / Society

•Gov’t/Society

•Measuring reward to society is difficult (reward of national parks?)

•Many times government is the only entity able to take on risk, regardless of reward

Recall how time can be represented in decision making models

•Examples of present value vs. future value and lump sum vs. annuities are in textbook

•For our purposes: focus on present value, both lump sum and annuity (series of payments).

Differentiate the types of biases

•What is a bias?

•Subjective view/probability – different from objective

•Many sources

•Alter the decision making

•Problem when it ends up being significantly different from the model

•What really biases our decision making?

•The unknown unknowns

Age biases

• People in certain age groups tend to interpret information about risk differently; frequently younger people take more risk than older people.

Cultural biases

• Certain culture views of risk differ.

Experience biases

• People who have experienced a low-probability/high-consequence event tend to overestimate its likelihood, people who have not experienced one, tend to underestimate; those who have lived through a plane crash tend to overestimate the likelihood of it happening again.

Gender biases

• People who tend to prefer one gender over the other, typically in the favor of men against women.

Media biases

• Risks that garner a lot of media attention (murder, terrorism, kidnapping, etc.…) are typically overestimated, while other risks (car accidents, health risks) tend to be underestimated

Define incentives

•Things that motivate individuals to perform an action.

•Incentives can be at the individual level, organizational level, or societal level

•Generally, we refer to incentive structures

Types of Incentives

•Financial - Most incentives

•Moral – “do the right thing”

•Natural – “curiosity, fear, anger, pain, joy, pursuit of happiness”

•Coercive – negative reinforcement

•Personal vs. social

•Political Incentives — short term vs. long term planning, Discount rate

Identify risks faced by individuals along the three elements of a loss exposure.

•Loss Exposures: Any condition or situation that presents a possibility of loss, regardless of whether that loss actually occurs.

•Three Elements to a loss exposure

1. Asset exposed to loss

2. Cause of loss

3. Financial consequences of the loss

Property Risk

•Asset exposed to loss: Real property (Land, buildings, crops, etc…)

•Personal property: Your stuff (furniture, jewelry, art, autos, watercraft, etc…)

•Cause of Loss: Fire, theft, windstorm, accidents, lost, pretty much anything you can think of

•Financial Consequences: Reduction in property value, Increased expenses, Lost income

Liability

•Asset exposed to loss: Money / other financial assets, General(non-economic), Special(economic), Punitive damages

•Cause of Loss:

1. Claim / lawsuit

2. Civil law vs. criminal law

3. Tort, contract, statutory

4. Negligence (duty owed, failed to fulfill, loss occurred, unbroken chain)

•Financial Consequences: Defense costs, Monetary damages

Specific Types of Liability

•Property owners

•Automobiles

•Employer-employee

•Parents and children

•Animals

Life – Premature Death

•Asset exposed to loss: Your life

•Cause of Loss: Premature death (illness, accident, stupidity)

•Financial Consequences

Financial Impact of Premature Death

•Wage earning adult:

1. Married

2. Single with dependents

3. Single with no dependents

•Non-wage earning adult:

1. Married

2. Single with dependents

3. Single with no dependents

4. Child

Life – Long Life

•Asset exposed to loss: Your savings / retirement / wealth

•Cause of Loss: Outliving assets, expenses > income for too long

•Financial Consequences: What happens when retired?

•Income

•Expenses: Which increase, Which decrease

Health / Disability

•Asset exposed to loss: Your health, livelihood

•Cause of Loss: Poor care, poor genes, bad luck, injury, illness, etc…

•Financial Consequences:

1. Ability to earn income may decrease, or cease (as in premature death)

2. Living expenses may continue (or increase)

3. Evaluate same exposure categories as premature death

Apply the risk management process to individual risks.

•Risk Management Process:

1. Determine Objectives

2. Identify Risks

3. Evaluate Risks

4. Choose your alternatives

5. Implement

6. Review & Evaluate

Application: What are the risks?

•Change throughout life e.g. premature death

•20’s – not many people relying on you/your income

•30’s – family life changing – significant risk

•40’s – your grown up (and don’t even know it) – highest this risk will ever be

•50’s – risk beginning to diminish

•60’s – not as big an issue

•70’s – not an issue

??? – not an issue

Identify the specific risks faced by college students today.

•Specific Risks – The College Years:

•Increased anxiety depression

•Sexual violence

•STD’s

•Poor physical health

•Partying, alcohol & drug abuse: Fentanyl, Smart Pills

Recognize the risks and rewards associated with a particular product/service.

Smart Pill Risks:

•Increased risk of cardiovascular problems

•High blood pressure

•Paranoia

•Potentially addictive

•Effects can be magnified when comingled with other drugs/alcohol

•Do you know what you are taking?

Smart Pill Rewards:

•Improved performance on learning tasks such as memorization, especially for longer term memory (more than one day) & since education now seems to be a competitive sport…

Recall some of the ethical considerations involved with cognitive enhancements

• Coercion and peer pressure: Others may feel forced to use them just to compete or keep up.

• Unequal access: Not everyone can afford or obtain them, increasing inequality.

• Health and safety: Exposes users to potential side effects, dependency, and health risks.

Recall the categories of organizational risks.

• Business

• Operational

• Hazard

• Financial

• Strategic

• Others

Categories of Risk: Business

Business Risk: Anything that threatens a company’s ability to achieve its financial goals.

•Involves deviations in profitability.

•Can be caused by many things such as prices, regulation, and competition.

•Very broad category. Many will define as risk caused by operational, hazard, financial or strategic risks.

Categories of Risk: Operational

Operational Risk: Losses that arise from internal sources.

•Causes include flawed or failed process, policies, systems, or events.

Categories of Risk: Hazard

Hazard Risk: Losses that arise from an event or accident.

•Causes can include fire, hurricanes, flooding, theft, and vandalism.

•Can also result from manufacturing operations.

Categories of Risk: Financial

Financial Risk: Potential variation due to financial causes.

•Causes include exchange rate, investment losses, credit risks, or liquidity risks.

Categories of Risk: Strategic

Strategic Risk: Potential losses (variation) from poor business decisions.

•Can relate to product mix, supplier choice, or financing options.

•Many decisions fall under “strategy”, if any of them are wrong/faulty => strategic risk.

•We discuss reputational risk here, but is often a separate classification.

Categories of Risk: Other

Other risk include:

•Legal risks

•Liability risks

•IT risks

Outline the overriding themes and the risk/reward tradeoffs of a given historical event.

• Overriding themes:

Corporate Strategy

Corporate Culture

Workplace Safety

Process Management

Regulatory Impact

• Risk/Reward Tradeoffs

•What is the upside of cost cutting?

•What is the upside of having an entrepreneurial corporate culture?

•What is the upside of decentralized management?

•How important is reputation?

Define big data, black swans, and grey swans.

• Big Data: The vast amount of data created by consumers in a digital environment maintained by organizations. For example, a collection of digital footprints of almost everyone.

• Black Swans: A metaphor for an event or occurrence that is an extreme outlier, difficult to predict, that is unexpected with high profile results that are beyond normal expectations. Often, psychological biases of humans can create a blindness to indicators around them. Unprecedented, unimagined, extremely rare, and unpredictable.

• Grey Swans: Conceivable but very unlikely, capable of a major impact, but often neglected by risk mangers due to the unlikely occurrence.

Recognize the role of behavioral analytics in risk management.

Future of behavioral analytics?

•Systems are pretty good at looking for potential risks ignoring the human element.

•Behavioral analytics adds that examination of the human component, mixed with statistics and external analysis.

•More complete or “intelligent” risk analytics.

Identify how to manage the risks of data driven decision-making.

•Oversight/Regulation: Laws, Auditors

•Embedded Morality

•Data models are inputs to decision makers, not decision makers.

Define strategic risk and its role in the global financial crisis.

•Strategic Risks: Potential losses (variation) from poor business decisions (Product mix, Supplier choice, Financing options).

•Many decisions fall under “strategy”, if any of them are wrong/faulty => strategic risk.

•Include reputational risk under strategic risk, but it is often a separate classification.

Define an adaptive strategy.

•Instead of developing one strategy based on “analysis, prediction and deduction,” create a set of “optimal conditions” for the continuous emergence of superior strategies.

Identify the four areas strategy should incorporate.

•Risk

•Boundaries

•Corporate Purpose

•Environment

Risk

•Understand that systemic risk is real.

•Contingencies need to be modeled (How can the organization be resilient?).

•Organizations need to balance the trade-off between efficiency and redundancy/excess capacity.

Boundaries

•Market definitions/segments?

•What activities should we pursue?

•How broad should our scope be?

•What are our core competencies?

Corporate Purpose

•“Shareholder value is a result, not a strategy.”

•Must consider contribution of all stakeholders.

•Must define corporate purpose:

•Stability

•Growth

Employees

Environment

•What type of growth is sustainable?

•Strategic must consider:

•Demographic trends

•Consumption trends

Compare the different organizational strategies of a group of companies.

•Strategic risks are extremely difficult to evaluate, quantify, and manage.

•Often those who come up with the strategies have a difficult time identifying what would cause those strategies to fail.

•Causes of failed strategies include:

•Big picture: financial, macroeconomic, & geopolitical risks

•Small picture: under-appreciated competitive threats

Recall the tradeoff between efficiency and redundancy with respect to supply chain.

•Key question is what events can cause a material disruption to an organization’s supply chain?

•Many companies have moved to “just in time” delivery, reducing the need to store excessive amounts of stock which can be costly.

•How can supply chain risks be identified and managed better?

•There is a real trade-off between efficiency and potential disruption.

List the four benefits of modeling supply chain risks.

•Methodical approach does not forget about small, low-cost commodity suppliers which can have a large impact.

•Other benefits of this approach:

1. Identifies hidden exposures.

2. Avoids the need for predictions about rare events.

3. Reveals supply chain dependencies and bottlenecks.

4. Promotes discussion and learning within the organization.

Recall the relationship between a company’s business model and its supply chain risks.

•Problem - Hard to Manage:

•Local cooking – more variation.

•Gets harder, not easier as volume increases.

•Real Tradeoffs: Efficiency vs. redundancy.

Outline the supply chain disruption caused by the COVID-19 pandemic and efforts to reduce risks in the future.

•Address Vulnerabilities Regularly

•Supply Chain Changes:

1. Likely reduction in just-in-time manufacturing.

2. Dependency on semiconductor chips may make companies consider efficiency vs. redundancy/backups.

•Vendor Relationships

•Role of the Chief Supply Chain Officer

Identify the risks and rewards associated with global shipping supply chain routes.

•Increased Middle East Conflicts

•Shipping Costs increasing:

1. Delivery delays

2. Direct property loss

3. Increased security expenses

4. Increased insurance premiums

•Risk Reduction:

1. Alternate routes (added time/cost)

2. Increased naval presence

3. Reduce tensions in Middle East