Decision Making

Decision Making

Roadmap for Good Decision Making

• Good decision making follows the 4 principles:

  • Cost-Benefit Principle

  • Opportunity Cost Principle

  • Marginal Principle

  • Interdependence Principle

Cost-Benefit Principle

• Definition: In making decisions, take into account the costs and benefits of any decision faced.

• Important Note: Consider costs and benefits broadly, not limited to direct out-of-pocket costs.

• Decision Rule: Pursue the choice if the benefits are at least as large as the costs.

Example: Buying Air Jordans

• Cost: $180 (price)

  • Additional Costs: shipping fees, taxes, driving to the store, time spent shopping, etc.

• Benefits: Evaluation involves determining willingness to pay for the shoes.

• Decision Rule: Buy if benefits are at least as large as the costs;

  • Condition: Willingness to pay ≥ Cost

Willingness to Pay / Costs

• If you dislike in-person shopping, factor this into your decision:

  • Option 1:

  • Costs = price + displeasure of shopping in person

  • Benefits = enjoyment of Air Jordans

  • Option 2:

  • Costs = price

  • Benefits = enjoyment of Air Jordans – displeasure of shopping in person

• Conclusion: Willingness to pay is higher when shopping online compared to in-person.

Economic Surplus

• Definition: Economic surplus = total benefits minus total costs from an economic activity.

• Buyer’s Perspective:

  • For a pair of $180 sneakers, if willingness to pay is $200:

  • Buyer’s economic surplus: $200 (benefit) - $180 (cost) = $20.

• Seller’s Perspective:

  • For a pair of $180 sneakers with a production cost of $100:

  • Seller’s economic surplus: $180 (benefit) - $100 (cost) = $80.

• Apply all 4 principles to maximize economic surplus!

Opportunity Cost Principle

• Definition: The opportunity cost of something is the most valuable alternative you are giving up to acquire it.

• Implication: Resources are scarce; every decision entails giving up something else.

  • Considerations: Limited money, time, attention, production capacity in a business.

• Decision Rule: Only take the action if the benefit is at least as large as the action’s opportunity cost!

Example: Opportunity Cost of Buying Air Jordans

• Monetary Cost: $180 that could be spent on other purchases (e.g., food, books, clothes).

• Attention Cost: Remembering the drop date; this attention can be utilized elsewhere (e.g., study).

• Time Cost: Traveling to the store incurs monetary (gas/bus) + time costs; this time can be allocated for studying instead.

• Opportunity Cost Summary: Buying Air Jordans means not spending money, time, and attention on alternate activities.

Distinguishing Opportunity Costs

• Not all costs are opportunity costs.

  • Sunk Costs: These are costs that have already been incurred and cannot be recovered.

  • Examples:

  • Purchasing a non-returnable Air Jordans cleaning brush.

  • Buying Air Jordans that cause discomfort.

  • Takeaway: Sunk costs are irrelevant for future decision-making.

Marginal Principle

• Definition: Move away from “yes or no” decisions towards marginal consideration; instead of asking whether or not to buy something, ask, “Should I buy one more?” or “Should I do this one more time?”.

• Combination of Principles: Combine the Marginal Principle with the Cost-Benefit Principle.

• Decision Rule: Yes if the benefit of one more unit is at least as large as the cost of one more unit.

  • Marginal Benefit: Extra benefit from one additional unit.

  • Marginal Cost: Extra cost from one additional unit.

Example: Buying Multiple Pairs of Air Jordans

• First Pair: Cost = $180, Benefit = $200:

  • Decision: Yes, buy it.

• Second Pair: Cost = $180, Benefit = $190:

  • Decision: Yes, buy it.

• Third Pair: Cost = $180, Benefit = $170:

  • Decision: No, do not buy.

Iterating the Marginal Principle

• Continually apply marginal questioning to determine how much to buy and whether to buy more Air Jordans:

  • Stop when Marginal Benefit < Marginal Cost.

  • The Rational Rule: If something is worthwhile, continue until marginal benefit is less than marginal cost.

Interdependence Principle

• Understanding that decisions are interconnected is critical in economic contexts.

  • Consideration Factors:

  1. How interdependent your choices are with other choices due to limited resources.

  2. How choices impact others’ decisions.

  3. How decisions in one market affect other markets.

  4. How today’s decisions are influenced by past and future choices.

Example: Buying Air Jordans

• Your Choices: Buying Air Jordans means $180 less for other purchases.

• Others' Choices: Your purchase could mean someone else misses out on a pair.

• Market Choices: The purchase might influence the prices of other apparel.

• Future Choices: Satisfaction with Air Jordans could influence future sneaker purchases.

Applying the Four Principles Together

• Marginal Principle: Focus on “one more” rather than overall quantities.

• Evaluate Marginal Costs and Benefits: Assess how additional units affect total costs and benefits.

• Consider Alternatives: Determine what you would forgo instead.

• Consider Broader Effects: Account for how your decisions reverberate through other choices, markets, and timelines.

Key Takeaways

• Marginal Principle: Focus on determining if it's worth one more.

• Cost-Benefit Principle: Assess if total benefits are greater than total costs.

• Opportunity Cost Principle: Identify the most valuable alternative missed by your choice.

• Interdependence Principle: Recognize connections within and across decisions, choices, and time.

Practice Examples

• Example 1: Binge Watching:

  • Situation: Decision on watching a new season of a favorite series.

  • Applying Cost-Benefit Principle: Weigh enjoyment against time and subscription fees.

  • Applying Opportunity Cost Principle: Consider alternatives like studying.

  • Applying Marginal Principle: Evaluate whether to watch ‘one more episode’ based on enjoyment versus fatigue.

  • Applying Interdependence Principle: Recognize how binge-watching affects spending behavior and social interactions.

Example 2: Going to Graduate School

• Situation: Deciding to pursue an MBA; evaluate costs and benefits, and opportunity costs by considering job loss consequences and benefits from attending.

Example 3: Hiring Decisions for a Hair Salon

• Situation: Determine the number of employees to hire.

  • Evaluate marginal benefit from each additional employee against their marginal costs.

  • Consider potential losses/gains of hiring too many workers given chair availability.

  • Follow rational rule; hire until marginal benefit equals marginal cost for profit maximization.