Managerial Decision Making
In this lesson, you’re expected to learn:
– how decision analysis models can be used to solve problems
– how to make decisions under certain or uncertain conditions
– how to make decisions under risk, conflict, or competition
What is Managerial Economics?
Managerial economics is the study of choice related to the allocation of scarce resources.
It is a science that helps to explain how resources such as labor, technology, land, and money can be allocated more efficiently.
Understanding managerial economics helps individuals to make better decisions systematically.
Application of Managerial Economics
Since the purpose of managerial economics is to apply economics for the improvement of managerial decisions in an organization, most concepts in managerial economics have a microeconomic focus.
However, since managers must consider the state of their environment in making decisions and the environment includes the overall economy, an understanding of how to interpret and forecast macroeconomic measures is useful in making managerial decisions.
Decision Analysis Models
Decision Analysis models can be used to determine optimal strategies in situations involving several decision alternatives and an uncertain pattern of future events.
Uncertain future events are called chance events and the outcomes of the chance events are called states of nature.
The goal of the decision-maker is to maximize profits or minimize losses.
Decision making is a frequent and important activity for business managers or executives and is related to risk levels.
With respect to risk, individuals act differently and can be grouped into three categories: risk-takers, risk neutral, and risk-averters.
When contrasted with a risk-taking entrepreneur, a professional manager is likely to be more cautious as a risk-taker (either risk neutral or risk averse).
Risks are related to returns – so the higher the risk, the greater the return and vice versa.
How to Solve Decision Problems
Influence diagrams, payoff tables, decision trees, and market research studies are used to solve decision problems.
• Influence diagram: shows the relationships among decisions, chance events, and consequences for a decision problem.
• Payoff table: shows the financial consequences (payoffs) in terms of the alternative decisions that can be made and the alternative states of nature that might result.
• Decision tree: a diagram showing the logical progression that occurs over time in terms of decisions and outcomes and is particularly useful in sequential decision problems – where a series of decisions need to be made with each in part depending on earlier decisions and outcomes.
Four general types of decisions exist, which require different decision procedures:
• Decisions under Certainty
• Decisions under Risk
• Decisions under Uncertainty
• Decisions under Conflict or Competition
Five different methods exist: (1) dominance, (2) lexicographic, (3) additive weighting, (4) effectiveness index, (5) satisficing.
The first four are optimization methods – i.e. they attempt to identify the very best option from all available alternatives and are suitable for idealized situations. The last method simply looks for the first satisfactory alternative from available alternatives, because it is a real-world method.
Risk is a condition faced by managers when they have to make a decision based on incomplete but reliable information.
Uncertain conditions exist when little or no reliable information is available. Certainty conditions exist when complete, reliable information is available.
Examples: tossing a fair coin, rolling a die etc.
The expected value of an action is the average payoff value we can expect if we repeat the action many times.
Expected Value = Average Payoff
This is a situation in which a decision must be made on the basis of little or no reliable factual information.
Example: When considering pricing of competitors
Under conditions of uncertainty, the rational, economic decision-maker will use expected monetary value (EMV) as the decision criterion.
The EMV of an act is the sum of the conditional profit (loss) of each event times the probability of each event occurring.
Four strategies for making decisions under uncertainty are:
(1) minimax strategy, (2) maximax strategy, (3) Hurwicz strategy, and (4) minimax regret strategy.
Here’s a quick recap:
Game theory is the study of strategically interdependent decision making.
It is a way to analyze the interaction between a group of rational individuals who behave strategically.
Interdependence means that any player is affected by what others do and his actions must depend on the prediction of others’ responses. In order for an individual to decide what to do, they must determine how others are going to act. This requires knowledge of other’s aims as well as the options available to them.
Game theory is a particularly useful tool for understanding why firms and individuals make the decisions they do, and how the decisions made by one individual affects others.
It has also been used to make decisions on price, output, product development, product promotion, and in other business scenarios.
Sensitivity analysis, also referred to as a what-if or simulation analysis, is a way to predict the outcome of a decision given a certain range of variables. By creating a given set of variables, the analyst can determine how changes in one variable impact the outcome.
Sensitivity analysis is an evaluation of how certain changes in inputs result in changes in output of a model or system.
For example, prices of raw materials change as demand fluctuates, and changes in the labor market cause changes in production costs.