TOPIC 3 Individual Decision Making RMI2302 Test 2 Study Guide Ultility Theory Utility as Basis for Decision Making Given the choice between A a gift of 500 no matter what and B a gift of 1000 given a coin lands on heads when tossed which would you choose People do not always make decisions based on maximizing their expected monetary value Expectation principle doesn t always provide an adequate basis for decision making by individuals Von Neumann and Morgenstern provide an alternate criterion that can be used for decision making Decisions are made so as to maximize expected utility rather than expected monetary value Utility Measures and Utility Function Von Neumann and Morgenstern proposed an index for measuring utility in situations involving risk for the decision maker Utility index is designed for predictive purposes Allows to predict which of several choices a person would prefer and thus enables him to take decisions Expected utility of A EUA U x1 1 U x2 Decision Maker Classifications Risk averse person who is always willing to accept a small cash certain amount than the expected values of a bet Most people are risk averse Risk seeker person who demands an amount of cash certain in excess of the expected monetary pay off utility function would be rising at increasing rate Risk neutral one who is neutral between a cash certain amount and a bet whose expected value is equal to that linear utility function Deriving the Utility Function Utility functions are usually a function of wealth Each individual looks at the utility of their wealth in each potential outcome and chooses their action based on expected utility Utility is increasing in wealth more is always better than less Utility is increasing at a decreasing rate 100 to a student is different than 100 to a millionaire Assume that people are generally risk averse Thinking Like An Economist The Cost Benefit Approach to Decisions Should I do activity x Assume C x represents the cost of activity x Assume B x represents the benefit of activity x If B x C x do x otherwise don t Stereo Example Should you get out of your chair to turn the music down or not Depends on how comfortable you are in the chair how much the music is annoying you etc What if someone offered you re a penny to turn it down What if someone offered you 1 000 Reservation price minimum amount it takes to get you out of the chair The Role of Economic Theory Common Pitfalls in Decision Making 4 Things 1 Ignoring Implicit Costs If doing activity x means not being able to do activity y the value of doing opportunity y is an opportunity cost of doing x Example 1 3 Should you go skiing or scrape plates Pay for scraping plates is 45 You are unwilling to do this for less than 30 Skiing is worth 60 to you and costs 40 for the ski package Benefit B skiing 30 60 90 Cost C skiing 40 45 85 Should you go skiing or scrape plates Note Some of the numbers from the previous slide should raise some questions Where did the 30 come from Where did the 60 come from Those are utility function equivalents the utility gained from skiing is equal to another 60 There is a difference between wealth and utility 2 Failing to Ignore Sunk Costs Sunk costs may seem relevant but in reality they re not and should be ignored Example 1 5 Should I drive to Boston or take the bus 250 mile trip Bus fare is 100 Hertz says the following chart contains typical costs of 10 000 mile driving year Common Pitfalls in Decision Making Interest and Insurance are sunk costs Remaining costs fuel and oil and maintenance total 2 000 per 10 000 miles Boston is 250 miles away so 0 20 per mile yields a cost of 50 to drive to Boston Since cost of driving is less than bus fare you should drive Still ignores some stuff stress of driving vs joy of riding bus 3 Measuring Costs and Benefits as Proportions Rather Than Absolute Dollar Amounts Would you drive an extra 15 minutes to Wal Mart if you could save 10 on a 20 clock Would you drive an extra 15 minutes to Wal Mart if you could save 10 on a tv for 1 010 You should answer the same way for both cases Even though you save 50 on the clock and less than 1 on the tv it s still 10 either way 4 Failure to Understand the Average Marginal Distinction Ask Should I increase the level by which I am currently engaging in activity x Must compare the benefit and cost of an additional unit of activity marginal cost and marginal benefit Cost benefit rule tells us to keep increasing the level of an activity as long as its marginal benefit exceeds marginal cost Example 1 9 How many boats should Tom launch Marginal cost is constant at 100 per launch so Tom should keep launching as long as marginal benefit is at least 100 Tom should launch 3 boats Common Pitfalls in Decision Making Marginal costs and benefits measures corresponding to the increment of an activity under consideration are relevant for choosing the level at which to pursue the activity This is NOT the same as average costs and benefits Using Marginal Benefit and Marginal Cost Graphically Susan is charged 4 cents per minute to call Hal The value to Susan measured in terms of her willingness to pay of an additional minute of conversation with Hal is shown in the chart below Where marginal cost and marginal benefit cross 400 min is optimal quantity The Invisible Hand Important insight of economic analysis The individual pursuit of self interest is often not only consistent with broader social objectives but actually even required by them Invisible hand mechanism breaks down when important costs of benefits accrue to people other than the decision makers themselves Would Parents Want Their Child to Marry Homo Economicus Homo economicus or economic man Many economists feel the larger material pay offs dominate other motives The stereotypical decision maker in the self interest model is labeled homo economicus Homo economicus doesn t experience sentiments that motivate people to vote return lost wallets etc Homo economicus cares only about personal material costs and benefits Positive Questions and Normative Questions Normative Question what should be Logging companies are cutting down the few remaining stands of virgin redwoods to use as timber to build homes Should the redwoods be protected Positive Question what the consequences will be If we ban cutting redwoods what will happen to the price of lumber How will employment in logging be affected The Government s Role in Society To understand how why what type of decisions
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