Chapter 1 - Managerial Decision Making

Takesh Luckho

What is Economics?

ECONOMICS is the study of how society decides:

WhatHowFor whom

to produce...

Early definitions Adam Smith who is generally regarded

as the father of economics, defined economics as “ a science which enquires into the nature and cause of the wealth of nation”. He emphasized the production and growth of wealth as the subject matter of economics

What is Economics?

Criticism of wealth oriented definition

Defined wealth in a a very narrow and restricted definition, in the sense that it considers only material and tangible goods.

Have given emphasis only to wealth and reduced man to secondary place in the study of economics.

According to Alfred Marshall “ Economics is on the one side a study of wealth and on the other, a more important side, a part of the study of man.”

According to Lord Robbins “ Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”

Traditional Definition

Modern Definition

Wants (ends) are unlimited and resources are limited.

Economics is the study of the allocation of scarce/limited resources among competing Wants (ends).

What is an economy then? == Is a system where goods are produced and exchanged to satisfy human wants

Significance/Advantages of Economics

Theoretical Advantages- Increase in Knowledge- Developing Analytical AttitudePractical Advantages- Significance for the consumers- Significance for producers- Significance for workers- Significance for politicians- Significance for academicians- Significance for administrators- Effective man-power planning- Helpful in fixing price- Solving distribution problems

Impact of a change in oil Prices

05

10152025303540

US$

per

bar

rel

Tripled in 1973-74, and doubled again in 1979-80 … and affected people all over the world.

An increase in the price of oil affects

What to produce less oil-intensive products

How to produce less oil-intensive techniques

For whom to produce oil producers have more buying

power, importers have less

Scarcity

• A basic human dilemma-Limited resources vs. unlimited wants

• Society has limited resources and therefore cannot produce all the goods and services they wish to have.

• According to Paul Samuelson, even if we combine all the resources that exist in the world and apply the best technique of production to them, yet, we will not be able to satisfy all the wants of the society.

• Wants are insatiable

Scarcity forces people to make choices about which wants they will satisfy.

Economic decision making involves examining the alternatives/choices that are available, establishing criteria for the decision making, evaluating each alternative/choice against the criteria, and making the decision.

ChoiceChoice

Opportunity Cost (Real cost)

For every choice there is an opportunity cost.

Opportunity cost is the next best alternative forgone.

Helps us view the true cost of decision making

Implies valuing different choices The concepts of scarcity, choice and

opportunity cost can be explained by the use of the Production Possibility Frontier (PPF)

Why use Economics in Management?

Managerial Economics is the integration of economic theory with business practices for the purpose of facilitating Decision Making and Forward Planning by the management.

The use of Economic Analysis is to make business decisions involving the best use (allocation) of scarce resources.

Economic Theory helps managers to collect the relevant information and process it in order to arrive at the optimal decision given the goals of a firm.

Decision Making Process

Decision making = choosing from alternative choices to solve a problem Identify the problem. Diagnose the situation. Collect and analyze data relevant to the issue. Ascertain solution that may be used in solving the

problem Analyze these alternative solutions. Select the approach that appears most likely to

solve the problem Implement it. Evaluate the decision and adjust if needed

Common problem faced by a Management

What price to sell and how much to output to produce?

Which is the best production technique?

What stock levels to hold? How much advertising is needed? Human Resource problems Investment and Financing questions

Decisions need to be taken by managers

As a manager, you would be faced with the following questions: What goods shall be produce? What shall be its legal form? How should the firm raise the necessary capital? What technique shall be adopted, and what shall

be the scale of operations? Where production is located? How shall its product be distributed? How shall resources be combined? What shall be the size of output? How shall it deal with its employees?

Types of Decision Making Process

To answer the above questions, three type of decision making system exists Organisational and personal decisions

Organisational decision – decisions taken in the role of a manager (e.g Strategy of the firm, approval of plans)

Personal decision – decisions taken not as a member of the company (e.g Retire, quit current job)

Basic and routine decisions Basic decision – decisions such as selection of

product line/raw materials, choice of plant location Routine decision - decisions that are repetitive in

nature and have little impact on the firm (e.g transport options, quotation format). As these type of decision are repetitive, firms generation formulate a list of procedures to guide managers in their decision

Types of Decision Making Process

Programmed and non-programmed decision Programmed decisions – similar to routine

decisions Non- programmed decisions – similar to basic

decisions

Decision Making Environment

Decision making is also subjective to the information environment under which the decision is being taken.

Certainty is defined as when decision makes are fully informed about a problem its alternative solutions, and their respective outcomes.

That is information about the problem, process and solution is fully available/known

Uncertainty is defined as a situation where little or no factual information is available about a problem, its alternative solution, and their respective outcomes.

That is information about the problem, process and solution is partially or not available/known existence of risk

Hence risk is defined as a situation where the decision marker does not have fully knowledge of the situation in the market before marking his decision. Success of the decision is subjected to chance

Decision Making Models

To solve a problem, the decision marker much define a framework/model to find the solution. Two main types of decision making model exists:

Classical model – Also called the rational model, it asserts that the manager is rational (make logical decision) and has the following assumptions:

The manager has completed information about the decision situation and operations under a condition of certainty.

The problem is clearly defined, and the decision-maker has knowledge of all possible alternatives and their outcomes.

Through the use of quantitative techniques, rationality, and logic, the decision-maker evaluates the alternatives and selects the optimum alternative -the one that will maximize the decision situation by offering the best solution to the problem.

Decision Making Models

Administrative model – as known as the behavioural model argue that people do not always make decisions with logic and rationality (faces a situation of bounded rationality)

Bounded rationality implies that individuals have boundaries to their rationality level due to their values/belief, lack of skills or lack of information.

Assumptions of the administrative model are: The manager has incomplete information about the decision

situation and operates under a condition of risk or uncertainty.

The problem is not clearly defined, and the decision-maker has limited knowledge of possible alternatives and their outcomes.

The decision-maker satisfies by choosing the first satisfactory alternative- one that will resolve the problem situation by offering a good solution to the problem.

Decision Making Techniques

Some useful techniques that has proved valuable in the decision making process

Marginal Analysis – marking use of the concept of “marginal” to take a decision

E,g: Profit maximising output is where Marginal Cost = Marginal Revenue

Financial Analysis – In this approach, the firm need to analyze the assets as well as liabilities, efficiency of capital investment, choice of project and various vital ratios.

Cost-Benefit analysis or project appraisal (payback, N.P.V, IRR) approach are some of the best available option

Decision Making Techniques

Group Techniques – decision take in consortium. Types of group decision making:

Brainstorming - Brainstorming is a technique in which group members spontaneously suggest keys to solve a problem. Its primary purpose is to generate a multitude of creative alternatives, regardless of the likelihood of their being implemented.

Nominal Group Technique - it involves the use of highly structured meeting agenda and restricts discussion or interpersonal communication during the decision making process. While the group members are all physically present, they are required to operate independently.

Delphi Group Technique - employs a written survey to gather expert opinions from a number of people without holding a group meeting. Unlike in brainstorming and nominal groups, Delphi group participants never meet fact to face (located in different cities)

Decision Making Tool

Linear Programming - is a mathematical method for determining a way to achieve the best outcome (such as maximum profit or minimising cost) in a given mathematical model for some list of variables represented in linear relationships. Assumption of linear programming:

Activities must be competing for limited resources. All relationships in the problem must be linear

E.g. Assume that a firm want to maximise its Total Profit subject to a labour (L) and land (M) constraint (as the amount of land and labour is limited in number) Max Π = Π(X,Y) subject to L1.X + L2.Y = L*

M1.X + M2.Y = M* X ≥ 0 and Y ≥ 0

To solve a linear programming problem, can make use of Graphical approach Simplex method

Decision Making Tool

H

A*D*2Q

Inventory Control is the supervision of supply, storage and accessibility of items in order to ensure an adequate supply is available to meet demand and thus avoid wastage. Economic order quantity is one of the oldest

classical inventory model minimizes total inventory holding costs and ordering costs. The EOQ formula is given as

Where

•Q = optimal order quantity

•D = annual demand qty

•A = Fixed cost per order

•H = Annual holding cost

Decision Making Tool Decision Tree – is a support tool that uses

of tree-like graph so as to make decisions. Decision making is based on the use of

probabilities, revenue, outcomes, cost or utility to make a decision.

A decision tree consists of 3 types of nodes: Decision nodes - commonly represented by squares Chance/probability nodes - represented by circles End nodes - represented by triangles

Decision Tree

Decision Node

Chance Node

Terminal Node

ActsActs EventsEvents OutcomesOutcomes

A1

A2

A3

E1

E2

E1

E2

E1

E2

O11

O12

O21

O22

O31

O32Do not need this action

Analysis done through roll-back principle