Decision-making context

1. Decision-making context Karl M. Rich, Lab 863 s.r.o. & Norwegian University of Life Sciences Jarkko K. Niemi, Natural Resources Institute Finland (Luke) This presentation was developed within the frame of the NEAT project, funded with support from the European Commission under the Lifelong Learning Programme (Grant no. 527 855). Please attribute the NEAT network with a link to www.neat-network.eu. Except where otherwise noted, this presentation is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.

2. Leaning objectives for this module • To understand the decision-making context • How is decision-making described in economics? • Which factors determine decisions by different stakeholders? • How do interactions between stakeholders influence decisions? • To be able to identify how economics analyses decisions

3. 1. Introduction Economics focuses on people and their decision-making

4. Introduction • Economics is the study of how scarce resources are or should be allocated (Black 1997, A dictionary of economics) • Decisions are needed to allocateresources • Economics highlights how and why people make choices under conditions of scarcity and the results of such choices on society. • Economics is about TRADEOFFS: Our needs are endless, but decisions to satisfy these needs are constrained by resource availability • Economics is about behavior and incentives, and how those influence choice

5. There are different economic actors (see lesson 1) • How do we study “how resources should be allocated”? • Who are the actors – who make the decisions? • What do these actors care about – i.e. how/why do they value(see previous lectures)different things? • Which options are there? • Which constraints are there? • How do we do that in the context of animal health? • Who are the actors, what are their values and goals, what can or cannot be chosen by them and why?

6. An example • Your car needs to be taken for service. Spend a few minutes by discussing in groups • Which actors are there in the process of getting the service? • From which options (services, service providers) can you choose? • How do you value different characteristics of service? • When you make your choice, which factors constrain your choice? • Next, think of yourself as a service provider (i.e. garage owner) • What kind of goals could you have as an entrepreneur? • Which factors affect what you can or cannot offer to a customer coming to your garage?

7. Scarcity, the basic economic problem • People have endless needs but only limited (scarce) resources • Because of scarcity, decisions must be made to allocate resources efficiently • How does a person determine efficiency? • Focus on consuming goods which can provide the highest value per resource (e.g. value for money)

8. Some key concepts – review from the previous lessons • Utility refers to how much happiness or satisfaction a person gets from consuming a set of goods • It is an abstract concept: there are no ”utility meters”! • Utility is a way of representing preferences and tradeoffs • It allows us to combine the happiness obtained by consuming different goods such as apples and bananas • To fulfill our needs, we make decisions on which needs are satisified and which are not ( tradeoffs). • Opportunity cost is the value of the second-best alternative that has to be given up to choose the first-best alternative

9. Preferences – review • Preferences refer to the ordering of alternatives. For example: • Do you like more apples than bananas? • Do you like more red than green apples? • Do you like more beef than pork? • Do you like more beef at €8 per kg than pork at €2 per kg? • Preferences are based on the amount of happiness that a person can get from consuming a good. An example of someone’s preferences 10 €/kg Less happiness More happiness

10. Factors affecting preferences - review • Tastes • Cultural factors, religion, norms, habits (e.g. seasonal demand for certain goods) • Biological factors: e.g. age, gender, physical characteristics • Social factors: e.g. education, occupation, marital status (e.g. singles and married persons have different needs) • Other factors

11. An example of a tradeoff: work and leisure • The more you work, the higher you value leisure • Higher compensation is required for you to exchange one hour of leisure to an additional hour of working • Working at weekends may carry a higher cost (opportunity cost) than working during office days because you have to give up more valuable time, such as time with your family or friends Wage rate €/h Hours worked

12. 2. The maximisation problem Economic actors strive for a goal Profit maximisation In sections 2 and 3 we will consider two groups (producers and consumers) which have different decision-making contexts

13. Economic actors can have different objectives • Important: yourclientmayhavedifferentgoalsthanyou! • Maximisehealth • Minimisecosts, e.g. ifonly a limitedquantitycanbeproduced • Maximiseprofit (=revenuesminuscosts) • Maximisingproductionorhealthmaynotmaximiseprofit! • Maximiseutility, i.e. happinessthatonecangetbyconsuminggoods, giventheirresources (e.g. income) available to get the goods • To maximiseutility, onemakestradeoffsbetweengoods (e.g. giveup a holiday in Spain to beable to spend a holiday in Italy) • Tradeoffsare made becauseresourcesarescarce

14. Veterinarians and clients affect each other’s business • Recall lesson 3: A vet’s effort to improve animal health can be regarded as an input • It is a cost to the client • It can cause changes in the client’s outputs and revenues • Hence the question: Is the vet able to increase a client’s revenues by more than the costs of the vet’s activity? • Note that the vet’s fee and prescribed medicine can be only a part of the cost. The advice of a vet can affect the consumption of other inputs as well! • Think how much value-added your advice can provide to the client?

15. Firms operate in the market • Most people enter business to make profit • To make profit, a firm must be able to sell its products, while the costs (monetary + non-monetary) of producing the good must be less than the sale price • Usually we assume that markets are perfectly competitive • There are many buyers and sellers which sell standardized products • Buyers and sellers know which opportunities there are • Firms are typically price takers, i.e. the price offered in the market is “take it or leave it”. If the price is too high, the buyer can go to another seller. No one firm in the market can influence the price of goods sold in the market.

16. Profit • Profit = revenue – cost • The farmer’s revenue is determined by the market prices (p) of inputs and output(s)and his/her production technology: f(x1, x2, x3, …), where • x1, x2, x3, … are different inputs into production (labor, feed, capital, etc.) • f(x1, x2, x3, …) describes how much output (e.g. milk) farmer can produce with certain amount of inputs • Each of these inputs has a cost associated with them i.e. x1costs w1, x2costs w2, etc.

17. Profit maximisation • Total profit (π) for the farmer is π= maximise(Poutput* f(x1, x2, x3, …) – w1x1-w2x2 – w3x3) • The costs and the revenues of production increase when production is increased, but in the relevant range the costs per unit of output usually increase more than the revenues per unit of output. • The law of diminishing returns: if the amount of one input is increased (while other inputs are held constant), amount of output added per unit of variable input will decrease • The profits are maximized where marginal (or additional) revenues equal to marginal (or additional) costs x1, x2, x3

18. Profit maximisation – example 1 (adapted from Frank and Bernanke 2008)

19. Profit maximisation – example 1 Economics and decision-making: different actors

20. Relationship between marginal cost, marginal revenue and average costs in example 1

21. Profit maximisation – illustrative example 2 Profits are maximized where marginal (or additional) revenues equal to marginal (or additional) costs

22. Low-hanging fruit • “Low-hanging fruit”: in expanding production, first use those resources with the lowest cost before using those with higher costs • First focus on business activities where you are able to get the highest reward (e.g. the highest return (%) on the capital invested)

23. Constraints can prevent your client from acting • Vet’s clients make decisions under constraints • They have limited resources: money, time, skills etc. • Even if clients would like to take actions for the benefit of their animals’ health, they may not have enough resources to do it! • Potential for a conflict between vet’s view and clients’ view

24. 3. The consumer Utility maximisation

25. Consumer’s perspective • Consumers consume to get more utility • Consumption decisions are constrained by the scarcity of resources (e.g. income  the budget constraint) • Consumption should be increased until the marginal benefit is smaller than the marginal cost • Diminishing marginal utility means that the extra utility from consuming something falls after a certain point • Consider an example where you spend all you income on two goods: milk and eggs

26. Milk My budget constraint: Price of eggs* quantity of eggs + Price of milk * quantity of milk = Income Eggs

27. My preferences represented through indifference curves. The curve shows how much I am willing to trade eggs for milk and still remain at the same level of happiness (utility) Milk Eggs

28. Indifference curves show tradeoffs. To stay at the same level of happiness moving from point A to point B, I have to get 3 portions of milk in return for giving up 1 egg. Milk B 3 A 1 Eggs

29. Milk More happiness (utility) as indifference curves move to the right Eggs

30. Choose the product mix where marginal benefits equal marginal cost or where indifference curve meets the budget constraint In other words, the marginal utility per euro of each good should be the same. Milk Eggs

31. 4. A group of actors is analysed differently from an individual actor Markets can play an important role in animal health issues

32. Market prices transmit information • If we take all farmers and consumers in the economy together, we get supply and demand curves. • Supply curves show the opportunity cost of supplying to the market • At higher prices, more people are willing to forgo other activities to supply a good to the market • Supply is determined by production technology, prices etc. • Demand curves show the willingness to pay for a good • At higher prices, only those with a high willingness to pay will buy • Demand is determined by income, prices etc.

33. Price of milk Supply Demand Quantity of milk

34. Price of milk Supply A disease can increase production costs and cause the supply curve to shift to the left, raising prices and reduce quantity supplied and consumed Demand Quantity of milk

35. Price of milk A disease can also cause the supply curve to shift to the right. This can happen e.g. if the disease does not reduce animal stock but reduces international trade. In this case, there would be a greater supply of meat in domestic markets Quantity of milk

36. Price of milk Supply Changes in preferences, income, or other markets can shift the demand curve. For instance, a zoonotic disease can make animal products less attractive. Then less would be consumed at the same price as earlier and the prices will be lower. Demand Quantity of milk

37. 5. Additional topics Things that influence decisions: Framing Incentives (information, risk)

38. Things that influence decision-making,… …. but not necessarily at all levels • Risk and uncertainty: Most people are risk-averse. Whenever there is decreasing marginal utility, there is also risk aversion • Asymmetric information: Actors are not equally informed about the situation • Strategic behavior • Externalities: Individual vs. collective benefits and costs. What is best for you may not be the best for your neighbour. • Market failures: Public goods, externalities • Ways to overcome these issues include contracts, insurance, taxes, property rights, etc.

39. The framing of situations matters • Consider the following two scenarios (from Kahneman and Tversky 1979) 1) Imagine your country is preparing for the outbreak of a disease expected to kill 600 people. There are two alternatives to act: a) If program A is adopted, exactly 400 people will die. b) If program B is adopted there is a 1/3 probability that no one will die and a 2/3 probability that 600 people will die. • Which program would you choose?

40. The framing of situations matters 2) Imagine your country is preparing for the outbreak of a disease expected to kill 600 people. There are two alternatives to act: a) If program A is adopted, exactly 200 people will be saved. b) If program B is adopted there is a 1/3 probability that 600 people will be saved and a 2/3 probability that no people will be saved. • Which program would you choose?

41. The framing of situation matters • On average, both programs results in exactly the same outcome. • Yet people often make different choices depending on how the risk is framed • Most choose B for scenario 1 (they choose to avoid the possibility of 600 deaths) • Most choose A for scenario 2 (they choose to save 200 lives with certainty)

42. Incentives to maintain biosecurity and report disease • Standard economic analysis assumes perfect information. But what if somebody has more information than another? • Adverse selection (hidden information): one party in a transaction uses information that is disadvantageous the party without the information • Example: a person insures a pet which he/she knows is sick • Moral hazard (hidden action): one party in a transaction takes advantage of asymmetric information and acts in a risky way after the transaction • Example: Not maintaining good biosecurity after having been insured • Solution: an incentive program that encourages both to maintain good biosecurity and to report the disease quickly

43. 6. Concluding remarks

44. Summary • People have endless needs but only limited resources. Hence, decisions must be made to allocate resources efficiently (tradeoffs) • Vets and their clients can have different goals and these differences can result in different decisions • Vet’s efforts can be regarded as an input which carries a cost (monetary and non-monetary) and contributes to outputs and revenues. How much value-added does a vet provide to the client? • Low-hanging fruit: first focus on business activities where you are able to get the highest reward. • Profits are maximized when marginal revenues equal to marginal costs. It is uneconomic to use more inputs than at this point.

45. Selected readings • Rushton, J. 2009. The Economics of Animal Health and Production. CABI, Wallingford, UK. • Bernanke, B. & Frank, R. H. (2008). Principles of microeconomics, 4th edition. McGraw Hill/Irwin, New York. • Rich, K. M., & Perry, B. D. (2011). The economic and poverty impacts of animal diseases in developing countries: new roles, new demands for economics and epidemiology. Preventive veterinary medicine, 101(3), 133-147. • Rich, K. M., Miller, G. Y., & Winter-Nelson, A. (2005). A review of economic tools for the assessment of animal disease outbreaks. Revue scientifique et technique (International Office of Epizootics), 24(3), 833-845. • Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica: Journal of the Econometric Society, 263-291.

46. Exercises Stakeholder role play Farm-level decision making: Production costs of disease prevention Farm-level decision making: Poultry production example

47. Exercise 1. Stakeholderrole play

48. Exercise 1 – Stakeholder role play • Divide into six groups corresponding to • Farmers • Industry • Government • Media • general public • environmental groups • Describe The ways in which your group interacts with the others The ways in which your group can affect an animal disease outbreak The reasons your group behaves as it does Represent your findings to other groups & contrast with their findings

49. Exercise 2. Farm-leveldecisionmaking: The cost of diseaseprevention

50. Exercise 2 – The cost of diseaseprevention • Mr. farmer is running a beef cattle farm which is experiencing continuous problems with an animal disease. Currently half of animals are sick. Mr. Farmer estimates that each sick animal is causing him a loss of €200. • The animals are divided into four groups. Each group can be treated separately with a new medicine to reduce the disease. Each group contains 50 animals and the medicine costs €12 per treated animal. • Mr. Veterinarian estimates that each additional group that is treated will reduce the number of sick animals by 20%. • Develop a table which indicates disease prevalence, treatment costs, disease losses and net costs of disease by the number of treated groups (0, 1, 2, 3, or 4). How many groups should be treated?