Making Decisions in Uncertain Times—Economics You Can Use

Making Decisions in Uncertain Times—Economics You Can Use Capt Kelly Padden, PhD Eaker Center for Professional Development Air University, Maxwell AFB

Outline • Overview • Economic Concepts • Decision Making: Rules of Thumb (and how to overcome your biases!) • Current events: Q&A • Summary

Overview • Text • Microeconomics – Frank, 2000 • Macroeconomics – Mankiw, 2000 • Judgment under Uncertainty: Heuristics and Biases –Tversky & Kahneman, 1974

Outline • Overview • Economic Concepts • Decision Making: Rules of Thumb (and how to overcome your biases) • Current events: Q&A • Summary

Economic Concepts The word Economy . . . comes from a Greek word for “One who manages a household.”

Economic Concepts • Working Definition: Economics is the study of how people and societies make decisions under conditions of scarcity (i.e. time, money) • Economists study: …how people make decisions …how people interact with each other …the forces and trends that affect the economy as a whole

Economic Concepts • Economists assume: • Unlimited Wants • Unbounded desire to “have more” • Applies to individuals, states, nations, and federal agencies like the DoD The Problem is… • Limited Resources • Used to satisfy unlimited wants • Includes capital, labor, land, & entrepreneurship

Economic Concepts • Assumptions (cont’d) • People have Transitive Preferences • All People are Rational!!! • Always consider opportunity costs • Act in our own self-interest . . . • . . . to maximize profits • . . . to maximize happiness (utility)

Economic Concepts • How do Economists model the decision making process? • Rational people think at the margin • The additional cost/benefit of doing one more thing or producing one more thing • People respond to incentives • People (societies) face tradeoffs • Leisure Time vs. Work • Food vs. Clothing • Guns vs. Butter

Economic Concepts Speaking of Leisure vs Work and Self-interest…

Economic Concepts There is no such thing as a “free lunch.” There are only tradeoffs between alternatives.

Outline • Overview • Economic Concepts • Decision Making: Rules of Thumb (and how to overcome your biases) • Current events: Q&A • Summary

Rules of Thumb • Decisions must be made because of uncertainty • “Beliefs” about uncertain events: • Qualitative: “I think that…,” “Chances are…” • Quantitative: Odds, numerical probabilities • What determines beliefs? • Objective: Scientific methods • Subjective: Rules of Thumb • Decision-making rules of thumb CAN help, but sometimes lead to severe and systematic errors

Rules of Thumb • Representativeness • Probabilities are evaluated by the degree to which event A resembles event B • Availability • Frequencies are assessed by the ease with which instances can be brought to mind • Adjustment and Anchoring • Estimates are made by starting from an initial value that is adjusted to yield the final answer

Representativeness: Probabilities are evaluated by the degree to which event A resembles event B • “Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.” • Steve is most likely a: • Farmer • Salesman • Librarian • Fighter Pilot Population surveyed: 70% Salesmen 30% Librarians Associated Bias: Insensitivity to Prior Probability

Representativeness: Probabilities are evaluated by the degree to which event A resembles event B • “Mary is visiting Las Vegas for the first time. She’s been watching the roulette table for an hour, trying to discern a pattern she can exploit. After observing a long run of red on the roulette wheel, she decides it’s time to place her bet. What should she do?” Associated Bias: Misconception of Chance

Representativeness: Probabilities are evaluated by the degree to which event A resembles event B • Which of these firms is more likely to be profitable in the future? • Acme Automotive is poised for the future, leveraging positive customer relationships with dynamic corporate leadership. • XYZ Car Parts has suffered from a high debt-to-equity ratio and a stock price well below the industry average this year. Associated Bias: Insensitivity to Predictability

Availability: Frequencies are assessed by the ease with which instances can be brought to mind • Based on what you hear, does the list I’m about to read to you contain the names of more men or more women (and no fair writing/tallying as I read)? • What is the probability of a major hurricane hitting the US Gulf Coast this year? • If you were to sample a word at random from any book (in English), is it more likely that the word starts with r or that r is the third letter? Associated Bias: Retrievability of Instances Associated Bias: Recency Effect Associated Bias: Effectiveness of a Search Set

Adjustment & Anchoring: Estimates are made by starting from an initial value that is adjusted to yield the final answer • What percentage of South American countries are member states of the United Nations? Associated Bias: Insufficient Adjustment

Adjustment & Anchoring: Estimates are made by starting from an initial value that is adjusted to yield the final answer • Estimate the product: 8x7x6x5x4x3x2x1 Next: 1x2x3x4x5x6x7x8 Survey Says: Associated Bias: Extrapolation

Outline • Overview • Economic Concepts • Decision Making: Rules of Thumb (and how to overcome your biases) • Currentevents: Q&A • Summary

Making Decisions in Uncertain Times—Economics You Can Use