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Engineering Economic Analysis

Engineering Economic Analysis. Chapter 1  Making Economic Decisions. Rational Decision-Making. You buy a $15 calculator and while paying for it, the cashier, a friend, advises that you can buy the same calculator for $10 in the store around the block. What do you do?

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Engineering Economic Analysis

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  1. Engineering Economic Analysis Chapter 1  Making Economic Decisions rd

  2. Rational Decision-Making • You buy a $15 calculator and while paying for it, the cashier, a friend, advises that you can buy the same calculator for $10 in the store around the block. What do you do? • Now suppose the item is a $1250 coat that can be bought for $1255 in that store around the block. What do you do? rd

  3. Irrational Decision Making? Kahneman: People may drive across town to save $5 on a $15 calculator but not drive across town to save $5 on a $1250 coat. When given a choice between getting $1000 with certainty OR a 50% chance of getting $2500, most choose the certain $1000 even though the mathematical expectation of the $2500 is $1250. This is risk-aversion. But Kahneman and Tversky found that most of the same people when confronted with a certain loss of $1000 versus a 50% chance of no loss or a $2500 loss chose the risky alternative, called risk-seeking behavior. rd

  4. When Words Decide • Asian flu expected to kill 600 people. • Which program do you prefer? • Program A: 200 people will be saved. • Program B: 1/3 chance all 600 will be saved and 2/3 chance nobody will. • ______________________________________________ • Which program do you prefer? • Program C: 400 people will die • Program D: 1/3 probability nobody will die; • 2/3 probability that all 600 will die. rd

  5. When Words Decide Asian flu expected to kill 600 people. Which program do you prefer? Program A: 200 people will be saved. 72% Program B: 1/3 chance all 600 will be saved and 2/3 chance nobody will. ______________________________________________ Which program do you prefer? Program C: 400 people will die Program D: 1/3 probability nobody will die; 78% 2/3 probability that all 600 will die. rd

  6. Words to the Wise • Phrasing of questions can have counterintuitive effect on how we make decisions. • When choosing between positive outcomes, we tend to be • risk averse; between negative outcomes, risk seeking. • Default options lure the masses due to laziness or impatience. • Example: To be an organ donor in the US, one must sign a form. 25% of Americans are organ donors. • In European countries, the default option is organ donor. • 90% are organ donors. • Take a break -- one can decide for 50. rd

  7. Taste Tests • Hamburgers 75% lean or • Hamburgers 25% fat. • Which hamburgers taste better? • Death tax or inheritance tax? • Death bonds or life settlement-backed security rd

  8. Rational Decision Making? • Students were told to assume they had just won $30 and were offered a fair coin-flip upon which they could either win or lose $9. 70% of the students opted for the coin-flip. • But when other students were offered $30 for certain versus a fair coin-flip in which they got either $21 (lose) or $39 (win), a much smaller proportion, 43%, opted for the coin-flip. Framing Counterterrorism vs. law enforcement or War rd

  9. Example 1 • Bill is 34, intelligent, unimaginative, compulsive, and generally lifeless. In school he was strong in math but weak in social studies and humanities. Rank order the following statements, using 1 for the most probable and 8 for the least probable. • a) Bill is a physician who plays poker for a hobby. 8 b) Bill is an architect 2 c) Bill is an accountant 1 d) Bill plays jazz for a hobby 6 e) Bill surfs for a hobby 4 f) Bill is a reporter 3 g) Bill is an accountant who plays jazz for a hobby 7 h) Bill climbs mountains for a hobby 5 rd

  10. Example 2 • Linda is 31, single, outspoken, and bright. She majored in philosophy. As a student she was deeply concerned with the issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Rank order the following statements, using 1 for the most probable and 8 for the least probable • a) Linda is a teacher in elementary school b) Linda works in a bookstore and takes Yoga classes c) Linda is active in the feminist movement d) Linda is a psychiatric social worker e) Linda is a member of the League of Women voters f) Linda is a bank teller g) Linda is an insurance salesperson h) Linda is a bank teller and is active in the feminist movement rd

  11. Example 3 • Imagine 2 urns filled with balls, one of which 2/3 are one color and 1/3 another. That is, there are twice as many of one color as the other. A drew 5 balls: 4 red; 1 white.B drew 20 balls: 12 red; 8 white. Who should feel more confident that the urn contains 2/3 red and 1/3 white, A or B? rd

  12. Example 4 • The frequency of occurrence of letters in the English language was studied. In typical texts, the relative frequency of letters in the first and third position was tallied. • a) R is more likely to appear in the first position. b) R is more likely to appear in the third position. rd

  13. Example 5 • A town is serviced by two hospitals. Each day, In the larger hospital about 45 babies are born; in the smaller hospital about 10 babies are born. • Assume 50% of all babies are boys, but that the exact percentage may vary.For one year each hospital recorded the number of days in which 60% or more of the babies born were boys. Which hospital do you think recorded the larger number of such days? • a) the larger hospital b) the smaller hospital c) the number would be about the same for the two hospitals. rd

  14. Example 6 • a) A sure win of $30b) 80% chance to win $45 versus c) 75% chance to end without winningd) 25% chance to enter into a) A sure win of $30 b) 80% chance to win $45 versus e) 25% chance to win $30 • f) 20% chance to win $45 rd

  15. Simpson's Paradox • Is it possible for B's batting average to be twice A's batting average for the first half and for the second half of the season, but for A's average to be higher than B's average for the whole season? If so, show; if not, prove. rd

  16. Rational Decision-Making • Define the problem. • Identify the decision criteria. • Allocate weights to the criteria. • Develop the alternatives. • Evaluate the alternatives. • Select the best alternative. rd

  17. Assumptions of Rational Decision-Making • Problem clarity • Known options • Clear preferences • Constant preferences • No time or cost constraints • Maximum payoff rd

  18. 0 1 2 3 4 Economic Decision-Making • For fixed input: maximize benefits • For fixed output: minimize costs • For neither: maximize profit Cash flow diagram rd

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