Recency Bias

1. Recency Bias • Salience – things our mind remembers • Recent things we remember • Hence, we over-weight that which happened recently, even if the odds are against it. • We hear of a shark attack on Cape Cod. So, we start to fear sharks even in Lake Michigan? Yup. • https://www.linkedin.com/pulse/recency-bias-our-financial-amnesia-dick-marcus/

2. Bewildering Choice in Financial Products • Thousands of stock and bond funds, and more every day • Yet, billions stashed in CDs & savings accounts • Once a decision is made, the tendency is not to change it • The success of 401-k investing is that it tends to be a one time decision with automatic investingelements • The relative failure of Roth IRAs because they tend not to be automatic

3. Decision Paralysis Trap • The phenomenon of decision paralysiscauses loss of wealth over time • We see a deal at a price below a previous reference price, then we tend to buy it • If see a deal and yet another deal on a higher quality product, then we tend to delay the decision • The more choice, the harder the choice • Market experiments with products tend to confirm decision paralysis

4. Mental Accounting Trap • The Las Vegas Honeymoon Roulette Story • Honeymooner takes $5 chip to roulette wheel • Bets on #17 three times in a row and wins • $214,375 and lets it ride just one more time • Hopes for $7.5 million, but loses. • Oh, well, he says, I just lost $5. • Money won in gambling is separated from other monies • Playing with house money • Money isn’t fungible under mental accounting

5. Self control forced savings penalties for early withdrawal “Christmas club” savings plans Budgeting & planning gifts tax rebates as “found money viewed as non-essential Different volatilities in sources or uses of funds bonus regular salary tax rebate gift lottery nest egg for a house Motives for Mental Accounts

6. Credit CardsandMental Accounts • Cash in wallet -- visual evidence of financial loss in purchase • Checking balance -- running subtotal of financial loss in a purchase • Credit card purchase -- harder to remember earlier expenditures, belated accounting of actions • Auction bids are HIGHER if participants pay for them with credit cards than with cash UWM EMBA

7. Financial Errors and mental accounts • Retirement savings: invest too conservatively even with 30 years ‘til retirement • Tendency to sell winners and hold losers: though winners have tax injury and selling losers have a tax benefit • Tendency to hold onto bequests:though best use may be to liquidate and reinvest

8. The Sunk Cost Trap • Once committed to a course of action, we feel cognitive dissonance if we stop. • Form of ‘Loss Aversion’ when faced with an outcome that is seen as a loss. • Possibly last game for Brett Farve in Green Bay in 2007. • You’ve paid $200 for your ticket. • You learn Farve is hurt and won’t play. • And there’s a terrible snow storm in Green Bay. • DO YOU GO?

9. Problems with Sunk Costs • Half-built large government project • seen in Nuclear Plants (WPPSS Bonds) • Example: A certain business Prof. has 2/3 of a medieval costume -- will he get the rest? • If stocks fall, can’t sell. This realizes the loss • Therefore, we tend to invest in risk-free securities such as money market accounts.

10. The Endowment Trap • If given an asset, people are reluctant to give it up. An “endowment effect.” • Value what you have more than if you were to buy it • Give coffee mugs to participants offer to purchase it back for $6, but few take it • Give $6 to each participant offer to sell mugs for $6, but few purchase • Endowment effect leads to keeping proven losers too long • So also can switching investments too often can be injurious to wealth UWM EMBA mug

11. When already invested in one choice and new alternatives are presented, many STAY with whatever is the initial endowment • No service charges at banks with large minimum balance vs. paying a service charge. • People appear to keep large minimum balances, even though more costly than paying a service charge. • Stay with a mutual fund family, once inside that family • Adam Bold frequently criticizes this behavior • From the Mutual Fund Store

12. The Anchoring Problem • Wording can alter one’s reference point • Example: Insurance purchases Q: Is having the lowest cost insurance important to you? • Leads toward selecting term life insurance Q: Is having a built in return and cash value important to you? • Leads toward selecting whole life insurance • The first answer to questions can anchor future decisions

13. AnchorsandFirst Impressions • The first thing seen or heard can become a reference, an anchor • The order of information affects decisions • First impressionsdominate (anchor) decisions in dating and (yes) in business investing • Financial choices can either be viewed as SELECTION of the best or REJECTION of the worst product • Emphasis onriskor emphasis on return shape the thinking.

14. Anchors & the Power of Suggestion • The agent says life insurance is typically 6 times annual income (now they say 10 times) • The salesman says that others paid $29.95, but for you it is discounted to $19.95 • You’re thinking of selling your house that you paid 80-G for in 1987 and note you are hoping to get 250-G to the prospective RE broker, what do you thinkshe’ll list it for?

15. The Ego Trap • How do you pronounce the capitol of Michigan, • “DE-troit” or “de-TROIT”? • Would you bet $50? • Likely you are overconfident • The greater amount of financial information given to a client, the more confident he or she becomes DETROIT

16. Overconfidence in Stocks & in Life • Heads I win, tails it’s chance • success is my own doing, but not failures. • Ask subordinates, how long a task will take • Tend to underestimate the time involved • ROR on restaurants overall below T-bill rate • Everyone thinks they know how to run it better • Evidence also from FSBO (Fizzbo Fallacy)

17. The Trap of Irrational Exuberance • Peer pressure, group psychology, and fads all speak of actions that copy others. • Tulipmania in seventeenth century Holland. • Speculative bubbles as self-fulfilling prophesies • Stock markets and Alan Greenspan’s and Shiller’s Irrational Exuberance • Incorrect rumors can add ‘noise’ to prices of securities

18. Example: Mutual Fund Returns • The S&P 500 earned 7.8% per year and the Barclay bond index earned 6.5% over 20 years. • A 50:50 mix would earn 7.2% per year. • But the average investor earned only 2.1%. • http://www.thestreet.com/story/11621555/1/average-investor-20-year-return-astoundingly-awful.htmlSource • So how can we explain this? • Buy and holdvs. switching for optimal asset allocation • Beware of fads in investing • How can we nudge ourselves to do better?

19. Executive MBA Program :Corporate Economics 752 • Chapter 6 of Farnham • In the long run, all inputs can change and all costs are variable • We live in the short run, but plan for the long run • A hospital can deliver more babies and will find its average cost declining • But, if too many expectant mothers come, the size and scale of the hospital or hospital chain has to adjust. • We look at the long run in Chapter 6 of Production Functions and Cost Function.

20. Production & Cost Analysis –> moving from the short run into the long run Average Cost

21. Average Cost • Definition: Average cost is simply the total cost of production divided by the number of units produced. AC = TC/Q • Average costs often decrease as quantity increases due to presence of fixed costs AC = (VC + FC)/Q • FC does not change as Q increases • Average costs are not relevant to extent decisions

22. Marginal Cost • Marginal cost is the cost to make and sell one additional unit of output. MC = TCQ+1 – TCQ. = D TC / D Q = dTC/dQ • Marginal cost is often lower than average cost (due to falling average costs) but not always. • Marginal costs matters in extent decisions

23. Extent(how much?) Decisions • Definition: Marginal cost (MC) is the additional cost required to produce and sell one more unit. • Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit. • If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit. • So, produce more when MR > MC; • Produce less when MR < MC. • Profits are maximized when MR = MC.

24. Marginal Analysis • Examples of extent decisions or “how many?” • Should you change the level of advertising? • Should you increase the quality of service? • Is your staff big enough, or too big? • How many parking spaces should you lease? • Marginal analysis answers these questions • This analysis tells you direction of change but not the distance. • You can only measure MR and MC at the current level of output – make a change and re-measure

25. How Many? A.K.A.Extent • American Express offers a Platinum Card to affluent customers • Numbers of Platinum Cards were limited to ensure high quality customer service in Japan, but consideration is now whether to expand. • With customer service technology advances, company considered expanding number of card holders • How many more should be added? • As more members are acquired, average spending per card member decreases because the financial threshold for membership is lowered • Costs of customer service rise for each additional member added, and growing beyond a certain point would require building and operating an additional call center • After analyzing the costs and benefits, American Express realized that it should expand its offering to only 15,000 more Platinum Card members • We call this an “extent” decision, because the company needed to decide “how many” platinum cards to provide. • We’ll examine how to make profitable extent decisions.

26. Marginal Analysis and Advertising • Discussion: How much advertising? • A $50,000 increase in the TV ad budget brings in 1,000 new customers • Estimated MCTV is $50 (the cost to get one more customer) • $50,000 / 1,000 = $50 • If the marginal revenue generated by this customer is greater than $50, do more advertising.

27. TVversusPhone Solicitation • Even if we do not know the marginal revenue, we can still use marginal analysis to make extent decisions • Compare TV advertising to telephone solicitation • Say you recently cut telephone budget by $10,000 and lost 100 customers • Estimated MCPH = $100= ($10,000 / 100) • So, to get one more customer costs $50 for TV and $100 for phone • MCPH > MCTV so shift ad dollars from phone to TV • TV vs. phone comparison assumes TV and phone customers generate same amount of marginal revenue Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium.

28. Production and Cost Analysis in the Long RunChapter 6 Production in China, why? • Lower labor cost • Large scale production facilities • Supply chains • Subsidies from the Chinese government • Supply of engineers • Lax regulations

29. Long Run Production Functions • All inputs are variable greatest output from any set of inputs • Q = f( K, L ) is two input example, both are variable • MP of capital and MP of labor are the derivatives of the production function MPL = Q /L • MP of both inputs decline as more input is applied, other things equal

30. Cobb-Douglas Production Functions: Q = A • K  • L  This is a Cobb-Douglas Production Function IMPLIES: Can be IRS, DRS or CRS: if  +  1, then CRS if  + < 1, then DRS if  + > 1, then IRS Coefficients are elasticities  is the capital elasticity of output  is the labor elasticity of output, which are a=EK and b=E L

31. Problem with a given LR Production Function • Suppose: Q = 1.4 L .70 K .35 Is the production function CRS? What is the labor elasticity of output? What is the capital elasticity of output? What happens to Q, if L increases 3% and capital is cut 10%? Q* = EL• L* + EK • K* = .7(+3%) + .35(-10%) = 2.1% -3.5% = -1.4%

32. Economies of Scale • CONSTANT RETURNS TO SCALE(CRS) • doubling of all inputs doubles output • INCREASING RETURNS TO SCALE(IRS) • doubling of all inputs MORE than doubles output • DECREASING RETURNS TO SCALE(DRS) • doubling of all inputs DOESN’T QUITE double output

33. Reasons for IRS 1.SPECIALIZATION • Adam Smith’s pin factory 2. INVENTORY ECONOMIES 3. SIZE-VOLUME LAWS • volume rises by cube 4. AVOID INHERENT INDIVISIBILITIES 5. QUANTITY DISCOUNTS • pecuniary and non-pecuniary quantity discounts

34. Reasons for DRS 1. INFLEXIBILITY e.g., Military or Post Office 2. HIGH COSTS OF MANAGING LARGE GROUPS use of divisions at G.M. 3. CAPACITY TO MAKE BIG DECISIONS IS LIMITED Austrian Argument --there is diminishing returns to the C.E.O. which cannot be completely delegated

35. Economies of Scope • FOR MULTI-PRODUCT FIRMS, COMPLEMENTARY IN PRODUCTION MAY CREATE SYNERGIES • especially common in Vertical Integration of firms • TC( Q 1 + Q 2) < TC (Q 1 ) + TC (Q 2 ) = Cost Efficiencies +

36. The Rayovac Company Founded in 1906, three entrepreneurs started a battery production company that grew to rival Energizer and Duracell. In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage of easy credit availability the company then bought many other battery production companies as well. A move the company said they made to take advantage of synergies or efficiencies and economies of scale. They expected that as they produced more of the same good, average costs would fall. The company also bought many unrelated companies (Remington) at the same time as the battery binge – the reasoning being that because of synergies, if they centralized the production of many different goods the costs of production would be lower. By February 2009 the new conglomerate was bankrupt Moral of the story?In business investments if you hear the words efficiency or synergy, keep your money. Spectrum Brands re-emerged in 2010 from bankruptcy

37. Long Run Cost Functions: Envelope of SRAC curves Ave Cost SRAC-small capital SRAC-med. capital SRAC-big capital LRAC--Envelope of SRAC curves Q

38. Long Run Costs SRMC1 • In Long Run, ALL inputs are variable • LRAC • long run average cost • ENVELOPE of SRAC curves • LRMC is FLATTER than SRMC curves LRMC SRAC1 LRAC Q

39. The Survivor Techniqueto study LR cost curves • The Survivor Techniqueexamines if some firm sizes are tending to succeed over time and if other sizes are declining. • This is a sort of Darwinian survival test for firm size. • Presently many banks are merging, leading one to conclude that small size offers disadvantages at this time. • Dry cleanersare not particularly growing in average size, however. George Stigler, Nobel laureate 1911-1991

40. Break Time

41. Estimating Production Functions Choice of data sets • cross sectionbest for long run analysis • output and input measures from a group of firms • or output and input measures from a group of plants in a firm • time seriesbest for short run analysis • output and input data for a firm over time

42. Choice of Functional Forms • Linear ?Q = a • K + b • L • is CRS • marginal product of labor is constant, MPL = b • can produce with zero labor or zero capital • isoquants are straight lines -- perfect substitutes in production K Q3 Q2 Q1 L

43. Leontief Production Functions K • Q = F(K,L) = min{bK, cL} • This is also known as fixed proportions • Must have one typists and one computerized word processing machine to produce written work. Q3 Q2 Q1 L

44. MultiplicativeCobb Douglas Production Function Q = A • K  • L  • IMPLIES • Can be CRS, IRS, or DRS • MPL = • QL • MPK =  • Q • Cannot produce with zero L or zero K • Log linear -- double log Ln Q = a + • Ln  • Ln L • coefficients are elasticities

45. ANSWERS Problem Suppose the following production function is estimated to be: ln Q = 2.33 + .19 ln K + .87 ln L • Take the sum of the coefficients • .19 + .87 = 1.06 • which shows that this production function is IRS. • 2. Use the Percentage Rate of • Change Rules #4 • Q* = E K • K* + E L • L* • Q* = (.19)•(-5%) + (.87)•(+2%) • = +.79% R 2 = .97 Q U E S T I O N S: 1. Is this CRS? 2. If L increases 2% & K decreases 5% what happens to output?

46. Executive MBA Program :Corporate Economics 752 • Biases and Blunders – Chapter 1 of Nudge by Thaler & Sunstein • Do we systematically make mistakes? • Cafeteria and food arrangement impacts us. • Grocery store arrangement impacts us. • Which prices are shown first, and second impact us. • Yes, we can be manipulated, at least somewhat. • What is Libertarian Paternalism? • Libertarian – is free to make your own decisions. • Paternalism – guiding like a parent. • Not oxymoronic, but using free choices with policy choices that tend to lead to better results. • Humans versus Econs(homo economicus) • What is a Choice Architecture? Econs Humans

47. The Disruptors’ FeastChapter 2: Define Reality • “Ignore the headlines, focus on the trend lines.” Bill Clinton • What are the trend lines in your business? • Globalization? Technology change? • Digital interface with customers? • Customers who want “experiences” not things? • Whatever it is, it leads to effects (disruption, volatility, and, yes, opportunities). See page 20.

48. We get Stuck in the Past • George Santayana said, “Those who cannot remember the past are condemned to repeat it.' • But the more common problem is people assume everything stays the same. It doesn’t. Arab Spring in 2010: Would Hosni Mubark always be the leader of Egypt? Most thought it would go to his son. Fall of Communism in 1991: Would the USSR always be with us and Mikhail Gorbachev stay? • How much did communication improvements contribute to these massive changes? • How much did urbanization contribute?

49. The Disruptors’ FeastChapter 3:Digital Technology • A critical trend line • Can you think of some technology that appears like it is just magic? • BCG is Boston Consulting Group, when reading chapter. • Gordon Moore (Intel’s founder) and Moore’s Law (1965) is the number of transistors per square inch on integrated circuits had doubled every year since their invention. Moore's law predicts that this will continue into the foreseeable future.

50. Learning & Digitals Effects • Many production processes get cheaper over time as it is faster, and simpler to do. • Learning-curve effects often show costs decline in volume. • Clearly, this is true also in digital technology. AC Volume