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

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

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

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

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

7 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

8 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

9 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

10 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

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

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

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

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 14

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 15

Representativeness: 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: A. Farmer B. Salesman C. Librarian D. Fighter Pilot 16 Population surveyed: 70% Salesmen 30% Librarians Associated Bias: Insensitivity to Prior Probability

“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?” 17 Representativeness: Representativeness: Probabilities are evaluated by the degree to which event A resembles event B Associated Bias: Misconception of Chance

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. 18 Representativeness: Representativeness: Probabilities are evaluated by the degree to which event A resembles event B Associated Bias: Insensitivity to Predictability

Availability: 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? 19 Associated Bias: Retrievability of Instances Associated Bias: Recency Effect Associated Bias: Effectiveness of a Search Set

Adjustment & Anchoring: 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? 20 Associated Bias: Insufficient Adjustment

Estimate the product: 8x7x6x5x4x3x2x1 Next: 1x2x3x4x5x6x7x8 Survey Says: 21 Associated Bias: Extrapolation Adjustment & Anchoring: Adjustment & Anchoring: Estimates are made by starting from an initial value that is adjusted to yield the final answer

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

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