Sunday, June 13, 2010

What If Analysis - 2

If they are inexpensive items that you can sample in a comparatively short period of time, it seems reasonable that you will try each, determine which you prefer based on that sampling experience, and thereafter develop a brand loyalty for the one you like. Before developing that brand loyalty you might go through the trial again to see if you get the same results. Sometimes random factors (like when you last brushed your teeth or what you’ve eaten previously) can influence your sense of taste and seemingly alter your preference. So you might want to control for that. But over time, you might very well become loyal to one product and no longer try the other. Alternatively, if they taste pretty much the same to you you’ll end up deciding on the basis of whichever is available or, when both are available, whichever is cheaper.

The economist Phillip Nelson in his article Information and Consumer Behavior, was the first to distinguish between “inspection goods” or “search goods,” where all the salient qualities of the goods can be determined in advance of purchase, from “experience goods” where the essence of the product can only be learned by consuming it. His point is that this distinction becomes critical for determining the market structure in which the products are bought and sold. The standard model of perfect competition implicitly assumes that all goods are inspection goods. With experience goods there can be a moral hazard on the part of producers, whose care and effort in making the goods can affect the quality the consumer ultimately experiences. Klein and Leffler, in their paper The Role of Market Forces in Assuring Contractual Performance, explain how markets overcome this moral hazard via firm reputations that offer a “reputational rent” to producers with a good track record. (Both of these articles should be freely available to students through the Library if students are on the Campus network or by using the Campus VPN from a remote location.)

You can’t very well do this sort of sampling in advance of taking your vacation when it comes to comparing something like going to the Grand Canyon to hanging out at the beach. Getting to either location from campus is a big trip, no matter whether you drive or fly. In this case it’s one or the other, but not both, at least not both this time around. Without knowing in advance, how does one plan and ensure the what if analysis is well done?

Planning can’t remove your ignorance, but you can try to account for it. You can make upper bound and lower bound guesses of what you expect the value to be and then see whether the preferred alternative varies as the value changes within those bounds. If not, you can be fairly confident that you are making a good choice. If the preferred choice does vary, then it’s a judgment call. Of course, when on vacation part of the fun is going on an adventure. Having everything perfectly predictable makes things dull, though it does make the planning exercise a bit easier and more exact.

Let’s consider other situations where a significant decision is being made while the decision maker will be ignorant of some of the consequences in making that choice, by the nature of the decision being made. For example, think of procurement. That word, procurement, may conjure up Department of Defense purchase of a new weapons system or a new type of armor for soldiers in the field. However, procurement happens in many other settings; it is a fact of life in any major enterprise. Periodically, large purchases are necessary to keep the enterprise up to date in its operations. For example, consider the purchase of a new enterprise software system, say for inventory management and control. In middle to large size business, the approach to such procurement becomes routinized to make it efficient by eliminating wasteful idiosyncrasies in process. Within government agencies, the procurement process is typically regulated by law.

Often the process involves some preliminary fact finding, then the writing of a request for proposals (RFP), after which a period is allotted so that vendors can submit bids under the RFP. This is followed by a period where the proposals are reviewed and duly considered, after which a tentative winner is selected and a negotiation of terms commences. If that negotiation successfully concludes, then the winner is announced and the other bidders are notified that they were not selected. If the negotiation breaks down, the next best bid may be reconsidered, in which case an attempt to negotiate with that bidder commences. RFPs can fail entirely in that the buyer views all the bids as unsatisfactory, in which case after a certain period another RFP can be issued to elicit the interest of other vendors.

Bids can look quite different from one another. Products that appear similar within a general category can have subtle differences that prove substantial to users. The firms producing these products can differ in their managerial approach, their size, their track record, their financial well being, and their strategic approach to future product development. Large procurements often come with an element of services bundled with the product, to facilitate implementation, to ensure that vendor warranties are valid, and to promote an ongoing relationship between customer and firm. Buyers, too, can be quite different in how they rank these factors. For a product that is new to market and apt to undergo substantial further development, some buyers will focus on how stable early versions of the product are, while other buyers may be more interested in shaping further development of the product down the road, and still other buyers may emphasize how well the product integrates with the rest of their current business.

Once the original fact finding has been completed, the “what if” analysis ensues. It occurs in all subsequent stages in the process. In writing the RFP, the buyer attempts to signal to the vendors those factors that are mandatory in the product and those other factors that are highly desirable. But such factors are rarely in fact as in a checklist, present or not, but instead depend on how well they are implemented. There is a beauty contest aspect in determining that. When the bids actually come in the buyer goes through the “what if” analysis anew. Typically each bid has strengths and weaknesses so that no one bid trumps the others in an obvious way. (If there are some bids that are trumped, they get removed from consideration rather quickly. The more difficult part of the process is in making a selection from those bids that remain viable.) And there remains substantial residual uncertainty about what is being purchased even after the bids have come in. In this sense procurement can be similar to major consumer decisions, like buying a home.

To determine the winning bid, each bid must be scored. Think of this scoring as happening on a component by component basis, where each feature gets assigned a dollar value and those values are then tallied as are the implied costs from implementing the purchase. The costs are netted from the benefits for each bid. The winning bid produces the highest net benefit. This process is the essence of performing cost-benefit analysis.

The MasterCard Company ran a series of highly entertaining commercials, Priceless, each showing an ordinary individual having some unique and delightful experience along with a bunch of accompanying purchases that could be made with their credit card. For the linked commercial, the unique experience was getting a hole in one in golf with a witness watching, while the itemized purchases were the greens fee, lunch, golf balls and tees. The cost-benefit analysis can’t be performed if there is an item or a set of items that are priceless. Every item must be assigned a dollar benefit or a dollar cost (or both). Are the writers of the MasterCard commercials really right that there are some things money can’t buy or does everything have its price?