Sunday, June 13, 2010

What If Analysis

The economics we are studying is mainly about decision making in prospect, meaning the choices to be made are upcoming and will be implemented in the near future. Yet people’s intuitive notion of buyer expenditure considers the behavior in retrospect, and likewise for seller cost. Think of a credit card statement which shows purchases for the previous month. Those purchases have already happened. If the bill has not yet been paid then the only prospective issue is to determine how much of the balance should be paid off on the current statement, all or only some part. (For some items on the list of purchases it may be possible to return the items and get a refund, in which case that too would be a choice in prospect. Mainly, however, the listed purchases are sunk and therefore not redeemable.)

Because much of our analysis is static, meaning time is not considered, it is quite easy to confuse the retrospective with the prospective and treat them as one and the same. In this essay we’ll belabor the difference between the two and refer to actuals when talking about the retrospective while referring to plans when talking about the prospective. What if analysis is a planning activity, an aid to decision making, a guide both to the choice that should be made and to the information that needs to be gathered in advance in making an informed choice. “What if” analysis also helps to highlight some of the implicit assumptions we’ve been making and bringing those assumptions into sharp focus.

Consider, for example, planning a vacation trip for next spring. The primary choice is where to go. A subsidiary but important consideration is how to get there – drive or fly – with the obvious consideration that driving shared between you and your friends will be considerably less expensive than flying, but that driving will chew up more time in getting to your destination as it will on the return trip. You’ll recall that we briefly considered this sort of decision in the first essay, Maps. Here we want to make a somewhat different point. In the Maps essay we talked about gathering information about the destination via travel books, recommendations from friends, or searching Web sites. But there are some things you can’t learn about in advance via doing this sort of background research. That is also true with regard to many other choices. Can you tell whether you prefer Coke to Pepsi without having tried both first? What about preferring Starkist Tuna to Chicken of the Sea? Or, more to the point of planning a vacation, whether you prefer hanging out at a beach to hiking in the Grand Canyon?

What do you do when you can’t know your preference between two similar alternatives till you’ve tried each of them out?