18 – Thinking like an economist 2: Decisions, decisions

Economics is fundamentally about decisions, either understanding the decisions that people make, or helping people (especially governments) to make decisions.

Some decisions are hard, but not complex. Offer my daughter Rosie a choice between two packets of potato chips of different flavours, and you are likely to set off a protracted period of agonising over the decision.

Some decisions are easy, even though they are embedded in complexity. A government decision to protect a particular piece of native vegetation in an agricultural region may have a range of ecological, economic and social consequences, but may nevertheless be easy to make if an iconic endangered species is discovered living in it.

But when a decision is complex, and the “right” choice is not obvious, the decision maker can benefit from some help in tackling it in a thorough and systematic way. Economists can provide this help, with advice on the application of “decision theory” or “decision analysis”. We are not the only discipline that makes use of decision theory, but we make more extensive use of it than most because of our particular interest in decisions. Economists focus on decisions where scarce resources have to be allocated among competing uses and where, as a consequence, trade-offs are required. This applies to all hard, complex decision problems.

One general contribution that economists can make is to clarify the elements of allocation decision problems, and thereby detail the information requirements for the problem to be fully specified and solvable. Put most simply, the elements consist of one or more objectives, some alternatives or options to choose from, some constraints that must not be violated, and some technical relationships describing how different options (or combinations of options) will affect the objective(s) (i.e. response functions that describe cause and effect).

Hugh Possingham (2001) (an ecologist) lists seven stages in the application of a decision theory approach.

1. Specify the management objective

2. List the management options (the decision variables)

3. Specify the current state of the system

4. Develop a model of the dynamics of the system being managed (cause-and-effect relationships)

5. Specify constraints that limit the decision variables

6. Be honest about what we don’t know (specify ranges of uncertainty)

7. Find solutions to the problem

To these I would add:

8. Investigate the sensitivity of the solutions to changes that reflect our uncertainty about the parameters of the problem.

Economists have a range of computer modelling tools available to help with steps 7 and 8.

Possingham is interested in improving the efficiency and cost-effectiveness of allocation decisions for environmental programs in Australia. He argues that past efforts to address environmental problems have not been efficient because, often, the problem is not properly posed, objectives are not clearly stated, constraints are not identified and relevant theory and data are not used in decisions. In other words, people have not taken a thorough and systematic approach to decision making.

To illustrate the potential gains from a more thorough and rigorous approach, consider the BushTender pilot program conducted by the state government in Victoria. They found that an improved allocation process for funding to protect remnant vegetation, with greater attention to maximising outcomes per dollar spent, can dramatically increase the resulting environmental benefits (Stoneham et al. 2003). Compared with the approach used in typical schemes to encourage fencing of remnant vegetation, and using a particular system for rating the environmental outcomes, the BushTender approach improved the cost-effectiveness of environmental expenditure by between 7 fold and 30 fold. That is a dramatic increase in environmental outcomes for a given level of expenditure.

David Pannell, The University of Western Australia

Further reading

Possingham, H. 2001. The business of biodiversity: applying decision theory principles to nature conservation. Tela Paper No. 9, Australian Conservation Foundation, Melbourne.

Stoneham, G., Chaudhri, V., Ha, A. and Strappazzon, L., 2003. Auctions for conservation contracts: an empirical examination of Victoria’s BushTender trial. Australian Journal of Agricultural and Resource Economics 47: 477-500.