A DECISION to take a particular action is usually made because it appears to be the best of the alternative actions available. These notes are a discussion of: or rational methods of estimating the value of each action and making comparisons between alternative actions. A comparison requires the definition of a set of alternative actions to remedy a situation.
Most applications of the ideas and techniques discussed use a closed system or version of a Cash Flow approach. This is essentially how an individual, and other parts of the private sector tend to view how their particular part of the global economy behaves during fixed time intervals. In a closed system approach conservation of value prevails. This allows an accounting system to balance the books (accounts), i.e. the sum of the plus must equal the sum of the minus accounts (+/debits = +/credits), or the algebraic sum of the values = 0.
A public sector Economics approach while it may from time to time appear to use closed systems assumptions for accounting purposes, actually proceeds on an open system organic model. This approach assumes that wealth (value) can be created or destroyed. This is a more realistic model but it is harder to analyse the implications of actions. Politicians who use this approach unwisely can create extreme difficulties for their constituents in the future. Using realistic assumptions and estimates allows the closed system idea to model behaviour quite accurately. The problem with the open system approach is it may produce unrealistic results because of there no easily defined checks and balances. However rigid application of a closed system model can also produce undesireable effects.
These notes tend to use the private sector or closed system approach. Some
discussion of public vs. private sector views is included. For practical
purposes this means that all forms of taxes must be considered by individuals
and private sector entities. Many levels of government are allowed to
ignore various forms of taxation. Taxes
and Inflation tend to make the comparisons
of alternatives complicated. Uncertainties about the future make forecasting
unknown values somewhat inexact.
The future state must
be assumed or formally stated. When we use a single estimate for some
future event we imply only one probable future and assume
certainty, (i.e. no stated uncertainty).
The descriptions of the alternatives may outline a number of specific actions such as the choice between items, or a range of quantities for a mixture, etc. The general classes of alternatives are either discrete, or continuous. Each type may require very different kinds of analysis.
"Primary comparisons lead to a decision between alternatives with equivalent outcomes which are unaffected by time". (Riggs, J.L.; Economic Decision Models for Engineers and Managers; LCcn 67-26885). There is always at least one alternative. It is the do nothing, or null alternative. If you choose to do something then there are at least two alternatives and a primary comparison is warranted.
A value system is required. The system must reflect the objectives that are expected to be achieved by the action. The most common and widely used value system is: money or monetary value. This discussion will focus on measures that behave the same as monetary value, but are not necessarily 'money'. An arbitrary value system should use a ratio scale if practical. The types of value scales are usually described as:
For precision we should use ratio scale values to rank alternatives by an ordinal scale. A transform from any value characteristic to a ratio scale like money is possible. The difficulties and techniques are discussed elsewhere. Initially assume the use of money or a value system that behaves like money. This QUANTIFIES value so it can be used mathematically.
Values for a particular entity, or action vary with time and place. Assume that place value is implicit in the value given. If transportation is required to locate an alternative to the required position, then the value should be adjusted to reflect the relocation cost.
An initial first step in making a comparison is to accurately estimate all the value flows and associated times related to each alternative subject to comparison. The accuracy and precision of valuations and comparisons cannot be better than those of the estimates. Good estimates are needed for good comparisons and decisions.
The next step is to reduce all the values associated with an action to a
common point in time. These values are
usually referred to as a
PRESENT VALUE (i.e. at time 0), or a FUTURE VALUE at time n. This
is done using the idea of EQUIVALENCY to eliminate the effect of timing.
A function that accurately transforms any value at any time to an equivalent
value at any other time is required. I call this procedure Time
Value. The effects of the probable changes in the amount of value
represented by the numerical values (amount of money) used in the future should
be included. These are inflation effects that will normally lower the
value represented by a sum of money in the future. However in times of
deflation the value of a sum will increase.
The most important concept in estimating value is to realize that it is not valid to add, or subtract values (costs, or revenues) that happen at different points in time. Many people find it hard to accept this fact because coins, or printed money, etc. appear to have the same value over considerable periods of time.
The transformation function commonly used is the 'end of period compound interest model'. Time is measured in discrete accounting periods, rather than as a continuum. This model has been used for centuries by the financial community and thus has validity. The periods may be as short or long as required. Modern computation techniques tend to reduce the length of a period.
Another effect on the estimate of the net amounts of money available from receipts (revenues) and disbursements (costs) are the applicable taxes. The most important of these are income Taxes. Remember that the only income available for spending is after tax income. Saving taxes is the equivalent to earning income.