Managerial Economics: How to Determine the Biggest Guaranteed Win
With the maxi-min criterion, your managerial economics decision is based upon the minimum or worst payoff associated with each action. For each action, you note the minimum payoff.
You make the best of a bad situation by choosing the action whose minimum payoff is best or largest.
Because it doesn’t know what’s going to happen to the price of oil, Global Airlines uses the maxi-min criterion to determine what fare to set. To apply the maxi-min criterion, Global takes the following steps:
Determine the worst payoff for reducing fares. For reduced fares, the possible payoffs are $50, $56, $43, and $35. The worst payoff is $35.
Determine the worst payoff for charging the same fares. For charging the same fares, the possible payoffs are $52, $51, $49, and $41. The worst payoff is $41.
Determine the worst payoff for raising fares. For raised fares, the possible payoffs are $42, $48, $47, and $44. The worst payoff is $42.
Chose the action with the best worst payoff. Global Airlines should raise fares because its worst payoff is $42 million, as compared to reduced fares’ worst payoff of $35 million and same fares’ worst payoff of $41 million.
Global Airlines raises fares because its worst payoff is $42 million. However, $42 million isn’t necessarily the profit it makes. The actual profit ultimately depends upon which state of nature actually occurs. So the actual profit depends on what actually happens to the price of oil.
The advantage of the maxi-min criterion is its simplicity. However, this criterion’s disadvantages include its emphasis on only the worst possible outcome of an action. Therefore, variation in payoffs and the better payoffs are ignored. In addition, this criterion ignores an outcome’s probability of occurring. It ignores risk.
The maxi-min criterion is used when you’re very conservative, and as a result you have a strong aversion to risk. This standard can be a good rule to use with a new business, when the firm’s continued existence necessitates that you avoid losses.