Trade-offs in Decision Making

We have difficulty in decision making is because very often there are more than one alternative to choose from, where one alternative would better satisfy one objective but worse in the other. In a real world situation, we can't always have all goods in one alternative. In such a situation, we have to make trade-off, i.e. seek balance amongst all alternatives and make a relatively balanced decision. The more objectives and the more alternatives you have in your decision making process, the more trade-offs you will have to make, and more difficult a task the decision maker has to do. 

An excellent method called "Even Swap Method" is useful to get one or more objectives removed from your consequence table so as to simply a complex decision, which adopts the concept of trade-off . I term it "Cancel-Out" method. The key to it is "compensation". 

Cancel-Out Method

This method aims to simplify the objective or alternative by cancelling out. The principle is to make consequences for the objective(s) in all alternatives equal so that you can "ignore" or "remove" them/ it from your consideration/ comparison. This is done by compensation, adopting trade-off concept, such that the objective can be cancelled out. 

Example:

At present, your company has 20% market share and has been making $200,000 this year. 

You have two objectives: 

1. Raise profits
2. Expand market share

The initial decision problem:

• Whether your company should invest in a new market next year?

Initial information sought:

• If invest, profits would drop to $100,000, but would increase your market share to 26% (because the cost for developing a new market).
  
• If don't invest, profits would rise to $250,000 , and would increase your market share only to 21% (just 1% increase next year).

Below is the summary of the situation by a consequence table (Figure 1)

Figure 1. Consequence table for whether your company invest in a new market next year.

From the consequence table in Figure 1, we can see that the problem clearer. 

Now, the key question to ask is:

• Whether the extra $150,000 profit ($250,000 - $100,000) from not investing is worth more than the extra 5% market share?

Additional Information sought:

• I want to know: How much increase of the market share is sufficient to compensate for the loss of $150,000 profit?

After market research has completed, you find the answer below. 

• Answer: 3% market share increase is able to compensate for the loss of $150,000 profit.

Now, we got the key information. So we can make use of trade-off concept for the compensation, for simplification of the consequence table, by making one of the objectives equal, then we are able to cancel it out from the table. 

How to cancel out "profit"?

If we know 3% market share rise is worth $150,000 profit loss, we can deduct the current profit ($250,000) by $150,000 loss in order to raise the current market share (21%) by 3%, then we come up with:

• Profit (Not invest) = $250,000  - $150,000 = $100,000
• Market share (Not invest) = 21% + 3% = 24%

See below for the consequence table after cancelled-out (Figure 2).

As you can see, the objective of "profit" in both alternatives now are equal so it can be removed. So you can barely compare market share, the answer is obvious that you should go for investing the new market next year.

Figure 2. Consequence table after cancelled out the objective "Profits".

How about cancel out "market share" instead?

Alternatively we can cancel out the objective of "market share" by raising the market share of "not invest" to 26%, so we can calculate how much loss in profit will we end up to?

• Market share = 21% + 3% + 2% = 26%
• Profit  (Not invest) = $250,000 (current profit at 21% market share) + $150,000 (because 3% market share is worth $150k) + $150,000 × 2/3 (this is to calculate the money worth for 2% market share) = $0 
• This means, you got $0 profit if you expand the market share to 26%.

See below for the resultant consequence table (Figure 3)

By making the market share equal, you can remove it. So all you can compare is profit. The answer is clear, which is the same as removing profit above, i.e. you should invest in a new market next year. 

 

Figure 3. Consequence table after cancelled out the objective "Market Share".

As long as we have the key information of: "3% market share increase is able to compensate for the loss of $150,000 profit", we can play around with the numbers and do our cancel-out. 

The trouble is that this kind of key information is usually hard to get, and that may not be reliable.

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Beauty of Trade-off

Trade-off is an important/ useful concept to think/ trade, because as said, more often than not, in real life, you can't have a cake and eat it. 

The essence of trade-off is that you trade off one thing for another thing. In another word, you have to sacrifice one thing in order to have another. While you give up on one thing, you need to have an equivalent compensation for your loss of that thing. The compensation can be money or another object at an equal money worth.

Whenever you do business, make investment decisions or any other kind decisions, you have to sacrifice one important objective in order to get another equally (or more) important objective to be fulfilled. A compensation for your sacrifice is needed. 

At this time, cancel-out approach comes to play. It is a good way to protect yourself from making regretful decisions. Instead of the traditional way of trading off one for another, cancel-out method secures you with a compensation. It can ensure that there is a compensation in place (in money terms or whatever) in order to make the objective in different alternatives equal so that you can remove it from your consideration. 

 

One of the real life examples I could think about:

Example 2:

If you are a landlord and desperately want to let your house to someone as soon as possible in order to cover the cost of upkeeping the house, insurance and mortgage, shorten the void period, council tax, etc. An unknown potential tenant comes forward and expresses his willingness to rent your house. However he can't provide any previous house renting record/reference, credit footprint/history, and employment history/record, but he promises he will pay the rent on time each month. Then what you would do?

• At first glance, it sounds only two alternatives are available: 
• To let to him, or 
• Not to let to him
  

Actually there are additional layers of thinking about alternatives (options) here, which is trade-off!

• Alternative 1: You can let to him with a standard tenancy term (e.g. 1 - 2 years), with additional terms & conditions. 
• Alternative 2: You can let to him with a shorter period (e.g. 6 months), with additional terms & conditions.
  
• Alternative 3: You deny him, rather wait for a longer time period for another potential tenant with a more reliable, better background turn up. But there is an uncertainty for you, which is you don't know how long you will need to pay the cost mentioned if the market is not stressed enough to bring another potential tenant comes to you soon.
• Alternative 4: You deny him outright, and lower the rent to below market so as to bring more tenants to you more quickly.
  

For alternatives 3 and 4, you rapidly reject them because (i) of time uncertainty; (ii) there is no guarantee that the next potential tenant can have a better background than the current one; and (iii) lower the rent to below market cannot cover all the costs. Even worse, it might reduce the chance of letting it out, because, at such a low rent, people would suspect there may be some sort of problems in your house that you are so desperately wanting to let it out. That would make your house less attractive and less competitive in the market.

Thus, only alternative 1 & 2 are left for your decision now. What would you do then?

 

How to Remove Your Concerns of Letting the House to Him

Under the alternative of letting out to this potential tenant, you can make some trade-offs to remove your concerns/ objectives. 

Ask yourself what concerns you have if you let the house to him: 

1. not paying rent,  
2. destroy/ not properly taking care of my house, and 
3. he can't be got hold.  

 

Applying Trade-off thinking

Below are the conditions you may add to the tenancy agreement for him, so as to remove your concerns:

1. Ask the tenant to pay in advance all the rent he needs to pay during the tenancy agreement period. --> Remove the concern of "not paying rent".
2. Ask the tenant to pay some deposit for repair/maintenance in case any damages are found in any furniture/facilities/properties in the house that are not due to wear-and-tear --> Remove the concern of "not properly taking care of my house" 
• However, in reality, there is an upper limit of deposit the tenant is required to pay. For instance, in England UK, there is no more than 5% deposit of the annual rent below £50,000. The deposit is however stored in an independent organisation (Tenancy Deposit Scheme). If needed, the landlord will have to claim the loss from the deposit scheme. This of course will create a hurdle, risk of unsuccessful claim, and time delay. This law-dependent variable will need to factor in.
3. Ask the tenant to provide a valid guarantor whom you can find in case he can't get touched with --> Remove the concern of "can't get hold of". A guarantor in place is not only for the purpose of securing the rent payment, but also someone whom the landlord can make contact to, and whom can bear some sort of responsibility for his behaviour, and anything to do with the house.
   

What you should avoid?

If you think you can add the fee for buying a home or landlord insurance to the tenancy agreement and ask the tenant to pay for you, then you are buying trouble for yourself. Why? because the tenant would think he had already paid for the damages he is about to make, so he should create one. This is stupid, and no insurance company would accept this kind of deal. In the end, this measure could not remove your concern but create yourself more trouble. This sort of "trade-off" is stupid, which should be avoided.

What you cannot avoid?

Some uncertainties like criminal acts that the potential tenant may commit in your house, which will introduce hassles to your life from police and neighbours etc. This uncertainty however can't (or insufficiently) be eliminated by imposing additional terms and conditions in your tenancy agreement. Unless you can check the person's background clearly before your letting, otherwise it is almost impossible to know the chance despite how he looks. 

If this concern weigh too high to you, and you judge this person may has high probability to be one (by subjective judgement, and this may require some experience and knowledge about the local area, population quality, etc), then you should reject him outright. Because such hassles, damages, and the subsequent hassle are much more costly than you use your own money to cover the expense of the house. The consequence may be long lasting which can be out of your imagination. 

And I suppose you can't ask the tenant to pay in advance to cover your potential loss in case of this happens, because you will need a huge sum of money to compensate for your loss including time, emotional torture, scary and worry. This is avoidance approach. Where the uncertainty and risk is too high to afford, you'd better avoid than do trade-off. In this case, please don't test your luck, you should refuse him outright.

All in all, this illustrates how it is done by making use of trade-off to remove your concerns and balance with your risk tolerance. By doing the above, you can let the house to an unknown tenant with a reasonable compensation for the potential loss you worry about. Applying "trade-off" thinking, which I think is better than not letting out to this tenant, to protect yourself from loss.

So, this is the trade-off thinking, a way to do business and make decision.  

Trade-off With Money

Trade-off is an useful approach to gauge/measure your loss or sacrifice with money. This is stemming from the idea of compensation, that is all about: "it is the compensation from this enough for me to give up the other".

Parameters we can use:

• Willing-to-pay (WTP): How much you would be willing to pay in order to rid yourself from the consequence. That means, how much money you are willing to sacrifice in order to get out of the trouble.
  
• Willing-to-accept (WTA): This is a measure of how much money you would be willing to accept to compensate for the loss/suffering from the consequence. That means, how much money you are willing to jump into trouble.
  

So, which one you should use to calculate the compensation is dependent of your current status:

WTP usually means you are already in suffering which you want to get out from it, whereas WTA means you are not in suffering but you are willing to get paid, as a compensation, to jump into the calamity/suffering to suffer/ bear the undesirable consequence.

• WTP: Use money to buy yourself out from suffering: the maximum amount of money to pay to avoid the undesirables.
• WTA: Get money to pay yourself for the suffering: the minimum amount of money to accept the undesirables.
  

WTA is more like a compensation for a hard job. And, there is a gap between WTP and WTA, which is WTA is higher than WTP by 2 to 17 times.

This is a framework to think of how to make a compensation for an objective which can't be measured, e.g., emotional suffering. For example, how much money a person asks for compensation as a result of certain abuse in his company.

Conclusion

Cancel-out method can be used to simplify many objectives in a consequence table such that a decision can be made easier. Certain things you should note:

• Seek certain relevant and key information/data. (This is the hardest part)
  
• Usually the information is that you reduce one criteria will raise another, so that compensation can be made. Otherwise, no cancel-out can be done.
  
• Cancel objectives one by one. Start with easiest one first to simply the consequence table, then do the harder ones.
• If the contrasting objectives exist, separate the compensation at different levels until you can see the difference. For instance, you can see, in Example 2, on top of "to let" or "not to let", there are more discrete alternatives in-between at different levels of compensation to trade off your risk.
• Alternatively, eliminate alternatives using consequence table, and eliminate objectives using ranking table and multiples <Smart Choices (3) | Consequence Table> are also useful.

I had applied trade-off concept to calculate the investment size <Quantifiable Risk Tolerance>.

More Topics:

Smart Choices (1) | Focus and Defining Problem

Smart Choices (2) | Eight Elements in PrOACT Approach

Smart Choices (3) | Comparing with Consequence Table

Uncertainty and Chance

Decision Tree

Assessing Risk Tolerance for Decision Making

Subjective Probability Estimation 

可量化的風險承受程度 (Quantifiable Risk Tolerance)

Reference

John S. Hammond, Ralph L. Keeney, Howard Raiffa, Smart Choices - A Practical Guide to Making Better Life Decisions, Broadway Books, 1999.

 

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