How do a company’s goals, constraints, incentives and market rivalry affect its economic decision-making?

©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages CHAPTER Introduction:

What This Book is About 1 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points ● Problem solving requires two steps:

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1) figure out what’s causing the problem 2) figure out how to fix it ● For both steps, predict how people behave ● Rational -actor paradigm: assumes that people act rationally, optimally, and self -interestedly ● Simply put, people respond to incentives ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● Good incentives come from rewarding good performance • Ex: commission on sales ● A well -designed organization aligns employee incentives with organizational goals ● Specifically, employees have enough information to make good decisions, and the incentive to do so ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● Three questions to find the source of the problem:

1) Who is making the bad decision? 2) Does the decision maker have enough information to make a good decision? 3) Does the decision maker have the incentive to make a good decision? ● Answers to these questions will suggest solutions:

1) Letting someone with better information or incentives make the decision 2) Giving the decision maker more information 3) Changing the decision maker’s incentives ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem: Over -bidding OVI G as T ract ● A young geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico ● The geologist knew the productivity of nearby tracts also owned by the company ● Knowing this, he recommended a bid of $5 million ● Senior management bid $20 million – far over the next highest bid of $ 750,000 ● What, if anything, is wrong? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem Solving ● The goal of this text is to provide tools to help identify and solve problems like this ● Two distinct steps:

1) Figure out what’s wrong • i.e., why overbidding occurred 2) Figure out how to fix it ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Model of Behavior ● Both steps require a model of behavior • Why are people making mistakes? • What can we do to make them change? ● Economists use the rational -actor paradigm to model behavior ● The rational actor paradigm states:

• People act rationally, optimally, self -interestedly • Meaning, they respond to incentives – to change behavior you must change incentives ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Answer to Overbidding Problem ● Answer the three questions:

1) Senior management made the bad decision to overbid 2) They had enough information to make the right decision 3) They didn’t have the incentive to do so ● A bonus system created incentives to over -bid. • Senior managers were rewarded for acquiring reserves regardless of their profitability • They had the young geologist “do what he could” to increase the size of estimated reserves • Bonuses also created an incentive to manipulate the reserve estimate ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Solution to Overbidding Problem Now that we know what is wrong, how do we fix it?

● Let someone else decide? NO ● Change information flow? NO ● Change incentives? YES • Change performance evaluation metric • Ex: Increased profitability as measurement of success instead of increased acquired reserves • Reward scheme • Ex: Make bonuses tied to profitability, not acquired reserves ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages NAR Problem ● In 2006, a TV reporter was sent into a National Auto Repair (NAR) shop with a perfectly good car ● The reporter came out with a new muffler and transmission – and a bill for over $8,000 ● The news story badly hurt NAR’s profits ● How do you solve this problem? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem -Solving Algorithm 1) Who is making the bad decision?

• The mechanic recommended unnecessary repairs 2) Does the decision maker have enough information to make a good decision?

• Yes, in fact, the mechanic is the only one with enough information to know whether repairs are necessary ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem -Solving Algorithm, cont. 3) Does the decision maker have the incentive to make a good decision?

• No, the mechanic is evaluated based on the amount of repair work he does, and receives bonuses or commissions tied to the amount of repair work ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages NAR Solution ● There was an incentive issue ● NAR tried two solutions 1) reorganized into two division – led to colluding 2) adopted flat pay – led to less incentive to work hard ● Suggested resolution: add an additional performance evaluation metric to original commission scheme • Ex: Sporadically send in “secret shoppers” like the news reporter ● This shows the trade -offs you face when creating solutions ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Ethics and Economics ● The rational -actor paradigm can make students uncomfortable • It seems to disregard personal ethics that guide behavior of most people ● You have to understand why unethical behavior occurs to fix it though • Be able to anticipate opportunistic behavior to know how to avoid it ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Value System ● Debates about ethics and economics really are about different value systems ● Deontologists : actions are good or ethical if they conform to a set of principles (ex: The Golden Rule) ● Consequentialists : actions are judged based on whether they lead to a good consequence ● Economics is more consequentialist • Uses analysis to understand the consequences of different solutions ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018 ). Managerial economics: a p roblem solving approach (5 th ed.). Boston, MA: Cengage Learning.

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