Chapter 1 Introduction: What This Book is About Managerial Economics: A Problem Solving Appraoch (2 nd Edition) Luke M. Froeb, Brian T. McCann, Website, managerialecon.com COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 1 – Summary of main points Problem solving requires two steps: First, figure out why mistakes are being made; and then figure out how to make them stop. The rational-actor paradigm assumes that people act rationally, optimally, and self- interestedly. To change behavior, you have to change incentives. Good incentives are created by rewarding good performance. A well-designed organization is one in which employee incentives are aligned with organizational goals. By this we mean that employees have enough information to make good decisions, and the incentive to do so. You can analyze any problem by asking three questions: (1) Who is making the bad decision?; (2) Does the decision maker have enough information to make a good decision?; and (3) the incentive to do so? Answers to these questions will suggest solutions centered on (1) letting someone else make the decision, someone with better information or incentives; (2) giving the decision maker more information; or (3) changing the decision maker’s incentives.

Problem: Over-bidding OVI gas tract A young geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico. With knowledge of the productivity of neighboring tracts also owned by company, the geologist recommended a bid of $5 million. Senior management, though, bid $20 million - far over the next highest- bid of $750,000. What, if anything, is wrong? The goal of this text is to provide tools to help diagnose and solve problems like this. 3

Problem solving Two distinct steps: Figure out what’s wrong, i.e., why the bad decision was made Figure out how to fix it 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 i.e., they respond to incentives – to change behavior you must change incentives. 4

How to figure out what is wrong Under the rational actor paradigm, mistakes are made for one of two reasons: lack of information or bad incentives. To diagnose a problem, ask 3 questions: 1. Who is making bad decision? 2. Do they have enough info to make a good decision? 3. Do they have the incentive to do so? 5

How to fix it The answers will suggest one or more solutions: 1. Let someone else make the decision, someone with better information or incentives. 2. Change the information flow. 3. Change incentives Change performance evaluation metric Change reward scheme Use benefit-cost analysis to choose the best (most profitable?) solution 6

Keep the ultimate goal in mind For a business or organization to operate profitably and efficiently the incentives of individuals need to be aligned with the goals of the company. How do we make sure employees have the information necessary to make good decisions? And the incentive to do so? 7

Analyze the over-bidding mistake Another clue: After winning the bid, the geologist increased the estimated reserves of the company. But, after a dry well was drilled, the reserve estimates were decreased. Senior Management stepped in and ordered an increase in the reserve estimate. Last clue: Senior management resigned several months later. 8

ANSWER: Manager bonuses for increasing reserves The bonus system created incentives to over-bid. Senior managers were rewarded for acquiring reserves regardless of their profitability Bonuses also created incentive to manipulate the reserve estimate. Now that we know what is wrong, how do we fix it? Let someone else decide? Change information flow? Change incentives? Performance evaluation metric Reward scheme 9

Ethics Does the rational-actor paradigm encourage self-interested, selfish behavior? NO! Opportunistic behavior is a fact of life. You need to understand it in order to control it. The rational-actor paradigm is a tool for analyzing behavior, not a prescription for how to live your life. 10

Why else this material is important Employers expect that you will know these concepts Further, employers will expect that you are able to apply them. 11

How do firms behave? Economists often assume the goal of the firm is profit maximization. Opinions do differ, however. Discussion: pricing of hotel rooms during home football game weekends Traditional economic view – level pricing leads to excess demand; how are rooms allocated then (rationing, arbitrageurs,...) Contrasting view – businesses should not raise prices during times of shortage; businesses have a responsibility to consumers and society Your view? Text view: firms serve consumers and society best by engaging in free and open competition within legal limits while attempting to maximize profits. Not a license to engage in illegal behavior No denying that concerns exist about the ethical dimension of business Reasonable people have disagreed for millennia on what constitutes “ethical” behavior 12

13 1. Introduction: What this book is about 2. The one lesson of business 3.Benefits, costs and decisions 4. Extent (how much) decisions 5. Investment decisions: Look ahead and reason back 6. Simple pricing 7.Economies of scale and scope 8. Understanding markets and industry changes 9. Relationships between industries: The forces moving us towards long-run equilibrium 10. Strategy, the quest to slow profit erosion 11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing 13. Direct price discrimination 14. Indirect price discrimination 15. Strategic games 16. Bargaining 17. Making decisions with uncertainty 18. Auctions 19.The problem of adverse selection 20.The problem of moral hazard 21. Getting employees to work in the best interests of the firm 22. Getting divisions to work in the best interests of the firm 23. Managing vertical relationships 24. You be the consultant EPILOG: Can those who teach, do? Managerial Economics - Table of contents