1. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PowerPoint Slides © Luke M. Froeb, Vanderbilt 2014

2. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Introduction: What This Book is About 2

3. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Main Points ▮ Problem solving requires two steps: 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. 3

4. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Main Points (continued) ▮ 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. 4

5. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Main Points (continued) ▮ 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. 5

6. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Problem: Over-bidding OVI gas tract ▮ 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? 6

7. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 7

8. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 8

9. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 9

10. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 10

11. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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? 11

12. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. ▮ 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. 12

13. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 13

14. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ethics and Economics ▮ The rational-actor paradigm can make students uncomfortable It seems to disregard personal ethics the guide behavior. ▮ You have to understand why unethical behavior occurs to fix it though Be able to anticipate opportunistic behavior to know how to avoid it 14

15. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 15