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Chapter 1
Introduction: What ThisBook is About
Managerial Economics: A Problem Solving Appraoch (2nd Edition)Luke M. Froeb, [email protected]
Brian T. McCann, [email protected]
Website, managerialecon.com
COPYRIGHT 2008Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
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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 alignedwith 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 makers incentives.
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Problem: Over-bidding OVI gas tract
A young geologist was preparing a bid recommendation for anoil tract in the Gulf of Mexico.
With knowledge of the productivity of neighboring tracts also
owned by company, the geologist recommended a bid of $5million.
Senior management, though, bid $20 million - far over thenext highest-bid of $750,000.
What, if anything, is wrong?
The goal of this text is to provide tools to help diagnose andsolve problems like this.
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Problem solving
Two distinct steps:
Figure out whats 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 modelbehavior. The rational actor paradigm states:
People act rationally, optimally, self-interestedly
i.e., they respond to incentives to change behavior you must changeincentives.
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How to figure out what is wrong
Under the rational actor paradigm, mistakes aremade 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?
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How to fix it
The answers will suggest one or more solutions:
1. Let someone else make the decision, someone withbetter 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 (mostprofitable?) solution
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Keep the ultimate goal in mind
For a business or organization to operate profitablyand efficiently the incentives of individuals need tobe aligned with the goals of the company.
How do we make sure employees have theinformation necessary to make good decisions?
And the incentive to do so?
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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 reserveestimates were decreased.
Senior Management stepped in and ordered anincrease in the reserve estimate.
Last clue:
Senior management resigned several months later.
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ANSWER: Manager bonuses forincreasing reserves The bonus system created incentives to over-bid.
Senior managers were rewarded for acquiringreserves regardless of their profitability
Bonuses also created incentive to manipulate thereserve 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
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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 analyzingbehavior, not a prescription for how to live your life.
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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.
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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 gameweekends
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 ofshortage; businesses have a responsibility to consumers and society
Your view?
Text view: firms serve consumers and society best by engaging in freeand 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 ofbusiness
Reasonable people have disagreed for millennia on what constitutes
ethical behavior
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131. Introduction: What this book is about2. The one lesson of business3.Benefits, costs and decisions4. Extent (how much) decisions5. Investment decisions: Look ahead and reason back
6. Simple pricing7.Economies of scale and scope8. Understanding markets and industry changes9. Relationships between industries: The forces moving us towards long-run equilibrium10. Strategy, the quest to slow profit erosion11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing13. Direct price discrimination14. Indirect price discrimination15. Strategic games16. Bargaining17. Making decisions with uncertainty18. Auctions
19.The problem of adverse selection20.The problem of moral hazard21. Getting employees to work in the best interests of the firm22. Getting divisions to work in the best interests of the firm23. Managing vertical relationships24. You be the consultantEPILOG: Can those who teach, do?
Managerial Economics -Table of contents