Transcript lecture 1 - Vanderbilt University

PowerPoint Slides © Luke M. Froeb, Vanderbilt 2014
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.
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Introduction:
What This Book
is About
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.
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.
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.
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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.
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.
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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.
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.
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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?
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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
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.
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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.
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.
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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.
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.
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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
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.
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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?
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.
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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.
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.
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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
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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
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.
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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
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.
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