Lecture # 1: Topic #1Introduction: What this

course is about Recommended reading: Managerial Economics: A Problem Solving Appraoch (2nd Edition)

Luke M. Froeb, luke.froeb@owen.vanderbilt.edu Brian T. McCann, brian.mccann@owen.vanderbilt.edu

Lecture #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.

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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.

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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?

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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

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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?

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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 reserve

estimates were decreased.• Senior Management stepped in and ordered an

increase in the reserve estimate.

• Last clue:• Senior management resigned several months

later.

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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

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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

analyzing behavior, 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 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

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Lecture #1: Topic #2The One Lesson of

Businessversus economics

Topic # 2 – Summary of main points• Voluntary transactions create wealth by moving assets from

lower- to higher-valued uses.

• Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, or price controls, destroys wealth.

• Economic analysis is useful to business for identifying assets in lower-valued uses.

• The art of business consists of identifying assets in low-valued uses and devising ways to profitably move them to higher-valued ones.

• A company can be thought of as a series of transactions. A well-designed organization rewards employees who identify and consummate profitable transactions or who stop unprofitable ones.

Introductory anecdote

• Two prominent hospitals recently refused patients for kidney transplants because the organs were from “directed donations.”

• Demand for organs is high – far exceeding supply - and many never receive them.

• Despite high demand and low supply, buying and selling organs is illegal.

• Why?

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Capitalism 101To identify money-making opportunities, you

must first understand how wealth is created (and sometimes destroyed).

• Definition: Wealth is created when assets are moved from lower to higher-valued uses

• Definition: Value = willingness to pay

• Desire + income

• The chief virtue of a capitalist economy is its ability to create wealth

• Voluntary transactions, between individuals or firms, create wealth.

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Example: Robinson Crusoe economy

• A house is for sale:

• The buyer values the house at $130,000 – top dollar

• The seller values the house at $120,000 – bottom line

• The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here, $128,000.

• The buyer and seller both benefit from this transaction:

• Buyer surplus = buyer’s value minus the price, $2,000

• Seller surplus = the price minus the seller’s value, $8,000

• Total surplus = buyer + seller surplus, $10,000 = difference in values

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Wealth-Creating transactions• Which assets do these transactions move to higher-

valued uses?

• Factory Owners    

• Real Estate Agents

• Investment Bankers        

• Corporate Raiders     

• Insurance Salesman

• Discussion: How does eBay create wealth?

• Discussion: Which individual has created the most wealth during your lifetime?

• Discussion: How do you create wealth?

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Do mergers create wealth?• The movement of assets to a higher-valued use is the

wealth-creating engine of capitalism.

• Our largest and most valuable assets are corporations

• Dell-Alienware merger:

• In 2006, Dell purchased Alienware, a manufacturer of high-end gaming computers.

• Dell left design, marketing, sales and support in Alienware’s hands; manufacturing, however, was taken over by Dell.

• With its manufacturing expertise, Dell was able to build Alienware’s computers at a much lower cost

• Despite this example, many mergers and acquisitions do not create value – and if they do, value creation is rarely so clear.

• To create value, the assets of the acquired firm must be more valuable to the buyer than to the seller.

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Does government create wealth?• Discussion: What’s the government’s role is

wealth creation?

• Enforcing property rights, contracts, to facilitate wealth creating transactions

• Discussion: Why are some countries so poor?

• No property rights, no rule of law

• Discussion: Much of the justification for government intervention comes from the assertion that markets have failed. One money manager scoffed at this idea. “The markets are working fine, but they’re giving people answers that they don’t like, so people cry market failure.”

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The one lesson of economics• Definition: an economy is efficient if all wealth-

creating transactions have been consummated.

• This is an unattainable, but useful benchmark

• The One Lesson of Economics: the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

• Policies should then be judged by whether they move us towards or away from efficiency.

• The economist’s solution to inefficient outcomes is to argue for a change in public policy.

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One lesson of economics (cont.)• Taxes Destroy Wealth:

• By deterring wealth-creating transactions – when the tax is larger than the surplus for a transaction.

• Which assets end up in lower-valued uses?

• Subsidies Destroy Wealth:

• Example: flood insurance – encourages people to build in areas that they otherwise wouldn’t

• Which assets end up in lower-valued uses?

• Price Controls Destroy Wealth:

• Example: rent control (price ceiling) in New York City - deters transactions between owners and renters

• Which assets end up in lower-valued uses?

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The one lesson of business

• Definition: Inefficiency implies the existence of unconsummated, wealth-creating transactions

• The One Lesson of Business: the art of business consists of identifying assets in lower valued uses, and profitably moving them to higher valued uses.

• In other words, make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them.

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The one lesson of business (cont.)

• Taxes create a profit opportunity

• Discussion: 1983 Sweden tax

• Subsidies create opportunity

• Discussion: health insurance

• Price-controls create opportunity

• Discussion: Regulation Q. & euro dollars

• Discussion: What about ethics?

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Companies create wealth• Companies are collections of transactions:

• They go from buying raw materials, capital, and labor (lower value)

• To selling finished goods & services (higher value)

• Why do some companies have difficulty creating wealth?

• They have trouble moving assets to higher-valued uses

• Analogy to taxes, subsidies, price controls on internal transactions

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Alternate intro anecdote

• Zimbabwe experienced economic contraction of approximately 30 percent per year from 1999 to 2003

• Unemployment rates have been as high as 80 percent and life expectancy has fallen over 20 years during the reign of Robert Mugabe

• Why has economic growth been so low?

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Alternate intro anecdote (cont.)

• One main problem occurred in 2000• Mugabe backed his supporters takeover of commercial

farms, essentially revoking property rights of these farmers

• The state resettled the confiscated lands with subsistence producers - many with no previous farming experience. Agricultural production plummeted.

• Farm debacle had economic ripple effects through the banking and manufacturing sectors

• Declining production deprived the country of ability to earn foreign currency and buy food overseas

• Widespread famine ensued

• The government's initial attack on private property eventually led to more direct intervention in the economy and the destruction of political freedom in Zimbabwe.

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Extra Discussion: Darwinian Evolution of Organizations• Pressure to evolve from two sources• Product market competition• Financial market: threat of takeover

• Discussion: extinct forms, Phycor

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