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Australia • Brazil • Mexico • Singapore • United Kingdom • United States

fifth edition

Managerial economics

A P R o B L e m s o LV i n G A P P Ro Ac h

luke M. Froeb Vanderbilt University

Mikhael Shor University of Connecticut

Brian T. McCann Vanderbilt University

Michael r. Ward University of Texas, Arlington

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Library of Congress Control Number: 2017947785

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Managerial Economics, Fifth Edition Luke M. Froeb, Brian T. McCann, Mikhael Shor, Michael R. Ward

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In loving memory of Lisa, and for our families: Donna, David, Jake, Halley, Scott, Chris, Leslie, Jacob, Eliana, Cindy, Alex, and Chris

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v

Preface: Teaching Students to Solve Problems xiii

SECTION I Problem Solving and Decision Making 1 1 Introduction: What This Book Is About 3 2 The One Lesson of Business 15 3 Benefits, Costs, and Decisions 25 4 Extent (How Much) Decisions 37 5 Investment Decisions: Look Ahead and Reason Back 49

SECTION II Pricing, Costs, and Profits 65 6 Simple Pricing 67 7 Economies of Scale and Scope 83 8 Understanding Markets and Industry Changes 95 9 Market Structure and Long-Run Equilibrium 113 10 Strategy: The Quest to Keep Profit from Eroding 125 11 Foreign Exchange, Trade, and Bubbles 137

SECTION III Pricing for Greater Profit 151 12 More Realistic and Complex Pricing 153 13 Direct Price Discrimination 163 14 Indirect Price Discrimination 171

SECTION IV Strategic Decision Making 183 15 Strategic Games 185 16 Bargaining 205

SECTION V Uncertainty 215 17 Making Decisions with Uncertainty 217 18 Auctions 233 19 The Problem of Adverse Selection 243 20 The Problem of Moral Hazard 255

BrieF COnTenTS

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vi BRIEF CONTENTS

SECTION VI Organizational Design 267 21 Getting Employees to Work in the Firm’s Best Interests 269 22 Getting Divisions to Work in the Firm’s Best Interests 283 23 Managing Vertical Relationships 295

SECTION VII Wrapping Up 307 24 Test Yourself 309

Epilogue: Can Those Who Teach, Do? 315

Glossary 317

Index 325

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vii

Preface: Teaching Students to Solve Problems xiii

SECTION I Problem Solving and Decision Making 1

CHAPTER 1 INTRODUCTION: WHAT THIS BOOk IS ABOUT 3 1.1 Using Economics to Solve Problems 3 1.2 Problem-Solving Principles 4 1.3 Test Yourself 6 1.4 Ethics and Economics 7 1.5 Economics in Job Interviews 9 Summary & Homework Problems 11 End Notes 13

CHAPTER 2 THE ONE LESSON Of BUSINESS 15 2.1 Capitalism and Wealth 16 2.2 Does the Government Create Wealth? 17 2.3 How Economics Is Useful to Business 18 2.4 Wealth Creation in Organizations 21 Summary & Homework Problems 21 End Notes 23

CHAPTER 3 BENEfITS, COSTS, AND DECISIONS 25 3.1 Background: Variable, Fixed, and Total Costs 26 3.2 Background: Accounting versus Economic Profit 27 3.3 Costs Are What You Give Up 29 3.4 Sunk-Cost Fallacy 30 3.5 Hidden-Cost Fallacy 32 3.6 A Final Warning 32 Summary & Homework Problems 33 End Notes 36

CHAPTER 4 ExTENT (HOW MUCH) DECISIONS 37 4.1 Fixed Costs Are Irrelevant to an Extent Decision 38 4.2 Marginal Analysis 39 4.3 Deciding between Two Alternatives 40

COnTenTS

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CONTENTSviii

4.4 Incentive Pay 43 4.5 Tie Pay to Performance Measures That Reflect Effort 44 4.6 Is Incentive Pay Unfair? 45 Summary & Homework Problems 46 End Notes 48

CHAPTER 5 INVESTMENT DECISIONS: LOOk AHEAD AND REASON BACk 49 5.1 Compounding and Discounting 49 5.2 How to Determine Whether Investments Are Profitable 51 5.3 Break-Even Analysis 53 5.4 Choosing the Right Manufacturing Technology 55 5.5 Shut-Down Decisions and Break-Even Prices 56 5.6 Sunk Costs and Post-Investment Hold-Up 57 Summary & Homework Problems 60 End Notes 62

SECTION II Pricing, Costs, and Profits 65

CHAPTER 6 SIMPLE PRICING 67 6.1 Background: Consumer Values and Demand Curves 68 6.2 Marginal Analysis of Pricing 70 6.3 Price Elasticity and Marginal Revenue 72 6.4 What Makes Demand More Elastic? 75 6.5 Forecasting Demand Using Elasticity 76 6.6 Stay-Even Analysis, Pricing, and Elasticity 77 6.7 Cost-Based Pricing 78 Summary & Homework Problems 78 End Notes 81

CHAPTER 7 ECONOMIES Of SCALE AND SCOPE 83 7.1 Increasing Marginal Cost 84 7.2 Economies of Scale 86 7.3 Learning Curves 87 7.4 Economies of Scope 89 7.5 Diseconomies of Scope 90 Summary & Homework Problems 91 End Notes 94

CHAPTER 8 UNDERSTANDING MARkETS AND INDUSTRy CHANGES 95 8.1 Which Industry or Market? 95 8.2 Shifts in Demand 96 8.3 Shifts in Supply 98 8.4 Market Equilibrium 99 8.5 Predicting Industry Changes Using Supply and Demand 100 8.6 Explaining Industry Changes Using Supply and Demand 103 8.7 Prices Convey Valuable Information 104 8.8 Market Making 106

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CONTENTS ix

Summary & Homework Problems 108 End Notes 111

CHAPTER 9 MARkET STRUCTURE AND LONG-RUN EqUILIBRIUM 113 9.1 Competitive Industries 114 9.2 The Indifference Principle 116 9.3 Monopoly 120 Summary & Homework Problems 121 End Notes 123

CHAPTER 10 STRATEGy: THE qUEST TO kEEP PROfIT fROM ERODING 125 10.1 A Simple View of Strategy 126 10.2 Sources of Economic Profit 128 10.3 The Three Basic Strategies 132 Summary & Homework Problems 134 End Notes 136

CHAPTER 11 fOREIGN ExCHANGE, TRADE, AND BUBBLES 137 11.1 The Market for Foreign Exchange 138 11.2 The Effects of a Currency Devaluation 140 11.3 Bubbles 142 11.4 How Can We Recognize Bubbles? 144 11.5 Purchasing Power Parity 146 Summary & Homework Problems 147 End Notes 149

SECTION III Pricing for Greater Profit 151

CHAPTER 12 MORE REALISTIC AND COMPLEx PRICING 153 12.1 Pricing Commonly Owned Products 154 12.2 Revenue or Yield Management 155 12.3 Advertising and Promotional Pricing 157 12.4 Psychological Pricing 158 Summary & Homework Problems 160 End Notes 162

CHAPTER 13 DIRECT PRICE DISCRIMINATION 163 13.1 Why (Price) Discriminate? 164 13.2 Direct Price Discrimination 166 13.3 Robinson-Patman Act 167 13.4 Implementing Price Discrimination 168 13.5 Only Schmucks Pay Retail 169 Summary & Homework Problems 169 End Notes 170

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CONTENTSx

CHAPTER 14 INDIRECT PRICE DISCRIMINATION 171 14.1 Indirect Price Discrimination 172 14.2 Volume Discounts as Discrimination 176 14.3 Bundling Different Goods Together 177 Summary & Homework Problems 178 End Notes 181

SECTION IV Strategic Decision Making 183

CHAPTER 15 STRATEGIC GAMES 185 15.1 Sequential-Move Games 186 15.2 Simultaneous-Move Games 188 15.3 Prisoners’ Dilemma 190 15.4 Other Games 195 Summary & Homework Problems 199 End Notes 202

CHAPTER 16 BARGAINING 205 16.1 Strategic View of Bargaining 206 16.2 Nonstrategic View of Bargaining 208 16.3 Conclusion 210 Summary & Homework Problems 211 End Note 214

SECTION V Uncertainty 215

CHAPTER 17 MAkING DECISIONS WITH UNCERTAINTy 217 17.1 Random Variables and Probability 218 17.2 Uncertainty in Pricing 222 17.3 Data-Driven Decision Making 223 17.4 Minimizing Expected Error Costs 226 17.5 Risk versus Uncertainty 227 Summary & Homework Problems 228 End Notes 231

CHAPTER 18 AUCTIONS 233 18.1 Oral Auctions 234 18.2 Second-Price Auctions 235 18.3 First-Price Auctions 236 18.4 Bid Rigging 236 18.5 Common-Value Auctions 238 Summary & Homework Problems 240 End Notes 242

CHAPTER 19 THE PROBLEM Of ADVERSE SELECTION 243 19.1 Insurance and Risk 243 19.2 Anticipating Adverse Selection 244

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CONTENTS xi

19.3 Screening 246 19.4 Signaling 249 19.5 Adverse Selection and Internet Sales 250 Summary & Homework Problems 251 End Notes 253

CHAPTER 20 THE PRoblEm of moRAl HAzARd 255 20.1 Introduction 255 20.2 Insurance 256 20.3 Moral Hazard versus Adverse Selection 257 20.4 Shirking 258 20.5 Moral Hazard in Lending 260 20.6 Moral Hazard and the 2008 Financial Crisis 261 Summary & Homework Problems 262 End Notes 265

SECTIoN VI organizational design 267

CHAPTER 21 GETTING EmPloyEES To WoRk IN THE fIRm’S bEST INTERESTS 269 21.1 Principal–Agent Relationships 270 21.2 Controlling Incentive Conflict 271 21.3 Marketing versus Sales 273 21.4 Franchising 274 21.5 A Framework for Diagnosing and Solving Problems 275 Summary & Homework Problems 278 End Notes 281

CHAPTER 22 GETTING dIVISIoNS To WoRk IN THE fIRm’S bEST INTERESTS 283 22.1 Incentive Conflict between Divisions 283 22.2 Transfer Pricing 285 22.3 Organizational Alternatives 287 22.4 Budget Games: Paying People to Lie 289 Summary & Homework Problems 291 End Notes 294

CHAPTER 23 mANAGING VERTICAl RElATIoNSHIPS 295 23.1 How Vertical Relationships Increase Profit 296 23.2 Double Marginalization 297 23.3 Incentive Conflicts between Retailers and Manufacturers 297 23.4 Price Discrimination 299 23.5 Antitrust Risks 300 23.6 Do Buy a Customer or Supplier Simply Because It Is Profitable 301 Summary & Homework Problems 302 End Notes 304

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CONTENTSxii

SECTION VII Wrapping Up 307

CHAPTER 24 TEST yOURSELf 309 24.1 Should You Keep Frequent Flyer Points for Yourself? 309 24.2 Should You Lay Off Employees in Need? 310 24.3 Manufacturer Hiring 310 24.4 American Airlines 311 24.5 Law Firm Pricing 311 24.6 Should You Give Rejected Food to Hungry Servers? 312 24.7 Managing Interest-Rate Risk at Banks 313 24.8 What You Should Have Learned 313

Epilogue: Can Those Who Teach, Do? 315

Glossary 317

Index 325

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xiii

teaching students to solve Problems1 by Luke Froeb

When I started teaching MBA students, I taught economics as I had learned it, using models and public policy applications. My students complained so much that the dean took me out to the proverbial woodshed and gave me an ultimatum, “improve customer satisfaction or else.” With the help of some disgruntled students who later became teaching assistants, I was able to turn the course around.

The problem I faced can be easily described using the language of eco- nomics: the supply of business education (professors are trained to provide abstract theory) is not closely matched to demand (students want practical knowledge). This mismatch is found throughout academia, but it is perhaps most acute in a business school. Business students expect a return on a fairly sizable investment and want to learn material with immediate and obvious value.

One implication of the mismatch is that teaching economics in the usual way—with models and public policy applications—is not likely to satisfy stu- dent demand. In this book, we use what we call a “problem-solving pedagogy” to teach microeconomic principles to business students. We begin each chapter with a business problem, like the fixed-cost fallacy, and then give students just enough analytic structure to understand the cause of the problem and how to fix it.

Teaching students to solve real business problems, rather than learn models, satisfies student demand in an obvious way. Our approach also allows stu- dents to absorb the lessons of economics without as much of the analytical “overhead” as a model-based pedagogy. This is an advantage, especially in a terminal or stand-alone course, like those typically taught in a business school. To see this, ask yourself which of the following ideas is more likely to stay with a student after the class is over: the fixed-cost fallacy or that the partial derivative of profit with respect to price is independent of fixed costs.

eleMenTS OF a PrOBleM-SOlving PedagOgy Our problem-solving pedagogy has three elements.

PreFaCe

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xiv PREFaCE

1. Begin with a Business Problem Beginning with a real-world business problem puts the particular ahead of the abstract and motivates the material in a straightforward way. We use narrow, focused problems whose solutions require students to use the analytical tools of interest.

2. Teach Students to view inefficiency as an Opportunity The second element of our pedagogy turns the traditional focus of benefit– cost analysis on its head. Instead of teaching students to spot and eliminate inefficiency, for example, by changing public policy, we teach them to view each underemployed asset as a money-making opportunity.

3. Use economics to implement Solutions After you find an underemployed asset, moving it to a higher-valued use is often hard to do, particularly when the inefficiency occurs within an organi- zation. The third element of our pedagogy addresses the problem of incentive alignment: how to design organizations where employees have enough infor- mation to make profitable decisions and the incentive to do so.

Again, we use the tools of economics to address the problem of implemen- tation. If people act rationally, optimally, and self-interestedly, then mistakes have only one of two causes: either people lack the information necessary to make good decisions or they lack the incentive to do so. This immediately sug- gests a problem-solving algorithm; ask:

1. Who is making the bad decision? 2. Do they have enough information to make a good decision? 3. Do they have the incentive to do so?

Answers to these three questions will point to the source of the problem and suggest one of three potential solutions:

1. Let someone else make the decision, someone with better information or incentives

2. Give more information to the current decision maker 3. Change the current decision maker’s incentives

The book begins by showing students how to use this algorithm, and subsequent chapters illustrate its use in a variety of contexts, for example, extent decisions, investments, pricing, bargaining, principal–agent relationships, and uncertain environments.

USing The BOOk The book is designed to be read cover-to-cover as it is short, concise, and accessible to anyone who can read and think clearly. The pedagogy is built around business problems, so the book is most effective for those with some work experience. Its relatively short length makes it reasonably easy to cus- tomize with ancillary material.

The authors use the text in full-time MBA programs, executive MBA programs (weekends), healthcare management executive programs (one night

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xvPREFaCE

a week), and nondegree executive education. However, some of our biggest customers use the book in online business classes at both the graduate and undergraduate levels.

In the degree programs, we supplement the material in the book with online interactive programs like Cengage’s MindTap. Complete Blackboard courses, including syllabi, quizzes, homework, slides, videos to complement each chapter, and links to supplementary material, can be downloaded from the Cengage website. Our ManagerialEcon.com blog is a good source of new business applications for each of the chapters.

In this fifth edition, we have updated and improved the presentation and ped- agogy of the book. The biggest substantive change is to Chapter 17, where we present the decomposition of an observed difference between two groups into a treatment effect + selection bias. Michael Ward has been using this in his classes at University of Texas at Arlington, and rewrote the chapter to include it. We are also beginning work to add interactive “activities” to the electronic text in MindTap, Cengage’s new learning platform. These activities help comprehension, especially for weaker students. In addition, we continue to rewrite and update the supple- mentary material: videos, worked video problems, and the test bank. In addition to the other updates throughout the text, Chapter 24 has two new sections.

We wish to acknowledge numerous classes of MBA, executive MBA, non- degree executive education, and healthcare management students, without whom none of this would have been possible—or necessary. Many of our for- mer students will recognize stories from their companies in the book. Most of the stories in the book are from students and are for teaching purposes only.

Thanks to everyone who contributed, knowingly or not, to the book. Professor Froeb owes intellectual debts to former colleagues at the U.S. Department of Justice (among them, Cindy Alexander, Tim Brennan, Ken Heyer, Kevin James, Bruce Kobayahsi, and Greg Werden); to former colleagues at the Federal Trade Commission (among them, James Cooper, Pauline Ippolito, Tim Muris, Dan O’Brien, Maureen Ohlhausen, Paul Pautler, Mike Vita, and Steven Tenn); to colleagues at Vanderbilt (among them, Germain Boer, Jim Bradford, Bill Christie, Mark Cohen, Myeong Chang, Craig Lewis, Rick Oliver, David Parsley, David Rados, Steven Tschantz, David Scheffman, and Bart Victor); and to numerous friends and colleagues who offered suggestions, problems, and anecdotes for the book (among them, Lily Alberts, Olafur Arnarson, Raj Asirvatham, Bert Bailey, Justin Bailey, Pat Bajari, Molly Bash, Sarah Berhalter, Roger Brinner, the Honorable Jim Cooper, Matthew Dixon Cowles, Abie Del Favero, Kelsey Duggan, Vince Durnan, Marjorie Eastman, Tony Farwell, Keri Floyd, Josh Gapp, Brock Hardisty, Trent Holbrook, Jeff and Jenny Hubbard, Brad Jenkins, Dan Kessler, Bev Landstreet [B5], Bert Mathews, Christine Milner, Jim Overdahl, Craig Perry, Rich Peoples, Annaji Pervajie, Jason Rawlins, Mike Saint, David Shayne, Jon Shayne, Bill Shughart, Doug Tice, Whitney Tilson, and Susan Woodward). We owe intellectual and pedagogical debts to Armen Alchian and William Allen3; Henry Hazlitt4; Shlomo Maital5; John MacMillan6; Steven Landsburg7; Ivan Png8; Victor Tabbush9; Michael Jensen and William Meckling10; and James Brickley, Clifford Smith, and Jerold Zimmerman.11 Special thanks to everyone who guided us through the publishing process, including Molly Umbarger, Christopher Rader, and Jason Fremder.

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xvi

end nOTeS

PREFaCE

1. Much of the material is taken from Luke M. Froeb and James C. Ward, “Teaching Managerial Economics with Problems Instead of Models,” in The International Handbook on Teaching and Learning Economics, eds. Gail Hoyt and KimMarie McGoldrick (Northampton, MA: Edward Elgar Publishing, 2012).

2. Armen Alchian and William Allen, Exchange and Production, 3rd ed. (Belmont, CA: Wadsworth, 1983).

3. Henry Hazlitt, Economics in One Lesson (New York: Crown, 1979).

4. Shlomo Maital, Executive Economics: Ten Essential Tools for Managers (New York: Free Press, 1994).

5. John McMillan, Games, Strategies, and Managers (Oxford: Oxford University Press, 1992).

6. Steven Landsburg, The Armchair Economist: Economics and Everyday Life (New York: Free Press, 1993).

7. Ivan Png, Managerial Economics (Maiden, MA: Blackwell, 1998).

8. http://www.mbaprimer.com 9. Michael Jensen and William Meckling,

A Theory of the Firm: Governance, Residual Claims and Organizational Forms (Cambridge, MA: Harvard University Press, 2000).

10. James Brickley, Clifford Smith, and Jerold Zimmerman, Managerial Economics and Organizational Architecture (Chicago: Irwin, 1997).

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1

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

Problem Solving and Decision Making

1Section

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3

1

In 1992, a junior geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico. She suspected that the tract contained a large accumulation of oil because her company, Oil Ventures International (OVI), had an adjacent tract with several productive wells. Since no competitors had neighboring tracts, none of them suspected a large accumulation of oil. Be- cause of this, she thought that the tract could be won relatively cheaply and recommended a bid of $5 million. Surprisingly, OVI’s senior management ig- nored the recommendation and submitted a bid of $21 million. OVI won the tract over the next-highest bid of $750,000.

If the board of directors asked you to review the bidding procedures at OVI, how would you proceed? Where would you begin your investigation? What questions would you ask?

You’d find it difficult to gather information from those closest to the bid- ding. Senior management would be suspicious and uncooperative because no one likes to be singled out for bidding $20 million more than was necessary. Likewise, our junior geologist would be reluctant to criticize her superiors. You might be able to rely on your experience—provided that you had run into a similar problem. But without experience, or when facing novel problems, you would have to rely on your analytic ability.

This book is designed to show you how to complete an assignment like this.

1.1 Using Economics to Solve Problems Solving a problem like OVI’s requires two steps: first, figure out what’s caus- ing the problem; and second, how to fix it. In this case, you would want to know whether the $21 million bid was too high at the time it was made, not just in retrospect. If the bid was too aggressive, then you’d have to figure out why the senior managers overbid and how to make sure they don’t do it again.

Introduction: What This Book Is About

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SECTION I • Problem Solving and Decision Making 4

Both steps require that you predict how people behave in different cir- cumstances, and this is where the economic content of the book comes in. The one thing that unites economists is their use of the rational-actor paradigm. Simply put, it says that people act rationally, optimally, and self-interestedly. The paradigm not only helps you figure out why people behave the way they do but also suggests ways to get them to change. To change behavior, you have to change self-interest, and you do that by changing incentives.

Incentives are created by rewarding good performance with, for exam- ple, a commission on sales or a bonus based on profitability. The performance evaluation metric (revenue, cost, profit, or return on investment, ROI) is sepa- rate from the reward structure (commission, bonus, raise, or promotion), but they work together to create an incentive to behave a certain way.

To illustrate, let’s go back to OVI’s story and try to find the source of the problem. After her company won the auction, our geologist increased the company’s oil reserves by the amount of oil estimated to be in the tract. But when the company drilled a well, it was essentially “dry,” so the acquisition did little to increase the size of the company’s oil reserves. Using the informa- tion from the newly drilled well, our geologist updated the reservoir map and reduced the estimated reserves to where they was before OVI won the tract.

Senior management rejected the lower estimate and directed the geologist to “do what she could” to increase the size of the estimated reserves. So, she revised the reservoir map again, adding “additional” (not real) reserves to the company’s asset base. The reason behind this behavior became clear when, several months later, OVI’s senior managers resigned, collecting bonuses tied to the increase in oil reserves that had accumulated during their tenure.

The incentive created by the bonus plan explains both the overbidding and overestimated reserves as rational, self-interested responses to the incentive created by the bonus. Senior managers overbid because they were rewarded for acquiring reserves, regardless of the price. Their ability to manipulate the reserve estimate made it difficult for shareholders and their representatives on the board of directors to spot the mistake.

To fix this problem, you would have to find a way to better align manag- ers’ incentives with the company’s goals, perhaps by rewarding management for increasing profitability, not just for acquiring reserves. This is not as easy as it sounds because it is typically hard to measure an employee’s contribution to company profitability. You can do this subjectively, with annual performance reviews, or objectively, using company earnings or stock price appreciation as performance metrics. But each of these performance measures can create problems, as we’ll see in later chapters.

1.2 Problem-Solving Principles This story illustrates our problem-solving methodology. First, we reduced the problem (overbidding) to a bad decision by someone at the firm (senior man- agement) by asking:

Q1: Who made the bad decision?

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ChaPTEr 1 • Introduction: What This Book Is about 5

Once we know the “who,” we can use economics to figure out the “why.” If people behave rationally, optimally, and self-interestedly, a bad decision oc- curs for one of two reasons: either (i) decision makers do not have enough information to make a good decision or (ii) they lack the incentive to do so. This suggests that we can isolate the source of almost any problem by asking two more questions:

Q2: Did the decision maker have enough information to make a good decision?

Q3: Did the decision maker have the incentive to make a good decision?

Answers to these three questions not only point to the source of the prob- lem but also suggest ways to fix it.

S1: Let someone else—someone with better information or better incentives— make the decision,

S2: Give more information to the current decision maker, or S3: Change the current decision makers’ incentives (the performance evalua-

tion metric or the reward scheme).

In OVI’s case, we see that (Q1) senior management made the bad decision to overbid; (Q2) they had enough information to make a good bid, but (Q3) they didn’t have the incentive to do so. One potential fix (S3) is to change the incentives of senior management so that they are rewarded for increasing profitability instead of oil reserves.

When reading about various business mistakes in the chapters that follow, you should ask yourself these three questions to see if you can find the cause of each problem, and a solution. By the time you finish the book, the analysis should become second nature.

Here are some practical tips that will help you develop problem-solving skills:

*Think about the problem from the organization’s point of view. Avoid the temptation to think about the problem from the employee’s point of view because you will miss the fundamental problem of goal alignment: how does the organization give employees enough information to make good decisions and the incentive to do so?

*Think about the organizational design. Once you identify a bad deci- sion, avoid the temptation to solve the problem by simply reversing the decision. Instead, think about why the bad decision was made and how to make sure that similar mistakes won’t be made in the future.

*What is the trade-off? Your solution may solve the problem you identify, but it may cause other problems. In this case, changing the incentives of senior management by giving them limited stock (that they cannot sell for five years) may solve the overbidding problem, but it may also makes their performance dependent on external factors like the global macro- economy, which are clearly beyond their control. Subject your solution to the same analysis. Ask the same three questions that allowed you to identify the initial problem.

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SECTION I • Problem Solving and Decision Making 6

*Don’t define the problem as the lack of your solution. This kind of think- ing may cause you to miss the best solution. For example, if you define a problem as “the lack of centralized purchasing,” then the solution will be “centralized purchasing” regardless of whether that is the best option. Instead, define the problem as “high acquisition cost,” and then examine “centralized purchasing” versus “decentralized purchasing” (or some other alternative) as potential solutions to the problem.

*Avoid jargon because most people misuse it. Force yourself to spell out what exactly you mean in simple language. It will help you think clearly and communicate precisely. As Einstein said, “If you can’t explain it simply, you don’t understand it well enough.” In addition, almost every scam is “sold” using jargon. If you use jargon, experienced listeners will instinctively mistrust you and your analysis.

1.3 Test Yourself In 2006, an investigative news program sent a TV reporter with a perfectly good car into a garage owned by National Auto Repair (NAR). The reporter came out with a new muffler and transmission—and a bill for over $8,000. After the story was aired on national TV, consumers began avoiding NAR, and profit plunged. What is the problem, and how do you fix it?

Let’s run the problem through our problem-solving algorithm:

Q1: Who made the bad decision?

The NAR mechanic recommended unnecessary repairs.

Q2: Did 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.

Q3: Did the decision maker have the incentive to make a good decision?

No, the mechanic receives bonuses or commissions tied to the amount of repair work, which rewards the mechanic for making needless repairs.

Although answers to the three questions clearly point to the source of the problem, solving it proved much more difficult. NAR tried two different solu- tions, but both failed.

First, the company reorganized into two divisions: one responsible for rec- ommending repairs and the other responsible for doing them. Those who rec- ommended repairs were paid a flat salary, but those who did the repairs were paid based on the amount of work they did.

PAUSE HERE AND TRY TO FIGURE OUT WHY THIS CHANGE DID NOT SOLVE THE PROBLEM.

Mechanics in the two divisions began colluding. In exchange for recom- mending unnecessary repairs, the service mechanic shared his incentive pay with the recommending mechanic. The unnecessary repairs continued.

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ChaPTEr 1 • Introduction: What This Book Is about 7

NAR then went back to single mechanic who both recommended and per- formed repairs, but replaced the incentive pay with a flat salary. Although this removed the incentive to do unnecessary repairs, it also removed the incentive to work hard, resulting in what economists call “shirking.” Since mechanics made the same amount of money regardless of whether they recommended and performed repairs, they ignored all but the most obvious problems.

Figuring out which solution is most profitable involves weighing the trade- offs associated with various solutions. For example, before implementing the two-division solution, NAR management should have asked whether the new decision maker had enough information to make good decisions, as well as the incentive to do so. The answer could have alerted NAR management to the potential for collusion between the recommending mechanic and the repairing mechanic. Similarly, this kind of analysis would have identified shirking by the mechanics as a cost of the flat-salary solution.

With the benefit of hindsight, I would have suggested a third potential solution: keep the original organizational design, but use an additional per- formance metric, based on reports provided by “secret shoppers” who bring good cars into the garage to test whether the mechanics order unnecessary repairs. If so, fire or penalize the mechanics who recommend unnecessary re- pairs. Secret shoppers are used successfully in other contexts, for example, in restaurants to measure service quality. By measuring and rewarding quality, restaurant chains are able to protect the value of a brand as a signal of quality. Similarly, using secret shoppers may have been able to protect the value of NAR’s brand as a signal of reliable service.

1.4 Ethics and Economics Using the rational-actor paradigm in this way—to change behavior by chang- ing incentives—makes some students uncomfortable because it seems to deny the altruism, affection, and personal ethics that motivate most people. These students resist learning the rational-actor paradigm because they think it im- plicitly endorses self-interested behavior, as if the primary purpose of econom- ics were to teach students to behave rationally, optimally, and selfishly.

These students would probably agree with a Washington Post editorial, “When It Comes to Ethics, B-Schools Get an F,”1 which blames business schools in general, and economists in particular, for the ethical lapses at FIFA, Goldman Sachs, and other organizations.

A subtle but damaging factor in this is the dominance of economists at business schools. Although there is no evidence that economists are personally less ethical than members of other disciplines, approaching the world through the dollar sign does make people more cynical.

What these students and the author, a former Harvard ethics professor, do not understand is that to control unethical behavior, we first have to un- derstand why it occurs. When we analyze problems like the one at OVI, we’re not encouraging students to behave opportunistically. Rather, we’re teaching

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SECTION I • Problem Solving and Decision Making 8

them to anticipate opportunistic behavior and to design organizations that are less susceptible to it. Remember, the rational-actor paradigm is only a tool for analyzing behavior, not advice on how to live your life.

It is also important to realize that these kinds of debates are often de- bates about value systems. Deontologists judge actions as good or ethical by whether they conform to a set of principles, like the Ten Commandments or the Golden Rule. Consequentialists, on the other hand, judge actions by their consequences. If the consequences of an action are good, then the action is deemed to be good or moral. We illustrate these contrasting value systems with a story about price gouging.2

When Notre Dame entered the 2006 season as one of the top-ranked football teams in the country, demand for local hotels during home games rose dramatically. In response, local hotels raised room rates. According to the Wall Street Journal, the Hampton Inn charged $400 a night on football week- ends for a room that cost only $129 on non football days. Rates climbed even higher for games against top-ranked foes. For the game against the University of Michigan, the South Bend Marriott charged $649 per night—$500 more than its normal weekend rate of $149.

On a campus founded by priests of the Congregation of Holy Cross, where many students dedicate a year after graduation to working with the underprivileged, these high prices caused alarm. The Wall Street Journal quotes Professor Joe Holt, a former priest who teaches ethics in the school’s executive MBA program, “It is an ‘act of moral abdication’ for businesses to pretend they have no choice but to charge as much as they can based on supply and demand.” The article further reports Mr. Holt’s intention to use the example of rising hotel rates on football weekends for a case study in his class on the integration of business and values.

Deontologists like Professor Holt would object on principle to the prac- tice of raising prices in times of shortage.3 We might label this the Spider Man Principle: with great power comes great responsibility. The laws of capitalism allow corporations to amass significant power; in turn, society should demand a high level of responsibility from corporations. In this case, while property rights give a hotel the option of increasing prices, possession of these rights does not relieve the hotel of its obligation to be concerned about the conse- quences of its choices. A simple beneficence argument might suggest that keep- ing prices low would be better for consumers.

Economics, on the other hand, gives us a consequentialist understanding of the practice by comparing high prices to the implied alternative. An econ- omist would show that if prices do not rise, the consequence would be excess demand for hotel rooms. Would-be guests would find their rooms rationed, perhaps on a first-come, first-served basis. More likely, arbitrageurs would set up a black market, by making early reservations, and then “selling” their reser- vations to customers willing to pay the market-clearing price. Not only would consumers end up paying the same price, but these “arbs” would make money that would have otherwise gone to the hotel. Without the ability to earn addi- tional profit during times of scarcity, hotels would have less incentive to build additional rooms, which would make the long-run problems even worse!

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ChaPTEr 1 • Introduction: What This Book Is about 9

Versions of this debate—between those who criticize business on ethical grounds and those who are trying to make money—have been going on in this country since its founding. Although a full treatment of the ethical di- mensions of business is beyond the scope of this book, many disagreements are really about whether morality should be defined by deontology or conse- quentialism. Once you realize that a debate is really a debate between value systems, it becomes much easier to understand opposing points of view, and to reach compromise with your adversaries. For example, if the government were considering price-gouging laws that made it illegal to raise prices on football weekends, a solution might involve donation of some of the profits earned on football weekends to a local charity. This might assuage the concerns of those who ascribe to the Spider Man principle.

As a footnote to this story, when someone offered our former priest $1,500 for his apartment on home-game weekends, he took the offer and now spends his weekends in Chicago. Apparently, his principles became too costly for him.

1.5 Economics in Job Inter views If this well-reasoned introduction doesn’t motivate you to learn econom- ics, read the following interview questions—all from real interviews of students. These questions should awaken interest in the material for those of you who think economics is merely an obstacle between you and a six-figure salary.

-------Original Message-------

From: “Student A” Sent: Friday, January 2, 2009, 3:57 PM Subject: Economics Interview Questions

I had an interview a few weeks ago where I was told that the position paid a very low base and was mostly incen- tive compensation. I responded that I understood he was simply “screening out” low productivity candidates

[NOTE: low productivity candidates would not earn very much under a sys- tem of incentive compensation, and so would be less likely to accept a job with strong incentive compensation].

I “signaled” back to him that this compensation struc- ture was acceptable to me, as I was confident in my abil- ities to produce value for the company, and for me.

[Note: “Signaling” and “screening” are both solutions to the problem of adverse selection, the topic of Chapter 19.]

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SECTION I • Problem Solving and Decision Making 10

-------Original Message-------

From: “Student B” Sent: Tuesday, January 18, 2000, 1:22 PM Subject: Economics Interview Questions

I got a question from Compaq last year for a market- ing internship position that partially dealt with sunk costs. It was a “true” case question where the inter- viewer used the Internet to pull up the actual products as he asked the question, “I am the product manager for the new X type server with these great features. It is to be launched next month at a cost of $5,500. Dell launched its new Y-type server last week; it has the same features (and even a few more) for a cost of $4,500. To date, Com- paq has put over $2.5 million in the development process for this server, and as such my manager is expecting above-normal returns for the investment.

My question to you is “what advice would you give to me on how to approach the launch of the product, that is, do I go ahead with it at the current price, if at all, even though Dell has a better product out that is less expensive, not forgetting the fact that I have spent all the development money and my boss expects me to report a super return?”

I laughed at the question because it was the very first thing we spoke about in the interview, catching me off- guard a bit. He wanted to see if I got caught worry- ing about all the development costs in giving advice to scrap the launch or continue ahead as planned. (I’m not an idiot and could see that coming a mile away ... thanks to economics, right? ! ! !)