[SOLVED] How to Trick the Guilty and Gullible into Revealing Themselves, reading assignment – Economics

These are readings for week 8.  The first link is typically a link to the original article.  The second link is typically a link to a blog post about the original article.Chapter 19(Note: You may need a Wall Street Journal subscription for 1a. 2 is a blogpost but has an academic paper if your interested)1a. How to Trick the Guilty and Gullible into Revealing Themselves1b. How do you uncover the truth?2. Advice for selling on eBay motors3a. What happens if young people don’t sign up for Obamacare?3b. Read chapter 19Chapter 20(Note: 1 is a blogpost)1. Why are young people leaving the workforce?2a. A black box for car crashes2b. Will auto black boxes reduce insurance costs?Chapter 211a. No Correlation between a College Degree and Coding1b. If Firms Can Measure Ability, Why Go To School?2a. How Chipotle transformed itself.2b. Promoting from withinAfter reading through the weekly readings navigate to the discussion board to answer the following questions.Determine if the following are an adverse selection problem or a moral hazard problem.1. Young people opting out of Obamacare2. Auto black boxes3. Unemployment via disability4. Zappos5. David Lee Roth’s brown M&Ms6. King Solomon’s test7. Defendant’s during the Middle AgesThis is an electronic version of the print textbook. Due to electronic rights restrictions,
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A PROBLEM SOLVING APPROACH
THIRD EDITION
?
Luke M. Froeb
Vanderbilt University
Brian T. McCann
Vanderbilt University
Mikhael Shor
University of Connecticut
Michael R. Ward
University of Texas, Arlington
Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
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Managerial Economics: A Problem Solving
Approach, Third Edition
Luke M. Froeb, Brian T. McCann, Mikhael Shor,
Michael R. Ward
Senior Vice President, LRS/Acquisitions & Solutions
Planning: Jack W. Calhoun
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For our families: Lisa, Jake, Halley, Chris, Leslie, Jacob,
Eliana, Cindy, Alex, and Chris
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BRIEF CONTENTS
Preface: Teaching Students to Solve Problems
SECTION I
Problem Solving and Decision Making
xiii
1
1 Introduction: What This Book Is About
3
2 The One Lesson of Business
11
3 Benefits, Costs, and Decisions
21
4 Extent (How Much) Decisions
33
5 Investment Decisions: Look Ahead and Reason Back
SECTION II
Pricing, Costs, and Profits
6 Simple Pricing
45
57
59
7 Economies of Scale and Scope
73
8 Understanding Markets and Industry Changes
85
9 Relationships Between Industries: The Forces Moving Us Toward
103
Long-Run Equilibrium
10 Strategy: The Quest to Keep Profit from Eroding
11 Foreign Exchange, Trade, and Bubbles
SECTION III
Pricing for Greater Profit
113
125
137
12 More Realistic and Complex Pricing
139
13 Direct Price Discrimination
149
14 Indirect Price Discrimination
157
SECTION IV
Strategic Decision Making
15 Strategic Games
16 Bargaining
SECTION V
Uncertainty
167
169
187
197
17 Making Decisions with Uncertainty
18 Auctions
199
213
19 The Problem of Adverse Selection
20 The Problem of Moral Hazard
SECTION VI
Organizational Design
223
233
243
21 Getting Employees to Work in the Firm’s Best Interests
22 Getting Divisions to Work in the Firm’s Best Interests
23 Managing Vertical Relationships
245
257
269
v
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vi
BRIEF CONTENTS
SECTION VII
Wrapping Up
279
24 You Be the Consultant
281
Epilogue: Can Those Who Teach, Do?
Glossary 291
Index 295
289
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CONTENTS
Preface: Teaching Students to Solve Problems
xiii
SECTION I
Problem Solving and Decision Making 1
CHAPTER 1
INTRODUCTION: WHAT THIS BOOK IS ABOUT
Using Economics to Solve Problems 3
Problem Solving Principles 4
Test Yourself 5
Ethics and Economics 6
Economics in Job Interviews 8
Summary & Homework Problems 10
End Notes 10
CHAPTER 2
THE ONE LESSON OF BUSINESS 11
Capitalism and Wealth 12
Does the Government Create Wealth? 13
Why Economics is Useful to Business 14
Wealth Creation in Organizations 16
Summary & Homework Problems 17
End Notes 19
CHAPTER 3
BENEFITS, COSTS, AND DECISIONS 21
Background: Variable, Fixed, and Total Costs 22
Background: Accounting Versus Economic Profit 23
Costs are What You Give Up 25
Sunk-Cost Fallacy 26
Hidden-Cost Fallacy 28
A Final Warning 28
Summary & Homework Problems 29
End Notes 31
CHAPTER 4
EXTENT (HOW MUCH) DECISIONS 33
Background: Average and Marginal Costs 34
Marginal Analysis 35
Incentive Pay 37
Tie Pay to Performance Measures that Reflect Effort
Is Incentive Pay Unfair? 39
3
38
vii
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viii CONTENTS
Summary & Homework Problems
End Notes 42
40
CHAPTER 5
INVESTMENT DECISIONS: LOOK AHEAD AND REASON BACK
Compounding and Discounting 45
How to Determine Whether Investments are Profitable 46
Breakeven Analysis 47
Choosing the Right Manufacturing Technology 48
Shutdown Decisions and Breakeven Prices 49
Sunk Costs and Post-Investment Hold-Up 50
Anticipate Hold-Up 51
Summary & Homework Problems 52
End Notes 55
SECTION II
Pricing, Costs, and Profits
CHAPTER 6
SIMPLE PRICING 59
Background: Consumer Values and Demand Curves
Marginal Analysis of Pricing 62
Price Elasticity and Marginal Revenue 64
What Makes Demand More Elastic? 66
Forecasting Demand Using Elasticity 67
Stay-Even Analysis, Pricing, and Elasticity 68
Cost-Based Pricing 69
Summary & Homework Problems 69
End Notes 72
45
57
60
73
CHAPTER 7
ECONOMIES OF SCALE AND SCOPE
Increasing Marginal Cost 74
Economies of Scale 75
Learning Curves 76
Economies of Scope 78
Diseconomies of Scope 79
Summary & Homework Problems 80
End Notes 82
CHAPTER 8
UNDERSTANDING MARKETS AND INDUSTRY CHANGES
Which Industry or Market? 85
Shifts in Demand 86
Shifts in Supply 88
Market Equilibrium 89
Predicting Industry Changes Using Supply and Demand 90
Explaining Industry Changes Using Supply and Demand 92
Prices Convey Valuable Information 95
Market Making 96
85
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CONTENTS
Summary & Homework Problems
End Notes 102
CHAPTER 9
ix
98
RELATIONSHIPS BETWEEN INDUSTRIES: THE FORCES MOVING US
TOWARD LONG-RUN EQUILIBRIUM 103
Competitive Industries 104
The Indifference Principle 105
Monopoly 109
Summary & Homework Problems 109
End Notes 111
CHAPTER 10
STRATEGY: THE QUEST TO KEEP PROFIT FROM ERODING
Strategy is Simple 114
Sources of Economic Profit 115
The Three Basic Strategies 119
Summary & Homework Problems 120
End Notes 122
CHAPTER 11
FOREIGN EXCHANGE, TRADE, AND BUBBLES
The Market for Foreign Exchange 126
The Effects of a Currency Devaluation 128
Bubbles 130
How Can We Recognize Bubbles? 131
Purchasing Power Parity 133
Summary & Homework Problems 134
End Notes 136
SECTION III
Pricing for Greater Profit
CHAPTER 12
MORE REALISTIC AND COMPLEX PRICING
Pricing Commonly Owned Products 140
Revenue or Yield Management 141
Advertising and Promotional Pricing 143
Psychological Pricing 143
Summary & Homework Problems 145
End Notes 147
CHAPTER 13
DIRECT PRICE DISCRIMINATION 149
Introduction 149
Why (Price) Discriminate? 150
Direct Price Discrimination 152
Robinson-Patman Act 153
Implementing Price Discrimination Schemes
Only Schmucks Pay Retail 154
Summary & Homework Problems 154
End Notes 155
113
125
137
139
153
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x
CONTENTS
CHAPTER 14
INDIRECT PRICE DISCRIMINATION 157
Introduction 157
Indirect Price Discrimination 158
Volume Discounts as Discrimination 161
Bundling Different Goods Together 162
Summary & Homework Problems 163
End Notes 166
SECTION IV
Strategic Decision Making
CHAPTER 15
STRATEGIC GAMES 169
Sequential-Move Games 170
Simultaneous-Move Games 172
What Can I Learn from Studying Games Like the Prisoners’ Dilemma?
Other Games 178
Summary & Homework Problems 182
End Notes 185
167
CHAPTER 16
BARGAINING 187
Strategic View of Bargaining 187
Nonstrategic View of Bargaining 190
Conclusion 192
Summary & Homework Problems 193
End Notes 195
SECTION V
Uncertainty
CHAPTER 17
MAKING DECISIONS WITH UNCERTAINTY
Random Variables and Probability 200
Uncertainty in Pricing 203
Run Experiments to Reduce Uncertainty 205
Minimizing Expected Error Costs 206
Risk Versus Uncertainty 207
Summary & Homework Problems 208
End Notes 211
CHAPTER 18
AUCTIONS 213
Oral Auctions 214
Second-Price Auctions 215
First-Price Auctions 216
Bid Rigging 216
Common-Value Auctions 217
Summary & Homework Problems
End Notes 221
177
197
199
219
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xi
CONTENTS
223
CHAPTER 19
THE PROBLEM OF ADVERSE SELECTION
Insurance and Risk 223
Anticipating Adverse Selection 224
Screening 225
Signaling 228
Adverse Selection and Internet Sales 229
Summary & Homework Problems 230
End Notes 232
CHAPTER 20
THE PROBLEM OF MORAL HAZARD 233
Introduction 233
Insurance 234
Moral Hazard versus Adverse Selection 235
Shirking 236
Moral Hazard in Lending 237
Moral Hazard and The 2008 Financial Crisis 239
Summary & Homework Problems 240
End Notes 242
SECTION VI
Organizational Design
CHAPTER 21
GETTING EMPLOYEES TO WORK IN THE FIRM’S BEST INTERESTS
Principal-Agent Relationships 246
Principles for Controlling Incentive Conflict 247
Marketing versus Sales 248
Franchising 249
A Framework for Diagnosing and Solving Problems 250
Summary & Homework Problems 252
End Notes 255
CHAPTER 22
GETTING DIVISIONS TO WORK IN THE FIRM’S BEST INTERESTS
Incentive Conflict between Divisions 258
Transfer Pricing 259
Functional Silos versus Process Teams 261
Budget Games: Paying People to Lie 262
Summary & Homework Problems 265
End Notes 268
CHAPTER 23
MANAGING VERTICAL RELATIONSHIPS 269
Incentive Conflicts Between Retailers and Manufacturers 270
A Variety of Contractual and Organizational Forms Can Address Incentive
Conflict 272
Tax Avoidance 273
Antitrust Risks 273
243
245
257
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xii
CONTENTS
Do Not Buy a Customer or Supplier Simply Because it is Profitable
Summary & Homework Problems 275
End Notes 278
SECTION VII
Wrapping Up 279
CHAPTER 24
YOU BE THE CONSULTANT 281
Low Profits on Rental Apartments 281
Excess Inventory of Prosthetic Heart Valves 282
High Transportation Costs at a Coal-Burning Utility
Overpaying for Acquired Hospitals 284
Losing Money on Homeowner’s Insurance 286
Quantity Discounts on Hip Replacements 286
What You Should Have Learned 287
End Note 288
Epilogue: Can Those Who Teach, Do?
Glossary 291
Index 295
274
284
289
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PREFACE
Teaching Students to Solve Problems1
by Luke Froeb
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. Students expect a return on a fairly sizable investment and want to learn material that has immediate and obvious value.
One implication of this mismatch is that teaching economics in the usual
way—with models and public policy applications—is not likely to satisfy student 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 show students how to solve the
problem.
Teaching students to solve problems, rather than learn models, satisfies student demand in a straightforward way as it allows students to “see” the value of
the education they are receiving. The problem-solving approach also allows students 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.
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 solution requires students to use the analytical tools
of interest.
xiii
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xiv TEACHING STUDENTS TO SOLVE PROBLEMS
Use Economic Analysis to Identify Profitable Decisions
The second element of our pedagogy is to show students how to use the rational actor paradigm to identify problems (mistakes) and solutions (profitable
ones). To do this, we turn the traditional focus of economics on its head. Instead of teaching students to spot and then eliminate inefficiency, for instance,
by changing public policy, we teach them to view each underemployed asset a
money-making opportunity. Making money is simple in principle, find an underemployed asset, buy it, and then sell it to someone who places a higher
value on it.
Find Ways to Implement Them
In practice, it is rarely that simple, particularly when the inefficiency occurs
within a larger organization. The third element of our pedagogy addresses
the problem of implementation: how to design an organization where employees have enough information to make profitable decisions, and the incentive to do so.
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 the incentive to do so. This immediately suggests a
problem-solving algorithm, ask:
1. Who is making the bad decision?
2. Do they have enough information to make a good decision?; and
3. 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; or
3. Change the current decision-maker’s incentives.
The book begins by showing students how to use this algorithm, and
then each chapter illustrates its use in a different context, such as investments,
pricing, 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 relatively easy to customize with ancillary material.
The authors use the text in Executive, full-time MBA programs, healthcare management programs and nondegree executive education. However,
some of our biggest customers use the book in online business classes, at
both the graduate and undergraduate levels.
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TEACHING STUDENTS TO SOLVE PROBLEMS
xv
In degree programs, we supplement the material in the book with online
interactive programs like the managerial economics module of South-Western’s
MBAPrimer.com or Samuel Baker’s Economic Interactive Tutorials.2 Complete
Blackboard courses, including syllabi, quizzes, homework, slides, and syllabi,
video lectures by the authors, 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 third edition, we have added updated new stories and applications, and updated and improved upon the presentation and pedagogy of the
book. We have also added two new coauthors. Both are award-winning teachers, and bring not only fresh ideas, but a wealth of examples and material
that we have added to the text and the ancillary material that accompanies
it. Mike Shor has been teaching game theory and pricing classes at the MBA
level for about a decade, and he has dramatically upgraded those parts of the
book. Mike Ward has been teaching out of the book since the first edition,
and his experience and knowledge have dramatically improved the exposition, as well upgraded and expanded the ancillary material that accompanies
the book. Our test bank has doubled in size.
We wish to acknowledge numerous classes of MBA, exec MBA, and
Healthcare Management students, without whom none of this would have
been possible—or necessary. Many of our former 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, Kelsey Duggan,
Lily Alberts, Raj Asirvatham, Olafur Arnarson, Pat Bajari, Fadi Bousamra,
Roger Brinner, the Honorable Jim Cooper, Matthew Dixon Cowles, Abie
Del Favero, Vince Durnan, Marjorie Eastman, Keri Floyd, Josh Gapp, Bill
Hostettler, Jeff and Jenny Hubbard, Brad Jenkins, Dan Kessler, Bev Landstreet (B5), Bert Mathews, Christine Millner, Jim Overdahl, Rich Peoples,
Annaji Pervaje, Jason Rawlins, Mike Saint, Jon Shayne, Bill Shughart, Doug
Tice, Whitney Tilson, Pam Wilmoth and Susan Woodward. We owe intellectual and pedagogical debts to Armen Alchian and William Allen,3 Henry
Hazlitt,4 Shlomo Maital,5 John MacMillan,6 Steven Landsburg,7 Ivan Png,8
Victor Tabbush,9 Michael Jensen and William Meckling,10 and James Brickley,
Clifford Smith, and Jerold Zimmerman.11 Thanks as well to everyone who
helped guide us through the publishing process, including Michael Worls,
Daniel Noguera, and Vanavan Jayaraman.
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xvi TEACHING STUDENTS TO SOLVE PROBLEMS
END NOTES
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 in Economics, ed. Gail
Hoyt, KimMarie McGoldrick, (Edward Elgar
Publishing, 2012).
2. http://hadm.sph.sc.edu/Courses/Econ/Tutorials
.html.
3. Armen Alchian and William Allen, Exchange
and Production, 3rd ed. (Belmont, CA:
Wadsworth, 1983).
4. Henry Hazlitt, Economics in One Lesson
(New York: Crown, 1979).
5. Shlomo Maital, Executive Economics: Ten
Essential Tools for Managers (New York: Free
Press, 1994).
6. John McMillan, Games, Strategies, and
Managers (Oxford: Oxford University Press,
1992).
7. Steven Landsburg, The Armchair Economist:
Economics and Everyday Life (New York:
Free Press, 1993).
8. Ivan Png, Managerial Economics (Malden,
MA: Blackwell, 1998).
9. http://www.mbaprimer.com.
10. Michael Jensen and William Meckling, A
Theory of the Eirm: Governance, Residual
Claims and Organizational Forms (Cambridge, MA: Harvard University Press, 2000).
11. James Brickley, Clifford Smith, and Jerold
Zimmerman, Managerial Economics and
Organizational Architecture (Chicago: Irwin,
1997).
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SECTION
1
Problem Solving and Decision
Making
1
2
3
4
5
Introduction: What This Book Is About
The One Lesson of Business
Benefits, Costs, and Decisions
Extent (How Much) Decisions
Investment Decisions: Look Ahead and Reason Back
1
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CHAPTER
1
Introduction: What This Book
Is About
In 1992, a junior geologist was preparing a bid recommendation for an oil tract in the Gulf
of Mexico. He suspected that this tract contained a large accumulation of oil because his
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. Because of this, he thought that the track could be won relatively cheaply, and
recommended a bid of $5 million. Surprisingly, OVI’s senior management ignored the recommendation and submitted a bid of $21 million. OVI won the tract–over the nexthighest bid of $750,000.
If the board of directors asked you to review the bidding procedures at OVI, how would
you proceed? What questions would you ask? Where would you begin your investigation?
You’d find it difficult to gather information from those closest to the bidding. 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 his 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 give you the analytic framework that would allow you to
complete an assignment like this.
USING ECONOMICS TO SOLVE PROBLEMS
To solve a problem like OVI’s, first, figure out what’s causing the problem, and then 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.
Both steps require that you predict how people behave in different circumstances, and this
is where the economic content of the book comes in. The one thing that unites economists is
3
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4
SECTION I • Problem Solving and Decision Making
their use of the rational-actor paradigm to predict behavior. Simply put, it says that people
act rationally, optimally, and self-interestedly. In other words, they respond to incentives. The
paradigm not only helps you figure out why people behave the way they do but also suggests
ways to motivate 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 example, a commission
on sales or a bonus based on profitability. The performance evaluation metric (sales, profit,
or similar outcome) is separate from the reward structure (commission, bonus, raise, promotion, or other reward), but they work together to create an incentive to behave a certain way.
Let’s go back to OVI’s story, and try to find the source of the problem. After his 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, they discovered only a
small amount of oil, so the acquisition did little to increase the size of the company’s oil reserves. Using the information from the well, our geologist updated the reservoir map and
reduced the reserve estimate by two-thirds.
Senior management rejected the lower estimate and directed the geologist to “do what
he could” to increase the size of the estimated reserves. So he revised the reservoir map
again, adding “additional” reserves to the company’s asset base. 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 allows us to understand the behavior of senior
management. Both the overbidding and the effort to inflate the reserve estimate were rational, self-interested responses to the incentive created by the bonus. Even if you didn’t know
about the geologist’s bid recommendation, you’d still suspect that the senior managers overbid because they had the incentive to do so. Senior managers’ 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 have to find a way to better align managers’ incentives with
the company’s goals. To do this, find a way to reward management for increasing profitability, not just for acquiring reserves. This is not as easy as it sounds because it is difficult
to measure a manager’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 metrics can create problems, as we’ll see in later chapters.
PROBLEM SOLVING PRINCIPLES
This story illustrates two principles that will help you learn to diagnose and solve problems.
Notice that (1) we reduced the problem (overbidding) to a bad decision by someone at the
firm (senior management) and (2) we used economics to diagnose the source of the problem. Under the rational actor paradigm, bad decisions happen for one of two reasons:
Either decision makers do not have enough information to make good decisions, or they
lack incentive to do so. Using this insight, you can isolate the source of almost any problem
by asking three simple questions:
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?
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CHAPTER 1 • Introduction: What This Book Is About
5
Answers to these three questions not only point to the source of the problem, but will also
suggest ways to fix it by:
1. letting someone else—someone with better information or better incentives—make the
decision,
2. giving more information to the current decision maker, or
3. changing the current decision makers’ incentives.
In OVI’s case, we see that (1) senior management made the bad decision to overbid;
(2) they had enough information to make a good decision, but (3) they didn’t have the
incentive to do so. One potential fix is to change the incentives of senior management so
that they are based on profitability, not oil reserves.
When reading about various business mistakes in this book, you should ask yourself
these three questions to see if you can diagnose the cause of each problem, and then try
one of the three solutions to fix it. 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 decision, 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? Every solution has costs as well as benefits. Avoid the temptation
to think only about the benefits, as it will make your analysis seem as if it were
done to justify a foregone conclusion. Use the three questions to spot problems
with a proposed solution; that is, in whatever solution you propose, make sure
decision makers have enough information to make good decisions and the incentive
to do so.
Don’t define the problem as the lack of your solution. This kind of thinking 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 you mean
in simple language. It will help your thinking and communication.
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 aired on national TV,
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6
SECTION I • Problem Solving and Decision Making
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:
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.
Answers to the three questions suggest that the use of quotas, commissions, or similar
compensation provides an incentive for mechanics to recommend unnecessary auto repair
services in order to meet quotas or receive larger commissions.
NAR tried two different solutions to fix the problem. First, they reorganized into two
divisions: one responsible for recommending repairs where mechanics were paid a flat salary, and the other responsible for doing them. Rather than solving the problem, however,
mechanics in the two divisions got together and began colluding. In exchange for recommending unnecessary repairs, the recommending mechanic received a portion of the commission received by the service mechanic for the work that was done.
After they recognized this new problem, NAR went back to the old organizational
structure, but they adopted flat pay for the mechanics. This removed the incentive to do unnecessary repairs, but it also removed the incentive to work hard. Since the mechanics made
the same amount of money regardless of whether they recommended and performed repairs, the mechanics ignored all but the most obvious problems.
This example illustrates several of the problem-solving principles above. First, it highlights the crucial role played by information. If you are going to let someone else make the
decision, as in the first solution, you have to ask whether the new decision maker has
enough information to make good decisions, as well as the incentive to do so. As a third
potential solution to this problem, I would keep the original commission scheme, but develop new sources of information (an additional performance evaluation metric) based on
reports provided by “secret shoppers” who bring cars into the garage in order to see if the
mechanics are ordering unnecessary repairs.
The example also illustrates the trade-offs you face when proposing solutions. The first
solution involved the costly duplication of effort by the two recommending and service mechanics, the second led to mechanic shirking, and the third would require a new reward
scheme based not only on a sales commission, but also on the reports of the secret shopper.
Figuring out which solution is most profitable involves weighing the trade-offs, and figuring
out whether the benefits of a particular solution are bigger than its costs.
ETHICS AND ECONOMICS
Using the rational-actor paradigm in this way—to change behavior by changing incentives—
makes some students uncomfortable because it seems to deny the altruism, affection, and
personal ethics that most people use to guide their behavior. These students resist learning the
paradigm because they think it implicitly endorses self-interested behavior, as if the primary purpose of economics were to teach students to behave rationally, optimally, and selfishly.
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CHAPTER 1 • Introduction: What This Book Is About
7
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 Enron, Goldman Sachs and other companies.
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, you first have to understand why it occurs.
When we analyze problems like the one at OVI, we’re not encouraging students to behave
opportunistically. Rather, we’re teaching 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 really debates 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. To illustrate these contrasting value systems, consider this 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 weekends for a room that cost only $129 a night on
nonfootball dates. 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 their 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 practice of raising
prices in times of shortage.3 We might label one such principle, 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 particular, property rights might give a hotel the option of increasing
prices, but possession of these rights does not relieve the hotel of its obligations to be concerned about the consequences of its choices. A simple beneficence argument might suggest
that keeping prices low would be better for consumers.
Economics, on the other hand, provides us a consequentialist defense of high prices by
comparing them to the implied alternative. In the case of the South Bend hotels, we would
compare the world with high prices to the alternative of not raising prices during periods of
high demand. Economists would show, using supply-demand analysis, that if prices did 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, then “selling” their reservations
to customers willing to pay the market-clearing price. Without the ability to earn additional
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8
SECTION I • Problem Solving and Decision Making
profit during times of scarcity, hotels would have less incentive to build additional rooms,
which would make the long-run problem even worse!
Versions of this debate—between those who criticize business on ethical grounds, and
those who are simply trying to make money—have been going on in this country since its
founding. Although a full treatment of the ethical dimensions of business is beyond the
scope of this book, many disagreements are really about whether morality should be defined by deontology or consequentialism. 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, you might
offer to donate 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 our story of prices in South Bend, 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.
ECONOMICS IN JOB INTERVIEWS
If this well-reasoned introduction doesn’t motivate you to learn economics, read the following interview questions—all from real interviews of my 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 incentive compensation. I responded that
I understood he was simply “screening out” low productivity candidates
[low productivity candidates would not earn very much under a system of
incentive compensation, and would be less likely to accept the position]. I “signaled” back to him that this compensation structure was acceptable to me, as I was confident in my abilities to produce value for
the company, and for me. [Note: “Signalling” and “screening” are both
solutions to the problem of adverse selection, the topic of Chapter 19.]
——-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 marketing internship position that partially dealt with sunk costs. It was a “true” case question
where the interviewer used the Internet to pull up the actual products
as he asked the question.
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CHAPTER 1 • Introduction: What This Book Is About
9
“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
their new Y type server last week; it has the same features (and even a
few more) for a cost of $4,500. To date, Compaq 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, i.e. 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 worrying 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? ! ! ! )
[NOTE: this is a version of what is called the “sunk cost fallacy” which
is covered in Chapter 3.]
——-Original Message——From: “Student C”
Sent: Tuesday, January 18, 2000 1:37 PM
Subject: Economics Interview Questions
I got questions regarding transfer price within entities of a company.
What prices could be used and why. [NOTE: the problem of transfer pricing is one of the most common sources of conflict between divisions and
is covered in Chapters 22 and 23.]
——-Original Message——From: “Student D”
Sent: Tuesday, January 18, 2000 1:28 PM
Subject: Economics Interview Questions
You are a basketball coach with five seconds on the clock, and you are
losing by two points. You have the ball and can take only one more shot
(there is no chance of a rebound). There is a 70% chance of making a twopointer, which would send the game into overtime with each team having
an equal chance of winning. There is only a forty percent chance of making a three-pointer (winning if made). Should you shoot the two- or the
three-point shot? [NOTE: This is an example of decision-making under
uncertainty, the subject of Chapter 17. For those of you who cannot
wait, the answer is take the three-point shot because it results a
higher probability of winning, 40% as opposed to 35% with a two-point
shot.]
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10
SECTION I • Problem Solving and Decision Making
SUMMARY & HOMEWORK PROBLEMS
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 selfinterestedly. 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.
Multiple-Choice Questions
See the end of the next chapter for multiplechoice questions.
Individual Problems
See the end of the next chapter for individual
homework problems.
Group Problems
See the end of the next chapter for group homework problems.
END NOTES
1. Amitai Etzioni, “When It Comes to Ethics,
B-Schools Get an F,” Washington Post, August
4, 2002.
2. Ilan Brat, “Notre Dame Football Introduces Its
Fans to Inflationary Spiral,” Wall Street Journal, September 7, 2006.
3. We thank Bart Victor for his enumeration of
these objections.
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?
CHAPTER
2
The One Lesson of Business
In the spring of 2011, Rick Ruzzamenti of Riverside, California, decided to donate his kid-
ney to an organization set up to match donors and recipients. His selfless act set off a domino chain of 60 operations involving 17 hospitals in 11 different states.1 Donors, unable to
help their loved ones because of incompatible antibodies, instead donated kidneys to others
who donated to others, and so on, until the chain ended six months later in Chicago,
Illinois.
The good news is that 30 people received new kidneys, and escaped the living hell of
dialysis. The bad news is that this complex barter system is the only legal way for Americans to get kidneys.2 It is so inefficient that only 17,000 of the 90,000 people on waiting
lists received kidneys last year.
To understand how complex and cumbersome this process is, imagine trying to use it
to find a new apartment. To make this concrete, suppose you wanted to move from Detroit
to Nashville. You would first try to find someone moving in the opposite direction, from
Nashville to Detroit. Failing that, you might try to find a three-way trade: find someone
moving from Nashville to Los Angeles, and another person moving from Los Angeles to
Detroit. Then swap the first apartment for the second, the second for the third, and the
third for the first. Finding a matched set of trades that have the desired moving times and
locations and types of apartments causes the same kinds of compatibility problems that
trading kidneys does.
There are two common, but very different, reactions to this kind of inefficiency. Economists see it as a threat, and something to be eleminated by, for example, getting rid of the
prohibition on buying and selling organs. Businesspeople, on the other hand, see it as an
opportunity, and something to be exploited. In this case, a creative entrepreneur could borrow $100 million at 20% interest, buy a hospital ship, anchor it in international waters,
and begin selling kidneys. Set up a database to match donors to recipients, broker sales,
and fly in experienced transplant teams. If she charges $200,000 and earns 10% on each
transaction, the break-even quantity is just 1,000 transplants each year. This represents
only 1% of the potential demand in the United States alone.
The goal of this chapter is to teach you how to find and profitably exploit money making opportunities like this one. Students who’ve had some economics training will find that
11
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12
SECTION I • Problem Solving and Decision Making
they have a slight head start, but learning how to make money requires as much creativity
and imagination as analytic ability.
CAPITALISM AND WEALTH
To identify money-making opportunities, like those in the kidney market, we first have to
understand how wealth is created and destroyed.
Wealth is created when assets move from lower- to higher-valued uses.
An individual’s value for a good or service is measured as the amount of money he or
she is willing to pay for it.3 To “value” a good means that you want it and can pay for it.4
If we adopt the linguistic convention that buyers are male and the sellers are female, we
say that a buyer’s “value” for an item is how much he will pay for it, his “top dollar.”
Likewise, a seller won’t accept less than her value, “cost,” or “bottom line.”
The biggest advantage of capitalism is that it creates wealth by letting a person follow
his or her self-interest.5 A buyer willingly buys if the price is below his value, and a seller
sells for the same selfish reason—because the price is above her value. Both buyer and seller
gain; otherwise, they would not transact.
Voluntary transactions create wealth.
Suppose that a buyer values a house at $240,000 and a seller at $200,000. If they can
agree on a price—say, $210,000—they both gain. In this case, the seller gets to sell at a
price that is $10,000 higher than her bottom line and the buyer gets to buy at a price that
is $30,000 below her top dollar.
Formally, the difference between the agreed-on price and the seller’s value is called
seller surplus.
Likewise, buyer surplus is the buyer’s value minus the price. The total surplus or gains
from trade created by the transaction is the sum of buyer and seller surplus ($40,000), the
difference between the buyer’s top dollar and the seller’s bottom line.
To see how well you understand the wealth creating process, try to figure out which assets are moving to higher-valued uses in the following examples:
●
●
●
●
Factory owners purchase labor from workers, borrow capital from investors, and sell
manufactured products to consumers. In essence, factory owners are intermediaries
who move labor and capital from lower-valued to higher-valued uses, determined by
consumers’ willingness to pay for the labor and capital embodied in manufactured
products.
AIDS patients sometimes sell their life insurance policies to investors at a discount of
50% or more. The transaction allows patients to collect money from investors, who
must wait until the patient dies to collect from the insurance company. This transaction
moves money across time, from investors who are willing and able to wait to those
who don’t want to wait.
RentStuff.com is an online, secure, collateral-backed mechanism to facilitate transactions between those who have stuff and those who want to rent stuff.
When consumers purchase insurance, they pay an insurance company to assume risk
for them. In this context, you can think of risk as a “bad,” the opposite of a “good,”
moving from consumers willing to pay to get rid of it to insurance companies willing to
assume it for a fee.
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CHAPTER 2 • The One Lesson of Business
●
13
In video games like Diablo III or World of Warcraft, thousands of people in lessdeveloped countries spend time playing the games to acquire “currency” that can be
used to acquire add-ons. These “gold farmers” sell the currency to other players for
cash on Web sites outside of the game environment.
Here’s a final example that is not so obvious. In 2004, a private equity consortium purchased Mervyn’s, a department store located in the western United States. They sold off the
real estate on which the stores were located, and the new owners set store rents at market
rates. As a consequence, rent payments doubled and the 59-year-old retailer went out of
business, throwing 30,000 employees out of work.
So how was wealth created by this transaction?
The answer is that the transactions moved the real estate to a higher-valued use.
Charging market rates to the retailer uncovered the real source of Mervyn’s profit, its
low rents. And once Mervyn’s had to pay market rates, the retail operation was exposed as a money-losing operation. The private equity group made money by shutting
it down. The laid-off workers were unhappy, of course, but they had been working for
a firm producing a service whose cost was above what consumers were willing to pay
for it. The economy, as a whole, is better off with assets in higher valued uses, but we
recoginize that individual workers may not be able to find a higher-valued use for their
labor.
How do you create wealth? Which assets do you move to higher-valued uses?
We close this section with a warning against critics of capitalism who think that if one
person makes money, someone else must be losing it. This is such a common mistake that it
even has a name, the “zero sum fallacy.” Policy makers often invoke this fallacy to justify
limits on pay, profitability, or prices, or even trade itself. They are missing the big idea,
that the voluntary nature of trade ensures that both parties gain.
DOES THE GOVERNMENT CREATE WEALTH?
Governments play a critical role in the wealth-creating process by enforcing property
rights and contracts—legal mechanisms that facilitate voluntary transactions.6 By making sure that buyers and sellers can keep the gains from trade, our legal system makes
trade much more likely and is responsible for our nation’s enormous wealth-creating
ability.7
Conversely, the absence of property rights contributes to poverty. The reasons are simple: Without private property and contract enforcement, wealth-creating transactions are
less likely to occur,8 and this stunts development. Ironically, many poor countries survive
largely on the wealth created in the so-called underground, or black market, economy,
where transactions are hidden from the government.
Interestingly, secure property rights are also associated with measures of environmental
quality and human well-being. In nations where property rights are well protected, more
people have access to safe drinking water and sewage treatment and people live about 20
years longer.9 In other words, if you give people ownership to their property, they take
care of it, invest in it, and keep it clean.
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14
SECTION I • Problem Solving and Decision Making
WHY ECONOMICS IS USEFUL TO BUSINESS
Economics can be used by business people to spot money-making opportunities (assets in
lower-valued uses). To see this, we begin with “efficiency,” one of the most useful ideas in
economics.
An economy is efficient if all assets are employed in their highest-valued uses.
Economists obsess about efficiency. They search for assets in lower-valued uses and
then suggest public policies to move them to higher-valued ones. A good policy facilitates
the movement of assets to higher-valued uses; and a bad policy prevents assets from moving
or, worse, moves assets to lower-valued uses.
Determining whether an economic policy is good or bad requires analyzing all of its
effects—the unintended as well as the intended effects. Henry Hazlitt, former editorial page
editor of the Wall Street Journal, reduced all of economics into a single lesson:10
The art of economics consists in looking not merely at the immediate but at the longer
effects of any act or policy; it consists of tracing the consequences of that policy not
merely for one group but for all groups.11
For example, recent proposals to prevent lenders from foreclosing on houses helps the
delinquent homeowners, but it also hurts lenders. They respond by raising the cost of new
loans, which hurts prospective home buyers. Determining whether the policy is good or bad
requires that we look not only at the happy faces of the family that gets to stay in a foreclosed home, but also at the sad faces of the family that can no longer afford to buy a
house because the cost of borrowing has increased. The trick to “seeing” these indirect effects is to look at the incentives.
But public policy is not the focus of this book. Rather it is how to make money.
Making money is simple in principle—find an asset employed in lower-valued use, buy
it, and then sell it to someone who places a higher value on it.
The one lesson of business: The art of business consists of identifying assets in lowvalued uses and devising ways to profitably move them to higher-valued ones.
In other words, each underemployed asset represents a potential wealth-creating transaction. The art of business is to identify these transactions and find ways to profitably consummate them.
For example, once the government banned kidney sales, it simultaneously created an incentive to try to circumvent the ban. Buying a hospital ship and sailing to international
waters is just one solution. According to recent research, there is a thriving illegal or “black
market” for kidneys in the United States. For about $150,000, organ brokers will connect
wealthy buyers with poor foreign donors, who receive a few thousand dollars and the
chance to visit an American city. Once there, transplants are performed at “brokerfriendly” hospitals with surgeons who are either complicit in the scheme or willing to turn
a blind eye. Kidney brokers often hire clergy to accompany their clients into the hospital to
ensure that the process goes smoothly.12
If the movement of assets to higher valued uses creates wealth, then anything that impedes asset movement destroys wealth. We discuss three such impediments: taxes, subsidies,
and price controls. These regulations create inefficiency but simultaneously create opportunities to make money.
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CHAPTER 2 • The One Lesson of Business
15
Taxes
The government collects taxes out of the total surplus created by a transaction. If the
tax is larger than the surplus, the transaction will not take place. In our housing example, if a sales tax is 25%, for instance, as in Italy, the tax will be at least $50,000 because the price has to be above the seller’s bottom line ($200,000). Since the tax is
more than the surplus created by the transaction, the buyer and seller cannot find a
mutually agreeable price that lets them pay the tax.13
The intended effect of a tax is to raise revenue for the government, but the unintended
consequence of a tax is that it deters some wealth-creating transactions.
These unconsummated transactions represent money-making opportunities. For example, in 1983, Sweden imposed a 1% “turnover” (sales) tax on stock sales on the Swedish
Stock Exchange. Before the tax, large institutional investors paid commissions that averaged 25 basis points (0.25%). The turnover tax, by itself, was four times the size of the
old trading costs, and it fell most heavily on these big institutional investors.
After the tax was imposed, institutional traders began trading shares on the London
and New York Stock Exchanges, and the number of transactions on the Swedish Stock
Exchange fell by 40%. Smart brokers recognized this opportunity and profited by moving their trades to London and New York. The Swedish government finally removed the
turnover tax in 1990, but the Swedish Stock Exchange has never regained its former
vitality.
Subsidies
The opposite of a tax is a subsidy. By encouraging low-value consumers to buy or highvalue sellers to sell, subsidies destroy wealth by moving assets from higher- to lowervalued uses—in exactly the wrong direction.
For example, government policies designed to extend credit to low-income Americans
increased homeownership from 64% to 69% of the population. Many of these recipients,
like Victor Ramirez, were able to afford houses only due to the subsidies. Once the housing
bubble burst, they could not afford to stay in them. “This was our first home. I had nothing to compare it to,” Mr. Ramirez says. “I was a student making $17,000 a year, my wife
was between jobs. In retrospect, how in hell did we qualify?”14
He qualified due to government subsidies. We know that these subsidies destroy wealth
because without them, the money would have been spent on different and higher-valued
uses. To see this, offer each potential homeowner a payment equal to the amount of the
subsidy. If they would rather spend the money on something besides a home loan, then
there is a higher-valued use for the money.
The same logic can be used to identify ways to profit from inefficiency. To see this, let’s
look at health insurance that fully subsidizes visits to the doctor. If you get a cold, you go
to the doctor, who charges the insurance company $200 for your care. This subsidy destroys wealth if you would rather self-medicate and keep the $200.
Employers who recognize this are starting to offer insurance that requires a large
deductible or copayment. These fees stop low-value doctor visits and dramatically reduce the cost of insurance. Employers either keep the money or use it to raise workers’
wages (by the amount they save on insurance) to attract better workers. These highdeductible policies are becoming more popular as companies struggle with the high
costs of health care.
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16
SECTION I • Problem Solving and Decision Making
Price Controls
A price control is a regulation that allows trade only at certain prices.
Two types of price controls exist: price ceilings, which outlaw trade at prices above the ceiling, and price floors, which outlaw trade at prices below the floor. The prohibition on buying and selling kidneys is a form of price ceiling. Americans are allowed to buy and sell
kidneys—but only at a price of zero or less.
Price floors above the buyer’s top dollar and price ceilings below a seller’s bottom
line deter wealth-creating transactions.15 In our kidney example, potential kidney sellers
are deterred from selling because they can do so only at a price of zero.
To see how to profit from this inefficiency, we turn to the case of taxis, which are regulated with a price ceiling.
As a result, taxis won’t take you to the outer reaches of your metropolitan area because
regulated fares won’t let taxis recover the cost of return trip. Taxis are poorly maintained
because the regulated fares don’t allow taxis to charge for better quality. Finally, taxis have a
well-deserved reputation for recklessness because there is no way for taxis to increase earnings except by increasing volume, which they do by driving from place to place as fast as
possible.
Über is an alternative to taxis that makes money by alleviating these inefficiencies. They
use a sophisticated dispatch service to match passengers to more lightly regulated livery and
limo services. Because the drivers are allowed to negotiate higher prices for better service,
Über’s cars have an incentive to travel to distant destinations, clean their cars, and drive
safely. You can tell that they are successful by the complaints from the taxis to subject
Über to the same price controls that taxis face.16
WEALTH CREATION IN ORGANIZATIONS
Companies can be thought of as collections of transactions, from buying raw materials like
capital and labor to selling finished goods and services. In a successful company, these
transactions move assets to higher-valued uses and thus make money for the company.
As we saw from the story of the oil company in the introductory chapter, a firm’s organizational design influences decision making within the firm. Some designs encourage profitable decision making; others do not. A poorly designed company will consummate
unprofitable transactions or fail to consummate profitable ones.
The inability of organizations to move assets to higher-valued uses is analogous to the
wealth-destroying effects of government policies. Organizations impose “taxes,” “subsidies,” and “price controls” within their companies that lead to unprofitable decisions. For
example, overbidding at the oil company was caused by a “subsidy” paid to management
for acquiring oil reserves. Senior management responded to the subsidy by acquiring
reserves, regardless of the price. Our solution to the problem was to eliminate the subsidy.
The analogy from the market-level problems created by taxes, subsidies, and pricecontrols, to the organization-level problems of goal alignment means that we are using
the same economic tools to analyze both types of problems. The target of the analysis
changes—from markets to organizations—but the analysis remains the same.
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CHAPTER 2 • The One Lesson of Business
17
SUMMARY & HOMEWORK PROBLEMS
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. Such
inefficiency implies a money-making
opportunity.
The art of business consists of finding 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.
5.
6.
7.
Multiple-Choice Questions
1. An individual’s value for a good or service
is the
a. the amount of money he or she used to
pay for a good.
b. the amount of money he or she is willing
to pay for it.
c. the amount of money he or she has to
spend on goods.
d. none of the above.
2. The biggest advantage of capitalism is that
a. It generates equality.
b. Prices assist in moving assets from highvalue to low-value uses.
c. It is fair.
d. It creates wealth by letting a person
follow his or her own self-interest.
3. Wealth-creating transactions are more likely
to occur
a. With private property rights.
b. With strong contract enforcement.
c. With black markets.
d. All of the above.
4. Government regulation
a. provides incentives to conduct business
in an illegal black market.
b. plays no role in generating wealth.
8.
9.
10.
c. is the best way to eliminate poverty.
d. does not enforce property rights.
An example of a price floor is
a. minimum wages.
b. rent controls in New York.
c. Both a and b
d. None of the above
A price ceiling
a. is a government-set maximum price.
b. is an implicit tax on producers and an
implicit subsidy to consumers.
c. will create a surplus.
d. causes an increase in consumer and producer surplus.
Taxes:
a. Impede the movement of assets to highervalued uses.
b. reduce incentives to work.
c. decreases the number of wealth creating
transactions.
d. All the above
A consumer values a car at $30,000 and it
costs a producer $20,000 to make the same
car. If the transaction is completed at
$24,000, the transaction will generate:
a. no surplus.
b. $4,000 worth of seller surplus and
unknown amount of buyer surplus.
c. $6,000 worth of buyer surplus and
$4,000 of seller surplus.
d. $6,000 worth of buyer surplus and
unknown amount of seller surplus.
A consumer values a car at $525,000 and a
producer values the same car at $485,000. If
sales tax is 8% and is levied on the seller,
then the sellers bottom line price is
a. $527,000.
b. $523,800.
c. $525,000.
d. $500,000.
Efficiency implies opportunity,
a. Always.
b. Never.
c. Only if accompanied by secure property
rights.
d. None of the above.
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18
SECTION I • Problem Solving and Decision Making
Individual Problems
2-1 Airline Delays
How will commercial airlines respond to the
threat of new $27,500 fines for keeping passengers on the tramac for more than 3 hours? What
inefficiency will this create?
2-2 Selling Used Cars
I recently sold my used car. If no new production
occurred for this transaction, how could it have
created value?
2-3 Flood Insurance
The U.S. government subsidizes flood insurance
because those who want to buy it live in the flood
plain and cannot get it at reasonable rates. What
inefficiency does this create?
2-4 Goal Alignment among Physicians
An elderly physician has built up his own practice into a quite valuable business. Now that
he is thinking of retiring, he wants to take on a
partner to learn the business and eventually buy
the practice in three years. Her compensation
will be a salary plus 25% of the profits if they
are below the historical average and 50% for
any increase above the historical average. The
eventual purchase price for the practice will be
5 times the average profits over the three years.
Discuss the efficiency aspects of such a contract.
Are the incentives of the buyer and seller
aligned?
2-5 Kraft and Cadbury
When Kraft recently bid $16.7 billion for Cadbury, Cadbury’s market value rose, but Kraft’s
market value fell by more. What does this tell
you about the value-creating potential of the
deal?
2-6 Price of Breast Reconstruction vs. Breast
Augmentation
Two similar surgeries, breast reconstruction and
breast augmentation, have different prices. Breast
augmentation is cosmetic surgery not covered by
health insurance. Patients who want the surgery
must pay for it themselves. Breast reconstruction following breast removal due to cancer is covered by
insurance. The price for one of the surgeries has increased by about 10% each year since 1995 while
the other has increased by only 2% per year. Which
of the surgeries has the lower inflation rate? Why?
Group Problems
G2-1 Goal Alignment in Your Company
Are your incentives aligned with the goals of
your company? If not, identify a problem
caused by goal misalignment. Suggest a change
that would address the problem. Compute
the profit consequences of the change.
G2-2 One Lesson of Business
Identify an unconsummated wealth-creating transaction (or a wealth-destroying one) created by
some tax, subsidy, price control, or other government policy, and then figure out how to profitably
consummate it (or deter it). Estimate how much
profit you would earn by consummating (or deterring) it.
G2-3 One Lesson of Business (within an
Organization)
Identify an unconsummated wealth-creating
transaction (or a wealth-destroying one) within
your organization, and figure out how to profitably consummate it (or deter it). Estimate how
much profit you would earn by consummating it
(or deterring) it.
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CHAPTER 2 • The One Lesson of Business
19
END NOTES
1. See Kevin Sack, “60 Lives, 30 Kidneys, All
Linked,” New York Times, February 18, 2012.
2. See Sally Satel and Mark J. Perry, “More Kidney Donors are Needed to Meet a Rising
Demand,” Washington Post, March 7, 2010.
3. This definition of value as “willingness to pay”
carries strong normative connotations, just as
other definitions of value carry strong alternative normative connotations. For example,
under Communism, a labor theory of value is
used. Value depends on how much labor produced it. This value (how much labor is
embodied in the good) has an independent existence even if no one wants to buy the good.
This can lead to situations where goods are
produced that nobody wants.
The defining tenet of Communism is “from
each according to his ability; to each according
to his need.” Communism is bad at creating
wealth because it allocates goods according to
“needs,” not “wants,” and because it’s tough
to gauge how much people need goods. Individuals have great incentive to claim they are
“needier” than they really are. In the political
arena, groups compete for government funds
by claiming they are the “neediest.”
Economists dislike the word need because it
is so often used to manipulate others into giving
away something. Listen to news reports about
proposed government spending cuts. Most often
those affected claim they “need” the programs
targeted for elimination. That sounds better
than saying they “want” the programs.
The definitions of value differ because
Communism and Socialism are more
concerned with the distribution of wealth than
with the creation of wealth, which is capitalism’s greatest concern. In other words, capitalism is concerned with making the proverbial
“pie” as large as possible, while Socialism and
Communism are concerned more about how to
slice up that pie. Socialism and Communism are
concerned more about how to slice up that pie.
4. It is the ability-to-pay component of value that
is behind most critiques of capitalism. Unless
you have enough money to purchase an item,
then you do not value it.
5. This is the idea behind the French phrase
laissez-faire (leave them alone).
6. “The only proper functions of a government
are: the police, to protect you from criminals;
the army, to protect you from foreign invaders; and the courts, to protect your property
and contracts from breach or fraud by others,
to settle disputes by rational rules, according
to objective law.” Ayn Rand, Atlas Shrugged
(New York: Random House, 1957), 977.
7. Tom Bethell, The Noblest Triumph: Property
and Prosperity through the Ages (New York:
St. Martin’s Press, 1995).
8. “The inherent vice of capitalism is the unequal
sharing of blessings; the inherent virtue of
socialism is the equal sharing of miseries”
(Winston Churchill).
9. Seth Norton, “Property Rights, the Environment, and Economic Weil-Being,” in Who
Owns the Environment? ed. Peter J. Hill and
Roger E. Meiners (Lannam, MD: Rowman
and Littlefield, 1998).
10. Henry Hazlitt, Economics in One Lesson
(New York: Crown, 1979).
11. For chilling examples of the unintended consequences of government policy, read Jagdesh
Bhagwati’s recent book, In Defense of Globalization (New York: Oxford University
Press, 2004). In 1993, for example, the U.S.
Congress seemed likely to pass Senator Tom
Harkin’s Child Labor Deterrence Act, which
would have banned imports of textiles made
by child workers. Anticipating its passage, the
Bangladeshi textile industry dismissed 50,000
children from factories. Many of these children ended up as prostitutes. Ironically, the
bill, which was designed to help children, had
the opposite effect.
12. Jeneen Interlandi, “Not Just Urban Legend,”
Newsweek, January, 19, 2009.
13. With a 25% tax, the seller receives 75% of the
sales price. If the tax is levied on the seller, her
bottom-line price increases to $266,667 =
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20
SECTION I • Problem Solving and Decision Making
$200,000/(0.75), which is above the buyer’s top
dollar of $240,000. If the tax is levied on the
buyer, his top dollar decreases to $192,000,
which is below the seller’s bottom line.
14. David Streitfeld and Gretchen Morgenson,
“Building Flawed American Dreams,” New
York Times, October 18, 2008.
15. Price floors below a seller’s bottom line and
price ceilings above a buyer’s top dollar have
no effect.
16. Megan Mcardle, “Why You Can’t Get a
Taxi,” The Atlantic, May 2012.
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?
CHAPTER
3
Benefits, Costs, and Decisions
B
ig Coal Power Company burns two types of coal from the Southern Powder River Basin in
Wyoming: 8800 Btu coal and 8400 Btu coal. The numbers refer to the amount of energy contained in one pound of coal. The coal is delivered by rail and barge to power plants that crush
it, burn it, and use the heat to create steam that drives generators that produce electricity.
The 8400 coal produces about 5% less electricity per ton than 8800 coal, so when the
price of 8400 fell 5% below the price of 8800, the plant manager did the obvious thing and
switched to the lower-cost coal. Not only did this move reduce the average cost of electricity produced at his plant (cost/Btu), but it also increased the manager’s compensation as the
company had adopted average cost as a metric to measure plant performance. Unfortunately, however, the move also reduced company profit.
When the plant manager made the switch to the cheaper but lower-energy coal, electricity output fell by 5%. He could not make up for this decrease by putting a bigger volume of the lower-energy coal through the plant because the conveyor belts and crushers
were already working at capacity. His parent company had to replace the lost electricity
with higher-cost natural gas, which was even more expensive than the 8800 coal.
The story illustrates several themes that are the topic of this chapter: First, a good decision
should have considered the all the costs of switching to the lower Btu coal, including the cost of
replacing the lost electricity; second, average costs can be a lousy indicator of plant performance; and finally, as we have already seen in Chapter 1, problems can arise when the incentives of a business unit are not aligned with the goals of the parent company. In fact, we can
use the problem-solving algorithm of Chapter 1 to identify the source of the problem:
1. Who is making the bad decision?
The plant manager made the switch to the lower-priced 8400 coal.
2. Did he have enough information to make a good decision?
Yes, presumably he knew that this would reduce his output.
3. Did he have the incentive to make a good decision?
No, because he was evaluated based on the average cost of electricity produced at his plant.
Even though mistakes like this seem painfully obvious, spotting them before they occur is
more difficult than it seems. The goal of this chapter is to teach you to think systematically
21
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22
SECTION I • Problem Solving and Decision Making
about the benefits and costs of the decisions you make. This is an important follow-on lesson
to that of Chapter 1, where we showed you how to give employees the information and
incentives to make profitable decisions. In this chapter, we introduce benefit-cost analysis to
show you how to recognize profitable decisions.
BACKGROUND: VARIABLE, FIXED, AND TOTAL COSTS
For decisions that affect output, knowing how costs vary with output will help you compute
some of the costs associated with these decisions. To illustrate, suppose that you are the manager of a new candy factory. To produce candy, you have to build a factory, purchase ingredients, and hire employees to run it and to sell your product. Suppose your factory cost is
$1 million/year in capital costs (e.g., a $10 million factory and a 10% cost of capital),
employees cost $50,000 total each, and ingredients cost $0.50/candy bar. If you decided to
produce 1,000 candy bars in a year, you need to hire 10 employees, but if you decide to produce 2,000 bars, you need 20 employees. For 2,000 bars, your production costs would be
$1,500,500—$1 million for the factory, $500,000 in employee costs, and $500 in ingredient
costs. If you decide to produce 2,000 bars, your costs would be $2,001,000—$1 million for
the factory, $1 million in employee costs, and $1,000 in ingredients.
Notice that some, but not all, of the costs change as you increase output. Total costs
increase as you produce more candy bars, but your factory capital costs are $1 million
regardless of the amount you produce. The capital cost is a fixed cost, as opposed to the
labor or ingredients, which vary with input. Costs that change with output level are called
variable costs. The distinction is a key lesson for this chapter:
Fixed costs do not vary with the amount of output. Variable costs change as output changes.
Table 3-1 shows total, fixed, and variable costs for the new candy factory at various
production levels. Notice that the fixed costs remain the same whether your factory produces nothing or 5,000 candy bars. Variable costs, on the other hand, rise and fall as output changes. Total costs show a similar pattern with the important exception that total
costs are also greater than zero regardless of output.
T AB LE 3.1
Candy Factory Costs
COSTS
Output
Fixed
Variable
Total
0
1,000,000
0
1,000,000
1,000
1,000,000
500,500
1,500,500
2,000
1,000,000
1,001,000
2,001,000
3,000
1,000,000
1,501,500
2,501,500
4,000
1,000,000
2,002,000
3,002,000
5,000
1,000,000
2,502,500
3,502,500
© Cengage Learning
To illustrate the relationships among these costs, we represent them graphically. Figure 3-1
shows the general relationship between output and total, fixed, and variable costs. For output
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CHAPTER 3 • Benefits, Costs, and Decisions
23
levels of zero, both fixed and total costs are greater than zero. Total and variable costs both
increase with output, and variable costs appear as the difference between the total cost curve
and the fixed cost line.1 To test your understanding of the distinction between fixed and
variable costs, ask yourself which of the following costs are variable:
●
●
●
Production Costs
●
Payments to your accountants to prepare your tax returns
Electricity to run the candy-making machines
Fees to design the packaging of your candy bar
Costs of material for packaging2
Total Costs
Variable Costs
Fixed Costs
Output Level
FI G U R E
3.1 Cost Curves
© Cengage Learning
BACKGROUND: ACCOUNTING VERSUS ECONOMIC PROFIT
We now leave our fictitious candy manufacturer to talk about a real one. In 1990, Cadbury
India offered its managers free housing in company-owned flats to offset the high cost of
living in Bombay (now Mumbai). In 1991, when Cadbury added low-interest housing loans
to its benefits package, managers took advantage of this incentive and purchased their own
homes, leaving the company flats empty. The empty flats remained on the company’s balance sheet for the next six years.
In 1997, Cadbury adopted Economic Value Added (EVA®), a financial performance
metric trademarked by Stern Stewart & Co. EVA®, like other economic performance metrics, charges each division within a firm for the amount of capital it uses. This gives management an incentive to incur capital expenditures only if they earn more than they cost. In
addition, it gives managers an incentive to reduce capital expenditures if they are earning
less than they cost. In this case, the main difference between ordinary accounting profit
and EVA® is that EVA® includes a capital charge of 15%, representing the return that Cadbury could have made had it invested the capital elsewhere.
After adopting EVA®, Cadbury India’s annual “economic” income dropped
by £600,000 (15% cost of capital times the £4,000,000 capital tied up in the apartments).3 To increase EVA®, senior managers decided to sell the unused apartments.
By charging each division for the amount of capital it used, the company gave
managers an incentive to sell the apartments because they were earning less than 15%.
Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
24
SECTION I • Problem Solving and Decision Making
T A BLE 3.2
Cadbury Income Statement
NET SALES
£6,738
Cost of Sales
£3,020
GROSS PROFIT
£3,718
Operating Expenses:
Selling, General, and Administrative
£2,654
Depreciation and Amortization
£215
Total Operating Expenses
£2,869
OPERATING INCOME
£849
Other Income (Expense):
Net Interest
(£226)
Other Income
(3)
Total…
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