Introduction: What This ere a cw’ Tn 1992, a jusior geloyist was preparog a bid recommendation for a ci tract inthe Galf of Mesico. He suspected tha this tact costained a large accumlaion of oil bcause his company, Oil Ventures lnterzatonal (OVD, hha an adjacent tract with several productive wells. Since no competitors had righboring rac, none of them suspeced a Taree accumilatien of of Because of this, he thongiht that the tact could fw wom relatively cheaply aad recommended 4 bid of $5 milion. Surprisingly, OVP ser manage ‘nent ignored the recommendation and submited a bel of $21 millon. OVL vor the tract over the next highest bid of $750,000. IE the boaed of diectors eaked you to review the bidding proceducen st OVE how would you pecceed? What questions would you ask? Where wwould you bests your lnvenigaion! "You'd find i difete to gather information fom thote coset tothe bid ing, Secior mangement would be surpiious ae uncooperative beaut 10 ‘one likes to be singled out for bidding $20 milion mere than was necessary. Likewise, our junior geologist would be reluctant to exticize his superion. You might be able to rey om your experience—provided that you had rin into a sindar problem, But without experience, or when facing novel problems, you would have to rely on your analytic abit. This book is designed to show you how to complete a assignment lice thi. iW using Economics to Solve Problems To solve a problem like OVDs, firs, figure out what's cuusing the problem, and second, how to fix i. In this case, you would want to know whether the ‘$21 million bid was too high atthe time it was made, not ju in retcogpect. IF the bid was too aggeestive, then you'd have to Bigure out why the senior mas. fgets overbid and how to make cure they dot’t do it again. Both stepe require that you predict how people Behave in different ci ccamatancss, and this where the econemic context of the hock comes iaA SECTION | ~ Problem Solving and Decision Making The one thing that nies economists is their use of the rational-actor paradigm to preciet behavior. Simply pu it says dat people act rationally Sotinally, and self-nerstedly. In other words they rexpond to incentives The paradigm not only helps you figure out why people behave the way they do but also suggests ways tp mocvate them to change. To change behavic, you have to change seleineret, end you do that by change inensves Invenives are cated hy ewnrding goo peronmanes with, fr example, 2 commision am sles 2 Hamas elon proiabiliy. The peviormance tralaton mri ewer, cor, profi, of snl outs) ix ssparata om She reward concture (commision, bon rie, oF promotion but dhey swore gether to create an incentive co behave acetain yay Tolustat lets go back to OVP sory and ry to fd the source of he rotlem, Alter his company won the aucion, ou gedogit increased the Companys oil eserves bythe anwount of ol eainased uo be in che tract. Dut wan the company dried x wall chey dicovered only a sal amoune of ol So the acqusiton di line wo increase the sizeof the company's oll serves. Using the information fom the well, oa gelegist updated the reservoir map and reduce the reserve estimate by tworhirds Senior management rejected the lower estimate and directed the geolagit to “do what be could? to increase the size ofthe estinated reserves. So he tevted the reervoir map again, adding “additional” reserves to the com ny’ astet base. The reason behind this behavior became clear when, se eral months later, OVFs senior managers resigned, collecting bonuses tied to the increase in ol reserves that had accumulated daring thet tenure Te incensive created by the bonus plan expluins the kehavior of senior rmanagement. Both the oveidding and the fore to inflate the reserve es fnate Were rational, self interested sesponses tothe incentive created hy the ions. Even if you didnt know abou the geologists bed reconmendaton, you'd stl suspect that the senior managers overid because they had the Ircuntive so dos. Senior manager’ ability to manipulate the reserve estimate tnade i diffcult for shacholders and their representatives ow the beard of Cizecors to pot che mistake. To fic tis problem, you have to find a way wo beter align manages incentives withthe company's goals. To do tis, find a way 10 ward ane fgement for increasing protabiity, noe jst for acquitng reserves. This fot as eaty as it sounds becuse it's dfcu w mexsure a managers cont hution co company proftabilty. You can do this subjectively, wth annual perforstance reviews, or objecively, ising company earnings or stock price Ipptecation as performance neti But each of these performance mais can create problens, at wel seein later chapters This story illustrates two principles that will help you learn to diagnese and solve problems. Novice that (1) we reduced the probler: (overbidding) co a cect mp rT at Tebad decision by somecne at the firm (senior mangement) and (2) we used economics to find the source of the problem. Under the rational-actor para digm, bad decisions happen for one of two reasons: either decision makers do not have enough information to make good decisions, ar they lack incen- tive to do so. Using this insight, you can isolate the source of almout any problem by asking theee simple questions: 1. Who is making the bed decision? 2. Does the decision maker have enough information to make a good decxion? 3. Does the decision maker have the incentive to make a good decision? Answers to these three questions not enly point to the source ofthe problem but will abo suggest ways to fix it by: 1 letting someone else—someone with better information or better incentiver—make the devision, 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 bed 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 fx is to change che incentives of senior management so that they are based on profitability, a0: oil eeverves. ‘When reading about various business mistakes in this book, you should ask yourself these theee questions 10 see if you can find the eause of exch problem, and then try ane of the theee alutions to fx it. By dhe time you Bn iah the book, the anclysis should become secoad nature, Here are some practical tips that will help you develop preblens-salving skal "Think about the problem from the onganization’s point of view. Avoid ‘the temptation to thick about the preblens from the emplayse’s point of view hecause you will mise the fundamental peoblem of goal alignment how does the organization give employees enough information to make ‘good decisions and the incentive to do 302 "Think about the organizational design. Once you identify a bad daciion, avoid che temptation to solve the problem by simply reversing the decision. Instead, think about why the kad decision was made, and how to make sare that cimilar mistakes won't he made in the future What isthe trade-off? Every solution has costs as well as benefits. Avoid ‘he tempzation to thitk only about the benefits, ar it will make your analysis seem as if it were done to justify your own foregone conclusion. Iastead, ase the three questions to spor problems with a proposed solu- ‘tors that is in whatever solution you propose, make sure decision ‘makers have enough information to make good decisions and the incen- tive te da sa