PPt1 2

CHAPTER
1 Introduction:
What This Book is About
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website for classroom use. ©Kamira/Shutterstock Images
SUMMARY OF MAIN POINTS
● Problem solving requires two steps:

1) figure out what’s causing the problem
2) figure out how to fix it
● For both steps, predict how people behave
● rational-actor paradigm: assumes that people act
rationally, optimally, and self-interestedly.
● Simply put, people respond to incentives.
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2
● Good incentives come from rewarding good
performance.
• Ex: commission on sales
● A well-designed organization aligns employee
incentives with organizational goals.
● Specifically, employees have enough information to
make good decisions, and the incentive to do so.
● Three questions to find the source of the problem:
1) Who is making the bad decision?
2) Does the decision maker have enough information
to make a good decision?
3) Does the decision maker have the incentive to make
a good decision?
● Answers to these questions will suggest solutions:
1) Letting someone with better information or
incentives make the decision
2) Giving the decision maker more information
3) Changing the decision maker’s incentives.
Problem: Over-bidding OVI gas tract
● A young geologist was preparing a bid

recommendation for an oil tract in the Gulf of
Mexico.
● The geologist knew the productivity of nearby
tracts also owned by the company.
● Knowing this, he recommended a bid of $5 million.
● Senior management bid $20 million – far over the
next highest bid of $750,000.
● What, if anything, is wrong?
Problem solving
● The goal of this text is to provide tools to help

identify and solve problems like this.
● Two distinct steps:
1) Figure out what’s wrong
• i.e., why overbidding occurred
2) Figure out how to fix it
Model of Behavior
● Both steps require a model of behavior

• Why are people making mistakes?
• What can we do to make them change?
● Economists use the rational-actor paradigm to model
behavior.
● The rational actor paradigm states:
• People act rationally, optimally, self-interestedly
• Meaning, they respond to incentives – to change
behavior you must change incentives.
Answer to Overbidding Problem
● Answer the three questions:

1) Senior management made the bad decision to overbid.
2) They had enough information to make the right
decision.
3) They didn’t have the incentive to do so.
● A bonus system created incentives to over-bid.
• Senior managers were rewarded for acquiring reserves
regardless of their profitabilit.y
• They had the young geologist “do what he could” to
increase the size of estimated reserves.
• Bonuses also created an incentive to manipulate the
reserve estimate.
Solution to Overbidding Problem
Now that we know what is wrong, how do we fix it?

● Let someone else decide? NO
● Change information flow? NO
● Change incentives? YES
• Change performance evaluation metric
• Ex: Increased profitability as measurement of success instead of
increased acquired reserves
• Reward scheme
• Ex: Make bonuses tied to profitability, not acquired reserves
NAR Problem
● In 2006, a TV reporter was sent into a National

Auto Repair (NAR) shop with a perfectly good
car
● The reporter came out with a new muffler and
transmission – and a bill for over $8,000
● The news story badly hurt NAR’s profits
● How do you solve this problem?
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.
Problem-Solving Algorithm
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.
NAR Solution
● There was an incentive issue

● NAR tried two solutions
1) reorganized into two division – led to colluding
2) adopted flat pay – led to less incentive to work hard
● Suggested resolution: add an additional performance
evaluation metric to original commission scheme
• Ex: Sporadically send in “secret shoppers” like the
news reporter
● This shows the trade-offs you face when creating
solutions
Ethics and Economics
● The rational-actor paradigm can make students

uncomfortable
• It seems to disregard personal ethics the guide
behavior.
● You have to understand why unethical behavior
occurs to fix it though
• Be able to anticipate opportunistic behavior to know
how to avoid it
Value System
● Debates about ethics and economics really are

about different value systems
● Deontologists: actions are good or ethical if they
conform to a set of principles (ex: The Golden
Rule)
● Consequentialists: actions are judged based on
whether they lead to a good consequence
● Economics is more consequentialist
• Uses analysis to understand the consequences of
different solutions

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CHAPTER

● Problem solving requires two steps:

● A young geologist was preparing a bid

● The goal of this text is to provide tools to help

2) Figure out how to fix it

● Both steps require a model of behavior

● Answer the three questions:

Now that we know what is wrong, how do we fix it?

● In 2006, a TV reporter was sent into a National

1) Who is making the bad decision?

3) Does the decision maker have the incentive to

● There was an incentive issue

● The rational-actor paradigm can make students

● Debates about ethics and economics really are

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