Managerial economics 3rd by froeb ch01

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 assu

11 Introduction:

What This Book

is About

Summary of Main Points

▮ Problem solving requires two steps: First, figure out why mistakes are being made; and then figure out how to

make them stop

▮ The rational-actor paradigm assumes that people act

rationally, optimally, and self-interestedly To change

behavior, you have to change incentives.

▮ Good incentives are created by rewarding good

performance.

▮ A well-designed organization is one in which employee

incentives are aligned with organizational goals By this

we mean that employees have enough information to

make good decisions, and the incentive to do so.

Summary of Main Points (continued)

▮ You can analyze any problem by asking three questions:

1 Who is making the bad decision?;

2 Does the decision maker have enough information to

make a good decision?; and

3 the incentive to do so?

▮ Answers to these questions will suggest solutions

centered on

1 letting someone else make the decision, someone

with better information or incentives;

2 giving the decision maker more information; or

3 changing the decision maker’s incentives.

Problem: Over-bidding OVI gas tract

▮ A young geologist was preparing a bid

recommendation for an oil tract in the Gulf of

Mexico

▮ With knowledge of the productivity of neighboring tracts also owned by company, the geologist

recommended a bid of $5 million.

▮ Senior management, though, bid $20 million - far over the next highest-bid of $750,000.

▮ What, if anything, is wrong?

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

diagnose and solve problems like this.

Problem solving

• Figure out what’s wrong, i.e., why the bad decision was made

• Figure out how to fix it

• Why are people making mistakes?

• What can we do to make them change?

behavior The rational actor paradigm states:

• People act rationally, optimally, self-interestedly

change incentives.

ANSWER:

Manager bonuses for increasing reserves

• Senior managers were rewarded for acquiring reserves regardless of their profitability

reserve estimate.

• Let someone else decide?

• Change information flow?

• Change incentives?