PowerPoint Slides © Luke M.

Froeb, Vanderbilt 2014

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 Introduction:
11
What This Book
is About

2
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 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.

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 Summary of Main Points (continued)
▮ 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.

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 Summary of Main Points (continued)
▮ 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.

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 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?

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 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

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 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.

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 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 profitability
• 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.

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 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

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 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?

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 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.
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 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
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 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

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 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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