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Chapter 1
Introduction: What This Book is
About
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 1 – Take Aways
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Problem solving requires two steps:
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You identify profitable decisions
You figure out how to implement them
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The rational-actor paradigm assumes that people act rationally, optimally, and
self-interestedly. To change behavior, you have to change people’s view of
what’s in their own self-interests by changing incentives.
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A well-designed organization is one in which employee incentives are aligned
with organizational goals.
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Good incentives are created by rewarding good performance.
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You can analyze any problem by asking three questions:
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Who is making the bad decision?
Do the decision makers have enough information to make a good decision?
Do the decision makers have incentives to make a good decision?
Introductory Anecdote: Oil Bidding
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Young geologist preparing bid recommendation for
Golf of Mexico oil tract
With knowledge of productivity of neighboring tract
also owned by company, geologist recommended
bid of $5 million
Senior management bid $20 million, beating out
next highest bid of $750,000
How would you go about solving this problem?
The goal of this text is to provide tools to help
diagnose and solve problems like this
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Course Goals
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Show you how to identify profitable decisions
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By using benefit-cost analysis
Then ensure that they are made in your
organization
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Make sure employees have the information
necessary to make good decisions
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And the incentive to do so
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Solving Problems
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Two issues
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What’s wrong?
How can we fix it?
Requires predicting human behavior
Economists utilize the rational-actor paradigm
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Methodology: Rational Actor Paradigm
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The one thing that unites economists is rational actor
paradigm
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People behave optimally, rationally, selfishly
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To change behavior, you change incentives.
Use paradigm to predict behavior
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Identify profitable decisions
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Using benefit-cost analysis
And then implement them
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Using “organizational architecture”
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Analyzing Overbidding
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Another piece of the story
 After winning the bid, geologist increased estimated reserves of
company
 But, after a dry well was drilled, reserve estimates were
decreased
 Executive stepped in and order increase to reserve estimate
Why were executives so interested in estimated reserves? Think
about incentives!
It turns out that executive bonuses were tied to increasing the
amount of estimated reserves.
Senior management resigned several months later collecting
sizeable bonuses tied to the “great job” they had done increasing
the reserves of the company
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Fixing the Problem
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Need to align the incentives of executives
with the goals of the company
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Easy to say but often hard to do
In general, bad decisions are made for two
reasons:
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Poor incentives
Poor information
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Questions to Diagnose and Solve Problems
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Ask three simple questions to diagnose the problem
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Who is making the bad decision?
Do they have enough information to make a good
decision?
Do they have an incentive to make a good decision?
Answers suggest potential solution paths
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Let someone else make the decision (someone with better
info or incentives)
Give more information to the current decision maker
Change the incentives of the decision maker
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Ethics
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Do we encourage self-interested, selfish
behavior by using the rational-actor
paradigm?
Opportunistic behavior is a fact of life
You need to understand how to recognize it
to protect yourself against it
The rational-actor paradigm is a tool, not a
prescription
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Ethics
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Do we encourage self-interested, selfish
behavior by using the rational-actor
paradigm?
Opportunistic behavior is a fact of life
You need to understand how to recognize it
to protect yourself against it
The rational-actor paradigm is a tool, not a
prescription
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Why Else This Material is Important
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Employers expect that you will know these concepts
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And, be able to apply them
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Ethics
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Economists often also share an assumption that the goal of the
firm is profit maximization
Opinions do differ, however
 Discussion: pricing of hotel rooms during home football game
weekends
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Traditional economic view – level pricing leads to excess demand;
how are rooms allocated then (rationing, arbitrageurs, . . .)?
Contrasting view – businesses should not raise prices during times of
shortage; businesses have a responsibility to consumers and society
Your view?
Text view: firms serve consumers and society best by engaging
in free and open competition within legal limits while attempting
to maximize profits.
 Not a license to engage in illegal behavior
 No denying that concerns exist about the ethical dimension of
business
 Reasonable people have disagreed for millennia on what
constitutes “ethical” behavior
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Alternate Intro Anecdote
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Joseph Jett was a star bond trader for KidderPeabody in the early 90’s, earning multi-million
dollar annual bonuses
Traded “strips” – separating interest payments from
government bonds and then putting back interest
payments with the stripped bonds
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Earns profit by taking advantage of yield differences
between zero-coupon bonds and interest-bearing bonds
But, Jett made profit regardless of yield
differences??
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Jett Anecdote (Part 2)
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KP computer systems were not designed to handle
this kind of trading
Although these were 5-day forward contracts, profits
were recognized immediately (equal to five days
interest); even though by day of settling, profits
would be zero.
By continuously increasing size of contracts, profits
continued to accrue
Jett and his supervisor rewarded with large bonuses
The moral
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People respond to incentives
Make sure your tracking systems are adequate to ensure
the behavior being rewarded is truly what you want
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Extra Discussion
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Why do seat belts kill?
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What does this say about rational actor paradigm?
Why does Landsburg say that “Taxes are bad only if
you can avoid them?”
Is the rational actor paradigm a narrow view of the
world?
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