MANAGERIAL ECONOMICS

CH 1
 3 CASES

1. OVI
2. NAR
3. Hotels (Price Control)
PROBLEM SOLVING REQUIRES TWO STEPS

1. Figure out why people are

making mistakes and then
2. Figure out how to prevent future ones
 RATIONAL-ACTOR PARADIGM

The rational-actor paradigm is a model of behavior that assumes that

people act rationally, optimally, and self-interestedly, that is, they
respond to incentives.
 INCENTIVES HAVE TWO PIECES:

1. A way of measuring performance and

2. A compensation scheme to reward good
(or punish bad performance).
 A WELL-DESIGNED ORG. IS ONE WHICH

EMPLOYEE INCENTIVES ARE ALIGNED WITH

ORGANIZATIONAL GOALS.
By this we mean that employees have
1. Enough information to make good decisions
2. The incentive to do so.
 3 QUESTIONS TO ANALYZE THE PROBLEM

Q1: Who made the bad decision?

Q2: Does the decision maker have enough information to
make a good decision?
Q3: Does the decision maker have the incentive to make a good
decision?
THE ANSWER TO THOSE Q’S WILL SUGGEST
ONE OF THE 3 SOLUTIONS:

S1: Let someone else make the decision, someone with better
information or incentives.
S2: Give the decision maker more information.
S3: Change the decision maker’s incentives.
OVI (OIL VENTURES INTERNATIONAL)
 THINK FROM THE ORGANIZATION’S POINT
OF VIEW

• What are the Organization’s/Company’s goals?

Maximize Profits, Max. Benefits, Min. Costs
 WHY DID THE SENIOR MGMT

a. Overbid
In spite of having enough information, why did Senior Mgmt overbid
(to acquire the oil tract)?
b. Manipulate the reserve estimate?
(It turned out that the oil tract did very little to increase the reserve
estimate.)
Q1: Senior Mgmt made the bad decision.
Q2: Senior Mgmt were given enough information.
Q3: They were given bonuses when
they increased the oil reserves…
 Q3: INCENTIVE TO MAKE A GOOD
DECISION? NO

Incentives: Senior Mgmt. were given bonuses when they increased oil
reserves
PEOPLE EXPLOIT OPPORTUNITIES!
Senior managers overbid because they were REWARDED for
acquiring reserves regardless of price.
 PEOPLE EXPLOIT OPPORTUNITIES

Low chance of detection and punishment:

Senior managers had the ability to manipulate the reserve estimate this
made it difficult for shareholders and their representatives on the board
of directors to spot the mistake.
 ALIGN MGMT.’S INCENTIVES WITH
COMPANY’S GOALS

• Rewarding mgmt. for increasing profitability not just for acquiring

reserves…
• Must be able to measure this
• How? Annual performance reviews, stock price appreciation
 Q3…..S3

S3: Change the incentive. (Must align the incentives with the
company’s goals.)
Would giving Senior Mgmt. limited stocks (that they cannot sell for
five years) be a better incentive?
The value of the stock does not fully depend on the performance of the
Senior Mgmt., but also on the global economy.
NATIONAL AUTO REPAIR (NAR)

It was reported in the news that:

NAR were doing unnecessary
repairs to the cars of their
customers.
 ORIGINAL SETUP

The mechanics were paid based on the amount of work they do. The
more repair, the bigger their salary.
Nobody was overseeing their work.

Result: Mechanics made unnecessary repairs in order for them to

receive more pay.
 ORIGINAL SET UP

Q1: Mechanic
Q2: Yes
Q3: No, because the more repair they do,
(even if those repairs are not needed),
the more money they make.
 SOLUTION 1

• Let someone else make the decision, someone with better

incentives…
 SOLUTION 1

DIVISION 1 DIVISION 2
• Recommended the work • Did the work on the vehicles
• Flat salary • Paid based on the amount of
work they do.
 SOLUTION 1

• Q1: Division 1
• Q2: Enough information.
• Q3: No, because they were given a flat salary.
 RESULTS OF SOLUTION 1:

Division 1 colluded with Division 2!

D1 recommended unnecessary repairs.
D2 the service mechanic, shared his incentive pay with the
recommending mechanic.
 SOLUTION 2

Original Set up, ONE DIVISION—FLAT SALARY

Removes the incentive to do unnecessary repairs
but also removes the incentive to work hard.
 AUTHOR’S SOLUTION

• Original set up.

• The mechanics were paid based on the amount of work they do. The
more repair, the bigger their salary.
• “secret shoppers”
 HOTELS AND PRICE CONTROLS

A prof. objects to the practice of raising prices in times of shortage.

 IF PRICES DO NOT RISE…

• Excess Demand for hotel rooms.

• Rationing ( first come, first serve)
• Black Market- arbitrageurs would make early reservations (when
rooms were available) and “sell” them to customers willing to pay the
market-clearing price.
 * Not only would the customers end up paying the same price, but
these “arbs” make money that would have otherwise gone to the hotel.
* As a result, hotels would have less incentive to build additional
rooms, improve their hotel, etc.