Ohio State University Project Management Case Study

Froeb
McCann
Shor
Wa r d
fif th e ditio n
Managerial
Economics
A PROBLEM SOLVING APPROACH
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fifth edition
Managerial
Economics
A PRO B LEM SOLV ING A P P RO ACH
Luke M. Froeb
Vanderbilt University
Mikhael Shor
University of Connecticut
Brian T. McCann
Vanderbilt University
Michael R. Ward
University of Texas, Arlington
Australia • Brazil • Mexico • Singapore • United Kingdom • United States
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
Managerial Economics, Fifth Edition
© 2018, 2016 Cengage Learning®
Luke M. Froeb, Brian T. McCann,
Mikhael Shor, Michael R. Ward
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In loving memory of Lisa, and for our families: Donna,
David, Jake, Halley, Scott, Chris, Leslie, Jacob, Eliana,
Cindy, Alex, and Chris
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Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
BRIEF CONTENTS
Preface: Teaching Students to Solve Problems
SECTION I
Problem Solving and Decision Making
1
 
1 Introduction: What This Book Is About 3
 
2 The One Lesson of Business 15
 
3 Benefits, Costs, and Decisions 25
 
4 Extent (How Much) Decisions 37
 
5 Investment Decisions: Look Ahead and Reason Back
SECTION II
Pricing, Costs, and Profits
xiii
49
65
 
6 Simple Pricing 67
 
7 Economies of Scale and Scope 83
 
8 Understanding Markets and Industry Changes 95
 
9 Market Structure and Long-Run Equilibrium 113
10 Strategy: The Quest to Keep Profit from Eroding 125
11 Foreign Exchange, Trade, and Bubbles 137
SECTION III
Pricing for Greater Profit 151
12
13
14
SECTION IV
Strategic Decision Making 183
15
16
SECTION V
More Realistic and Complex Pricing 153
Direct Price Discrimination 163
Indirect Price Discrimination 171
Strategic Games 185
Bargaining 205
Uncertainty 215
17
18
19
20
Making Decisions with Uncertainty 217
Auctions 233
The Problem of Adverse Selection 243
The Problem of Moral Hazard 255
v
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vi
BRIEF CONTENTS
SECTION VI
Organizational Design
21
22
23
SECTION VII
Getting Employees to Work in the Firm’s Best Interests 269
Getting Divisions to Work in the Firm’s Best Interests 283
Managing Vertical Relationships 295
Wrapping Up
24
267
Test Yourself
307
309
Epilogue: Can Those Who Teach, Do?
Glossary
Index
315
317
325
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
CONTENTS
Preface: Teaching Students to Solve Problems
SECTION I
Problem Solving and Decision Making
CHAPTER 1
Introduction: What This Book Is About  3
1.1 Using Economics to Solve Problems
1.2 Problem-Solving Principles 4
1.3 Test Yourself 6
1.4 Ethics and Economics 7
1.5 Economics in Job Interviews 9
Summary & Homework Problems 11
End Notes 13
CHAPTER 2
xiii
1
3
The One Lesson of Business  15
2.1 Capitalism and Wealth 16
2.2 Does the Government Create Wealth? 17
2.3 How Economics Is Useful to Business 18
2.4 Wealth Creation in Organizations 21
Summary & Homework Problems 21
End Notes 23
CHAPTER 3
Benefits, Costs, and Decisions
25
3.1 Background: Variable, Fixed, and Total Costs 26
3.2 Background: Accounting versus Economic Profit 27
3.3 Costs Are What You Give Up 29
3.4 Sunk-Cost Fallacy 30
3.5 Hidden-Cost Fallacy 32
3.6 A Final Warning 32
Summary & Homework Problems 33
End Notes 36
CHAPTER 4
Extent (How Much) Decisions 37
4.1 Fixed Costs Are Irrelevant to an Extent Decision
4.2 Marginal Analysis 39
4.3 Deciding between Two Alternatives 40
38
vii
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viii
CONTENTS
4.4 Incentive Pay 43
4.5 Tie Pay to Performance Measures That Reflect Effort
4.6 Is Incentive Pay Unfair? 45
Summary & Homework Problems 46
End Notes 48
CHAPTER 5
Investment Decisions: Look Ahead and Reason Back 49
5.1 Compounding and Discounting 49
5.2 How to Determine Whether Investments Are Profitable
5.3 Break-Even Analysis 53
5.4 Choosing the Right Manufacturing Technology 55
5.5 Shut-Down Decisions and Break-Even Prices 56
5.6 Sunk Costs and Post-Investment Hold-Up 57
Summary & Homework Problems 60
End Notes 62
SECTION II
Pricing, Costs, and Profits
CHAPTER 6
Simple Pricing
51
65
67
6.1 Background: Consumer Values and Demand Curves
6.2 Marginal Analysis of Pricing 70
6.3 Price Elasticity and Marginal Revenue 72
6.4 What Makes Demand More Elastic? 75
6.5 Forecasting Demand Using Elasticity 76
6.6 Stay-Even Analysis, Pricing, and Elasticity 77
6.7 Cost-Based Pricing 78
Summary & Homework Problems 78
End Notes 81
CHAPTER 7
44
68
Economies of Scale and Scope 83
7.1 Increasing Marginal Cost 84
7.2 Economies of Scale 86
7.3 Learning Curves 87
7.4 Economies of Scope 89
7.5 Diseconomies of Scope 90
Summary & Homework Problems 91
End Notes 94
CHAPTER 8
Understanding Markets and Industry Changes
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
95
Which Industry or Market? 95
Shifts in Demand 96
Shifts in Supply 98
Market Equilibrium 99
Predicting Industry Changes Using Supply and Demand 100
Explaining Industry Changes Using Supply and Demand 103
Prices Convey Valuable Information 104
Market Making 106
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CONTENTS
Summary & Homework Problems
End Notes 111
CHAPTER 9
108
Market Structure and Long-Run Equilibrium
113
9.1 Competitive Industries 114
9.2 The Indifference Principle 116
9.3 Monopoly 120
Summary & Homework Problems 121
End Notes 123
CHAPTER 10
Strategy: The Quest to Keep Profit from Eroding 125
10.1 A Simple View of Strategy 126
10.2 Sources of Economic Profit 128
10.3 The Three Basic Strategies 132
Summary & Homework Problems 134
End Notes 136
CHAPTER 11
Foreign Exchange, Trade, and Bubbles 137
11.1 The Market for Foreign Exchange 138
11.2 The Effects of a Currency Devaluation 140
11.3 Bubbles 142
11.4 How Can We Recognize Bubbles? 144
11.5 Purchasing Power Parity 146
Summary & Homework Problems 147
End Notes 149
SECTION III
Pricing for Greater Profit 151
CHAPTER 12
More Realistic and Complex Pricing 153
12.1 Pricing Commonly Owned Products 154
12.2 Revenue or Yield Management 155
12.3 Advertising and Promotional Pricing 157
12.4 Psychological Pricing 158
Summary & Homework Problems 160
End Notes 162
CHAPTER 13
Direct Price Discrimination 163
13.1 Why (Price) Discriminate? 164
13.2 Direct Price Discrimination 166
13.3 Robinson-Patman Act 167
13.4 Implementing Price Discrimination 168
13.5 Only Schmucks Pay Retail 169
Summary & Homework Problems 169
End Notes 170
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ix
x
CONTENTS
CHAPTER 14
Indirect Price Discrimination 171
14.1 Indirect Price Discrimination 172
14.2 Volume Discounts as Discrimination 176
14.3 Bundling Different Goods Together 177
Summary & Homework Problems 178
End Notes 181
SECTION IV
Strategic Decision Making 183
CHAPTER 15
Strategic Games
185
15.1 Sequential-Move Games 186
15.2 Simultaneous-Move Games 188
15.3 Prisoners’ Dilemma 190
15.4 Other Games 195
Summary & Homework Problems 199
End Notes 202
CHAPTER 16
Bargaining
205
16.1 Strategic View of Bargaining 206
16.2 Nonstrategic View of Bargaining 208
16.3 Conclusion 210
Summary & Homework Problems 211
End Note 214
SECTION V
Uncertainty
215
CHAPTER 17
Making Decisions with Uncertainty
217
17.1 Random Variables and Probability 218
17.2 Uncertainty in Pricing 222
17.3 Data-Driven Decision Making 223
17.4 Minimizing Expected Error Costs 226
17.5 Risk versus Uncertainty 227
Summary & Homework Problems 228
End Notes 231
CHAPTER 18
Auctions 233
18.1 Oral Auctions 234
18.2 Second-Price Auctions 235
18.3 First-Price Auctions 236
18.4 Bid Rigging 236
18.5 Common-Value Auctions 238
Summary & Homework Problems 240
End Notes 242
CHAPTER 19
The Problem of Adverse Selection
19.1 Insurance and Risk 243
19.2 Anticipating Adverse Selection
243
244
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CONTENTS
19.3 Screening 246
19.4 Signaling 249
19.5 Adverse Selection and Internet Sales
Summary & Homework Problems 251
End Notes 253
CHAPTER 20
250
The Problem of Moral Hazard 255
20.1 Introduction 255
20.2 Insurance 256
20.3 Moral Hazard versus Adverse Selection 257
20.4 Shirking 258
20.5 Moral Hazard in Lending 260
20.6 Moral Hazard and the 2008 Financial Crisis 261
Summary & Homework Problems 262
End Notes 265
SECTION VI Organizational Design 267
CHAPTER 21
Getting Employees to Work in the Firm’s Best Interests
21.1 Principal–Agent Relationships 270
21.2 Controlling Incentive Conflict 271
21.3 Marketing versus Sales 273
21.4 Franchising 274
21.5 A Framework for Diagnosing and Solving Problems
Summary & Homework Problems 278
End Notes 281
CHAPTER 22
269
275
Getting Divisions to Work in the Firm’s Best Interests 283
22.1 Incentive Conflict between Divisions 283
22.2 Transfer Pricing 285
22.3 Organizational Alternatives 287
22.4 Budget Games: Paying People to Lie 289
Summary & Homework Problems 291
End Notes 294
CHAPTER 23
Managing Vertical Relationships 295
23.1 How Vertical Relationships Increase Profit 296
23.2 Double Marginalization 297
23.3 Incentive Conflicts between Retailers and Manufacturers 297
23.4 Price Discrimination 299
23.5 Antitrust Risks 300
23.6 Do Buy a Customer or Supplier Simply Because It Is Profitable 301
Summary & Homework Problems 302
End Notes 304
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xi
xii
CONTENTS
SECTION VII
Wrapping Up
CHAPTER 24
Test Yourself 309
24.1
24.2
24.3
24.4
24.5
24.6
24.7
24.8
307
Should You Keep Frequent Flyer Points for Yourself? 309
Should You Lay Off Employees in Need? 310
Manufacturer Hiring 310
American Airlines 311
Law Firm Pricing 311
Should You Give Rejected Food to Hungry Servers? 312
Managing Interest-Rate Risk at Banks 313
What You Should Have Learned 313
Epilogue: Can Those Who Teach, Do?
Glossary
Index
315
317
325
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Preface
Teaching Students to Solve Problems1
by Luke Froeb
When I started teaching MBA students, I taught economics as I had learned
it, using models and public policy applications. My students complained so
much that the dean took me out to the proverbial woodshed and gave me
an ultimatum, “improve customer satisfaction or else.” With the help of some
disgruntled students who later became teaching assistants, I was able to turn
the course around.
The problem I faced can be easily described using the language of economics: the supply of business education (professors are trained to provide
abstract theory) is not closely matched to demand (students want practical
knowledge). This mismatch is found throughout academia, but it is perhaps
most acute in a business school. Business students expect a return on a fairly
sizable investment and want to learn material with immediate and obvious
value.
One implication of the mismatch is that teaching economics in the usual
way—with models and public policy applications—is not likely to satisfy student demand. In this book, we use what we call a “problem-solving pedagogy”
to teach microeconomic principles to business students. We begin each chapter
with a business problem, like the fixed-cost fallacy, and then give students just
enough analytic structure to understand the cause of the problem and how to
fix it.
Teaching students to solve real business problems, rather than learn models,
satisfies student demand in an obvious way. Our approach also allows students to absorb the lessons of economics without as much of the analytical
“overhead” as a model-based pedagogy. This is an advantage, especially in a
terminal or stand-alone course, like those typically taught in a business school.
To see this, ask yourself which of the following ideas is more likely to stay
with a student after the class is over: the fixed-cost fallacy or that the partial
derivative of profit with respect to price is independent of fixed costs.
Elements of a Problem-Solving Pedagogy
Our problem-solving pedagogy has three elements.
xiii
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xiv
Preface
1. Begin with a Business Problem
Beginning with a real-world business problem puts the particular ahead of the
abstract and motivates the material in a straightforward way. We use narrow,
focused problems whose solutions require students to use the analytical tools
of interest.
2. Teach Students to View Inefficiency as an Opportunity
The second element of our pedagogy turns the traditional focus of benefit–
cost analysis on its head. Instead of teaching students to spot and eliminate
inefficiency, for example, by changing public policy, we teach them to view
each underemployed asset as a money-making opportunity.
3. Use Economics to Implement Solutions
After you find an underemployed asset, moving it to a higher-valued use is
often hard to do, particularly when the inefficiency occurs within an organization. The third element of our pedagogy addresses the problem of incentive
alignment: how to design organizations where employees have enough information to make profitable decisions and the incentive to do so.
Again, we use the tools of economics to address the problem of implementation. If people act rationally, optimally, and self-interestedly, then mistakes
have only one of two causes: either people lack the information necessary to
make good decisions or they lack the incentive to do so. This immediately suggests a problem-solving algorithm; ask:
1. Who is making the bad decision?
2. Do they have enough information to make a good decision?
3. Do they have the incentive to do so?
Answers to these three questions will point to the source of the problem
and suggest one of three potential solutions:
1. Let someone else make the decision, someone with better information or
incentives
2. Give more information to the current decision maker
3. Change the current decision maker’s incentives
The book begins by showing students how to use this algorithm,
and subsequent chapters illustrate its use in a variety of contexts, for
example, extent decisions, investments, pricing, bargaining, principal–agent
relationships, and uncertain environments.
Using the Book
The book is designed to be read cover-to-cover as it is short, concise, and
accessible to anyone who can read and think clearly. The pedagogy is built
around business problems, so the book is most effective for those with some
work experience. Its relatively short length makes it reasonably easy to customize with ancillary material.
The authors use the text in full-time MBA programs, executive MBA
programs (weekends), healthcare management executive programs (one night
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preface
xv
a week), and nondegree executive education. However, some of our biggest
customers use the book in online business classes at both the graduate and
undergraduate levels.
In the degree programs, we supplement the material in the book with
online interactive programs like Cengage’s MindTap. Complete Blackboard
courses, including syllabi, quizzes, homework, slides, videos to complement
each chapter, and links to supplementary material, can be downloaded from
the Cengage website. Our ManagerialEcon.com blog is a good source of new
business applications for each of the chapters.
In this fifth edition, we have updated and improved the presentation and pedagogy of the book. The biggest substantive change is to Chapter 17, where we
present the decomposition of an observed difference between two groups into a
treatment effect + selection bias. Michael Ward has been using this in his classes at
University of Texas at Arlington, and rewrote the chapter to include it. We are also
beginning work to add interactive “activities” to the electronic text in MindTap,
Cengage’s new learning platform. These activities help comprehension, especially
for weaker students. In addition, we continue to rewrite and update the supplementary material: videos, worked video problems, and the test bank. In addition
to the other updates throughout the text, Chapter 24 has two new sections.
We wish to acknowledge numerous classes of MBA, executive MBA, nondegree executive education, and healthcare management students, without
whom none of this would have been possible—or necessary. Many of our former students will recognize stories from their companies in the book. Most of
the stories in the book are from students and are for teaching purposes only.
Thanks to everyone who contributed, knowingly or not, to the book. Professor
Froeb owes intellectual debts to former colleagues at the U.S. Department of
Justice (among them, Cindy Alexander, Tim Brennan, Ken Heyer, Kevin James,
Bruce Kobayahsi, and Greg Werden); to former colleagues at the Federal Trade
Commission (among them, James Cooper, Pauline Ippolito, Tim Muris, Dan
O’Brien, Maureen Ohlhausen, Paul Pautler, Mike Vita, and Steven Tenn); to
colleagues at Vanderbilt (among them, Germain Boer, Jim Bradford, Bill Christie,
Mark Cohen, Myeong Chang, Craig Lewis, Rick Oliver, David Parsley, David
Rados, Steven Tschantz, David Scheffman, and Bart Victor); and to numerous
friends and colleagues who offered suggestions, problems, and anecdotes for
the book (among them, Lily Alberts, Olafur Arnarson, Raj Asirvatham, Bert
Bailey, Justin Bailey, Pat Bajari, Molly Bash, Sarah Berhalter, Roger Brinner,
the Honorable Jim Cooper, Matthew Dixon Cowles, Abie Del Favero, Kelsey
Duggan, Vince Durnan, Marjorie Eastman, Tony Farwell, Keri Floyd, Josh Gapp,
Brock Hardisty, Trent Holbrook, Jeff and Jenny Hubbard, Brad Jenkins, Dan
Kessler, Bev Landstreet [B5], Bert Mathews, Christine Milner, Jim Overdahl, Craig
Perry, Rich Peoples, Annaji Pervajie, Jason Rawlins, Mike Saint, David Shayne,
Jon Shayne, Bill Shughart, Doug Tice, Whitney Tilson, and Susan Woodward).
We owe intellectual and pedagogical debts to Armen Alchian and William Allen3;
Henry Hazlitt4; Shlomo Maital5; John MacMillan6; Steven Landsburg7; Ivan Png8;
Victor Tabbush9; Michael Jensen and William Meckling10; and James Brickley,
Clifford Smith, and Jerold Zimmerman.11 Special thanks to everyone who guided
us through the publishing process, including Molly Umbarger, Christopher Rader,
and Jason Fremder.
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xvi
Preface
END NOTES
1. Much of the material is taken from Luke
M. Froeb and James C. Ward, “Teaching
Managerial Economics with Problems
Instead of Models,” in The International
Handbook on Teaching and Learning
­Economics, eds. Gail Hoyt and KimMarie
McGoldrick (Northampton, MA: Edward
Elgar ­Publishing, 2012).
2. Armen Alchian and William Allen,
Exchange and Production, 3rd ed.
(Belmont, CA: Wadsworth, 1983).
3. Henry Hazlitt, Economics in One Lesson
(New York: Crown, 1979).
4. Shlomo Maital, Executive Economics: Ten
Essential Tools for Managers (New York:
Free Press, 1994).
5. John McMillan, Games, Strategies, and
Managers (Oxford: Oxford University
Press, 1992).
6. Steven Landsburg, The Armchair Economist:
Economics and Everyday Life (New York:
Free Press, 1993).
7. Ivan Png, Managerial Economics (Maiden,
MA: Blackwell, 1998).
8. http://www.mbaprimer.com
9. Michael Jensen and William Meckling,
A Theory of the Firm: Governance,
Residual Claims and Organizational
Forms (Cambridge, MA: Harvard
University Press, 2000).
10. James Brickley, Clifford Smith, and Jerold
Zimmerman, Managerial Economics and
Organizational Architecture (Chicago:
Irwin, 1997).
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Section
1
Problem Solving and
Decision Making
1 Introduction: What This Book Is About
2 The One Lesson of Business
3 Benefits, Costs, and Decisions
4 Extent (How Much) Decisions
5 Investment Decisions: Look Ahead and Reason
Back
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
1
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
1
Introduction: What This
Book Is About
In 1992, a junior geologist was preparing a bid recommendation for an oil
tract in the Gulf of Mexico. She suspected that the tract contained a large
accumulation of oil because her company, Oil Ventures International (OVI),
had an adjacent tract with several productive wells. Since no competitors had
neighboring tracts, none of them suspected a large accumulation of oil. Because of this, she thought that the tract could be won relatively cheaply and
recommended a bid of $5 million. Surprisingly, OVI’s senior management ignored the recommendation and submitted a bid of $21 million. OVI won the
tract over the next-highest bid of $750,000.
If the board of directors asked you to review the bidding procedures at
OVI, how would you proceed? Where would you begin your investigation?
What questions would you ask?
You’d find it difficult to gather information from those closest to the bidding. Senior management would be suspicious and uncooperative because no
one likes to be singled out for bidding $20 million more than was necessary.
Likewise, our junior geologist would be reluctant to criticize her superiors.
You might be able to rely on your experience—provided that you had run into
a similar problem. But without experience, or when facing novel problems,
you would have to rely on your analytic ability.
This book is designed to show you how to complete an assignment like
this.
1.1 Using Economics to Solve Problems
Solving a problem like OVI’s requires two steps: first, figure out what’s causing the problem; and second, how to fix it. In this case, you would want to
know whether the $21 million bid was too high at the time it was made, not
just in retrospect. If the bid was too aggressive, then you’d have to figure out
why the senior managers overbid and how to make sure they don’t do it again.
3
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4
SECTION I • Problem Solving and Decision Making
Both steps require that you predict how people behave in different circumstances, and this is where the economic content of the book comes in. The
one thing that unites economists is their use of the rational-actor paradigm.
Simply put, it says that people act rationally, optimally, and self-interestedly.
The paradigm not only helps you figure out why people behave the way they
do but also suggests ways to get them to change. To change behavior, you have
to change self-interest, and you do that by changing incentives.
Incentives are created by rewarding good performance with, for example, a commission on sales or a bonus based on profitability. The performance
evaluation metric (revenue, cost, profit, or return on investment, ROI) is separate from the reward structure (commission, bonus, raise, or promotion), but
they work together to create an incentive to behave a certain way.
To illustrate, let’s go back to OVI’s story and try to find the source of
the problem. After her company won the auction, our geologist increased the
company’s oil reserves by the amount of oil estimated to be in the tract. But
when the company drilled a well, it was essentially “dry,” so the acquisition
did little to increase the size of the company’s oil reserves. Using the information from the newly drilled well, our geologist updated the reservoir map and
reduced the estimated reserves to where they was before OVI won the tract.
Senior management rejected the lower estimate and directed the geologist
to “do what she could” to increase the size of the estimated reserves. So, she
revised the reservoir map again, adding “additional” (not real) reserves to the
company’s asset base. The reason behind this behavior became clear when,
several months later, OVI’s senior managers resigned, collecting bonuses tied
to the increase in oil reserves that had accumulated during their tenure.
The incentive created by the bonus plan explains both the overbidding and
overestimated reserves as rational, self-interested responses to the incentive
created by the bonus. Senior managers overbid because they were rewarded
for acquiring reserves, regardless of the price. Their ability to manipulate the
reserve estimate made it difficult for shareholders and their representatives on
the board of directors to spot the mistake.
To fix this problem, you would have to find a way to better align managers’ incentives with the company’s goals, perhaps by rewarding management
for increasing profitability, not just for acquiring reserves. This is not as easy as
it sounds because it is typically hard to measure an employee’s contribution to
company profitability. You can do this subjectively, with annual performance
reviews, or objectively, using company earnings or stock price appreciation
as performance metrics. But each of these performance measures can create
problems, as we’ll see in later chapters.
1.2 Problem-Solving Principles
This story illustrates our problem-solving methodology. First, we reduced the
problem (overbidding) to a bad decision by someone at the firm (senior management) by asking:
Q1: Who made the bad decision?
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Chapter 1 • Introduction: What This Book Is About
5
Once we know the “who,” we can use economics to figure out the “why.”
If people behave rationally, optimally, and self-interestedly, a bad decision occurs for one of two reasons: either (i) decision makers do not have enough
information to make a good decision or (ii) they lack the incentive to do so.
This suggests that we can isolate the source of almost any problem by asking
two more questions:
Q2: Did the decision maker have enough information to make a good
decision?
Q3: Did the decision maker have the incentive to make a good decision?
Answers to these three questions not only point to the source of the problem but also suggest ways to fix it.
S1: Let someone else—someone with better information or better incentives—
make the decision,
S2: Give more information to the current decision maker, or
S3: Change the current decision makers’ incentives (the performance evaluation metric or the reward scheme).
In OVI’s case, we see that (Q1) senior management made the bad decision
to overbid; (Q2) they had enough information to make a good bid, but (Q3)
they didn’t have the incentive to do so. One potential fix (S3) is to change
the incentives of senior management so that they are rewarded for increasing
profitability instead of oil reserves.
When reading about various business mistakes in the chapters that follow,
you should ask yourself these three questions to see if you can find the cause
of each problem, and a solution. By the time you finish the book, the analysis
should become second nature.
Here are some practical tips that will help you develop problem-solving
skills:
*Think about the problem from the organization’s point of view. Avoid
the temptation to think about the problem from the employee’s point of
view because you will miss the fundamental problem of goal alignment:
how does the organization give employees enough information to make
good decisions and the incentive to do so?
*Think about the organizational design. Once you identify a bad decision, avoid the temptation to solve the problem by simply reversing the
decision. Instead, think about why the bad decision was made and how
to make sure that similar mistakes won’t be made in the future.
*What is the trade-off? Your solution may solve the problem you identify,
but it may cause other problems. In this case, changing the incentives of
senior management by giving them limited stock (that they cannot sell
for five years) may solve the overbidding problem, but it may also makes
their performance dependent on external factors like the global macroeconomy, which are clearly beyond their control. Subject your solution
to the same analysis. Ask the same three questions that allowed you to
identify the initial problem.
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6
SECTION I • Problem Solving and Decision Making
*Don’t define the problem as the lack of your solution. This kind of thinking may cause you to miss the best solution. For example, if you define
a problem as “the lack of centralized purchasing,” then the solution will
be “centralized purchasing” regardless of whether that is the best option.
Instead, define the problem as “high acquisition cost,” and then examine
“centralized purchasing” versus “decentralized purchasing” (or some other
alternative) as potential solutions to the problem.
*Avoid jargon because most people misuse it. Force yourself to spell out
what exactly you mean in simple language. It will help you think clearly
and communicate precisely. As Einstein said, “If you can’t explain it
simply, you don’t understand it well enough.” In addition, almost every
scam is “sold” using jargon. If you use jargon, experienced listeners will
instinctively mistrust you and your analysis.
1.3 Test Yourself
In 2006, an investigative news program sent a TV reporter with a perfectly
good car into a garage owned by National Auto Repair (NAR). The reporter
came out with a new muffler and transmission—and a bill for over $8,000.
After the story was aired on national TV, consumers began avoiding NAR,
and profit plunged. What is the problem, and how do you fix it?
Let’s run the problem through our problem-solving algorithm:
Q1: Who made the bad decision?
The NAR mechanic recommended unnecessary repairs.
Q2: Did the decision maker have enough information to make a good decision?
es, in fact, the mechanic is the only one with enough information to
Y
know whether repairs are necessary.
Q3: Did the decision maker have the incentive to make a good decision?
o, the mechanic receives bonuses or commissions tied to the amount of
N
repair work, which rewards the mechanic for making needless repairs.
Although answers to the three questions clearly point to the source of the
problem, solving it proved much more difficult. NAR tried two different solutions, but both failed.
First, the company reorganized into two divisions: one responsible for recommending repairs and the other responsible for doing them. Those who recommended repairs were paid a flat salary, but those who did the repairs were
paid based on the amount of work they did.
AUSE HERE AND TRY TO FIGURE OUT WHY THIS CHANGE DID
P
NOT SOLVE THE PROBLEM.
Mechanics in the two divisions began colluding. In exchange for recommending unnecessary repairs, the service mechanic shared his incentive pay
with the recommending mechanic. The unnecessary repairs continued.
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Chapter 1 • Introduction: What This Book Is About
7
NAR then went back to single mechanic who both recommended and performed repairs, but replaced the incentive pay with a flat salary. Although this
removed the incentive to do unnecessary repairs, it also removed the incentive
to work hard, resulting in what economists call “shirking.” Since mechanics
made the same amount of money regardless of whether they recommended
and performed repairs, they ignored all but the most obvious problems.
Figuring out which solution is most profitable involves weighing the tradeoffs associated with various solutions. For example, before implementing the
two-division solution, NAR management should have asked whether the new
decision maker had enough information to make good decisions, as well as the
incentive to do so. The answer could have alerted NAR management to the
potential for collusion between the recommending mechanic and the repairing
mechanic. Similarly, this kind of analysis would have identified shirking by the
mechanics as a cost of the flat-salary solution.
With the benefit of hindsight, I would have suggested a third potential
solution: keep the original organizational design, but use an additional performance metric, based on reports provided by “secret shoppers” who bring
good cars into the garage to test whether the mechanics order unnecessary
repairs. If so, fire or penalize the mechanics who recommend unnecessary repairs. Secret shoppers are used successfully in other contexts, for example, in
restaurants to measure service quality. By measuring and rewarding quality,
restaurant chains are able to protect the value of a brand as a signal of quality.
Similarly, using secret shoppers may have been able to protect the value of
NAR’s brand as a signal of reliable service.
1.4 Ethics and Economics
Using the rational-actor paradigm in this way—to change behavior by changing incentives—makes some students uncomfortable because it seems to deny
the altruism, affection, and personal ethics that motivate most people. These
students resist learning the rational-actor paradigm because they think it implicitly endorses self-interested behavior, as if the primary purpose of economics were to teach students to behave rationally, optimally, and selfishly.
These students would probably agree with a Washington Post editorial,
“When It Comes to Ethics, B-Schools Get an F,”1 which blames business
schools in general, and economists in particular, for the ethical lapses at FIFA,
Goldman Sachs, and other organizations.
A subtle but damaging factor in this is the dominance of economists
at business schools. Although there is no evidence that economists are
personally less ethical than members of other disciplines, approaching the
world through the dollar sign does make people more cynical.
What these students and the author, a former Harvard ethics professor,
do not understand is that to control unethical behavior, we first have to understand why it occurs. When we analyze problems like the one at OVI, we’re
not encouraging students to behave opportunistically. Rather, we’re teaching
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8
SECTION I • Problem Solving and Decision Making
them to anticipate opportunistic behavior and to design organizations that are
less susceptible to it. Remember, the rational-actor paradigm is only a tool for
analyzing behavior, not advice on how to live your life.
It is also important to realize that these kinds of debates are often debates about value systems. Deontologists judge actions as good or ethical by
whether they conform to a set of principles, like the Ten Commandments or
the Golden Rule. Consequentialists, on the other hand, judge actions by their
consequences. If the consequences of an action are good, then the action is
deemed to be good or moral. We illustrate these contrasting value systems
with a story about price gouging.2
When Notre Dame entered the 2006 season as one of the top-ranked
football teams in the country, demand for local hotels during home games
rose dramatically. In response, local hotels raised room rates. According to the
Wall Street Journal, the Hampton Inn charged $400 a night on football weekends for a room that cost only $129 on non football days. Rates climbed even
higher for games against top-ranked foes. For the game against the University
of Michigan, the South Bend Marriott charged $649 per night—$500 more
than its normal weekend rate of $149.
On a campus founded by priests of the Congregation of Holy Cross,
where many students dedicate a year after graduation to working with the
underprivileged, these high prices caused alarm. The Wall Street Journal quotes
Professor Joe Holt, a former priest who teaches ethics in the school’s executive
MBA program, “It is an ‘act of moral abdication’ for businesses to pretend
they have no choice but to charge as much as they can based on supply and
demand.” The article further reports Mr. Holt’s intention to use the example
of rising hotel rates on football weekends for a case study in his class on the
integration of business and values.
Deontologists like Professor Holt would object on principle to the practice of raising prices in times of shortage.3 We might label this the Spider Man
Principle: with great power comes great responsibility. The laws of capitalism
allow corporations to amass significant power; in turn, society should demand
a high level of responsibility from corporations. In this case, while property
rights give a hotel the option of increasing prices, possession of these rights
does not relieve the hotel of its obligation to be concerned about the consequences of its choices. A simple beneficence argument might suggest that keeping prices low would be better for consumers.
Economics, on the other hand, gives us a consequentialist understanding
of the practice by comparing high prices to the implied alternative. An economist would show that if prices do not rise, the consequence would be excess
demand for hotel rooms. Would-be guests would find their rooms rationed,
perhaps on a first-come, first-served basis. More likely, arbitrageurs would set
up a black market, by making early reservations, and then “selling” their reservations to customers willing to pay the market-clearing price. Not only would
consumers end up paying the same price, but these “arbs” would make money
that would have otherwise gone to the hotel. Without the ability to earn additional profit during times of scarcity, hotels would have less incentive to build
additional rooms, which would make the long-run problems even worse!
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Chapter 1 • Introduction: What This Book Is About
9
Versions of this debate—between those who criticize business on ethical
grounds and those who are trying to make money—have been going on in
this country since its founding. Although a full treatment of the ethical dimensions of business is beyond the scope of this book, many disagreements
are really about whether morality should be defined by deontology or consequentialism. Once you realize that a debate is really a debate between value
systems, it becomes much easier to understand opposing points of view, and to
reach compromise with your adversaries. For example, if the government were
considering price-gouging laws that made it illegal to raise prices on football
weekends, a solution might involve donation of some of the profits earned on
football weekends to a local charity. This might assuage the concerns of those
who ascribe to the Spider Man principle.
As a footnote to this story, when someone offered our former priest
$1,500 for his apartment on home-game weekends, he took the offer and now
spends his weekends in Chicago. Apparently, his principles became too costly
for him.
1.5 Economics in Job Interviews
If this well-reasoned introduction doesn’t motivate you to learn economics, read the following interview questions—all from real interviews of
students. These questions should awaken interest in the material for those of
you who think economics is merely an obstacle between you and a six-figure
salary.
——-Original Message——From: “Student A”
Sent: Friday, January 2, 2009, 3:57 PM
Subject: Economics Interview Questions
I had an interview a few weeks ago where I was told that
the position paid a very low base and was mostly incentive compensation. I responded that I understood he was
simply “screening out” low productivity candidates
[NOTE: low productivity candidates would not earn very much under a system of incentive compensation, and so would be less likely to accept a job
with strong incentive compensation].
I “signaled” back to him that this compensation structure was acceptable to me, as I was confident in my abilities to produce value for the company, and for me.
[Note: “Signaling” and “screening” are both solutions to the problem of adverse
selection, the topic of Chapter 19.]
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10
SECTION I • Problem Solving and Decision Making
——-Original Message——From: “Student B”
Sent: Tuesday, January 18, 2000, 1:22 PM
Subject: Economics Interview Questions
I got a question from Compaq last year for a marketing internship position that partially dealt with sunk
costs. It was a “true” case question where the interviewer used the Internet to pull up the actual products
as he asked the question, “I am the product manager for
the new X type server with these great features. It is to
be launched next month at a cost of $5,500. Dell launched
its new Y-type server last week; it has the same features
(and even a few more) for a cost of $4,500. To date, Compaq has put over $2.5 million in the development process
for this server, and as such my manager is expecting
above-normal returns for the investment.
My question to you is “what advice would you give to me on
how to approach the launch of the product, that is, do I go
ahead with it at the current price, if at all, even though
Dell has a better product out that is less expensive, not
forgetting the fact that I have spent all the development
money and my boss expects me to report a super return?”
I laughed at the question because it was the very first
thing we spoke about in the interview, catching me offguard a bit. He wanted to see if I got caught worrying about all the development costs in giving advice to
scrap the launch or continue ahead as planned. (I’m not
an idiot and could see that coming a mile away … thanks
to economics, right? ! ! !)
[NOTE: the interviewer was testing Student B to see whether he would commit the “sunk-cost fallacy,” covered in Chapter 3.]
——-Original Message——From: “Student C”
Sent: Tuesday, January 18, 2000, 1:37 PM
Subject: Economics Interview Questions
I got questions regarding transfer price within entities
of a company.
What prices could be used and why.
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Chapter 1 • Introduction: What This Book Is About
11
[NOTE: the problem of transfer pricing is one of the most common sources of
conflict between divisions and is covered in Chapters 22 and 23.]
——-Original Message——From: “Student D”
Sent: Tuesday, January 18, 2000 1:28 PM
Subject: Economics Interview Questions
You are a basketball coach with five seconds on the
clock, and you are losing by two points. You have the
ball and can take only one more shot (there is no chance
of a rebound). There is a 70% chance of making a twopointer, which would send the game into overtime with
each team having an equal chance of winning. There is
only a 40% chance of making a three-pointer (winning if
made). Should you shoot the two- or the three-point shot?
[NOTE: This is an example of decision making under uncertainty, the subject
of Chapter 17. For those of you who cannot wait, the answer is take the threepoint shot because it results a higher probability of winning, 40%, as opposed
to 35% = (70%) × (50%) for a two-point shot.]
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
•
•
•
•
Problem solving requires two steps:
(i) figure out why people are making mistakes and then (ii) figure out how to prevent future ones.
The rational-actor paradigm is a model of
behavior that which assumes that people act
rationally, optimally, and self-interestedly,
that is, they respond to incentives.
Incentives have two pieces: (i) a way of
measuring performance and (ii) a compensation scheme to reward good (or punish
bad) performance.
A well-designed organization is one in
which employee incentives are aligned with
organizational goals. By this we mean that
employees have (i) enough information to
•
•
make good decisions and (ii) the incentive
to do so.
You can analyze any problem by asking
three questions:
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?
Answers to these questions will suggest one
of three 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.
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12
SECTION I • Problem Solving and Decision Making
Multiple-Choice Questions
1. Why might performance compensation
caps be bad?
a. Different pay rates promote dissent.
b. Compensation caps can discourage
employees from being productive after
the cap.
c. Compensation caps can discourage
employees from being productive
before the cap.
d. Both b and c.
2. What is a possible consequence of a performance compensation reward scheme?
a. It creates productive incentives.
b. It creates harmful incentives.
c. Both a and b.
d. Neither a nor b.
3. Which of the following is NOT one of the
three problem-solving principles laid out in
Chapter 1?
a. Under whose jurisdiction is the
problem?
b. Who is making the bad decision?
c. Does the decision maker have enough
information to make a good decision?
d. Does the decision maker have the
incentive to make a good decision?
4. Why might it be bad for hotels to not
charge higher prices when rooms are in
higher demand?
a. Arbitrageurs might establish a black
market by reserving rooms and then
selling the reservations to customers.
b. Rooms may be rationed.
c. Without the profit from these high
demand times, hotels would have less
of an incentive to build or expand,
making the long-run scarcity problem
even worse.
d. All of the above.
5. The rational-actor paradigm assumes that
people do NOT
a. act rationally.
b. use rules of thumb.
c. act optimally.
d. act self-interestedly.
6. The problem-solving framework analyzes
firm problems
a. from the organization’s point of view.
b. from the manager’s point of view.
c. from the worker’s point of view.
d. from society’s point of view.
7. Why might welfare for low-income
households reduce the propensity to
work?
a. It will not.
b. It reduces the incentive to work.
c. It is unfair.
d. It encourages jealousy.
8. Why might a “bonus cap” for executives be
a bad policy for the company?
a. It isn’t. Executives shouldn’t make
more than a certain amount.
b. It would sow discontent.
c. It would encourage shirking after the
executives reached the cap.
d. The cap could be set too high, so
executives may work too hard and
not reach it.
9. What might happen if a car dealership
is awarded a bonus by the manufacturer
for selling a certain number of its cars
monthly, but the dealership is just short of
that quota near the end of the month?
a. It may sell the remaining cars at huge
discounts to hit the quota.
b. It creates an incentive to sell cars from
different manufacturers.
c. It would ruin the relationship between
the dealer and the manufacturer.
d. Potential buyers will lose buying
power at the dealer.
10. Why might a supermarket advertise low
prices on certain high-profile items and sell
them at a loss?
a. It is a way for companies to be
charitable.
b. The store will sell other groceries
to the same customers, often at a
markup.
c. It would not.
d. This reduces the incentives of trade.
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Chapter 1 • Introduction: What This Book Is About
Individual Problems
1-1 Goal Alignment at a Small Manufacturing
Concern
The owners of a small manufacturing concern
have hired a vice president to run the company
with the expectation that he will buy the company after five years. Compensation of the new
vice president is a flat salary plus 75% of the
first $150,000 profit, and then 10% of profit
over $150,000. Purchase price for the company
is set at 4.5 times earnings (profit), computed as
average annual profitability over the next five
years.
a. Plot the annual compensation of the vice
president as a function of annual profit.
b. Assume the company will be worth $10
million in five years. Plot the profit of buying the company as a function of annual
profit.
1-2 Goal Alignment at a Small Manufacturing Concern (cont.)
Does this contract align the incentives of the
new vice president with the profitability goals
of the owners?
1-3 Goal Alignment at a Small Manufacturing
Concern (cont.)
Redesign the contract to better align the incentives of the new vice president with the profitability goals of the owners.
1-4 Goal Alignment at New York City Schools
A total of 1,800 New York City teachers who
lost their jobs earlier this year have yet to apply
13
for another job despite the fact that there are
1,200 openings. Why not?
1-5 Goal Alignment between Airlines and Flight
Crews
Planes frequently push back from the gate on
time, but then wait 2 feet away from the gate
until it is time to queue up for take-off. This
increases fuel consumption, and increases the
time that passengers must sit in a cramped
plane awaiting take-off. Why does this happen?
1-6 Goal Alignment between Hospitals and the British Government
In 2008, the Labour Party in Britain promised
that patients would have to wait for no more
than four hours to be seen in an emergency
room. The National Health Service started rewarding hospitals that met this goal. What do
you think happened? (HINT: It was not good.)
Group Problems
G1-1 Goal Alignment with Your Company
Are your incentives aligned with the goals
of your company? If not, identify a problem
caused by goal misalignment. Suggest a change
that would address the problem. Compute the
profit consequences of the change.
G1-2 Contracts at Your Company
Identify a contract between your company and
a supplier or customer. Does it align the incentives of the parties? If not, suggest a change that
would address the problem. Compute the profit
consequences of the change.
End Notes
1. Amitai Etzioni, “When It Comes to Ethics,
B-Schools Get an F,” Washington Post,
August 4, 2002.
2. Ilan Brat, “Notre Dame Football Introduces
Its Fans to Inflationary Spiral,” Wall Street
Journal, September 7, 2006.
3. We thank Bart Victor for his enumeration of
these objections.
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Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
2
The One Lesson of
Business
I
n the spring of 2011, Rick Ruzzamenti of Riverside, California, decided to
donate his kidney to an organization set up to match donors and recipients.
His selfless act set off a domino chain of 60 operations involving 17 hospitals
in 11 different states.1 Donors, unable to help their loved ones because of
incompatible antibodies, donated kidneys to others who donated to others,
and so on, until the chain ended six months later in Chicago.
The good news is that 30 people received new kidneys and escaped the
living hell of dialysis. The bad news is that this complex barter system is the
only legal way for Americans to get kidneys.2 It is so inefficient that only
17,000 of the 90,000 people on waiting lists received kidneys last year.
To understand how complex and cumbersome this process is, imagine trying
to use it to find a new apartment. Suppose you wanted to move from Detroit to
Nashville. You would first try to find someone moving in the opposite direction,
from Nashville to Detroit. Failing that, you might try to find a three-way trade:
find someone moving from Nashville to Los Angeles, and another person moving
from Los Angeles to Detroit. Then swap the first apartment for the second, the
second for the third, and the third for the first. Finding a matched set of trades
that have the desired moving times, locations, and types of apartments causes the
same kinds of compatibility problems that trading kidneys does.
There are two common, but very different, reactions to this kind of
inefficiency. Economists see it as a threat, and something to be eliminated, for
example, by replacing this complex barter system with a simple market.
Businesspeople, on the other hand, see this kind of inefficiency as an
opportunity to make money. In this case, a creative entrepreneur could borrow
$100 million at 20% interest, buy a hospital ship, anchor it in international
waters, set up a database to match donors to recipients, broker sales, and fly
in experienced transplant teams. If she charges $200,000 and earns 10% on
each transaction, the break-even quantity is just 1,000 transplants each year.
This represents only 1% of the potential demand in the United States alone.
15
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16
SECTION I • Problem Solving and Decision Making
The goal of this chapter is to show you how to exploit inefficiency as
an opportunity to make money. Students who’ve had some economics
training will find that they have a slight head start, but learning how to turn
inefficiency into opportunity requires as much creativity and imagination as
analytic ability.
2.1 Capitalism and Wealth
To identify money-making opportunities, like those in the kidney market, we
first have to understand how wealth is created and destroyed.
Wealth is created when assets move from lower- to higher-valued uses.
An individual’s value for a good or a service is measured as the amount
of money he or she is willing to pay for it.3 To “value” a good means that you
want it and can pay for it.4
If we adopt the linguistic convention that buyers are male and the sellers
are female, we say that a buyer’s “value” for an item is how much he will
pay for it, his “top dollar.” Likewise, a seller won’t accept less than her value,
“cost,” or “bottom line.”
The biggest advantage of capitalism is that it creates wealth by letting
people follow their self-interest.5 A buyer willingly buys if the price is below
his value, and a seller sells for the same selfish reason. Both buyer and seller
gain; otherwise, they would not transact.
Voluntary transactions create wealth.
Suppose that a buyer values a house at $240,000 and a seller at $200,000.
If they can agree on a price—say, $210,000—they both gain. In this case, the
seller sells at a price that is $10,000 higher than her bottom line and the buyer
buys at a price that is $30,000 below his top dollar.
Formally, the difference between the agreed-on price and the seller’s value
is called seller surplus. Likewise, buyer surplus is the buyer’s value minus the
price. The total surplus or gains from trade created by the transaction is the
sum of buyer and seller surplus ($40,000), the difference between the buyer’s
top dollar and the seller’s bottom line.
To see how well you understand the wealth-creating process, try to
identify the assets moving to higher-valued uses in the following examples:
•
•
Factory owners purchase labor from workers, borrow capital from investors, and sell manufactured products to consumers. In essence, factory
owners are intermediaries who move labor and capital from lower-valued
to higher-valued uses, determined by consumers’ willingness to pay for
the labor and capital embodied in manufactured products.
AIDS patients sometimes sell their life insurance policies to investors at
a discount of 50% or more. The transaction allows patients to collect
money from investors, who must wait until the patient dies to collect
from the insurance company. This transaction moves money across time,
from investors (who are willing to wait) to AIDS patients (who want the
money now).
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Chapter 2 • The One Lesson of Business
•
•
•
17
Rover.com is an online service to match dog owners to dog walkers, pet
sitters, and overnight boarders. Since its founding in 2011, Rover has
become the largest marketplace for pet-sitting services, with over 65,000
registered sitters.
When consumers purchase insurance, they pay an insurance company to
assume risk for them. In this context, you can think of risk as a “bad,”
the opposite of a “good,” moving from a consumer who wants to get rid
of it to an insurance company willing to assume it for a fee.
In video games like Diablo III or World of Warcraft, thousands of people in
less-developed countries spend time playing the games to acquire “currency”
that can be used to acquire add-ons. These “gold farmers” sell the currency
to other players for cash on Web sites outside of the game environment.
Here’s a final example that is not so obvious. In 2004, a private equity consortium purchased Mervyn’s, a department store located in the western United
States. It sold off the real estate on which the stores were located, and the
new owners set store rents at market rates. As a consequence, rent payments
doubled and the 59-year-old retailer went out of business, throwing 30,000
employees out of work.
PAUSE FOR A MOMENT AND TRY TO FIGURE WHY THIS
TRANSACTION CREATED WEALTH.
The private equity group unbundled Mervyn’s land-owning activity from
its retail activity. Once Mervyn’s stores had to pay market rents, it became
clear that the retail activity was losing money because its costs were higher
than the value it produced. The economy, as a whole, is better off without
such money-losing ventures.
How do you create wealth? Which assets do you move to higher-valued uses?
We close this section with a warning against the idea that if one person
makes money, someone else must be losing out. This mistake is so common
that it even has a name, “the zero-sum fallacy.” Policy makers often invoke
the fallacy to justify limits on profitability, or prices, or trade. It is a fallacy because the voluntary nature of trade requires that both parties gain; otherwise,
the transaction would not occur.
2.2 Does the Government Create Wealth?
Governments play a critical role in the wealth-creating process by enforcing
property rights and contracts—legal mechanisms that facilitate voluntary
transactions.6 By making sure that buyers and sellers can keep the gains from
trade, our legal system makes trade more likely, which contributes to America’s enormous wealth-creating ability.7
Conversely, the absence of property rights contributes to poverty. The
reasons are simple: without private property and contract enforcement,
wealth-creating transactions are less likely to occur. 8 Ironically, many poor
countries survive largely on the wealth created in the so-called underground, or
black-market economy, where transactions are hidden from the government.
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SECTION I • Problem Solving and Decision Making
Secure property rights are also associated with measures of environmental quality and human well-being. In nations where property rights are well
protected, more people have access to safe drinking water and sewage treatment and they live about 20 years longer.9 If you give people ownership to their
property, they have an incentive to take care of it, invest in it, and keep it clean.
2.3 How Economics Is Useful to Business
Economics can be used by business people to spot money-making opportunities (assets in lower-valued uses). To see this, we begin with “efficiency,” one of
the most useful ideas in economics.
An economy is efficient if all assets are employed in their highest-valued uses.
Economists are obsessed with efficiency. They search for assets in lowervalued uses and then suggest public policies to move them to higher-valued
ones. A good policy facilitates the movement of assets to higher-valued uses;
and a bad policy prevents assets from moving or, worse, moves assets to lowervalued uses.
Determining whether a policy is good or bad requires analyzing all of its
effects—the unintended as well as the intended effects. Using this idea, Henry
Hazlitt reduced all of economics into a single lesson:10
The one lesson of economics: The art of economics consists in looking
not merely at the immediate but at the longer effects of any act or policy;
it consists of tracing the consequences of that policy not merely for one
group but for all groups.11
For example, recent proposals to prevent lenders from foreclosing on
houses helps the delinquent homeowners, but it also hurts lenders. If lenders
cannot foreclose on bad loans, this raises the cost of making loans, which, in
turn, hurts prospective home buyers.
Determining whether the policy is good or bad requires that we look not
only at the happy faces of the family that gets to stay in a foreclosed home,
but also at the sad faces of the family that can no longer afford to buy a house
because the cost of borrowing has gone up. The trick to “seeing” these indirect
effects is to look at incentives. In this chapter, we apply the rational actor paradigm to the problem of finding money making opportunities.
Making money is simple in principle—find an asset employed in lowervalued use, buy it, and sell it to someone who places a higher value on it.
The one lesson of business: the art of business consists of identifying
assets in low-valued uses and devising ways to profitably move them to
higher-valued ones.
In other words, each underemployed asset represents a potential
wealth-creating transaction. The art of business is to identify these transactions and find ways to profitably consummate them.
For example, once the government banned kidney sales, it simultaneously
created an incentive to try to circumvent the ban. Buying a hospital ship and
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Chapter 2 • The One Lesson of Business
19
sailing to international waters is just one solution. According to recent research, there is a thriving illegal or “black market” for kidneys in the United
States. For about $150,000, organ brokers will connect wealthy buyers with
poor foreign donors, who receive a few thousand dollars and the chance
to visit an American city. Once there, transplants are performed at “broker-friendly” hospitals with surgeons who are either complicit in the scheme
or willing to turn a blind eye. Kidney brokers often hire clergy to accompany
their clients into the hospital to ensure that the process goes smoothly.12
Anything that impedes asset movement destroys potential wealth. We discuss three such impediments: taxes, subsidies, and price controls. These regulations create inefficiency which also means opportunity.
Taxes
The government collects taxes out of the total surplus created by a transaction. If the tax is larger than the surplus, the transaction will not take place. In
our housing example, if a sales tax is 25%, for instance, as in Italy, the tax will
be at least $50,000 because the price has to be at least $200,000, the seller’s
bottom line. Since the tax is more than the surplus created by the transaction,
the buyer and seller cannot find a mutually agreeable price that lets them pay
the tax.13
The one lesson of economics tells us that the intended effect of a tax is to
raise revenue for the government, but the unintended consequence of a tax is
that it deters some wealth-creating transactions.
The one lesson of business tells us that these unconsummated transactions represent money-making opportunities. For example, in 1983, Sweden
imposed a 1% “turnover” (sales) tax on stock sales on the Swedish Stock Exchange. Before the tax, large institutional investors paid commissions that averaged 25 basis points (0.25%). The turnover tax, by itself, was four times the
size of the old trading costs, and it fell most heavily on these big institutional
investors.
After the tax was imposed, institutional traders began trading shares on
the London and New York Stock Exchanges, and the number of transactions
on the Swedish Stock Exchange fell by 40%. Smart brokers recognized this
opportunity and profited by moving their trades to London and New York.
The Swedish government finally removed the turnover tax in 1990, but the
Swedish Stock Exchange has never regained its former vitality.
Subsidies
The opposite of a tax is a subsidy. By encouraging low-value consumers to buy
or high-value sellers to sell, subsidies destroy wealth by moving assets from
higher- to lower-valued uses—in exactly the wrong direction.
For example, government policies designed to extend credit to low-income Americans increased homeownership from 64% to 69% of the population. Many of these recipients, like Victor Ramirez, were able to afford houses
only due to the subsidies. Mr. Ramirez says. “I was a student making $17,000
a year, my wife was between jobs. In retrospect, how in hell did we qualify?”14
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SECTION I • Problem Solving and Decision Making
He qualified due to government subsidies. We know that these subsidies
destroy wealth because, without them, the money would have been spent differently. A simple test will tell us whether the subsidy is inefficient: offer each
potential homeowner a payment equal to the amount of the subsidy. If they
would rather spend the money on something other than a home, then there is
a higher-valued use for the money.
The same logic can be used to identify ways to profit from inefficiency. To
see this, let’s look at health insurance that fully subsidizes visits to the doctor.
If you get a cold, you go to the doctor, who charges the insurance company
$200 for your care. This subsidy destroys wealth if you would rather selfmedicate and keep the $200.
Employers who recognize this are starting to offer insurance that requires
a large deductible or copayment. These fees stop low-value doctor visits and
dramatically reduce the cost of insurance. Employers can either keep the
money or use it to raise workers’ wages (by the amount they save on insurance) to attract better workers. These high-deductible policies are becoming
more popular with companies like Whole Foods Market that have recognized
the inefficiency.
Price Controls
A price control is a regulation that allows trade only at certain prices.
There are two types of price controls: price ceilings, which outlaw trade at
prices above the ceiling, and price floors, which outlaw trade at prices below
the floor. The prohibition on buying and selling kidneys is a form of price
ceiling. Americans are allowed to buy and sell kidneys—but only at a price of
zero.
Price floors above the buyer’s top dollar or price ceilings below a seller’s
bottom line deter wealth-creating transactions. 15 In our kidney example,
potential kidney sellers are deterred from selling because they can do so only
at a price of zero.
To see how to profit from this kind of inefficiency, we turn to the case
of taxis, which are regulated with a fixed price. This functions like a price
ceiling when you need to get you to the outer reaches of your metropolitan
area because the fixed fares won’t let taxis recover the cost of return trip. In
addition, taxis are often poorly maintained because regulated fares don’t allow
taxis to charge for better quality. Finally, taxis have a well-deserved reputation
for recklessness because there is no way for taxis to increase earnings except
by increasing volume, which they do by driving from place to place as fast as
possible.
Uber is an alternative to taxis that makes money, in part, by exploiting
these regulatory inefficiencies. Flexible pricing and consumer ratings give Uber
drivers an incentive to go to distant destinations, to clean their cars, and to
drive safely.16
Beyond avoiding the inefficiency created by taxi regulation, Uber’s success is also due to: (i) a more efficient driver–passenger matching technology;
(ii) larger scale, which supports faster matches; and (iii) surge pricing, which
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Chapter 2 • The One Lesson of Business
21
allows it to more closely match supply with demand throughout the day. The
surge pricing can be thought of as a way around inefficiency of fixed fares
mandated by regulation.17
2.4 Wealth Creation in Organizations
Companies can be thought of as collections of transactions, from buying raw
materials like capital and labor to selling finished goods and services. In a successful company, these transactions move assets to higher-valued uses and thus
make money for the company.
As we saw from the story of the oil company in the introductory chapter, a
firm’s organizational design influences decision making within the firm. Some
designs encourage profitable decision making; others do not. A poorly designed
company will consummate unprofitable transactions or fail to consummate
profitable ones.
The reasons for this are analogous to the wealth-destroying effects of
government policies: organizations impose “taxes,” “subsidies,” and “price
controls” within their companies that either deter profitable transactions or
encourage unprofitable ones. For example, overbidding at the oil company
was caused by a “subsidy” paid to management for acquiring oil reserves.
Senior management responded to the subsidy by acquiring reserves, regardless
of the price. One solution to the problem was to eliminate the subsidy.
The analogy between the market-level problems created by taxes, subsidies, and price controls and the organization-level problems of goal alignment
suggests is that we are using the same economic tools to analyze both types of
problems. The target of the analysis changes—from markets to organizations—
but the principles are the same.
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
•
•
•
•
Voluntary transactions create wealth by
moving assets from lower- to higher-valued
uses.
Anything that impedes the movement of
assets to higher-valued uses, like taxes, subsidies, or price controls, destroys wealth.
Efficiency means that each asset is
employed in its highest-valued use. Each
inefficiency implies a money-making
opportunity.
The art of business consists of finding an
asset in lower-valued use and devising ways
to profitably move it to higher-valued one.

•
A company can be thought of as a series of
transactions. A well-designed organization
rewards employees who identify and consummate profitable transactions or who
stop unprofitable ones.
Multiple-Choice Questions
1. An individual’s value for a good or service is
a. the amount of money he or she used to
pay for a good.
b. the amount of money he or she is willing to pay for it.
c. the amount of money he or she has to
spend on goods.
d. None of the above.
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SECTION I • Problem Solving and Decision Making
2. The biggest advantage of capitalism is that
a. it allows the market to self-regulate.
b. it allows a person to follow his
self-interest.
c. it allows voluntary transactions, which
create wealth.
d. All of the above.
3. Wealth-creating transactions are more
likely to occur
a. with private property rights.
b. with strong contract enforcement.
c. with black markets.
d. All of the above.
4. Which of these actions creates value?
a. Buying a struggling firm and selling off
its assets for more than the purchase
price
b. A baseball slugger drawing paying fans
into the ballpark
c. A student increasing his decisionmaking ability with an MBA
d. All of the above
5. Which of the following are examples of a
price floor?
a. Minimum wages
b. Rent controls in New York
c. Both a and b
d. None of the above
6. A price ceiling
a. is a government-set maximum price.
b. is an implicit tax on producers and an
implicit subsidy to consumers.
c. will create a surplus.
d. causes an increase in consumer and
producer surplus.
7. Taxes
a. impede the movement of assets to
higher-valued uses.
b. reduce incentives to work.
c. decrease the number of wealth-creating
transactions.
d. All of the above.
8. A consumer values a car at $20,000 and
it costs a producer $15,000 to make the
same car. If the transaction is completed at
$18,000, the transaction will generate
a. no surplus.
b. $5,000 worth of seller surplus and
unknown amount of buyer surplus.
c. $2,000 worth of buyer surplus and
$3,000 of seller surplus.
d. $3,000 worth of buyer surplus and
unknown amount of seller surplus.
9. A consumer values a car at $525,000 and
a seller values the same car at $485,000.
If sales tax is 8% and is levied on the
seller, then the seller’s bottom-line price is
(rounded to the nearest thousand)
a. $527,000.
b. $524,000.
c. $525,000.
d. $500,000.
10. Voluntary transactions
a. always produce gains for both parties.
b. produce gains for at least one party.
c. always increase wealth for everyone.
d. are inefficient.
Individual Problems
2-1 Airline Delays
How will commercial airlines respond to the
threat of new $27,500 fines for keeping passengers on the tarmac for more than three hours?
What inefficiency will this create?
2-2 Selling Used Cars
I recently sold my used car. If no new production occurred for this transaction, how could it
have created value?
2-3 Flood Insurance
The U.S. government subsidizes flood insurance
because those who want to buy it live in the
flood plain and cannot get it at reasonable rates.
What inefficiency does this subsidy create?
2-4 France’s Labor Unions Force Early Closing Times
In 2013, France’s labor unions won a case
against Sephora to prevent the retailer from
staying open late and forcing its workers to
work “antisocial hours.” The cosmetics store
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Chapter 2 • The One Lesson of Business
23
does about 20% of its business after 9 P.M.,
and the 50 sales staff who work the late shift
are paid an hourly rate that is 25% higher than
the day shift. Many of them were students or
part-time workers, who were put out of work
by these new laws. Identify the inefficiency, and
figure out a way to profit from it.
for one of the surgeries has increased by about
10% each year since 1995, whereas the other
has increased by only 2% per year. Which of
the surgeries has the lower inflation rate? Why?
2-5 Kraft and Cadbury
Identify an unconsummated wealth-creating
transaction (or a wealth-destroying one) created by some tax, subsidy, price control, or
other government policy, and then figure out
how to profitably consummate it (or deter it).
Estimate how much profit you would earn by
consummating (or deterring) it.
When Kraft recently bid $16.7 billion for Cadbury, Cadbury’s market value rose, but Kraft’s
market value fell by more. What does this tell
you about the value-creating potential of the
deal?
2-6 Price of Breast Reconstruction versus Breast
Augmentation
Two similar surgeries, breast reconstruction
and breast augmentation, have different prices.
Breast augmentation is cosmetic surgery not
covered by health insurance. Patients who want
the surgery must pay for it themselves. Breast
reconstruction following breast removal due
to cancer is covered by insurance. The price
Group Problems
G2-1 One Lesson of Business
G2-2 One Lesson of Business (within an
Organization)
Identify an unconsummated wealth-creating
transaction (or a wealth-destroying one) within
your organization, and figure out how to profitably consummate it (or deter it). Estimate how
much profit you would earn by consummating
it (or deterring) it.
End Notes
1. See Kevin Sack, “60 Lives, 30 Kidneys, All
Linked,” New York Times, February 18,
2012.
2. See Sally Satel and Mark J. Perry, “More
Kidney Donors Are Needed to Meet a Rising
Demand,” Washington Post, March 7, 2010.
3. An individual’s value for a good or service is
measured as the amount of money he or she
is willing to pay for it. It is the ability-to-pay
component of value that is behind most critiques of capitalism. Unless you have enough
money to purchase an item, you do not
value it.
But other theories of value have even bigger
problems. For example, under Communism,
a labor theory of value is used. Value depends on how much labor produced it. This
definition (the amount of labor embodied in
the good), if used to guide decisions, could
lead to situations where goods are produced
that nobody wants. The defining tenet of
Communism is “from each according to his
ability; to each according to his need.” Communism is bad at creating wealth because
it allocates goods according to “needs,” not
“wants,” and because it’s tough to gauge
how much people need goods. Individuals
have great incentive to claim they are “needier” than they really are. In the political
arena, groups compete for government funds
by claiming they are the “neediest.” Economists dislike the word need because it is so
often used to manipulate others into giving
away something. Listen to news reports
about proposed government spending cuts.
Most often those affected claim they “need”
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24
SECTION I • Problem Solving and Decision Making
the programs targeted for elimination. That
sounds better than saying they “want” the
programs. The definitions of value differ because Communism and Socialism are more
concerned with the distribution of wealth
than with the creation of wealth, which
is capitalism’s greatest concern. In other
words, capitalism is concerned with making
the proverbial “pie” as large as possible,
while Socialism and Communism are concerned more about how to slice up that pie.
4. This is the idea behind the French phrase
laissez-faire (leave them alone).
5. “The only proper functions of a government
are: the police, to protect you from criminals; the army, to protect you from foreign
invaders; and the courts, to protect your
property and contracts from breach or fraud
by others, to settle disputes by rational
rules, according to objective law.” Ayn Rand,
Atlas Shrugged (New York: Random House,
1957), 977.
6. Tom Bethell, The Noblest Triumph: Property and Prosperity through the Ages (New
York: St. Martin’s Press, 1995).
7. “The inherent vice of capitalism is the
unequal sharing of blessings; the inherent
virtue of socialism is the equal sharing of
miseries” (Winston Churchill).
8. Seth Norton, “Property Rights, the Environment, and Economic Well-Being,” in Who
Owns the Environment? ed. Peter J. Hill and
Roger E. Meiners (Lanham, MD: Rowman
and Littlefield, 1998).
9. Henry Hazlitt, Economics in One Lesson
(New York: Crown, 1979).
10. For chilling examples of the unintended
consequences of government policy, read
Jagdish Bhagwati’s book, In Defense of
Globalization (New York: Oxford University Press, 2004). In 1993, for example, the
U.S. Congress seemed likely to pass Senator
Tom Harkin’s Child Labor Deterrence Act,
which would have banned imports of textiles made by child workers. Anticipating
its passage, the Bangladeshi textile industry
dismissed 50,000 children from factories.
Many of these children ended up as prostitutes. Ironically, the bill, which was designed
to help children, had the opposite effect.
11. Jeneen Interlandi, “Not Just Urban Legend,” Newsweek, January, 19, 2009.
12. With a 25% tax, the seller receives 75%
of the sales price. If the tax is levied on the
seller, her bottom-line price increases to
$266,667 5 $200,000 / (0.75), which is
above the buyer’s top dollar of $240,000.
If the tax is levied on the buyer, his top dollar decreases to $192,000, which is below
the seller’s bottom line.
13. David Streitfeld and Gretchen Morgenson,
“Building Flawed American Dreams,” New
York Times, October 18, 2008.
14. Price floors below a seller’s bottom-line
and price ceilings above a buyer’s top dollar have no effect.
15. Megan Mcardle, “Why You Can’t Get a
Taxi,” The Atlantic, May 2012.
16. Judd Cramer and Alan B. Krueger, “Disruptive Change in the Taxi Business: The
Case of Uber,” American Economic Review
106, no. 5 (2016): 177–182.
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3
Benefits, Costs,
and Decisions
B
ig Coal Power Company burns two types of coal from the Southern Powder
River Basin in Wyoming: high-energy 8,800 coal and low-energy 8,400 coal.
The numbers refer to the amount of energy contained in one pound of coal,
for example, 8,400 Btu/lb. Power plants crush the coal, and then burn it to
produce electricity.
The 8,400 coal generates about 5% less electricity per ton than 8,800
coal, so when the price of 8,400 fell 20% below the price of 8,800 coal, the
plant manager did the obvious thing and switched to the lower-price coal.
Not only did this reduce the average cost of electricity but it also increased
the manager’s compensation because his performance evaluation was based
on the average cost of electricity (cost/Btu). Unfortunately, however, the move
also reduced company profit.
Because the conveyor belts and crushers were already at capacity, the
manager was unable to increase the tonnage going through the plant. Electricity output fell by 5%, the difference between the amount of electricity produced by the two different coals, and the parent company had to replace the
lost electricity with higher-cost natural gas. Company profit fell by $5 million,
computed as the cost of replacing the lost electricity with natural gas, minus
the savings from using lower-price 8,400 coal.
Even though mistakes like this seem obvious in retrospect, spotting them
before they occur can be very difficult. The goal of this chapter is to show you
how to use benefit-cost analysis not only to spot mistakes but also to identify
profitable decisions that should have been made instead.
25
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SECTION I • Problem Solving and Decision Making
3.1 Background: Variable, Fixed, and Total Costs
Knowing how costs vary with output allows you to compute the costs associated with the consequence of a decision that changes output.
Variable costs vary with output, but fixed costs do not.
Production Costs
To illustrate, suppose that you are the manager of a new candy factory. To produce candy, you build a factory, purchase ingredients, and
hire employees. Suppose your factory’s capital costs are $1 million/year
(e.g., a $10 million factory and a 10% cost of capital), employees can be
hired for $50,000 each and ingredients cost $0.50/candy bar. If you decide
to produce 1,000 candy bars in a year, you need to hire 10 employees, but
if you decide to produce 2,000 bars, you need 20 employees. For 1,000
bars, your production costs would be $1,500,500—$1 million for the factory, $500,000 in employee costs, and $500 in ingredient costs. For 2,000
bars, your production costs would be $2,001,000—$1 million for the factory, $1 million in employee costs, and $1,000 in ingredient costs (a total of
1,001,000 in variable costs).
Notice that labor costs and ingredient costs vary with output, but factory capital costs are $1 million regardless of how much you produce. We
say that labor costs and ingredient costs are variable, while the capital cost
is fixed. The distinction is important for decisions on how much to produce
and sell.
To illustrate the relationships among these costs, we plot them against
output in Figure 3.2. For output levels of zero, both fixed and total costs are
greater than zero. Total and variable costs both increase with output, and variable costs appear as the difference between the total cost curve and the fixed
cost line.1
Total Costs
Variable Costs
Fixed Costs
Output Level
FIGURE 3.2 Cost Curves
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Chapter 3 • Benefits, Costs, and Decisions
27
3.2 Background: Accounting versus Economic Profit
We now leave our fictitious candy manufacturer to talk about a real one. In
1990, Cadbury India offered its employees free housing in company-owned
flats (apartments) to offset the high cost of living in Bombay (now Mumbai). In 1991, when Cadbury added low-interest housing loans to its benefits package, employees took advantage of this incentive and purchased their
own homes, leaving the company flats empty. The empty flats remained on the
company’s balance sheet for the next six years.
In 1997, Cadbury adopted Economic Value Added (EVA®), a financial
performance metric trademarked by Stern Stewart & Co. The main difference
between ordinary accounting profit and EVA® is that EVA® includes a capital
charge of 15%, representing the return that Cadbury could have made if it
had invested the capital tied up in the apartments.
By charging each division within a firm for the amount of capital it
uses, EVA® gives division managers an incentive to incur capital expenditures only if they earn more than they cost, for example, by giving division managers an incentive to reduce capital expenditures if they earn less
than 15%.
After adopting EVA®, Cadbury India’s annual EVA® dropped by £600,000
(15% cost of capital times the £4,000,000 capital tied up in the apartments).2
In response, senior managers decided to sell the unused apartments as they
were earning less than the company’s cost of capital.
If the Cadbury managers had a good sense of their factories’ variable,
fixed, and total costs, why were they holding on to the company-owned
flats?
To answer this question, we recognize another important distinction: the
difference between accounting costs and what economists call “economic
costs.” The difference is especially important to big decisions about whether
to buy or sell assets. For these decisions, you have to figure out what else you
could do with the money if you decide to sell an asset. We measure the cost
of using capital on any project by the returns we could get from investing it
elsewhere, which accounting costs do not do.
Table 3.1 presents a recent annual income statement for Cadbury.3 The
firm sold over £6 billion in goods for the year, and after subtracting various
expenses, it ended up with a profit of £431 million, which represents a return
of approximately 6.4% on sales. Expense categories include items such as the
following:
•
•
•
•
Costs paid to its suppliers for product ingredients
General operating expenses, such as salaries to factory managers and
marketing expenses
Depreciation expenses related to investments in buildings and
equipment
Interest payments on borrowed funds
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SECTION I • Problem Solving and Decision Making
TABLE 3.1
Cadbury Income Statement (amounts in millions of pounds)
Net Sales
Cost of Sales
£6,738
£3,020
Gross Profit
£3,718
Operating Expenses
Selling, General, and Administrative Expenses
£2,654
Depreciation and Amortization
£215
Total Operating Expenses
£2,869
Operating Income
£849
Other Income (Expense)
Net Interest
£(226)
Other Income
£(3)
Total Other Income (Expense)
Earnings before Provision for Income Taxes
Provision for Income Taxes
Net Earnings
£(229)
£620
£(189)
£431
These types of expenses are the accounting costs of the business.
Economists, however, are interested in all the relevant costs of decisions,
including the implicit costs that do not show up in the accounting statements.
For an example of an implicit cost, look at the income statement again. Notice
that it lists payments to one class of capital providers of the company (debt
holders). Interest is the cost that creditors charge for the use of their capital. But creditors are not the only providers of capital. Stockholders provide
equity, just as bondholders provide debt. Yet the income statement reflects no
charge for equity even though this is an important consideration for investment decisions.
Suppose that Cadbury receives £4 billion in equity financing. If these
equity holders expect an annual return of 12% on their money (£480 million),
we would subtract this amount from the £431 million in net earnings to
get a better idea of the economic profit of the business, −£49 million.
Negative economic profit means that the firm is earning less than shareholders
expect.
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Chapter 3 • Benefits, Costs, and Decisions
29
Had Cadbury shareholders expected only a 10.77% rate of return, the
economic return would have been close to zero, and investors would have
been satisfied. However, given that they expected a 12% return, they “lost”
money in this investment, relative to what they could have earned elsewhere.
In practical terms, a firm may show an accounting profit while experiencing an economic loss. The two amounts are not the same because economic
profit recognizes both explicit and implicit costs of capital. A failure to consider these hidden or implicit costs is why the Cadbury India managers continued to hold on to flats. By adopting EVA®, the firm made visible the hidden
cost of equity, and the mangers sold the abandoned flats.
In general, managers should consider all the benefits and costs of a decision. To show you how to do this, we introduce what economists call “opportunity costs.”
3.3 Costs Are What You Give Up
When deciding between two alternatives, you obviously want to choose the
one that returns the highest profit. Accordingly, we define the “opportunity
cost” of one alternative as the forgone opportunity to earn profit from the
other.
With this definition, costs imply decision-making rules, and vice versa.
If the benefit of the first alternative is larger than its cost—the profit of the
second alternative—then choose the first. Otherwise, choose the second. This
link is made explicit in Figure 3.3, showing a decision where the profit of A is
greater than the cost of A (the profit of B).
The opportunity cost of an alternative is what you give up to pursue it.
Henceforth, when we use the term cost, we are referring to opportunity cost. Because costs depend on what you give up, and this depends on
Manager
A
Profit of A
B
Profit of B (Opp’t Cost of A)
FIGURE 3.3 Opportunity Cost
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30
SECTION I • Problem Solving and Decision Making
the decision that you are trying to make, costs and decisions are inherently
linked.
To illustrate the link, consider the company’s decision to hold onto the
company-owned flats and earn, say, 2%. The opportunity cost of the decision
is the forgone opportunity to invest capital in the company’s other operations
and earn a .12% return.
3.4 Sunk-Cost Fallacy
The general rule for making decisions is simple.
onsider all costs and benefits that vary with the consequence of a decision
C
(If you miss some, that is the hidden-cost fallacy.)
ut consider only costs and benefits that vary with the consequence of the
B
decision. (If you take account of irrelevant costs or benefits, that is the
sunk- or fixed-cost fallacy.)
These are the relevant costs and benefits of a decision.
In this section and the next, we examine these two mistakes in more
detail.
One of the most frequent causes of the sunk-cost fallacy is the “overhead”
allocated to various activities within a company. Because overhead does not
vary with most business decisions, it should not influence them. Look back at
the income statement in Table 3.1. Overhead costs appear in the line item of
Selling, General, and Administrative Expenses. An example of such an overhead
expense would be costs associated with the corporate headquarters staff or with
the sales force. These costs are considered fixed because output can be increased
without the need to increase the corporate staff, like the CFO or CEO.
For example, suppose that you are in charge of a new products division
and are considering launching a product that you will be able to distribute
through your existing sales force, without incurring extra expenses. However,
if you launch the new product, your division will be forced to pay for a portion
of the sales force. If this “overhead” charge is big enough to deter an otherwise
profitable product launch, then you commit the sunk-cost fallacy. Overhead
expenses are analogous to a “tax” on launching a new product. In this case,
the tax deters a profitable product launch, a wealth-creating transaction.
Depreciation4 is another common cause of the sunk-cost fallacy. To see
how this causes problems, consider a washing machine plant that is considering outsourcing its plastic agitators rather than making them internally as had
been done for several years. The firm received a bid of $0.70 per unit from a
trusted supplier and compared the bid to its internal production costs of $1.00
per unit, consisting of $0.60 for material, $0.20 for labor, $0.10 for depreciation, and $0.10 for other overhead.
The costs of depreciation and overhead 5 are not relevant to an outsourcing decision because the firm incurs these costs regardless of whether
it decides to outsource. The relevant cost of internal production is $0.80,
and the relevant cost of outsourcing is $0.70. Multiply the cost difference
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Chapter 3 • Benefits, Costs, and Decisions
31
by one million agitators/year, and the firms would save $100,000 if it
outsourced the part.
In this case, identifying the right decision was easier than implementing
it. Six years earlier, the plant had incurred $1 million worth of tooling costs
to make molds for the agitators. Following accounting principles, the cost of
the tooling was recorded as an “asset” on the plant’s balance sheet. Each year,
the accountants charged the plant $100,000/year for using this asset, which
was expected to last for 10 years. After the first year, the value of the asset
had shrunk to $900,000; after the second, $800,000; and so on. This is called
“straight-line depreciation.”
Six years after incurring the tooling expense, there was still $400,000
worth of undepreciated capital left on the company’s balance sheet. Accountants told the manager that if he decided to outsource the agitator, these
“assets” would become “worthless,” and the manager would be forced to take
a charge6 against his division’s profitability. The $4…
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