11 Introduction: What This Book is About Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Summary of Main Points ▮ Problem solving requires two steps: First, figure out why mistakes are being made; and then figure out how to make them stop ▮ The rational-actor paradigm assumes that people act rationally, optimally, and self-interestedly To change behavior, you have to change incentives ▮ Good incentives are created by rewarding good performance ▮ A well-designed organization is one in which employee incentives are aligned with organizational goals By this we mean that employees have enough information to make good decisions, and the incentive to so Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Summary of Main Points (continued) ▮ You can analyze any problem by asking three questions: Who is making the bad decision?; Does the decision maker have enough information to make a good decision?; and the incentive to so? ▮ Answers to these questions will suggest solutions centered on letting someone else make the decision, someone with better information or incentives; giving the decision maker more information; or changing the decision maker’s incentives Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Problem: Over-bidding OVI gas tract ▮ A young geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico ▮ With knowledge of the productivity of neighboring tracts also owned by company, the geologist recommended a bid of $5 million ▮ Senior management, though, bid $20 million - far over the next highest-bid of $750,000 ▮ What, if anything, is wrong? ▮ The goal of this text is to provide tools to help diagnose and solve problems like this Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Problem solving ▮ Two distinct steps: • Figure out what’s wrong, i.e., why the bad decision was made • Figure out how to fix it ▮ Both steps require a model of behavior • Why are people making mistakes? • What can we to make them change? ▮ Economists use the rational actor paradigm to model behavior The rational actor paradigm states: • People act rationally, optimally, self-interestedly  i.e., they respond to incentives – to change behavior you must change incentives Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ANSWER: Manager bonuses for increasing reserves ▮ The bonus system created incentives to over-bid • Senior managers were rewarded for acquiring reserves regardless of their profitability ▮ Bonuses also created incentive to manipulate the reserve estimate ▮ Now that we know what is wrong, how we fix it? • Let someone else decide? • Change information flow? • Change incentives? Performance evaluation metric  Reward scheme  Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... Good incentives are created by rewarding good performance ▮ A well-designed organization is one in which employee incentives are aligned with organizational goals By this we mean that employees... accessible website, in whole or in part Summary of Main Points (continued) ▮ You can analyze any problem by asking three questions: Who is making the bad decision?; Does the decision maker have enough... tract in the Gulf of Mexico ▮ With knowledge of the productivity of neighboring tracts also owned by company, the geologist recommended a bid of $5 million ▮ Senior management, though, bid $20 million