Froeb McCann Shor Wa r d fif th e ditio n Managerial Economics A PROBLEM SOLVING APPROACH Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Fit your coursework into your hectic life. Make the most of your time by learning your way. Access the resources you need to succeed wherever, whenever. Study with digital flashcards, listen to audio textbooks, and take quizzes. Review your current course grade and compare your progress with your peers. Get the free MindTap Mobile App and learn wherever you are. Break Limitations. Create your own potential, and be unstoppable with MindTap. MINDTAP. POWERED BY YOU. cengage.com/mindtap Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Unless otherwise noted, all content is © Cengage Senior Vice President: Erin Joyner copyright herein may be reproduced or distributed in any form Product Director: Jason Fremder ALL RIGHTS RESERVED. No part of this work covered by the or by any means, except as permitted by U.S. copyright law, without the prior written permission of the copyright owner. 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Find your local representative at www.cengage.com. Cengage Learning products are represented in Canada by Nelson Education, Ltd. To learn more about Cengage Learning Solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.cengagebrain.com Printed in the United States of America Print Number: 01 Print Year: 2017 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 In loving memory of Lisa, and for our families: Donna, David, Jake, Halley, Scott, Chris, Leslie, Jacob, Eliana, Cindy, Alex, and Chris Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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? Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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! Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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.] Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 18 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 20 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 22 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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” Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 26 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 28 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. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 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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