Cengage Webinar:Managerial Economics:

A Problem-solving Approach

(2nd Edition)Managerial Economics: A Problem Solving Appraoch (2nd Edition)

Luke M. Froeb, luke.froeb@owen.vanderbilt.edu Brian T. McCann, brian.mccann@owen.vanderbilt.edu

Website, managerialecon.com

COPYRIGHT © 2008Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Why is teaching economics to MBA’s so difficult?

Students with varying backgrounds: English majors vs. Engineers;

Econ. and Business majors;

Executive MBA’s and non-degree Exec. Ed.

Healthcare professionals

Terminal class: Last microeconomics class most MBA’s will take

Students want practical knowledge Not abstract theory

Do MBA’s learn differently than we do?

Solution

Use a problem-based pedagogy (instead of model-based)Begin with a real business problem

Give students just enough analytical structure to understand the problem and find a solution

Teaches students to solve problems by Identifying profitable decisions (benefit-cost analysis)

And implement them (principal-agent theory)

Links study of economics to other MBA disciplinesAccounting, finance, statistics, marketing, strategy,

operations

Example: Over-bidding OCS gas tract

• A young geologist was preparing a bid recommendation for an gas tract in the Gulf of Mexico.

• With knowledge of the productivity of neighboring tracts also owned by company, the geologist recommended a bid of $5 million.

• Senior management, though, bid $21 million - far over the next highest-bid of $750,000.

• What, if anything, is wrong?

• The goal of this text is to provide tools to help diagnose and solve problems like this.

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Analyze the over-bidding mistake

• Another clue:• After winning the bid, the geologist increased

the estimated reserves of the company.• But, after a “dry” well was drilled, the reserve

estimates were decreased.• Senior Management stepped in and rejected the

decrease in the estimate (kept it high)

• Last clue:• Senior management resigned several months

later.

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ANSWER: Manager bonuses for increasing reserves• The bonus system created incentives to over-

bid. • Senior managers were rewarded for acquiring

reserves regardless of their profitability

• Bonuses also created incentive to manipulate the reserve estimate.

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Problem solving

• Two distinct steps:• Figure out what’s wrong, i.e., why the bad decision was

made• Figure out how to fix it

• Both steps require a model of behavior• Why are people making mistakes?• What can we do to make them change?

• Economists use the rational actor paradigm to model behavior. The rational actor paradigm states:• People act rationally, optimally, self-interestedly

• i.e., they respond to incentives – to change behavior you must change incentives.

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Keep the ultimate goal in mind

Align the incentives of employees with the profitability goals of the company.

• How do we make sure employees have the information necessary to make good decisions?

• And the incentive to do so?

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How to figure out what is wrong

• Under the rational actor paradigm, mistakes are made for one of two reasons: • lack of information or• bad incentives.

• To diagnose a problem, ask 3 questions:1. Who is making bad decision?

2. Do they have enough info to make a good decision?

3. Do they have the incentive to do so?

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How to fix it

• The answers will suggest one or more solutions: 1. Let someone else make the decision, someone

with better information or incentives.

2. Change the information flow.

3. Change incentives• Change performance evaluation metric• Change reward scheme

• Use benefit-cost analysis to choose the best (most profitable?) solution

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Coverage & Changes to 2nd ed.

• Traditional coverage (see TOC)

• Changes to second edition• Examples from the financial crisis• Additional material

• Insights from behavioral econ (psychological pricing, barriers to rational decision making)

• Iceland: Trade, Foreign Exchange, Bubbles

• Chapters cut into smaller pieces• Uncertainty & Auctions

• Long-run equilibrium & Strategy

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121. Introduction: What this book is about2. The one lesson of business3.Benefits, costs and decisions4. Extent (how much) decisions5. Investment decisions: Look ahead and reason back6. Simple pricing7.Economies of scale and scope8. Understanding markets and industry changes9. Relationships between industries: The forces moving us towards long-run equilibrium10. Strategy, the quest to slow profit erosion11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing13. Direct price discrimination14. Indirect price discrimination15. Strategic games16. Bargaining 17. Making decisions with uncertainty 18. Auctions19.The problem of adverse selection20.The problem of moral hazard21. Getting employees to work in the best interests of the firm22. Getting divisions to work in the best interests of the firm23. Managing vertical relationships24. You be the consultantEPILOG: Can those who teach, do?

Managerial Economics - Table of contents