Managerial Economics, 3rd Edition Class Notes

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11. INTRODUCTION: WHAT THIS BOOK IS ABOUTProblem SolvingEthics and EconomicsEconomics in Job InterviewsMain PointsProblem solving requires two steps: First, figure out why mistakes are being made; and thenfigure out how to make them stop.Therational-actor paradigmassumes that people act rationally, optimally, and self-interestedly.To change behavior, you have to change incentives.Good incentives are created by rewarding good performance.A well-designed organization is one in which employee incentives are aligned with organizationalgoals. By this we mean that employees have enough information to make good decisions, and theincentive to do so.It follows that you can analyze problems by asking three questions: (1) Who is making the baddecision?; (2) Does the decision maker have enough information to make a good decision?; and(3) the incentive to do so?Answers to these questions will suggest solutions centered on (1) letting someone else make thedecision, someone with better information or incentives; (2) giving the decision maker moreinformation; or (3) changing the decision maker’s incentives.Teaching NoteIt is useful toopen with a business problem, like the over-bidding in the introduction, the Kidder-Peabodyanecdote, or any of the anecdotes in the concluding chapter “you be the consultant.” Then ask the studentsto assume that they are a consultant brought in to the company to figure out what is wrong.Play 20questions, and make them ask questions that have “yes” or “no” answers until they figure out what iswrong.Students will invariably use the rational actor paradigm to do this.Point this out to them.Tellthem that this class is trying to show them how to use this paradigm more formally.At the beginning of each of my lectures,students’problem solving skillscan be reinforcedby askingthem to solve a specific problem.The trick is to dribble out the information, bit by bit, to engage thestudents and keep them guessing what the problem is.Note that some students will typically define the problem as the lack of a particular solution.When thishappens, use the opportunity to point out how this approach locks you into aparticular solution.Showthem how not to do this.Only thenformally introducethem tothe rational actor paradigm and show how it can be used to bothidentify why problems occur and what can be done to change behavior.I tell them that the key step insolving problems is to bring it down to an individual decision level.First, find out who made a baddecision. Under the rational actor paradigm there are only two reasons for making mistakes: not enoughinformation or bad incentives.Find out which it is.Bottom line is that problems can be identified byasking three questions:1. Who made the bad decision?2. Did they have enough information to make a good decision?3. Did they have the incentive to make a good decision?

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2Point outthat incentives have two pieces: a performance evaluation metric and a way to reward goodperformance, or punish bad performance.The Brickley, Smith, and Zimmerman article is a goodreference for this.Various solutions to the problem will likewise center on:1. Changing decision rights (letting someone else make the decision);2. Changing information flows; or3. Changing incentivesi. Performance evaluationii. Compensation linking performance torewards.Tell them the “goal” is to align the incentives of employees with the goals of the organization.Aftergiving students this paradigm, ask them to fix the problem.Solicit suggestions, and ask other studentswhat they like or don’t like about the various proposed solutions.The message is that there are onlytradeoffs and no universal solutions, i.e., the answer to every question is “it depends.”The point of theclass is to teach your students to recognize and evaluate the tradeoffs.If you want to focus on information rather than incentives, use the Sears automotive example in the“additional anecdote” below (What do tonsillectomies have in common with auto repair?).This is aparticularly good example for teaching the lesson, “there are no solutions, only tradeoffs.”None of thethree solutions is very good: (1) If you leave the decision making with the mechanics, you have to makesure they don’t recommend needless repairs; (2) if you change their incentives to flat salary, you canexpect shirking; and (3) giving the decision making to someone else results in costly duplication. Be sureto draw the analogy to the current health care debate. It will shake your students up when they realize thedreary choices in front of them.In-class ProblemIf you do not assign it, the following question (Individual HW Chapter 2) is a good one to motivateproblem solving. Tell them to put themselves in the role of the newly hired manager. Ask them what theproblem is; and then how to solve it.Goal Alignment at a Small Manufacturing ConcernThe owners of a small manufacturing concern have hired a manager to run the company with theexpectation that he will buy the company after five years. Compensation of the new vice president is a flatsalary plus 75% of first $150,000 of profit, and then 10% of profit over $150,000. Purchase price for thecompany is set as 4½ times earnings (profit), computed as average annual profitability over the next fiveyears. Does this contract align the incentives of the new vice president with the goals of the owners?Answer:No.Both the purchase price and the profit sharing create perverse incentives.The VP keeps $0.75 ofeach dollar earned up to $150,000, but only $0.10 of each dollar earned after $150K. Since earning morerequires more effort (increasing marginal effort), the VP has little incentive to earn more than $150,000.And every dollar the VP earns raises the price that he will eventually pay for the company by $4.50,effectively penalizing him for increasing company profitability.Supplementary MaterialBlog EntriesManagerialEcon.com (Chapter 1)AuxiliarySlidesJohn Stossel’s Video “GREED,” by ABC News

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3ReadingsJames Brickley, Clifford Smith, Jerold Zimmerman, “The Economics of Organizations,”Journal ofFinancial Economics,Vol. 8:2 (Summer, 1995) pp. 19-31.This article provides the basis for our study of behavior within organizations. The authorspresent a methodology for diagnosing and repairing problems within an organization.Theirtake on the rational actor paradigm is slightly different than mine:They would diagnoseproblems by asking three questions:i.Who is making the bad decision?;ii.How are they evaluated?; andiii.How are they compensated?Answers to these questions will suggest solutions to the problem centered on:i.Re-assigning decision rights;ii.Changing evaluation schemes; and/oriii.Changing compensation schemes.This is very similar to my approach. But I group evaluation and compensation schemes into“incentives” and ask explicitly about information.Good very short story illustrating how markets turn self interest (greed) into groupinterest:Doti,Capitalism & Greed, This is a greatveryshort story of two stores during a Chicago snowstorm: one kept prices low and ran out of goods while the other doubled prices and was able tokeep operating, even inducing kids to bring produce from the farmers markets on their sleds.Makes students think.Additional Anecdotes: Sears Automotive and Kidder-PeabodySEARS AUTOMOTIVE:What do tonsillectomies have in common with auto repair?In 1992 charges were brought against Sears whose mechanics were recommendingunnecessary autorepairs.The problem was traced to the incentive system used by Sears (and others in the industry):“[the] use of quotas, commissions, or similar compensation may provide incentives for sales personnel tosell unnecessary auto repair services in order to meet quotas or receive larger commissions.”Sears tried to fix the problem by re-organizing into two divisions, one responsible for recommendingrepairs; and the other responsible for doing them.Rather than solving the problem, however, the twodivisions got together and began colluding.In exchange for recommending unnecessary repairs, theservice division paid the recommending division for recommending them.Sears finally adopted flat payfor the mechanics, which led to shirking.This exampleis usedinVanderbilt's MMHCclass (syllabus) to illustrate the difficulties of aligning theincentives of providers with the goals of payers.President Obama tried to make the same point when heaccusedphysicians of performing unnecessary tonsillectomies.However, as the Sears example suggests,there are no "fixes" to the problem, only tradeoffs:Incentives matter, yet maybe the truth is that medicine is a highly complex science in which theevidence changes rapidly and constantly. That’s one reason tonsillectomies are so much rarer nowthan they were in the 1970s and 1980s—but still better for some patients over others. As theAmerican AcademyofOtolaryngology put it in apressrelease responding toMr.Obama’scommentary, clinical guidelines suggest that “In many cases, tonsillectomy may be a more effective

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4treatment,andlesscostly,thanprolongedorrepeatedtreatmentsforaninfectedthroat.”Mr. Obama seems to think that such judgments are easy. “If there’s a blue pill and a red pill and theblue pill is half the price of the red pill and works just as well,” he asked, “why not pay half price forthe thing that’s going to make you well?” But usually the red and blue treatments are available—aswell as the green, yellow, etc.—because of the variability of disease, human biology and patientpreference. And the really hard cases, especially when government is paying for health care, are thosefor which there’s only a red pill and it happens to be very expensive.KIDDER-PEABODY:In 1992 Joseph Jett became a star bond trader for Kidder-Peabody, earning a two-million-dollar bonus.As his monthly profits grew, he was allowed to risk more and more capital in his trading portfolio, andwas eventually promoted to head of the Government Trading Desk.By the end of 1993, Jett had beenpromoted to managing director.He also received the “Chairman’s Award” for outstanding performance,in addition to a $9 million year-end bonus.Joseph Jett traded “strips,” which involved separating the interest payments from the principal on agovernment bond. He specialized in putting interest payments back together with the stripped bonds, thusreconstructing original bond. This activity earns profits by taking advantage of yield differences betweenzero-coupon bonds (no interest payments) and interest-bearing bonds.However, at Kidder-Peabody, this activity seemed to earn profits—even in the absence of any yielddifferences.The antiquated information system at Kidder-Peabody tracked zero-coupon bonds by priceinstead of yield, which overstated their value once they entered the system.The information systemrewarded Jett contemporaneously for sales of five-day forward contracts on reconstructed bonds.Thisallowed Jett to realize contemporaneous profits that would disappear in five days, when the computerrecorded the future reconstruction. However, by rolling the contracts forward, Jett was able to keep theseprofits on the books.In order to make this work, Jett had to continuously increase the size of hisportfolio.Early in 1994, the information system at Kidder began having trouble keeping up with Jett’s tradingactivity.From 1992-1994, Jett had traded about $1.7 trillion in government securities, about half of alloutstanding government debt.When the source of the profits was uncovered, Kidder liquidated Jett’spositions, and the company was sold to Paine-Webber for under-performing the market.Joseph Jett was fired for refusing to cooperate with the resulting internal investigation but was cleared ofcriminal fraud charges in 1996. Kidder’s civil suit to collect $9 million from Jett was rejected by theNASD (National Association of Securities Dealers).He was fined by an SEC administrative judge butwas allowed to keep $3.7 million in compensation earned while at Kidder.Jett’s boss, Edward Cerullo, was forced to resign in 1994.The Securities and Exchange Commissioncharged him with failing to supervise Jett’s trading activities.He was suspended from working in theindustry for one year, but walked away with $9 million in severance pay and deferred compensation.

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12. THE ONE LESSON OF BUSINESSCapitalism & WealthDo Mergers Move Assets to Higher-Valued Uses?Does the Government Create Wealth?Economics versusBusinessWealth Creation inOrganizationsMain Points•Voluntary transactions create wealth bymoving assets from lower-to higher-valued uses.•Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, orprice controls, destroys wealth.•The art of business consists of identifying assets in low-valued uses and devising ways toprofitably move them to higher-valued ones.•A company can be thought of as a series of transactions. A well-designed organization rewardsemployees who identify and consummate profitable transactions or who stop unprofitable ones.Teaching NoteA common teaching tip is tobegin with a brief overview of “where have we been, where are we going,and how are we going to get there?” Students like this, as it puts what we are doing into perspective. Inthis case, remind them in the first chapter we showed students how to align the incentives of individualswith the goals of an organization (give them enough information to make good decisions and theincentive to do so); in this chapter we show them how to identify profitable decisions.Start out talking about the wealth creating mechanism of capitalism is the movement of assets to highervalued uses, and that taxes, price controls, and subsidies slow down the movement of assets, or encourageassets to move in the wrong direction.Then remind them that decision making in firms can either moveassets to higher valued uses, or not, and that the point of this lecture is to show them how to makeprofitable decisions by learning how to compute the benefits and costs of a decision.The main point of this chapter is to introduce the metaphor that ties all the business problems together:Identifying assets in lower valued uses, and then figuring out how to profitably move them to highervalued uses.Get them thinking about how to use this metaphor to help identify problems (which assetsare in lower valued uses) as well as how to solve them (how do we profitably move them to a highervalued use?).Open this class by asking students how wealth is created (by moving assets to higher valued uses).If thestudent answers correctly, ask the respondent what they mean by “value” (ability to pay).If you getanother correct answer, confront the student by asking “do you mean that a poor student, growing up inpoverty, does NOT value education?” (Yes, that is correct.). With executive MBA’s, you might want toask students how they, or their company, create wealth. Relate it back to moving assets to higher valueduses.The “one lesson of business” is to find assets in lower valued uses and find a way to profitably movethem to a higher valued use.Alternatively, the lesson can be rephrased as seeking out unconsummatedwealth creating transactions and finding ways to profitably consummate them. This theme will tie all thebook chapters together.Many students have taken a microeconomics class, and then I use a “compare and contrast” approach toexplain how micro differs from managerial. Several points to reinforce:

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2Economists are concerned with public policy; MBA’s with making money.Economics tools help you spot assets in lower valued uses and to design public policy to facilitatethe movement of assets to higher valued uses.MBA’s use economics to spot assets in lowervalued uses so they can buy them, and profitably move them to a higher valued use.Economists see inefficiency as something to be eliminated; MBA’s as something to be exploited.Elimination of inefficiency is a by-product of their effort to exploit it.Illustrate the difference between micro and managerial by looking at the effects of three policies onmarginal transactions: price controls (prevent some voluntary wealth creating transactions); taxes (determovement of some assets to higher valued uses), and subsidies (move some assets to lower valued uses).Then, after you have identified assets in lower valued uses, ask what an economist would do (changepolicy) and what an MBA would do (buy the asset, and sell it to someone who valued it more highly.)Focus only on the “marginal” transactions that are affected by the policies.Instructorsmay also want to talk about the role of government in facilitating wealth creating transactions.Compare and contrast countries, like Zimbabwe, with those of Hong Kong or the US (PJ O’Rourke’sbook,Eat the Rich, is great on this account).The paradox is that there is more wealth creating potentialin countries like these because the government’s rules have put assets in lower valued uses, but the samegovernment rules make it difficult to move them to higher valued uses.Close the lecture by noting that organizations have trouble creating wealth for analogous reasons:internal taxes, subsidies, or price controls that impede the movement of assets to higher valued useswithin the organization. Use an example, (my favorite is Phycor, a physician management company thatpurchased physician practices with stock, and this reduced the incentive of physicians to work hard,essentially by turning owner/managers into stockholders of a larger entity), or refer back to the two storiesin the first chapter.In-class ProblemAsk a student for an example of a price control, tax, or subsidy, and then ask them which assets end up inlower valued uses. Ask someone else if they can figure out a way to make money from the inefficiency?If you get no volunteers, ask someone to analyze the effects of the minimum wage.Do this withoutsupply and demand; instead talk about the transactions that are deterred by the regulation (employerswilling to hire at a wage below the minimum wage and those willing to work at below the minimum wageare deterred from transacting). Ask if there is a way to make money by consummating these transactions(outsourcing, start a temp agency, etc.).Supplementary MaterialBlog EntriesManagerialEcon.com (Chapter2)Auxiliary SlidesLarry the Liquidator Speech to the Shareholders from “Other People’s Money”Gordon Gecko’s ‘Greed is Good’ speech from Wall StreetReasonTV’s “Gas Lines, Gouging, and Huricane SandyReadingsSteven Landsburg, “The Iowa Car Crop,”The Armchair Economist,(New York: The Free Press, 1993)pp. 197-202.

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3This reading illustrates the idea that “voluntary transactions create wealth” by making the case forinternational trade.Steven Landsburg, “Why Taxes are Bad:The Logic of Efficiency,”The Armchair Economist,(NewYork: The Free Press, 1993) pp. 60-72.This reading illustrates the concept of efficiency and shows how taxes cause inefficiency.MBAprimer.com,ManagerialEconomicsModule,Section1.“UsingEconomicsinManagementDecisions.”http://mbaprimer.comThis interactive, online hypertext motivates the study of economics for MBA’s.At the end of thetext there is a short, five question quiz so that the students can “self test.”Frédéric Bastiat,“Candlemakers’ Petition.”(http://bastiat.org/en/petition.html)One of the most famous documents in the history of free-trade literature isBastiat’s famous parody,in which heimagined the makers of candles and street lamps petitioning the French Chamber ofDeputies for protection from a most dastardly foreign competitor, the sun.Example of how taxes destroy wealth;but they also create opportunities for thoseknow how to evadethemA [Massachusetts]lawmaker who voted to hike the state sales and alcohol taxes was spottedbrazenly piling booze in his car-adorned with his State House license plate-in the parking lot ofa tax-free New Hampshire liquor storeMilton Friedman,“The Social Responsibility of Business is to Increase its Profits,”The New York TimesMagazine, (Sept. 13, 1970).A clear articulation of what my colleagues in the Divinity School refer to as the “Andrew CarnegieDichotomy,” a company should make as much money for its shareholders as possible in order to letthem do “good” with the money, should they choose.Additional Anecdote: ZimbabweDiscuss the following article“Mugabe should heed the warnings of Hayek,” by Marian Tupy,Financial Times, Copyright2005 The Financial Times Limited, Published: July 27 2005Available online athttp://www.ft.com/cms/s/939cb766-fe3c-11d9-a289-00000e2511c8.htmlThe article summarizes the negative economic consequences associated with the expropriation of privateproperty of (white) commercial farmers in Zimbabwe in 2000.

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13.BENEFITS, COSTS, AND DECISIONSBackground: Variable, Fixed and Total CostsBackground: Accounting vs. Economic ProfitCosts Are What You Give UpFixed-or Sunk-Cost FallacyHidden-Cost FallacyEconomic Value Added®Does EVA® work?Psychological Biases and Decision-MakingMain Points•Costs are associated with decisions,notactivities.•Theopportunity costof an alternative is the profit you give up to pursue it.•In computing costs and benefits, considerallcosts and benefits that vary with the consequencesof a decision andonlythose costs and benefits that vary with the consequences of the decision.These are therelevant costsandbenefitsof a decision.•Fixed costsdo not vary with the amount of output.Variable costschange as output changes.Decisions that change output will change only variable costs.•Accounting profit does not necessarily correspond to real or economic profit.•Thefixed-cost fallacyorsunk-cost fallacymeans that you consider irrelevant costs. A commonfixed-cost fallacy is to let overhead or depreciation costs influence short-run decisions.•Thehidden-cost fallacyoccurs when you ignore relevant costs. A common hidden-cost fallacy isto ignore the opportunity cost of capital when making investment or shutdown decisions.•EVA® is a measure of financial performance that makesvisiblethe hidden cost of capital.•Rewarding managers for increasing economic profit increases profitability, but evidence suggeststhat economic performance plans work no better than traditional incentive compensation schemesbased on accounting measures.Teaching NoteThe main point of this lecture is to get students to understand that costs and decisions are intrinsicallyrelated to one another.Illustrate this with a simple decision tree, choosing between two mutuallyexclusive alternatives, and the profit associated with each alternative.The benefit of each alternative isthe profit associated with the alternative, and the cost is the forgone profit of the alternative not chosen.Benefit-cost analysis is easy in principle, but difficult in practice (which is why business school costs somuch).Remind them that whenever they get confused about applying benefit-cost analysis, step back andrecall what decision you are trying to make. Then compute the profit of each alternative, and choose theone with the highest profit.Drill this last point home:“if you start your analysis by looking at costs, you will always becomeconfused; if you start your analysis with a question, you will never get confused.”CONSIDER ALLCOSTS THAT VARY WITH THE CONSEQUENCES OF A DECISION; BUT ONLY COSTS THATVARY WITH THE CONSEQUENCE OF A DECISION.Then bait the students by looking at one and asking where she works and asking what are the costs of herdivision.If she “bites” and start listing the costs, yell at her and say “HAVEN’T YOU BEEN PAYINGATTENTION?” Costs are defined ONLY by the decision you are trying to make. For example, the costs

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2associated with a pricing decision are very different than the costs associated with a decision to outsourceproduction.Then tell them that there are only two mistakes they can make:ignoring relevant costs (the hidden-costfallacy) and taking into account irrelevant costs (the sunk-or fixed-cost fallacy). I illustrate the costs witha football game. Going to a game because you purchased the ticket cheaply even though you can scalp itfor much more (the hidden-cost fallacy); or staying past half time even though your team is losing badlybecause you want to get your money’s worth (sunk-cost fallacy).TABLE 3-2 Outsourcing a Washing Machine AgitatorThe second point of the lecture is to get students to understand the accounting costs are not economiccosts.Make fun of accountants as “bean counters.”In business the biggest sunk-cost fallacy isassociated with depreciation, and tell them the story in the text of a GE profitable outsourcing opportunitythat was NOT realized (see table above) because the accountants decided to dump the un-depreciatedtooling costs onto the manager’s income statement should he decide to outsource, which meant that themanager would forgo a $40,000 bonus, tied to division income.Point out thatthe accountants were justfollowing GAAP procedures (If you pronounce it as G-ah-ah-P, to make it sound like a sheep, studentswill laugh).You can have a lot of fun with this anecdote.Ask students how to fix this problem.Most will say thatthey should not penalize the division manager for doing the right thing, and say that senior managementshould step in to re-adjust his bonus?Then ask them what kind of incentive that this creates for divisionmanagers (they will complain to senior management about every decision that is not properly recognizedand rewarded).You can also shorten the depreciation time.Ask student if they still think this is a problem if the samemanager was the one who incurred the tooling costs 6 years ago? What about 1 year ago? (un-depreciatedassets of $900K.)They should come to the realization that if the division manager could have foreseenthat outsourcing would become profitable, then you should penalize him for making the wrong decision.But this also gives managers an incentive to ignore profitable outsourcing opportunities after they havemade investment decisions.You can also have an interesting discussion about ethics.Compare and contrast the behavior of thewashing machine plant manager who decided not to outsource even though outsourcing was moreprofitable alternative for GE, to the behavior of the oil company executives who deliberately overbid forthe oil in Chapter 1. Ask students what the difference is. Stake out a position that they were both doingwhat the company asked them to do through the incentives set up by the company. (Point out that this isa version of the Adolf Eichmann defense “I was just following orders”).

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3You can also ask for examples of the sunk cost fallacy in class. Corporate overhead often comes up.The biggest hidden cost fallacy is the hidden cost of capital (it does not appear in accounting statements).Here I like to talk about EVA® as making visible the hidden cost of capital.Success stories can bedownloaded from the Stern Stewart web site (http://www.sternstewart.com/).All it does is make visiblethe hidden cost of capital.In-class ProblemTell students that GM or Chysler is losing money, and ask a student if they would recommend shuttingdown. Ask them how much money GM would save by shutting down.Supplementary MaterialBlogEntriesManagerialEcon.com (Chapter 3)Auxiliary SlidesAmerican Made from “Outsourcing”“The 10 Principles ofEconomics”from the Standup EconomistReadingsMBAprimer.com,ManagerialEconomicsModule,Section2.“UnderstandingtheSeller’sCost”http://mbaprimer.comThis interactive, online hypertext includes a short, five question quiz so that the students can “selftest.” I give a very similar five question quiz to make sure that the students learn this material well.Samuel L. Baker,Economics Interactive Tutorials,http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html1. Total Cost, Variable Cost, and Marginal CostSimilar to the MBA Primer but with less attention to the graphic design aspects.Harvard Business School Note: “Relevant Costs and Revenues,” HBS 9-892-010This reading illustrates the idea that the relevant costs and revenues are those that vary with theconsequence of the decision.It goes through a couple of different decisions and identifies whichaccounting costs are relevant, and which are not.Additional Anecdote: Coca-ColaAs an example of a company that did not ignore its cost of capital, consider Coca-Cola in the 1980s. Ithad very little debt because it preferred to raise equity capital from its stockholders. It also had adiversified product line, including products like aquaculture and wine. But none of these activities earnedas much as its soft drink division. The opportunity cost of investing in these unrelated businesses was theforgone opportunity to expand the soft drink division, which at the time was earning a 16 percent returnon capital.Although these other businesses were earning a positive 10 percent rate of return on capital,the opportunity cost of that capital was 16 percent.CEO Robert Goizueta correctly decided to sell offthese under-performing divisions and invest the capital in its soft drink division.By makingdecisionswhosebenefitsweregreaterthantheircosts, thetopicofthischapter,Coca-Colaincreaseditsprofitability.

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14. EXTENT (HOW MUCH) DECISIONSBackground: Average and Marginal CostsMarginal AnalysisIncentive PayTie Pay to Performance Measures that Reflect EffortIf Incentive Pay is So Good, Why Don’t More Companies Use it?Main PointsDo not confuse average and marginal costs.Average cost(AC) is total cost (fixed and variable) divided by total units produced.Average cost is irrelevant to an extent decision.Marginal cost(MC) is the additional cost incurred by producing and selling one more unit.Marginal revenue(MR) is the additional revenue gained from selling one more unit.Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount(maximizing profit).The relevant costs and benefits of anextent decisionare marginal costs and marginal revenue. Ifthe marginal revenue of an activity is larger than the marginal cost, then do more of it.An incentive compensation scheme that increases marginal revenue or reduces marginal cost willincrease effort. Fixed fees have no effects on effort.A good incentive compensation scheme links pay to performance measures that reflect effort.Teaching NoteYou canbegin with the anecdote of the truck leasing company leasing too many trucks (see the additionalanecdote for this chapter) and note that this is an extent decision (“how much”).Who made the baddecision? Did they have enough information to make a good decision; and the incentive to do so?Depending on whether they have read the book, follow up with the anecdote of the hospital obstetricsdepartment whose head wanted to expand operations because the MR>MC.But the OB department lost$700 on each patient so the CEO was reluctant to expand. It illustrates the basic idea of the chapter, thatthe relevant costs and benefits of the decision arenotaverage costs but rather the marginal costs.Shutting down the OB department was not an option due to community pressure.After students get theright answer, remind them that whenever they get confused, go back to the decision they are trying tomake. Then the benefit cost analysis will be clear.Tell them that marginal analysis is simple—you break up the extent decision into tiny steps and takeanother step if the benefits of taking another step are bigger than the costs of taking another step.Marginal analysis can tell you ONLY which direction to step; it cannot tell you how far to step.Then go through a simple example, like the long distance phone company increasing TV advertising by$50,000 and this yielded 1,000 new customers; the cost of another customer is $50 (sometimes called“customer acquisition cost”).If the benefit of another customer is greater than $50, then do moreadvertising; if it is less, do less advertising. Stress that the informational requirements: marginal analysistells you only which direction to go, it does not tell you how far to go.Get there by taking steps, andrecomputing marginal costs and benefits.

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2Then compare two alternate ways of acquiring customers:TV advertising vs. phone solicitation.If yourecently cut back on phone solicitation expenditures by $10,000 and this lost you 100 customers, thencustomer acquisition costs by phone solicitation are $100/customer.So cut back further on phonesolicitation and use the savings to finance more TV advertising.Again, marginal analysis tells you onlywhich direction to move, not how far to move. When you make these changes, make them one at a timeso that you can gather information on the marginal effectiveness of each medium.Now that they think they understand this logic ask them the logging question:which bid should youaccept for a tract of timber containing 100 trees. One bid is for $150/tree, and the other bid is for $15,000for the right to harvest all the trees.If the forest is a mix of fir (worth $50/tree) and pine worth($150/tree) the logger will harvest only the pine.The second contract is essentially a fixed cost withrespect to the decision of how many trees to cut down, so the logger ignores it and cuts down all the trees.The decision of how hard to work is an extent decision and is governed by the logic of marginal analysis.Segue to the example ofwhich incentive compensation to use:a ten percentcommissionrate($1000/sale) or a five percent ($500/sale) commission rate plus a $50,000/year flat salary. Each year youexpect the salesperson to sell 100 units at a price of $10,000 per unit. If some sales are easy to make (costless than $500 of effort to make) and some sales are hard to make (cost more than $500 if effort) the salesperson will make only the easy sales under this weaker incentive compensation. Make the analogy: justas the higher MC of cutting trees reduced the incentive to cut, so too does the lower commission ratereduce the marginal benefit of making sales. Economists call this “shirking.”If you want to have fun, re-ask the “ethics” question: what is the difference between the sales person on5% commission who doesn’t make the hard sales and the senior management at the gas company whoover bid deliberately for the offshore oil tract. Insist that there is none.Illustratethe practical difficulties of instituting incentive pay (tie pay to performance measures that reflecteffort)with an anecdote. A consulting firm instituted incentive pay by moving the COO from a $75K flatsalary to a $50K salary plus 1/3 of every dollar his office earned over $150K.Ask someone why onlyearnings over $150K?(Because the first $150K would be earned with little or no effort).Earnings forthe incentive compensation contract were defined as the revenues minus the costs over which the COOhad control. Reinforce the point that accounting earnings are NOT related to the relevant marginal costsof effort.A separate set of books was kept that reflected employee effort.Ask students if theydiscovered the separate set of books, whether they would be suspicious that something illegal was goingon.In-class ProblemQUESTION: A firm recently spent $100 on Google Adwords and generated 100 extra visits to the firm’sweb site, 5 of which resulted in a purchase.To pay for the change, they dropped the banner advertisingon ESPN.com, saving $1000, but which also reduced the number of visits to their web site by 500, and 20fewer sales.Sales from visitors from ESPN.com were, on average, 25% higher than sales from visitorsfrom Googel Adwords.Evaluate the decision to shift advertising money from ESPN.com to GoogleAdwords.ANSWER:On Google Adwords, the marginal effectiveness of advertising is 1 sale for $20 dollars($100/5); while the marginal benefit of advertising on ESPN is 1 sale for $50 ($1000/20).But since asale from ESPN is more valuable than a sale on Google Adwords, 20 sales from ESPN.com is “equivalentto” 25 sales from Google Adwords, thus the marginal effectiveness of ESPN.com advertising is $1000/25or 1 sale for $40.

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3Supplementary MaterialBlog EntryManagerialEcon.com (Chapter 4)Auxiliary SlidesVideo on pandering for the marginal voter from “Swing Vote”ReadingsMBAprimer.com,ManagerialEconomicsModule,Section2.“UnderstandingSellers’Costs.”http://mbaprimer.comInteractive, online hypertext covers same material.At the end of the text there is a short, fivequestion quiz so that the students can “self test.”I give a very similar five question quiz to makesure that the students learn this material well.Samuel L. Baker,Economics Interactive Tutorials,http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html2. Marginal Cost and the Price-Taking Firm'sOptimal Output Rate4. Demand5. Elasticity6. Elasticity IISimilar to the MBA Primer but with less attention to the graphic design aspects.Harvard Business School Note:"Basic Quantitative Analysis for Marketing", HBS9-584-149.Break even quantities, prices, and relevant costs for marketing decisions.Harvard Business School Note:"A Note on Microeconomics for Strategists" pp 1-9, HBS9-799-128.Summarizes the core ideas about the microeconomics of markets that are most relevant to businessstrategy.Additional Anecdotes: Truck Leasing and American ExpressLeasing companiespurchase capital equipment, like airplanes or trucks, and then lease the equipment tothe firms that actually use them.On its face, it is hard to see why this is a wealth-creating transactionsince the end-users could borrow money and purchase the equipment themselves.The answer is thatbanks, due to the way they are regulated, are more willing to lend to companies with less debt. By leasingequipment, a company moves debt, albeit with assets, off its balance sheet, which makes it easier toborrow more heavily.The enhanced borrowing ability of low-debt companies makes leasing morevaluable than owning.In the fall of 2000, one such truck leasing company was having trouble making money. The companypurchased over-the-road trucks for $92,000 and then leased them to various transport companies, rangingfrom small owner-operators to large publicly owned firms with fleets of over a hundred trucks.The problem could be traced to incentives of the sales force. Salespeople who negotiated the leases werepaid a commission equal to $2,000 for each truck they leased, regardless of the profitability of the lease.Sales people responded to this incentive by leasing as many trucks as they could. The easiest way to dothis was to charge low rates, which resulted in low profits for the leasing company.

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4We call this an “extent” decision, because the company implicitly decided “how many” trucks to leasethrough its compensation scheme.In this chapter, we show how to identify and implement profitableextent decisions.American Expressoffers its Platinum Card to an affluent customer segment whose annual income isabove $100,000 USD.In 2001, there were approximately 2,000 Platinum cardholders in the Japanesemarket.To further its goal of delivering the most customer-oriented service among credit card providersin Japan, the company set a limit on the number of the Platinum cardholders. With technology advancing,however, the company began to consider whether it could expand the membership of the PlatinumCardholders without sacrificing the quality of service, thus increasing market share and profits.In order to maximize its profit, American Express needed to determine how many more members itshould acquire.As more members are acquired, average spending per card member decreases becausethe financial threshold for membership is lowered.At the same time, costs of customer service rise foreach additional platinum member added.Growing beyond a certain point would require building andoperating an additional call center. After analyzing the costs and benefits, American Express realized thatit should expand its offering to acquire a total of 15,000 Platinum Card members to maximize its profits.We call this an “extent” decision, because the company needed to decide “how many” platinum cards toprovide. In this chapter, we show you how to make profitable extent decisions.

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15. INVESTMENT DECISIONS: LOOK AHEAD AND REASON BACKHow to Determine whether Investments are ProfitableBreak-Even AnalysisChoosing the Right Manufacturing TechnologyShutdown Decisions and Break-Even PricesSunk Costs and Post-investment Hold-UpSolutions to the Hold-Up ProblemMain PointsInvestments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates (rate at which they valuefuture vs current dollars) lend to those with high discount rates.Companies, like individuals, have different discount rates, determined by their cost of capital.They invest only in projects that earn a return higher than the cost of capital.TheNPV rulestates that if the present value of the net cash flow of a project is larger than zero,the project earnseconomic profit(i.e., the investment earns more than the cost of capital).Although NPV is the correct way to analyze investments, not all companies use it. Instead, theyuse break-even analysis because it is easier and more intuitive.Break-even quantityis equal to fixed cost divided by the contribution margin. If you expect tosell more than the break-even quantity, then your investment is profitable.Avoidable costscan be recovered by shutting down. If the benefits of shutting down (you recoveryour avoidable costs) are larger than the costs (you forgo revenue), then shut down. The break-even price is average avoidable cost.If you incursunk costs, you are vulnerable topost-investment hold-up. Anticipate hold-up andchoose contracts or organizational forms that minimize the costs of hold-up.Once relationship-specific investments are made, parties are locked into a trading relationshipwith each other, and can be held up by their trading partners. Anticipate hold-up and chooseorganizational or contractual forms to give each party both the incentive to make relationship-specific investments and to trade after these investments are made.Teaching NoteContinuing with the theme that costs are related to decisions, this chapter identifies the relevant benefitsand costs of investment decisions. I begin with the anecdote of how TVA “held up” Mobil Oil after theymade a three month investment in an engineering audit of TVA’s lubrication needs, and tell studentsMobil did not “look ahead and reason back”, one of the main lessons of the chapter (this anecdote is at thebeginning of the Sunk Costs and Post-Investment Hold-Up section of the chapter).Start by talking about NPV analysis as an “if and only if” proposition. Investments cover the (hidden?)cost of capital if and only if they have a positive NPV. To set this up, talk about compounding anddiscounting as the inverse of compounding.Talk about behavior of people with high discount rates(smoking, uneducated, over weight), i.e., unwilling to undertake investments unless they return a lot ofmoney.Then talk about entry decisions, introduce break even quantities, and give an example. Thentell the storyof John Deere abandoning its large fixed cost but low MC factory in favor of buying Versatile, a companythat assembled off-the-shelf components in a large garage (low fixed cost, but high MC).If expected

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