mid term questions

MANAGERIALS IXTH ED I T ION

AND ORGANIZATIONAL ARCHITECTURE

JAMES A. BRICKLEY CLIFFORD W. SMITH JEROLD L. ZIMMERMAN

ECONOMICS

Managerial Economics and Organizational Architecture

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Managerial Economics and Organizational Architecture Sixth Edition

JAMES A. BRICKLEY CLIFFORD W. SMITH JEROLD L. ZIMMERMAN

William E. Simon Graduate School of Business Administration

University of Rochester

MANAGERIAL ECONOMICS AND ORGANIZATIONAL ARCHITECTURE, SIXTH EDITION

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Library of Congress Cataloging-in-Publication Data

Brickley, James A. Managerial economics and organizational architecture / James A. Brickley, Clifford

W. Smith, Jerold L. Zimmerman, William E. Simon, Graduate School of Business Administration, University of Rochester.—Sixth edition.

pages cm.—(The McGraw-Hill series in economics) ISBN 978-0-07-352314-9 (alk. paper)

1. Managerial economics. 2. Organizational effectiveness. I. Title. HD30.22.B729 2015 658—dc23

2014043202

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

Dedicated to our children— London, Nic, Alexander, Taylor, Morgan, Daneille, and Amy.

PREFACE The past few decades have witnessed spectacular business failures and scandals. In 2001 and 2002, Enron, WorldCom, Arthur Andersen, as well as other prominent com- panies imploded in dramatic fashion. Internationally, scandals emerged at companies such as Parmalat, Royal Dutch Shell, Samsung, and Royal Ahold. In 2007 and 2008, prominent financial institutions around the world shocked financial markets by reporting staggering losses from subprime mortgages. Société Générale, the large French bank, reported over $7 billion in losses due to potentially fraudulent securities trading by one of its traders. JPMorgan Chase bailed out Bear Stearns, a top-tier in- vestment bank, following their massive subprime losses. Washington Mutual and Lehman Brothers were added to the list of “top business failures of all time.”

Due to these cases and others, executives now face a more skeptical investment community, additional government regulations, and stiffer penalties for misleading public disclosures. A common perception is that bad people caused many of these problems. Others argue that the sheer complexity of today’s world has made it virtu- ally impossible to be a “good” manager. These views have raised the cry for in- creased government regulation, which is argued to be a necessary step in averting fu- ture business problems.

We disagree with this view. We suggest that many business problems result from poorly structured organizational architectures. The blueprints for many of these prominent business scandals were designed into the firms’ “organizational DNA.” This book, in addition to covering traditional managerial economic topics, examines how firms can structure organizations that channel managers’ incentives into actions that create, rather than destroy, firm value. This topic is critical to anyone who works in or seeks to manage organizations—whether for-profit or not-for-profit.

New Demands: Relevant Yet Rigorous Education Thirty years ago, teaching managerial economics to business students was truly a “dis- mal science.” Many students dismissed standard economic tools of marginal analysis, production theory, and market structure as too esoteric to have any real relevance to the business problems they anticipated encountering. Few students expected they would be responsible for their prospective employers’ pricing decisions. Most sought positions in large firms, eventually hoping to manage finance, operations, marketing, or information systems staffs. Traditional managerial economics courses offered few insights that obviously were relevant for such careers. But a new generation of economists began applying traditional economic tools to problems involving corporate governance, merg- ers and acquisitions, incentive conflicts, and executive compensation. Their analysis fo- cused on the internal structure of the firm—not on the firm’s external markets. In this book, we draw heavily from this research and apply it to how organizations can create value through improved organizational design. In addition, we present traditional economic topics—such as demand, supply, markets, and strategy—in a manner that emphasizes their managerial relevance within today’s business environment.

Today’s students must understand more than just how markets work and the prin- ciples of supply and demand. They also must understand how self-interested parties within organizations interact, and how corporate governance mechanisms can control these interactions. Consequently, today’s managerial economics course must cover a broader menu of topics that are now more relevant than ever to aspiring managers facing this post-Enron world. Yet, to best serve our students, offering

vi

Preface vii

relevant material must not come at the expense of rigor. Students must learn how to think logically about both markets and organizations. The basic tools of economics offer students the skill set necessary for rigorous analysis of business problems they likely will encounter throughout their careers.

Besides the heightened interest in corporate governance, global competition and rapid technological change are prompting firms to undertake major organizational restructurings as well as to produce fundamental industry realignments. Firms now attack problems with focused, cross-functional teams. Many firms are shifting from functional organizational structures (manufacturing, marketing, and distribution) to flatter, more process-oriented organizations organized around product or region. Moreover, this pace of change shows no sign of slowing. Today’s students recognize these issues; they want to develop skills that will make them effective executives and prepare them to manage organizational change.

Business school programs are evolving in response to these changes. Narrow tech- nical expertise within a single functional area—whether operations, accounting, fi- nance, information systems, or marketing—is no longer sufficient. Effective man- agers within this environment require cross-functional skills. To meet these challenges, business schools are becoming more integrated. Problems faced by man- agers are not just finance problems, operations problems, or marketing problems. Rather, most business problems involve facets that cut across traditional functional areas. For that reason, the curriculum must encourage students to apply concepts they have mastered across a variety of courses.

This book provides a multidisciplinary, cross-functional approach to managerial and organizational economics. We believe that this is its critical strength. Our interests span economics, finance, accounting, information systems, and financial in- stitutions; this allows us to draw examples from a number of functional areas to demonstrate the power of this underlying economic framework to analyze a variety of problems managers face regularly.

We have been extremely gratified by the reception afforded the first five editions of Managerial Economics and Organizational Architecture. Adopters report that the earlier editions helped them transform their courses into one of the most popular courses within their curriculum. This book has been adopted in microeconomics, human resources, and strategy courses in addition to courses that focus specifically on organizational economics. The prior editions were founded on powerful economic tools of analysis that examine how managers can design organizations that motivate self-interested individuals to make choices that increase firm value. Our sixth edition continues to focus on the fundamental importance of markets and organizational de- sign. We use the failures of Enron (Chapter 1), Société Générale (Chapter 1), Arthur Andersen (Chapter 22), and Adelphia (Chapter 10) as case studies to illustrate how poorly designed organizational architectures can be catastrophic. Other books provide little coverage of such managerially critical topics as developing effective organiza- tional architectures, including performance-evaluation systems and compensation plans; assigning decision-making authority among employees; and managing transfer- pricing disputes among divisions. Given the increased importance of corporate gover- nance, this omission has been both significant and problematic. Our primary objective in writing this book is to provide current and aspiring managers with a rigorous, sys- tematic, comprehensive framework for addressing such organizational problems. To that end, we have endeavored to write the underlying theoretical concepts in simple, intuitive terms and illustrate them with numerous examples—most drawn from actual company practice.

viii Preface

The Conceptual Framework Although the popular press and existing literature on organizations are replete with jargon—TQM, reengineering, outsourcing, teaming, venturing, empowerment, and cor- porate culture—they fail to provide managers with a systematic, comprehensive frame- work for examining organizational problems. This book uses economic analysis to develop such a framework and then employs that framework to organize and integrate the important organizational problems, thereby making the topics more accessible.

Throughout the text, readers will gain an understanding of the basic tools of eco- nomics and how to apply them to solve important business problems. While the book covers the standard managerial economics problems of pricing and production, it pays special attention to organizational issues. In particular, the book will help read- ers understand:

• How the business environment (technology, regulation, and competition in input and output markets) drives the firm’s choice of strategy.

• How strategy and the business environment affect the firm’s choice of organi- zational design—what we call organizational architecture.

• How the firm’s organizational architecture is like its DNA; it plays a key role in determining a firm’s ultimate success or failure, since it affects how people in the organization will behave in terms of creating or destroying firm value.

• How corporate policies such as strategy, financing, accounting, marketing, in- formation systems, operations, compensation, and human resources are inter- related and thus why it is critically important that they be coordinated.

• How the three key features of organizational architecture—the assignment of decision-making authority, the reward system, and the performance-evaluation

system—can be structured to help managers to achieve their desired results.

These three components of or- ganizational architecture are like three legs of the accompanying stool. Firms must coordinate each leg with the other two so that the stool remains functional. More- over, each firm’s architecture must match its strategy; a balanced stool in the wrong setting is dysfunc- tional: Although milking stools are quite productive in a barn, tavern owners purchase taller stools.

Reasons for Adopting Our Approach This book focuses on topics that we believe are most relevant to managers. For in- stance, it provides an in-depth treatment of traditional microeconomic topics (demand, supply, pricing, and game theory) in addition to corporate governance topics (assign- ing decision-making authority, centralization versus decentralization, measuring and

The components of organizational architecture are like three legs of a stool. It is important that all three legs be designed so that the stool is balanced. Changing one leg without the careful consideration of the other two is typically a mistake.

Performance Evaluation (What are the key performance measures

used to evaluate managers and employees?)

Rewards (How are people rewarded for meeting performance goals?)

Decision-Rights Assignment (Who gets to make what decisions?)

Preface ix

rewarding performance, outsourcing, and transfer pricing). We believe these topics are more valuable to prospective managers than topics typically covered in economics texts such as public-policy aspects of minimum-wage legislation, antitrust policy, and income redistribution. A number of other important features differentiate this book from others currently available, such as:

• Our book provides a comprehensive, cross-functional framework for analyzing organizational problems. We do this by first describing and integrating important research findings published across several functional areas, then demonstrating how to apply the framework to specific organizational problems.

• This text integrates the topics of strategy and organizational architecture. Students learn how elements of the business environment (technology, compe- tition, and regulation) drive the firm’s choice of strategy as well as the interaction of strategy choice and organizational architecture.

• Reviewers, instructors, and students found the prior editions accessible and engaging. The text uses intuitive descriptions and simple examples; more technical material is provided in appendices for those who wish to pursue it.

• Numerous examples drawn from the business press and our experiences illus- trate the theoretical concepts. For example, the effect of the 9/11 terrorist attacks on demand curves is described in Chapter 4 and how one devastated company located in the World Trade Center responded is discussed in Chapter 14. These illustrations, many highlighted in boxes, reinforce the underlying principles and help the reader visualize the application of more abstract ideas. Each chapter begins with a specific case history that is used throughout the chapter to unify the material and aid the reader in recalling and applying the main constructs.

• Nontraditional economics topics dealing with strategy, outsourcing, leader- ship, organizational form, corporate ethics, and the implementation of man- agement innovations are examined. Business school curricula often are criti- cized for being slow in covering topics of current interest to business, such as corporate governance. The last six chapters examine recent management trends and demonstrate how the book’s framework can be used to analyze and understand topical issues.

• Problems, both within and at the end of chapter, are drawn from real organiza- tional experience—from the business press as well as our contact with execu- tive MBA students and consulting engagements. We have structured exercises that provide readers with a broad array of opportunities to apply the framework to problems like ones they will encounter as managers.

Organization of the Book • Part 1: Basic Concepts lays the groundwork for the book. Chapter 2 summa-

rizes the economic view of behavior, stressing its management implications. Chapter 3 presents an overview of markets, provides a rationale for the exis- tence of organizations, and stresses the critical role of the distribution of knowledge within the organization.

• Part 2: Managerial Economics applies the basic tools of economic theory to the firm. Chapters 4 through 7 cover the traditional managerial-economics top- ics of demand, production and cost, market structure, and pricing. These four chapters provide the reader with a fundamental set of microeconomic tools and

use these tools to analyze basic operational policies such as input, output, and product pricing decisions. Chapters 8 and 9 focus on corporate strategy—the former on creating and capturing values and the latter on employing game the- ory methods to examine the interaction between the firm and its competitors, suppliers, as well as other parties. These chapters also provide important background material for the subsequent chapters on organizations: A robust understanding of the market environment is important for making sound orga- nizational decisions. Chapter 10 examines conflicts of interest that exist within firms and how contracts can be structured to reduce or control these conflicts.

• Part 3: Designing Organizational Architecture develops the core frame- work of the book. Chapter 11 provides a basic overview of the organiza- tional-design problem. Chapters 12 and 13 focus on two aspects of the as- signment of decision rights within the firm—the level of decentralization chosen for various decisions followed by the bundling of various tasks into jobs and then jobs into subunits. Chapters 14 and 15 examine compensation policy. First we focus on the level of compensation necessary to attract and retain an appropriate group of employees. We then discuss the composition of the compensation package, examining how the mix of salary, fringe ben- efits, and incentive compensation affects the value of the firm. In Chapters 16 and 17, we analyze individual and divisional performance evaluation. Part 3 concludes with a capstone case on Arthur Andersen.

• Part 4: Applications of Organizational Architecture uses the framework that we have developed to provide insights into contemporary management is- sues. Chapters 18 through 23 discuss the legal form of organization, outsourc- ing, leadership, regulation, ethics, and management innovations.

Fitting the Text into the Business Curriculum Our book is an effective tool for a variety of classes at the MBA, executive MBA, and undergraduate level. Although this text grew out of an MBA elective course in the eco- nomics of organizations at the University of Rochester, the book’s modular design al- lows its use in a variety of courses. We have been encouraged by the creativity instruc- tors have shown in the diversity of courses adopting this text. Besides the introductory microeconomics course, this book also is used in elective courses on corporate gover- nance, strategy, the economics of organizations, and human resources management. The basic material on managerial economics is presented in the first 10 chapters. The tools necessary for understanding and applying the organizational framework we de- velop within this text have been selected for their managerial relevance. In our experi- ence, these economics tools are invaluable for those students with extensive work experience, and for those who didn’t major in economics as an undergraduate. Those with an economics background may choose to forgo components of this material. We have structured our discussions of demand, production/cost, market structure, pricing, and strategy to be optional. Thus, readers who do not require a review of these tools can skip Chapters 4 through 9 without loss of continuity.

We strongly recommend that all readers cover Chapters 1 through 3 and 10; these chapters introduce the underlying tools and framework for the text. Chapters 4 through 9, as we noted above, cover the basic managerial-economics topics of demand, costs, production, market structure, pricing, and strategy. Chapters 11 through 17 develop the organizational architecture framework; we recommend that these be covered in

x Preface

sequence. Finally, Chapters 18 through 23 cover special managerial topics: outsourc- ing, leadership, regulation, ethics, and the process of management innovation and man- aging organizational change. They are capstone chapters—chapters that apply and il- lustrate the framework. Instructors can assign them based on their specific interests and available time.

Sixth Edition This book is noted for using economics to analyze real-world management problems. The sixth edition maintains and extends this focus. Changes from the fifth edition include:

• Learning objectives have been added to focus on the core concepts of the chap- ter to aid in the assessment of learning outcomes.

• Extended and more in-depth coverage of important managerial economics concepts, including supply and demand analysis, comparative advantage, con- stant versus increasing cost industries, price competition with differentiated products, inter-temporal decisions (Fisher Separation Theorem) and behav- ioral economics.

• Managerial applications, examples, exhibits, and other boxed materials have been updated.

• Key managerial insights from important recent research in organizational economics have been added.

• Data has been updated, where appropriate.

• We have responded in various ways to reader feedback from earlier editions.

Supplements The following ancillaries are available for quick download and convenient access via the Instructor Library material available through McGraw-Hill Connect®.

• PowerPoint Presentations: Fully updated for the sixth edition, each chapter’s PowerPoint slides are closely tied to the book material and are enhanced by animated graphs. You can edit, print, or rearrange the slides to fit the needs of your course.

• Test Bank: The test bank offers hundreds of questions categorized by level of difficulty, AACSB learning categories, Bloom’s taxonomy, and topic.

• Computerized Test Bank: McGraw-Hill’s EZ Test is a flexible and easy-to- use electronic resting program that allows you to create tests from book- specific items. It accommodates a wide range of question types and you can add your own questions. Multiple versions of the test can be created and any test can be exported for use with course management systems. EZ Test Online gives you a place to administer your EZ Test-created exams and quizzes online. Addition- ally, you can access the test bank through McGraw-Hill Connect®.

• Instructor’s Manual: The instructor’s Manual provides chapter overviews, teaching tips, and suggested answers to the end-of-chapter Self-Evaluation Problems and Review Questions.

Preface xi

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xii Preface

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xiv

ACKNOWLEDGMENTS No textbook springs from virgin soil. This book has its intellectual roots firmly planted in the work of dozens who have toiled to develop, test, and apply organiza- tion theory. As we detailed in the preface to the first edition, the genesis of this book was a course William Meckling and Michael Jensen taught on the economics of or- ganizations at the University of Rochester in the 1970s. Bill’s and Mike’s research and teaching stimulated our interest in the economics of organizations, prompted much of our research focused on organizational issues, and had a profound effect on this text. No amount of citation or acknowledgments can adequately reflect the encouragement and stimulation that they provided, both personally and through their writings.

Bill and Mike emphasized three critical features of organizational design: (1) the assignment of decision rights within the organization, (2) the reward system, and (3) the performance-evaluation system. These three elements, which we call organi- zational architecture, serve as an important organizing device for this book. As read- ers will discover, this structure offers a rich body of knowledge useful for managerial decision making.

Important contributions to the literature on the economics of organizations have been made by a host of scholars. Through the work of these individuals, we have learned a tremendous amount. A number of our colleagues at Rochester also con- tributed to the development of the book. Ray Ball, Rajiv Dewan, Shane Heitzman, Scott Keating, Stacey Kole, Andy Leone, Glenn MacDonald, Larry Matteson, David Mayers, Kevin Murphy, Michael Raith, Mike Ryall, Greg Schaffer, Ronald Schmidt, Larry Van Horn, Karen Van Nuys, Ross Watts, Gerald Wedig, Michael Weisbach, and Ron Yeaple offered thoughtful comments and suggestions that helped to clarify our thinking on key issues. Don Chew, editor of the Journal of Applied Corporate Fi- nance, provided invaluable assistance in publishing a series of articles based on the book; his assistance in writing these articles improved the exposition of this book enormously. Our collaboration with Janice Willett on Designing Organizations to Create Value: From Strategy to Structure (McGraw-Hill, 2003) enriched our under- standing and exposition of many important topics.

This project also has benefited from an extensive development effort. In addition to generations of Simon School students, dozens of colleagues both in the United States and overseas formally reviewed the manuscript and gave us detailed feedback, for which we are very grateful. We offer our sincere thanks to following reviewers, for their thorough and thoughtful suggestions:

Avner Ben-Ner, University of Minnesota Arnab Biswas, University of West Florida Ben Campbell, The Ohio State University Xiujian Chen, Binghampton University Kwang Soo Cheong, John Hopkins University Abbas Grammy, California State University—Bakersfield Charles Gray, University of Saint Thomas Folke Kafka, University of Pittsburgh Brian Kench, University of Tampa Tom Lee, California State University—Northridge Matthew Metzgar, University of North Carolina Ronald Necoechea, Roberts Wesleyan College Harlan Platt, Northeastern University

Acknowledgments xv

Farhad Rassekh, University of Hartford Amit Sen, Xavier University Richard Smith, University of California—Riverside Neil Younkin, Saint Xavier University

We owe special thanks to Henry Butler, Luke Froeb, Mel Gray, and Chris James; each provided insightful comments on the material. In addition, we are grateful for feedback from over 500 individuals who completed various surveys. Their thoughts served to guide our refinement of this work. We appreciate the efforts of Kathleen DeFazio who provided secretarial support. Finally, we wish to thank our colleagues at McGraw-Hill/Irwin—especially Mike Junior—for their encouragement to pursue this project. Through their vision and publishing expertise, they provided us with insights and feedback to help expand our audience while adhering to our mission.

This book represents the current state of the art. Nonetheless, development is on- going as the research evolves and as we continue to learn. Managerial Economics and Organizational Architecture covers an exciting, dynamic area. We hope that a small portion of that excitement is communicated through this text. Reviewers, instructors, and students frequently mention the relevance of material to the business community, the accessibility of the text, and the logical flow within the text’s framework. However, in the final analysis, it is instructors and their students who will determine the true value of our efforts.

We appreciate the extensive feedback we have received from many readers; their generous comments have improved this edition substantially. Although we had a def- inite objective in mind as we wrote this book, it is important to be open to sugges- tions and willing to learn from others who are traveling a similar yet distinct path. Al- though we are unlikely to please everyone, we will continue to evaluate suggestions critically and to be responsive where consistent with our mission. If readers would like to share their thoughts on this work or their classroom experiences, please feel free to contact any of us at the University of Rochester. Many thanks in advance for the assistance.

[email protected] [email protected]

[email protected]

xvi

Contents in Brief

Part 1: Basic Concepts

Chapter 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 2 Economists’ View of Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Chapter 3 Exchange and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

Part 2: Managerial Economics

Chapter 4 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Chapter 5 Production and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Chapter 6 Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Chapter 7 Pricing with Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Chapter 8 Economics of Strategy: Creating and Capturing Value . . . . . . . . . . 257 Chapter 9 Economics of Strategy: Game Theory . . . . . . . . . . . . . . . . . . . . . . . 296 Chapter 10 Incentive Conflicts and Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 329

Part 3: Designing Organizational Architecture

Chapter 11 Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355 Chapter 12 Decision Rights: The Level of Empowerment . . . . . . . . . . . . . . . . . 376 Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits . . . . . . . . 410 Chapter 14 Attracting and Retaining Qualified Employees . . . . . . . . . . . . . . . . 438 Chapter 15 Incentive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469 Chapter 16 Individual Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 502 Chapter 17 Divisional Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 537

Capstone Case Study on Organizational Architecture: Arthur Andersen LLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571

Part 4: Applications of Organizational Architecture

Chapter 18 Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578 Chapter 19 Vertical Integration and Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . 615 Chapter 20* Leadership: Motivating Change within Organizations . . . . . . . . . . . 654 Chapter 21 Understanding the Business Environment:

The Economics of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655 Chapter 22 Ethics and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . 684 Chapter 23* Organizational Architecture and the Process

of Management Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714

Index 715

Glossary* G-1

*These Web chapters and the Glossary can be found online via the Instructor Library material available through McGraw-Hill Connect®.

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Contents

Part 1: Basic Concepts Chapter 1: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Managerial Economics and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . 3

Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Economic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

Economic Darwinism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Survival of the Fittest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Economic Darwinism and Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Purpose of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Our Approach to Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

Chapter 2: Economists’ View of Behavior . . . . . . . . . . . . . . . . . . . . .14 Economic Behavior: An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

Economic Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 Marginal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Creativity of Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18

Graphical Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Individual Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Indifference Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Opportunities and Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Individual Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Changes in Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Motivating Honesty at Merrill Lynch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Alternative Models of Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Only-Money-Matters Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Happy-Is-Productive Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Good-Citizen Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Product-of-the-Environment Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Which Model Should Managers Use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Behavioral Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Decision Making under Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Expected Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Variability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Certainly Equivalent and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Risk Aversion and Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Appendix A: Consumer Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem . . . . . . 61

xviii Contents

Chapter 3: Exchange and Markets . . . . . . . . . . . . . . . . . . . . . . . . . 66 Goals of Economic Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Property Rights and Exchange in a Market Economy . . . . . . . . . . . . . . . . . . . . . . . 68

Dimensions of Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Basics of Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 The Price Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Shifts in Curves versus Movements along Curves . . . . . . . . . . . . . . . . . . . . . .79 Using Supply and Demand Analysis for Qualitative Forecasts . . . . . . . . . . . .79 Linear Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Supply and Demand—Extended Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Price versus Quantity Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Short-Run versus Long-Run Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84 Industry Cost Increases and Price Adjustments . . . . . . . . . . . . . . . . . . . . . . . .86

Prices as Social Coordinators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Efficient Exchange and Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90 Measuring the Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Externalities and the Coase Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

Markets versus Central Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 General versus Specific Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Knowledge Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 Specific Knowledge and the Economic System . . . . . . . . . . . . . . . . . . . . . . 102 Incentives in Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Contracting Costs and Existence of Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Contracting Costs in Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Contracting Costs within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

Managerial Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Appendix: Shareholder Value and Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . 114

Part 2: Managerial Economics Chapter 4: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Demand Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Law of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Elasticity of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 Linear Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

Other Factors That Influence Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Prices of Related Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Other Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Industry versus Firm Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Network Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Product Attributes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Product Life Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Demand Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Interviews . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Price Experimentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142

Statistical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Appendix: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

Chapter 5: Production and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Production Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

Returns to Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .158 Returns to a Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159

Choice of Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162 Production Isoquants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162 Isocost Lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .164 Cost Minimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165 Changes in Input Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167

Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168 Cost Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169 Short Run versus Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .171 Minimum Efficient Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175 Learning Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .177 Economies of Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178

Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179 Factor Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .180 Cost Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .184 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .185 Appendix: The Factor-Balance Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .191

Chapter 6: Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195 Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195

Firm Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195 Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .198

Barriers to Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 Incumbent Reactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .202 Incumbent Advantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .203 Exit Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204

Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .206 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208

Nash Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208 Output Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .210 Price Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213 Cooperation and the Prisoners’ Dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . .214

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217

Chapter 7: Pricing with Market Power . . . . . . . . . . . . . . . . . . . . . . 223 Pricing Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .224 Benchmark Case: Single Price per Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225

Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225 Estimating the Profit-Maximizing Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . .228 Potential for Higher Profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231

Contents xix

Homogeneous Consumer Demands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .232 Block Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .232 Two-Part Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .233

Price Discrimination—Heterogeneous Consumer Demands . . . . . . . . . . . . . . . . . .234 Exploiting Information about Individual Demands . . . . . . . . . . . . . . . . . . . .236 Using Information about the Distribution of Demands . . . . . . . . . . . . . . . . .239

Bundling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .242 Other Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244

Multiperiod Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244 Strategic Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246 Legal Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .247

Implementing a Pricing Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .248 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250

Chapter 8: Economics of Strategy: Creating and Capturing Value . . . . . . . . . . . . . . . . . . . . .257

Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .258 Value Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .259

Production and Producer Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . .261 Consumer Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .261 Other Ways to Increase Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262 New Products and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Cooperating to Increase Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Converting Organizational Knowledge into Value . . . . . . . . . . . . . . . . . . . . .266 Opportunities to Create Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .267

Capturing Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .270 Superior Factors of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .273 A Partial Explanation for Walmart’s Success . . . . . . . . . . . . . . . . . . . . . . . . .278 All Good Things Must End . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280

Economics of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Benefits of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Costs of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284

Strategy Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Understanding Resources and Capabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Understanding the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Combining Environmental and Internal Analyses . . . . . . . . . . . . . . . . . . . . .287 Strategy and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . .288 Can All Firms Capture Value? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291

Chapter 9: Economics of Strategy: Game Theory . . . . . . . . . . . . . . 296 Game Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .297 Simultaneous-Move, Nonrepeated Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299

Analyzing the Payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299 Dominant Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .300 Nash Equilibrium Revisited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301 Competition versus Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303 Mixed Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .306 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .308

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Sequential Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310 First-Mover Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .312 Strategic Moves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .312 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .313

Repeated Strategic Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .314 Strategic Interaction and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . .316 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .318 Appendix: Repeated Interaction and the Teammates’ Dilemma . . . . . . . . . . . . . . .323

Chapter 10: Incentive Conflicts and Contracts . . . . . . . . . . . . . . . 329 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330 Incentive Conflicts within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332

Owner-Manager Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332 Other Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .334

Controlling Incentive Problems through Contracts . . . . . . . . . . . . . . . . . . . . . . . . .334 Costless Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335 Costly Contracting and Asymmetric Information . . . . . . . . . . . . . . . . . . . . . .338 Postcontractual Information Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340 Precontractual Information Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .343

Implicit Contracts and Reputational Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . .347 Incentives to Economize on Contracting Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . .349 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350

Part 3: Designing Organizational Architecture

Chapter 11: Organizational Architecture . . . . . . . . . . . . . . . . . . . . 355 The Fundamental Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357

Architecture of Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357 Architecture within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358

Architectural Determinants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .360 Changing Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364 Interdependencies and Complementarities within the Organization . . . . . . .365

Corporate Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366 When Management Chooses an Inappropriate Architecture . . . . . . . . . . . . . . . . . .370 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371

Evaluating Management Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .372 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .372

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .373

Chapter 12: Decision Rights: The Level of Empowerment . . . . . . . 376 Assigning Tasks and Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378 Centralization versus Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .380

Benefits of Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .380 Costs of Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382 Illustrating the Trade-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .385 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .389

Lateral Decision-Right Assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393

xxii Contents

Assigning Decision Rights to Teams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 Benefits of Team Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 Costs of Team Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .395 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .395

Decision Management and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .397 Decision-Right Assignment and Knowledge Creation . . . . . . . . . . . . . . . . . . . . . .399 Influence Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .401 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403 Appendix: Collective Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .407

Chapter 13: Decision Rights: Bundling Tasks into Jobs and Subunits . . . . . . . . . . . . . . . . . . .410

Bundling Tasks into Jobs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411 Specialized versus Broad Task Assignment . . . . . . . . . . . . . . . . . . . . . . . . . .411 Productive Bundling of Tasks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .415

Bundling of Jobs into Subunits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416 Grouping Jobs by Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .417 Grouping Jobs by Product or Geography . . . . . . . . . . . . . . . . . . . . . . . . . . . .419 Trade-offs between Functional and Product or Geographic Subunits . . . . . .420 Environment, Strategy, and Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . .423 Matrix Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424 Mixed Designs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426 Network Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426 Organizing within Subunits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426

Recent Trends in Assignments of Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . .427 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .432 Appendix: Battle of the Functional Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436

Chapter 14: Attracting and Retaining Qualified Employees . . . . . . 438 Contracting Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .440 The Level of Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441

The Basic Competitive Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441 Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .442 Compensating Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .444 Costly Information about Market Wage Rates . . . . . . . . . . . . . . . . . . . . . . . .446

Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .447 Reasons for Long-Term Employment Relationships . . . . . . . . . . . . . . . . . . .447 Costs of Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .448

Pay in Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .449 Careers and Lifetime Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .449 Influence Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .454

The Salary–Fringe Benefit Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .455 Employee Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .455 Employer Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457 The Salary–Fringe Benefit Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463

Chapter 15: Incentive Compensation . . . . . . . . . . . . . . . . . . . . . . . 469 The Basic Incentive Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .470

Incentives from Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473 Optimal Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474

Contents xxiii

Effective Incentive Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .476 Principal-Agent Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .476 Informativeness Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .482 Group Incentive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483 Multitasking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .485 Forms of Incentive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .486 Incentive Compensation and Information Revelation . . . . . . . . . . . . . . . . . . .487 Selection Effects of Incentive Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .488

Does Incentive Pay Work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .493 Appendix: Multitasking Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .498

Chapter 16: Individual Performance Evaluation . . . . . . . . . . . . . . . 502 Setting Performance Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .505

Time and Motion Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506 Past Performance and the Ratchet Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . .506

Measurement Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .507 Opportunism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .509

Gaming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510 Horizon Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .511

Relative Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .511 Within-Firm Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .512 Across-Firm Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .513

Subjective Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .513 Multitasking and Unbalanced Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .514 Subjective Evaluation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .515 Problems with Subjective Performance Evaluations . . . . . . . . . . . . . . . . . . .517

Combining Objective and Subjective Performance Measures . . . . . . . . . . . . . . . . .520 Team Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521

Team Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522 Evaluating Teams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524

Government Regulation of Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .525 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527 Appendix: Optimal Weights in a Relative Performance Contract . . . . . . . . . . . . . .533

Chapter 17: Divisional Performance Evaluation . . . . . . . . . . . . . . . 537 Measuring Divisional Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539

Cost Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539 Expense Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .542 Revenue Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .543 Profit Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .544 Investment Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .544

Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .549 Economics of Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .550 Common Transfer-Pricing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .556 Reorganization: The Solution If All Else Fails . . . . . . . . . . . . . . . . . . . . . . . .560

Internal Accounting System and Performance Evaluation . . . . . . . . . . . . . . . . . . . .560 Uses of the Accounting System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .560 Trade-offs between Decision Management and Decision Control . . . . . . . . .561

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564 Capstone Case Study on Organizational Architecture: Arthur Andersen LLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571

Part 4: Applications of Organizational Architecture

Chapter 18: Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . 578 Publicly Traded Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .580

Corporate Form of Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .580 Stock Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .581 Stock Ownership Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .581 Governance Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582

Separation of Ownership and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Incentive Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Survival of Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .583 Benefits of Publicly Traded Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . .583

Top-Level Architecture in U.S. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . .584 Sources of Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .585 Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .586 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .591 Top Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .594 External Monitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .598

International Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .601 Market Forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604 Sarbanes-Oxley Act of 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .606 Corporate Governance: An Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . .608 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .610 Web Appendix: Choosing among the Legal Forms of Organization . . . . . . . . . . . A-1

Chapter 19: Vertical Integration and Outsourcing . . . . . . . . . . . . . 615 Vertical Chain of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .617 Benefits of Buying in Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .620 Reasons for Nonmarket Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621

Contracting Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .624 Taxes and Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .626 Other Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .627

Vertical Integration versus Long-Term Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .627 Incomplete Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .628 Ownership and Investment Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .628 Specific Assets and Vertical Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . .629 Asset Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632 Other Reasons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633 Continuum of Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .634

Contract Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635 Contracting with Distributors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636

Free-Rider Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636 Double Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .638 Regulatory Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .641

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Trends in Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .642 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .645 Appendix: Ownership Rights and Investment Incentives . . . . . . . . . . . . . . . . . . . .650

Web Chapter 20: Leadership: Motivating Change within Organizations . . . . . . 654

Leadership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-3 Vision Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-3 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-4

Decision Making within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-5 Incentive Problems and Organizational Politics . . . . . . . . . . . . . . . . . . . . . .20-5 Understanding Attitudes toward Change . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-5

Changing Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-7 Proposal Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-9

Maintaining Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-9 Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-10 Distributional Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-10

Marketing a Proposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Careful Analysis and Groundwork . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Relying on Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Emphasizing a Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-13

Organizational Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-14 Sources of Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-14 Tying the Proposal to Another Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . .20-17 Coalitions and Logrolling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-18 Is Organizational Power Bad? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-19

The Use of Symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-20 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-21 Appendix: Strategic Value of Commitment and Crisis . . . . . . . . . . . . . . . . . . . . .20-23

Chapter 21: Understanding the Business Environment: The Economics of Regulation . . . . . . . . . . . . . . . . . . .655

Importance of Regulation to Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .656 Economic Motives for Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . .658

Defining and Enforcing Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . .658 Redressing Market Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .660 Redistributing Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666

Economic Theory of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .668 Demand for Regulation: Special Interests . . . . . . . . . . . . . . . . . . . . . . . . . . .669 Supply of Regulation: Politicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .669 Market for Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .671 Deadweight Losses, Transaction Costs, and Wealth Transfers . . . . . . . . . . . .674

Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .675 Restricting Entry and Limiting Substitutes . . . . . . . . . . . . . . . . . . . . . . . . . . .675 Forming Coalitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .678 On Business Participation in the Political Process . . . . . . . . . . . . . . . . . . . . .679

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .681

Chapter 22: Ethics and Organizational Architecture . . . . . . . . . . . 684 Ethics and Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .687

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Corporate Mission: Ethics and Policy Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . .689 Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .689 Value Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .690 Corporate Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .692 Economists’ View of Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . .693 Corporate Policy Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .695 Mechanisms for Encouraging Ethical Behavior . . . . . . . . . . . . . . . . . . . . . . .698

Contracting Costs: Ethics and Policy Implementation . . . . . . . . . . . . . . . . . . . . . .702 Codes of Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .704

Altering Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .705 Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .706 Corporate Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .709

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .710

Web Chapter 23: Organizational Architecture and the Process of Management Innovation . . . . . . . . . . . . . . . . .714

Management Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-3 The Demand for Management Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-5

The Rise of TQM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-6 Other Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-7

Why Management Innovations Often Fail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-8 Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-8 Underestimating Costs of Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-11 Failure to Consider Other Legs of the Stool . . . . . . . . . . . . . . . . . . . . . . . .23-12

Managing Changes in Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . .23-16 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-19

Index 715

Web Glossary G-1

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chapter

1 C H A P T E R O U T L I N E

Managerial Economics and Organizational Architecture

Organizational Architecture

Economic Analysis

Economic Darwinism

Survival of the Fittest

Economic Darwinism and Benchmarking

Purpose of the Book

Our Approach to Organizations

E nron Corporation was created in 1985 by the merger of two gas pipeline companies. Convinced that impending deregulation of the energy business would create opportunities for firms with the vi- sion to recognize and the willingness to exploit them, Enron moved

aggressively to build and implement an innovative business model. It was a pioneer in the trading of derivative securities tied to assets like natural gas, electricity, and coal. In its transformation from a traditional, capital- intensive gas pipeline company, it established a dramatically smaller re- liance on hard assets, a flatter management structure, and an entrepreneur- ial, risk-taking environment—one that was quite open to creative and unconventional products and practices. It garnered tremendous recognition for these accomplishments; for six years in a row, it was named “Most In- novative” among Fortune’s Most Admired Companies list.

By 2000, Enron operated in several different business segments: transportation and distribution, supplying gas and electric transmission ser- vices; wholesale services, providing energy services and other products to energy suppliers and other firms; retail services, offering business cus- tomers energy products and services; broadband services, providing various service providers with access to a fiber-optic cable network; and other busi- nesses, including water resources and wind energy. In 1990, 80 percent of Enron’s revenues came from its regulated gas pipeline business, but by 2000, over 90 percent of revenues came from its wholesale energy opera- tions and services segment. Enron’s management argued that vertically integrated giants—like ExxonMobil, whose balance sheet was awash with oil reserves, gas stations, refineries, and other hard assets—were dinosaurs. “In the old days, people worked for the assets,” said CEO Jeffrey Skilling. “We’ve turned it around—what we’ve said is the assets work for the people.”

To finance this rapidly expanding array of businesses Enron relied on its bright young CFO, Andrew Fastow. In addition to tapping traditional sources of debt and equity capital, Fastow made extensive use of sophisti- cated partnerships whose financing details were kept off Enron’s balance

Introduction

L E A R N I N G O B J E C T I V E S

1. Define organizational architecture and discuss how economics can be used to help managers solve organizational problems and structure more effective orga- nizational architectures.

2. Define Economic Darwinism and discuss its implications related to the bench- marking of business practices.

P A R T O N E B a s i c C o n c e p t s

2 Part 1 Basic Concepts

sheet.1 For example, to finance its water business, Enron formed Azurix Corporation and raised $695 million by selling one-third of the company to public investors. Enron also formed a partnership called the Atlantic Water Trust in which it held a 50 percent stake. Enron’s partner was Marlin Water Trust, which was marketed to in- stitutional investors. To help attract lenders, Enron guaranteed the debt with its own stock: If Enron’s credit rating fell below investment grade and the stock fell below a stipulated price, Enron itself would be responsible for the partnership’s $915 million debt.

So long as Enron prospered, these guarantees appeared to cost the company little. But several of Enron’s business segments began to experience significant problems. In late summer of 2000, a power shortage in California resulted in blackouts. Enron (along with other energy companies) was blamed by state politicians: California launched an investigation into price gouging by Enron and other power marketers. Enron’s investment in water concessions in Brazil and England ran into political ob- stacles. For instance, British regulators cut the rates that it was allowed to charge its customers. Enron had a 65 percent stake in a $3 billion power project in India. But the power plant became embroiled in a dispute with its largest customer, who refused to pay for electricity. Following the September 11, 2001, terrorist attacks, the pre- cipitous fall in oil prices generated losses for Enron’s trading operations, and tech- nology changes produced a glut of broadband services.

After reaching a peak of nearly $70 billion in August 2000, Enron’s market value collapsed. Its bankruptcy filing in December 2001 is one of the most spectacular business failures ever seen.2 November 2004 saw it emerge from one of the most complex bankruptcies in U.S. history. After 2006 Enron existed as an assetless shell corporation.

What went wrong? According to BusinessWeek,

Enron didn’t fail just because of improper accounting or alleged corruption at the top. . . . The unrelenting emphasis on earnings growth and individual initiative, coupled with a shocking absence of the usual corporate checks and balances, tipped the culture from one that rewarded aggressive strategy to one that increasingly relied on unethical corner cutting. In the end, too much leeway was given to young, inexperienced managers without the necessary controls to minimize failures. This was a company that simply placed a lot of bad bets on businesses that weren’t so promising to begin with.

Thus, BusinessWeek suggests, Enron’s problems were rooted in a fundamentally flawed organizational design. At fault were three key aspects of the company’s cor- porate structure. First, in the course of flattening its management structure, Enron delegated an extraordinary level of decision-making authority to lower-level em- ployees without retaining an appropriate degree of oversight. Second, performance was evaluated largely on near-term earnings growth and success in closing deals. Third, the company offered enormous compensation to its top performers, which en- couraged excessive risk taking. Enron’s internal risk management group was charged with reviewing deals, but the performance appraisals of the 180 employees within the group were based in part on the recommendations of the very people who

1It should be noted that Fastow was recognized by CFO Magazine in October 1999 with their CFO Excellence Award for Capital Structure Management.

2While the largest U.S. corporate bankruptcy at the time, Enron is now far from the largest. Lehman Brothers ($691 billion in 2008), Washington Mutual ($327 billion in 2008), WorldCom ($103.9 billion in 2002), General Motors ($91 billion in 2009 and CIT Group ($80.4 billion in 2009) were all greater in size.

Chapter 1 Introduction 3

generated the deals. Enron’s problems appear to stem, at least in part, from its organizational design.

Managerial Economics and Organizational Architecture Standard managerial economics books address a number of questions that are im- portant for organizational success:

• Which markets will the firm enter?

• How differentiated will the firm’s products be?

• What mix of inputs should the firm use in its production?

• How should the firm price its products?

• Who are the firm’s competitors, and how are they likely to respond to the firm’s product offerings?

Addressing these questions is certainly important—and in this book, we do—yet this tale of Enron’s implosion suggests that this list is woefully incomplete. It is also im- portant to address questions about the internal organization of the firm. A poorly de- signed organization can result in lost profits and even in the failure of the institution.

With the benefit of hindsight, it seems easy to identify elements of Enron’s orga- nization that, if changed, might have reduced the likelihood of its collapse. But the critical managerial question is whether before the fact one reasonably could be ex- pected to identify the potential problems and to structure more productive organiza- tions. We believe the answer to this fundamental managerial question is a resound- ing yes. To examine these issues, a rich framework that can be applied consistently is required.

We are not, of course, the first to recognize the importance of corporate organiza- tion or to offer analysis of how to improve it. The business section of any good book- store displays a virtually endless array of prescriptions: benchmarking, empower- ment, total quality management, reengineering, outsourcing, teaming, corporate culture, venturing, matrix organizations, just-in-time production, and downsizing. The authors of all these books would strongly agree that the firm’s organization and the associated policies, adopted by management, can have profound effects on per- formance and firm value; and all buttress their recommendations with selected sto- ries of firms that followed their advice and realized fabulous successes.

The problem with such approaches, however, is that each tends to focus on a par- ticular facet of the organization—whether it be quality control, or worker empower- ment, or the compensation system—to the virtual exclusion of all others. As a con- sequence, the suggestions offered by the business press are regularly myopic. These publications tend to offer little guidance as to which tools are most appropriate in which circumstances. The implicit assumption of most is that their technique can be successfully adopted by all companies. This presumption, however, is invariably wrong. Ultimately, this literature fails to provide managers with a productive frame- work for identifying and resolving organizational problems.

Organizational Architecture

In contrast to the approach of most business best sellers, we seek to provide a sys- tematic framework for analyzing such issues—one that can be applied consistently in addressing organizational problems and structuring more effective organizations.

4 Part 1 Basic Concepts

In this book, we offer a framework that identifies three critical aspects of corporate organization:

• The assignment of decision rights within the company • The methods of rewarding individuals • The structure of systems to evaluate the performance of both individuals and

business units

Not coincidentally, these are the same three aspects of the organization we identified in the Enron case.

We introduce the term organizational architecture to refer specifically to these three key aspects of the firm. We hesitate to simply use “organization” to refer to these three corporate features because common usage of that term refers only to the organization’s hierarchical structure—that is, decision-right assignments and report- ing relationships—while it generally ignores the performance-evaluation and reward systems. We thus use organizational architecture to help focus specific attention on all three of these critical aspects of the organization.

Stated as briefly as possible, our argument is that successful firms assign decision rights in ways that effectively link decision-making authority with the relevant infor- mation for making good decisions. When assigning decision rights, however, senior leadership—including both management and the company's Board of Directors— must also ensure that the company’s reward and performance-evaluation systems pro- vide decision makers with appropriate incentives to make value-increasing decisions.

Depending on its specific circumstances, the firm will assign decision-making authority differently (some will decentralize particular decisions but centralize oth- ers) and will tailor its reward and performance-evaluation systems. Even though no two firms might adopt precisely the same architecture, successful firms ensure that these three critical aspects of organizational architecture are coordinated.

Our approach is integrative in the sense that it draws on a number of disciplines: accounting, finance, information systems, marketing, management, operations, politi- cal science, and strategy. But what also distinguishes our approach most clearly from that of the best sellers is our central reliance on the basic principles of economics.

Economic Analysis

Economics long has been applied to questions of pricing policy—for example, “how would raising the price of the firm’s products affect sales and firm value?” We ad- dress standard managerial-economics questions involving pricing, advertising, scale, and the choice of inputs to employ in production. In addition, we apply these same tools to examine questions of organizational architecture. For example, “how would changing a division from a cost center to a profit center change incentives, alter em- ployee decisions, and impact firm value?”

In essence, economics provides a theory to explain the way individuals make choices. For example, in designing organizations, it is important to keep in mind that individuals respond to incentives. Managers and employees can be incredibly re- sourceful in devising methods to exploit the opportunities they face. This also means, however, that when their incentives are structured inappropriately, they can act in ways that reduce the firm’s value. In choosing corporate policies, it is critical that managers anticipate potential responses by customers, suppliers, or employees that might produce undesirable outcomes. Neglecting to do so invites individuals to “game” the system and can result in utter failure of well-intentioned policies.

Chapter 1 Introduction 5

We use economics to examine how managers can design organizations that moti- vate individuals to make choices that will increase a firm’s value. For example, the evidence suggests that the problem highlighted in the accompanying box on chief executive officers slashing R&D budgets prior to their retirement is not widespread.3

The research suggests that these perverse incentives can be controlled by basing the CEO’s incentive compensation on stock prices and by managing CEO succession, so that decision rights are gradually transferred to the successor over the years prior to the final departure. Moreover, CEOs’ postretirement opportunities for election to board seats appear linked to performance over the final years of their tenure.4

Standard economic analysis generally characterizes the firm simply as a “black box” that transforms inputs (labor, capital, and raw materials) into outputs. Little consideration traditionally has been given to the internal architecture of the firm.5 In recent years, economists have focused more on questions of organizational architec- ture.6 But little effort has been devoted to synthesizing the material in an accessible form that emphasizes the managerial implications of the analysis. We apply the basic tools of economics to examine the likely effect on a firm’s value of decisions such as centralization versus decentralization, the bundling of tasks into specific jobs and jobs into business units within the firm, the use of objective versus subjective per- formance measures, compensating employees through fixed versus variable (or “in- centive”) compensation, and retaining activities within the firm versus outsourcing. In sum, we examine how managers can structure organizational architecture to mo- tivate individuals to make choices that increase the firm’s value.

R&D and Executive Turnover Suppose a firm links the CEO’s bonus to earnings and the CEO plans to retire in two years. The CEO might reduce the firm’s research and development budget to boost earnings this year and next. Five years down the road, earnings will suffer with no new products coming on stream. By then, however, this CEO will be long gone. In fact, research suggests that this can be a problem for some R&D-intensive firms.

Source: P. Dechow and R. Sloan (1991), “Executive Incentives and the Horizon Problem,” Journal of Accounting and Economics 14, 51–89.

ACADEMIC APPLICATIONS

3K. Murphy and J. Zimmerman (1993), “Financial Performance Surrounding CEO Turnover,” Journal of Accounting and Economics 16, 273–315.

4J. Brickley, J. Linck, and J. Coles (1999), “What Happens to CEOs after They Retire? New Evidence on Career Concerns, Horizon Problems, and CEO Incentives,” Journal of Financial Economics 52, 341–378.

5Of course, there are several notable exceptions: F. Knight (1921), Risk, Uncertainty, and Profit (London School of Economics: London); R. Coase (1937), “The Nature of the Firm,” Economica 4, 386–405; and F. Hayek (1945), “The Use of Knowledge in Society,” American Economic Review 35, 519–530.

6For example, R. Coase (1960), “The Problem of Social Cost,” Journal of Law and Economics 3, 1–44; S. Cheung (1969), “Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements,” Journal of Law and Economics 12, 23–42; A. Alchian and H. Demsetz (1972), “Production, Information Costs, and Economic Organization,” American Economic Review 62, 777–795; K. Arrow (1974), The Limits of Organization (W. W. Norton: New York); M. Jensen and W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, 305–360; Y. Barzel (1982), “Measurement Costs and the Organization of Markets,” Journal of Law and Economics 25, 27–48; O. Williamson (1985), The Economic Institutions of Capitalism: Firms, Markets, Rational Contracting (Free Press: New York); and B. Holmstrom and J. Tirole (1989), “The Theory of the Firm,” in R. Schmalensee and R. Willig (Eds.), Handbook of Industrial Economics (North-Holland: New York).

6 Part 1 Basic Concepts

In this analysis, ideas of equilibrium—the interplay of supply and demand in product, labor, and capital markets—represent important constraints on manager- ial decisions. Understanding how prices and quantities change in response to changes in costs, product characteristics, or the terms of sale is a critical manage- rial skill. For example, the more than five-fold increase in crude oil prices from below $12 per barrel in 1999 to over $135 in 2008 prompted oil companies to

MANAGERIAL APPLICATIONS

Economic Incentives and the Subprime Mortgage Crisis “Subprime mortgages” are made to borrowers who do not qualify for standard market interest rates because of problems with their credit histories or inability to prove that they have enough income to support the monthly payments. In March 2007, the value of U.S. subprime mortgages was estimated at $1.3 trillion with over 7.5 million mortgages outstanding. During the second half of 2007, investors in subprime mortgages such as banks, mortgage lenders, real estate investment trusts, and hedge funds reported losses of close to $100 billion as a result of subprime mortgage defaults and devaluations. The stock market fell and became quite volatile as more details about the mortgage crisis were revealed over time.

One important factor that contributed to this crisis was the incentives of the mortgage brokers that originated the loans. Mortgage brokers, who originated nearly 70 percent of residential mortgages in recent years, don’t lend their own money. They are paid for originating loans, which are sold to other investors who bear the primary risk. In many cases, the more loans they originate, the higher their compensation.

The financial incentives for originating mortgages motivated financial companies to offer products that made it easier for borrowers to qualify for the loans. For example, companies began offering “stated income loans” that required no proof of income. Consistent with the theory in this book, some borrowers overstated their incomes. In a recent review of 100 of these so-called liar loans, almost 60 percent of the stated amounts were exaggerated by over 50 percent. For example, in Atlanta a borrower received a $1.8 million loan by stating that he and his wife were top executives at a marketing firm who earned more than $600,000 per year with personal assets totaling $3 million. In reality, he was a phone company technician who earned $105,000 per year with savings of only $35,000.

The financial incentives and associated lack of controls produced not only risky loans but also billions of dollars of fraud. Rings of fraudulent borrowers would (1) recruit people with good credit to apply for very large loans using false income and asset statements, (2) find home appraisers to significantly inflate the values of the underlying properties, (3) pay the much lower asking prices to the sellers, and (4) pocket the difference, splitting the proceeds among the members of the ring. The houses then would go into foreclosure as the loans were not repaid.

Banking executives subsequently testified that they did not foresee this problem—“fraud was not really a consideration in our world.” The premise of this book is that a careful analysis of the underlying organizational architecture (incentives and decision-right assignments) can help managers anticipate these types of problems and develop mechanisms to reduce their severity.

Source: M. Corkery (2007), “Fraud Seen as a Driver in Wave of Foreclosures,” The Wall Street Journal (December 21), A1.

MANAGERIAL APPLICATIONS

Creative Responses to a Poorly Designed Incentive System A manager at a software company wanted to find and fix software bugs more quickly. He devised an incentive plan that paid $20 for each bug the Quality Assurance people found and $20 for each bug the programmers fixed. Since the programmers who created the bugs were also in charge of fixing them, they responded to the plan by creating bugs in software programs. This action increased their payoffs under the plan—there were more bugs to detect and fix. The plan was canceled within a single week after one employee netted $1,700 under the new program.

Source: S. Adams (1995), “Manager’s Journal: The Dilbert Principle,” The Wall Street Journal (May 22), A12.

Chapter 1 Introduction 7

increase production, encouraged petrochemical companies to alter their input mix to economize on a now-more-expensive input, made salespeople reevaluate their decisions about contacting potential customers by phone rather than in person, and encouraged auto producers to focus more on gas economy in the design of new models. Yet these incentives to change depend on the structure of the organization. For instance, a salesperson is less likely to switch to greater reliance on telephone and mail when the firm reimburses all selling expenses than when salespeople are responsible for the costs of contacting potential customers.

Economic Darwinism Survival of the Fittest7

The collapse of Enron, Charles Darwin might have noted, is an example of how com- petition tends to weed out the less fit. As described in The Origin of Species, natural history illustrates the principle of “survival of the fittest.” In industry, we see economic Darwinism in operation as competition weeds out ill-designed organiza- tions that fail to adapt. Competition in the marketplace provides strong pressures for efficient decisions—including organizational decisions. Competition among firms dictates that those firms with low costs are more likely to survive. If firms adopt in- efficient, high-cost policies—including their organizational architecture—competi- tion will place strong pressures on these firms to either adapt or close.

Fama and Jensen suggest that “the form of organization that survives in an activ- ity is the one that delivers the product demanded by customers at the lowest price while covering costs.” This survival criterion helps highlight that while a well- crafted organizational architecture can contribute to a firm’s success, it is not suffi- cient for success. The firm must have a business strategy that includes products for which the prices customers are willing to pay exceed costs. The potential for value creation by a company that manufactures only buggy whips is quite limited no mat- ter how well structured the firm’s organizational architecture.

Nonetheless, given a firm’s business strategy (including its product mix), its choice of organizational architecture can have an important impact on profitability and value. An appropriate architecture can lower costs by promoting efficient pro- duction; it also can boost the prices customers are willing to pay by helping to ensure high-quality production, reliable delivery, and responsive service.

Economic Darwinism and Benchmarking

In the biological systems that Darwin analyzed, the major forces at work were ran- dom mutations in organisms and shocks from the external environment (for instance, from changes in weather). But in the economic systems on which we focus, pur- poseful voluntary changes occur. For instance, in order to compete more effectively with Coke, Pepsi copied many of Coke’s practices. Pepsi spun off its fast-food chains

7This section draws on A. Alchian (1950), “Uncertainty, Evolution, and Economic Theory,” Journal of Political Economy 58, 211–221; G. Stigler (1951), “The Economics of Scale,” Journal of Law and Economics 1, 54–71; and E. Fama and M. Jensen (1983), “Separation of Ownership and Control,” Journal of Law and Economics 26, 301–325.

8 Part 1 Basic Concepts

(Taco Bell, KFC, and Pizza Hut) to focus on its core business—just as Coca Cola had done. Also, Pepsi changed its network of bottlers. One analyst remarked, “Pepsi is starting to look a lot more like Coke.”8 In fact, this practice has been formalized in the process of benchmarking.

Benchmarking generally means looking at those companies that are doing some- thing best and learning how they do it in order to emulate them. But this process also occurs in less formal ways. As Armen Alchian argued, “Whenever successful enter- prises are observed, the elements common to those observed successes will be asso- ciated with success and copied by others in their pursuit of profits or success.”9 For example, if the cover article in the next Fortune reports an innovative inventory con- trol system at Toyota, managers across the country—indeed, around the globe—will read it and ask, Would that work in my company, too? Undoubtedly, the managers with the strongest interest in trying it will be those within firms currently suffering inventory problems.10 Some will achieve success, but others may experience disas- trous results caused by unintended though largely predictable organizational “side effects” (like Fastow’s unchecked incentive for risk taking).

8N. Harris (1997), “If You Can’t Beat ’Em, Copy ’Em,” BusinessWeek (November), 50. 9A. Alchian. “Uncertainty, Evolution, and Economic Theory,” The Journal of Political Economy, Vol. 58, No. 3 (Jun., 1950), p. 218.

10This raises the question of why any firm with an innovative idea would voluntarily disclose it. Perhaps the free publicity outweighs the lost competitive advantage.

MANAGERIAL APPLICATIONS

Economic Darwinism: The Growth in Lead Directors The collapse of Enron in December 2001 and subsequent scandals at Adelphia, Tyco, WorldCom, and other companies in 2002 shook public confidence in corporate governance. In July 2002, the United States enacted the Sarbanes–Oxley Act, which mandated substantial changes in corporate accounting and governance practices. Additional scandals and failures during the 2007–2008 financial crisis raised additional concerns about corporate governance and motivated additional legislation and regulation.

These events altered the basic business environment for publicly traded corporations. Over the past decade, investors, regulators, stock exchanges, the media and the general public have placed increased pressure on corporate boards of directors to become more independent and diligent in their monitoring of CEOs. One important trend in corporate governance has been the large increase in presiding and lead directors. Presiding directors are independent directors (a director with no other direct ties to the company or corporate management) who chair executive sessions of outside directors. Lead directors are more powerful, taking on additional responsibilities (such as serving as the principal liaison between the independent directors and the CEI and taking the lead role in overseeing formal evaluations of board members and the CEO). In 2003, only 36 percent of S&P 500 firms had presiding or lead directors, compared to 90 percent in 2013. Over 60 percent of the S&P 500 firms with presiding or lead directors in 2013 employed the more powerful position of lead director.

If you were to benchmark the current governance practices of large publicly traded corporations, you would find the appointment of a lead director is a dominant surviving practice in the current business environment. “One size,” however, is unlikely to fit all firms. Managers should not simply adopt the prevailing organizational practices of other firms. More careful analysis is required.

Source: Spencer Stuart (2013), “Spencer Stuart Board Index 2013,” www.spencerstuart.com.

Chapter 1 Introduction 9

Although competition tends to produce efficiently organized firms over the longer run, uncritical experimentation with the organizational innovation du jour can ex- pose the firm to an uncomfortably high risk of failure. Organizational change is ex- pensive. Moreover, successful organizations are not just a collection of “good ideas.” The elements of a successful organization must be carefully coordinated: The differ- ent elements of the firm’s architecture must be structured to work together to achieve the firm’s goals. For this reason, it is important to be able to analyze the likely con- sequences of a contemplated organizational change and forecast its impact on the en- tire firm.

This concept of economic Darwinism thus has important managerial implica- tions. First, existing architectures are not random; there are sound economic ex- planations for the dominant organization of firms in most industries. Second, sur- viving architectures at any point in time are optimal in a relative rather than an absolute sense; that is, they are the best among the competition—not necessarily the best possible. Third, if the environment in which the firm operates changes—if technology, competition, or regulation change—then the appropriate organiza- tional architecture normally changes as well. These three observations together suggest that although improvements in architecture are certainly always possible, a manager should resist condemning prevailing structures without careful analysis. Before undertaking major changes, executives should have a good understanding of how the firm arrived at its existing architecture and, more generally, develop a broader perspective of why specific types of organizations work well in particular settings. Finally, an executive should be particularly skeptical of claimed benefits of proposed organizational changes if the environment has been relatively stable.

Purpose of the Book The primary thrust of this book is to provide a solid conceptual framework for ana- lyzing organizational problems and structuring an effective organizational architec- ture. The book also provides basic material on managerial economics and discusses how it can be used for making operational decisions—for example, input, output, and pricing decisions. This material additionally supplies a set of tools and an un- derstanding of markets, that is, important for making good organizational decisions.

MANAGERIAL APPLICATIONS

Organizing Xerox Service Center Xerox has developed an expert system to assist employees who answer the company service center’s 800 number to help callers who have problems with their photocopy machines. The system is designed to lead the employee through a set of questions to diagnose and fix the problem. If the machine operator cannot fix the problem with the assistance of the input from the service center employee, a service representative is dispatched to make a service call. This expert system is designed to evolve more effective prompts as experience accumulates. This will be accomplished by having service representatives call the service center after a service call. The nature of the problem and the actions taken are to be entered into the system. Xerox bases pay for the individuals who answer the 800 number on the number of service calls they handle; it bases compensation for service representatives on the number of service calls they make. Discuss the incentives these compensation practices create.

10 Part 1 Basic Concepts

Our Approach to Organizations

We begin with two basic notions: People act in their own self-interest, and individu- als do not all share the same information. As we have indicated, this framework sug- gests that the three critical elements of organizational architecture are the assignment of decision rights, the reward system, and the performance-evaluation system. Suc- cessful organizations assign decision rights in a manner that effectively links deci- sion-making authority with the relevant information to make good decisions. Corre- spondingly, successful organizations develop reward and performance-evaluation systems that provide self-interested decision makers with appropriate incentives to make decisions that increase the values of their organizations.

It is also important to note that modern organizations are extremely complex and that developing an understanding of how people within them behave is difficult. As in any book that addresses this set of topics, we face difficult trade-offs between adding more institutional richness to infuse more texture of the actual environment versus omitting details to keep the analysis more focused and manageable. At certain points (especially where little prior formal analysis of the problem exists), we take quite complex problems and discuss them in terms of simplified examples. Nonethe- less, our experience suggests that in these cases, we derive important managerial in- sights to these topics through our admittedly simple examples.

Finally, we believe that a powerful feature of this economic framework is that it can be extended readily to incorporate a broad array of other managerial policies such as finance, accounting, information systems, human relations, operations, and marketing. In this sense, this book can play an important integrating role across the entire business curriculum. Such integration is becoming increasingly important with the expanded use of cross-functional teams within the business community.

MANAGERIAL APPLICATIONS

Transfers of Organizational Architecture across the Global Economy In 1996, Tianjin Optical & Electrical Communication Group was typical of a Chinese state-owned company. Although the electronics manufacturer boasted skilled technicians, mismanagement left the company at the brink of bankruptcy. Motorola, Inc., changed that. It offered to take Tianjin Optical as a supplier, but only if Tianjin adopted the U.S. telecommunications company’s quality-control and management practices. By 1999, Tianjin Optical was selling a third of its production to Motorola and reported a small profit. “Now, we think we can survive,” says Zhang Bingjun, Tianjin Optical’s chairman.

Each Tianjin employee receives an average of two weeks a year in classroom instruction stressing modern management practices. That effort has paid off: The Tianjin assembly lines produce a slim cellular phone every 2 seconds with virtually the same defect rate as in Motorola’s U.S. plants. Motorola also provides training for more than 100 outside suppliers to boost the quality of their output. Motorola budgets about $2 million annually to “show [potential suppliers] Western management practices and create a mindset where they understand what we’re doing and why,” says a training director, Ying Shea.

This assistance in establishing a more effective organizational architecture and internal operating policies provided by a U.S. multinational corporation to its Chinese partners is but one example of the vital role that foreign businesses play within the Chinese business sector. Since China opened itself to foreign investment three decades ago, foreign companies have become an important conduit for economic reform. They have introduced not just modern production technology but also more efficient organizational architecture to the Chinese business community. Some estimates suggest that including these collateral benefits, foreign firms and their joint ventures account for as much as a fifth of China’s trillion-dollar economy.

Source: E. Guyot (1999), “Foreign Companies Bring China More Than Jobs,” The Wall Street Journal (September 15), A26.

1 2

Chapter 1 Introduction 11

ANALYZING MANAGERIAL DECISIONS: Société Générale

Société Générale was founded in the 1860s and in 2013 was France’s third largest bank. Beginning in the mid-1980s, it pioneered some of the most com- plex instruments in international finance and became a global powerhouse in trading derivatives like futures and options. Through its trading activities, the bank earned billions of dollars and gained the respect of bankers throughout the world. In January 2008, Risk, a monthly magazine about risk management, named Société Générale its “Equity Derivatives House of the Year.”

In late January 2008, Société Générale an- nounced that it had discovered fraudulent securities trading by one of its low-level traders, Jérôme Kerviel. The bank reported that it expected the fraud to cost it a staggering $7.14 billion, making it one of the largest financial frauds in history. The announcement shocked the financial markets and made front-page headlines around the world. Ob- servers questioned whether the bank could ever re- gain its former reputation and whether it could con- tinue to exist without merging with another bank.

Société’s CEO Daniel Bouton asserted that the fraud was the result of one employee’s illegal activ- ities, did not involve other employees at the bank, and represented the aberrant and unexplainable ac- tions of one “rogue trader.” He characterized Kerviel’s actions as “irrational” since the trades were made on behalf of the bank “netting the trader no personal gains.” Bouton emphasized that Kerviel was a low-level employee who had an an- nual salary and bonus for 2007 of less than $145,700.

In principle Kerviel engaged in a quite simple operation: arbitrage-trading on small differences between various stock market indexes such as the CAC in France and the DAX in Germany. Kerviel should have been able to lock in a virtually riskless profit by selling a security on the exchange with the higher price, while simultaneously buying an equiv- alent instrument on the exchange with the lower price. And although price differences are typically small, such arbitrage can produce a substantial profit if done in sufficient volume. In this arbitrage busi- ness, although Société Générale might accumulate large positions on both exchanges, those securities

that it bought and those it sold should balance. The bank was supposed to face little net exposure to price changes.

What the bank discovered was that Kerviel had bought securities on both markets. In effect, he had made enormous bets that European stock prices would increase. But they had fallen, and as a result the bank incurred a substantial loss.

The subsequent investigation revealed that Kerviel had been placing huge unhedged bets on European stocks for over a year. Prior to becoming a trader he had worked in the bank’s trading ac- counting office. His knowledge of the bank’s risk- management system allowed him to conceal the trades and bypass the firm’s control system. He knew the timing of the nightly reconciliation of the day’s trades and would delete and then re enter his unauthorized transactions without being caught. Bank managers, however, had apparently dismissed several warning signs about Kerviel’s transactions. For example, the surveillance office at Eurex, one of Europe’s biggest exchanges, alerted a compli- ance officer at the bank that for seven months a trader named Kerviel had engaged in “several transactions” that raised red flags. Kerviel’s super- visors accepted his explanations for these trades apparently without much investigation.

Various bank officials, investigators, and traders who worked with Kerviel have concluded that So- ciété Générale “allowed a culture of risk to flour- ish, creating major flaws in its operations” that en- abled Kerviel’s actions to proceed. Several current and former employees interviewed by the New York Times, indicated that Société Générale traders were rewarded for making risky investments with the bank’s money and that it was not uncommon for traders briefly to exceed limits imposed on their trading, despite controls meant to prohibit this ac- tivity. Risk taking apparently was “embraced, as long as it made money for the bank.” Top execu- tives and other managers at the bank had received large bonuses because of the bank’s successful trading operations.

Kerviel told investigators that all he wanted was to be respected and to earn a large bonus. He had come from a modest background and did not have the

12 Part 1 Basic Concepts

A. Alchian (1950), “Uncertainty, Evolution, and Economic Theory,” Journal of Political Economy 58, 211–221.

M. Jensen (1983), “Organization Theory and Methodology,” The Accounting Review 58, 319–339.

M. Jensen and W. Meckling (1992), “Specific and General Knowledge, and Organizational Struc- ture,” Journal of Applied Corporate Finance 8:2, 4–18.

1–1. Briefly describe Economic Darwinism.

1–2. The Wall Street Journal11 reports that

Franchisees, who pay fees and royalties in exchange for using franchisers’ business formats, have become much more militant in recent years about what they see as mistreatment by franchisers. In general, Ms. Kezios is seeking federal and state laws to give franchisees more power in franchise arrangements. Among her goals: creating legally pro- tected exclusive territories for franchisees.

How would you expect existing franchisees to react to this proposed regulation? How would you expect a potential new franchisee to react to this proposed regulation?

Solutions to Self-Evaluation Problems 1–1. Economic Darwinism is the economic counterpart of natural selection in biology. Competi-

tion in the marketplace weeds out those organizations that are less efficient and fail to adapt to the environment. The result is survival of the fittest.

1–2. Reducing the likelihood of encroachment by the franchiser benefits the existing franchisees to the extent that it shifts future profits from the franchiser to the franchisee. Thus, existing franchisees are likely to favor the proposed regulation. Potential new franchisees are less likely to favor the proposal. Presumably, they will have to pay a higher price for a new fran- chise if the franchiser has to grant the franchisee an exclusive territory. The potential fran- chisee might prefer to have a nonexclusive territory at a lower price. In any case, the fran- chiser is unlikely to favor the proposal; if it were efficient to convey exclusive territories, the original contract could have been structured that way.

1–1. What are the three aspects of organizational architecture?

1–2. In the process of benchmarking, a colleague of yours notes that Lincoln Electric, a producer of electric arc welders, has much higher productivity than does your company. Unlike your

Review Questions

Self-Evaluation Problems

Suggested Readings

educational pedigree of many of his coworkers who had advanced degrees in math or engineering from the prestigious Grandes Ecoles—the MITs of France. He was noted for working very long hours and had worked his way up in the bank from being a clerk to a trader. One of his primary goals was to have his supervisors recognize his “financial genius.”

1. Do you agree with Société Générale’s CEO that Kerviel’s actions were “irrational”?

2. Discuss how the bank’s organizational archi- tecture contributed to the problem.

3. What lessons might you learn from this case if you were an executive at another bank?

Source: This application is based on a series of articles from the New York Times published in early 2008. In particular see N. D. Schwartz and K. Bennhold, 2008, “A Trader’s Secrets, a Bank’s Missteps,” nytimes.com (February 5).

11J. A. Tannenbaum (1995), “Focus on Franchising: Franchisee Gains,” The Wall Street Journal (June 19), B2.

Chapter 1 Introduction 13

firm, Lincoln has an extensive piece-rate compensation system; much of its employees’ total compensation is simply the number of units produced times the piece rate for that type unit. Your colleague recommends that your company adopt a piece-rate compensation sys- tem to boost productivity. What do you advise?

1–3. In the life insurance industry, we see two major ownership structures—common stock in- surers and mutual insurers. In a common stock company, the owners—its stockholders—are a separate group from its customers—the policyholders. In a mutual, the policyholders are also the owners of the company. It has been argued that mutual insurance companies are dinosaurs—they are large, slow, bureaucratic, and inefficient. How would you respond to such an argument?

chapter

2 C H A P T E R O U T L I N E

Economic Behavior: An Overview

Economic Choice Marginal Analysis Opportunity Costs Creativity of Individuals

Graphical Tools Individual Objectives Indifference Curves Opportunities and Constraints Individual Choice Changes in Choice

Motivating Honesty at Merrill Lynch Managerial Implications Alternative Models of Behavior

Only-Money-Matters Model Happy-Is-Productive Model Good-Citizen Model Product-of-the- Environment Model

Which Model Should Managers Use? Behavioral Economics Decision Making under Uncertainty

Expected Value Variability Risk Aversion Certainty Equivalent and Risk Premium Risk Aversion and Compensation

Summary Appendix A: Consumer Choice Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem

I n May 2002, Merrill Lynch agreed to pay $100 million to settle charges that its analysts had recommended stocks to clients that they privately thought were poor investments. Internal e-mails provided strong sup- port for this claim leveled by the New York State attorney general. For

example, InfoSpace, an Internet services company, was rated highly in ana- lysts’ reports distributed to clients, yet privately the analysts suggested that it was a “powder keg” and a “piece of junk.” Although InfoSpace’s share price dropped from $261 to $14, Merrill analysts never recommended sell- ing the stock. Merrill analysts rated Excite@Home “accumulate or buy,” while privately the investment team called it a “piece of crap.”

This episode at Merrill sent shock waves through other major investment houses—indeed through the entire investment community. Other investment firms publicly stated that they were taking strong steps to make sure that the situation at Merrill would not be repeated within their organizations. Fortune magazine ran a cover story entitled, “In Search of the Last Honest Analyst.”1 The scandal generated significant concerns throughout the world among both the general public and government regulators. For example, the New York attorney general began a sweeping investigation of analysts at Salomon Smith Barney and other investment firms that had recommended WorldCom to investors. In July 2002, WorldCom became the biggest company ever to file for bankruptcy in U.S. history. In December 2002, the nation’s 10 top investment banks agreed to a $1.2 billion settlement with regulators aimed at “protecting investors from brokerages’ conflicts of interest.”

Economists’ View of Behavior

L E A R N I N G O B J E C T I V E S

1. Describe the economic model of behavior. 2. Define and apply marginal analysis in managerial decisions. 3. Define and apply the concept of opportunity costs. 4. Use graphs to explain, predict, and affect behavior in a wide range of

applications.

5. Contrast the implications of the economic model with those from other behavioral models used by some managers.

6. Identify the key concepts that are used to mitigate risk when making decisions under uncertainty.

1June 10, 2002, issue.

Chapter 2 Economists’ View of Behavior 15

Managers at Merrill, Salomon Smith Barney, and other investment companies had to act quickly to address this potential problem. As a first step, management had to understand what motivated the Merrill analysts to mislead their investment clients. Only then could they choose a policy to redress the situation. If management thought this problem was caused by a few dishonest employees, the appropriate response would have been to try to identify and fire those employees. If, instead, management believed the problem was caused by disgruntled employees taking out their frustra- tions on customers, a potential response would have been to adopt a job-enrichment program to increase employee satisfaction and, it would be hoped, analyst honesty. Alternatively, Merrill Lynch might have created incentives through its compensation plan that caused its analysts to issue misleading investment reports. If so, the appro- priate response would be to restructure its compensation plan. Many other assump- tions and responses are possible.

The example of Merrill Lynch illustrates a general point: Managers’ responses to problems are likely to depend on their understanding of people’s motives and their forecast of people’s reactions—their responses thus depend on their underlying model of behavior. Most managerial actions attempt to change the behavior of indi- viduals, such as employees, customers, union officials, or subcontractors. Managers with different understandings (or models) of what motivates behavior are likely to make different decisions and take different actions.

We begin this chapter by briefly summarizing the general framework economists use to examine individual behavior. Selected graphical tools are introduced to aid our analysis. Next, we use this economic framework to analyze the problem at Merrill Lynch. The managerial implications of this analysis are discussed. We contrast this economic view of behavior with alternative views and explore why the economic framework is particularly useful in managerial decision making. Finally, we analyze decision making under uncertainty. In Appendix A, we analyze the problem of con- sumer choice in more detail and in Appendix B, we illustrate how the graphical frame- work we present in this chapter can be used for analyzing inter-temporal choices.

Economic Behavior: An Overview Individuals have unlimited wants. People generally want greater wealth, more atten- tive service, larger houses, more luxurious cars, and additional personal material items. They want more time for leisure activities. Most also want to improve the plight of others—starving children, the homeless, and disaster victims. People are concerned about vitality, religion, integrity, and gaining the respect and affection of others.

In contrast to wants, resources are limited. Households face limited incomes that preclude all the purchases and expenditures that household members might like to make. The available amount of land, trees, and other natural resources is finite. There are only 24 hours in a day. People become ill; death is inevitable.

Economic Choice

Economic analysis is based on the notion that individuals assign priorities to their wants and choose their most preferred options from the available alternatives. If Kathy Measer is confronted with a choice between a laptop or a desktop computer, she can tell you whether she prefers one over the other or whether she is indifferent

16 Part 1 Basic Concepts

between the two. Depending on the relative prices of the two products, she purchases her preferred alternative. If Kathy has a weekly budget of $1,000, she considers the many ways she might spend the money and then chooses the package of goods and services that will maximize her personal happiness. She cannot make all desired pur- chases on her limited budget. However, this choice is optimal for Kathy, given her limited resources.

Economists do not assert that people are selfish in the sense that they care only about their own personal consumption. Within the economic paradigm, people also care about such things as charity, family, religion, and society. For instance, Kathy will donate $100 to her church, as long as the donation provides greater satisfaction than alternative uses of the money.

Economists, however, often assume for modeling purposes that people care only about their own wealth to simplify the analysis. While wealth is not the only thing that people care about, it is very important to most people. Economic models based on this simplifying assumption often perform quite well relative to more complicated models that add unnecessary complexity to the analysis. Some situations, however, can require models that are based on different assumptions.

Economists do not contend that individuals are supercomputers that make infalli- ble decisions. Individuals are not endowed with perfect knowledge and foresight, nor is additional information costless to acquire and process.2 For example, Kathy might order an item from a restaurant menu only to find that she dislikes what she is served. Within this economic paradigm, she simply does the best she can in the face of her imperfect knowledge. But she learns from her experience and does not repeat the same mistakes in judgment time after time.3

Marginal Analysis

Marginal costs and benefits are the incremental costs and benefits that are associated with making a decision.4 It is the marginal costs and benefits that are important in economic decision making. An action should be taken whenever the incremental benefits of that action exceed its incremental costs. Mary O’Dwyer has a contract to help sell products for an office supply company. She is paid $50 for every sales call that she makes to customers. Thus, Mary’s marginal benefit for making each addi- tional sales call is $50. Mary enjoys playing tennis more than selling. If she places a marginal value of more than $50 on the tennis that she would forgo by making an

2Economists sometimes use the idea of bounded rationality. Under this concept, individuals act in a purposeful and intendedly rational manner. However, they have cognitive limitations in storing, processing, and communicating information. It is these limitations which make the question of how to organize economic activity particularly interesting. H. Simon (1957), Models of Man (John Wiley & Sons: New York).

3At least this learning appears to occur outside the comics. For decades, Charlie Brown from Peanuts continued to try to kick the football held by Lucy van Pelt. Yet Lucy always pulled the ball at the last second. Few individuals are as incurably optimistic as Charlie Brown—they learn.

4Technical note: Marginal costs and benefits are typically defined as changes in costs and benefits associated with very small changes in a decision variable. For instance, the marginal costs of production are the additional costs from producing a small additional amount of the product (for instance, one more unit). Often decisions involve discrete choices, such as whether or not to build a new plant. In these cases, it is not possible to define a small change in the decision variable. Incremental costs and benefits are those costs and benefits which vary with such a decision. For our present discussion, the technical distinction between marginal and incremental is not important.

Chapter 2 Economists’ View of Behavior 17

extra call, she should not make any more sales calls that day—the marginal costs would have exceeded the marginal benefits. She continues to make additional sales calls as long as the reduction in tennis playing is valued at less than $50.5

Marginal analysis is a cornerstone of modern economic analysis. In economic de- cision making, “bygones are forever bygones.” Costs and benefits that have already been incurred are sunk (assuming they are nonrecoverable) and hence are irrelevant to the current economic decision. Mary paid $5,000 to join a tennis club last month. This fee does not affect her current decision of whether to play tennis or make an extra sales call. That expenditure is ancient history and does not affect Mary’s cur- rent trade-offs.

As another example, consider Ludger Hellweg who owns a company that installs wood floors. He is offered $20,000 to install a new floor. The cost of his labor and other operating expenses (excluding the wood) are $15,000. He has wood for the job in inventory. It originally cost him $2,000. Price increases have raised the market value of the wood to $6,000, and this value is not expected to change in the near fu- ture. Should he accept the contract?

He should compare the incremental costs and benefits from the project. The mar- ginal benefit is $20,000. The marginal cost is $21,000—$15,000 for the labor and operating expenses and $6,000 for the wood. The historic cost for the wood of $2,000 is not relevant to the decision. To replace the wood used on this job costs

MANAGERIAL APPLICATIONS

Marginal Analysis of Customer Profitability Banks often provide multiple products and services to the same customer (checking and savings accounts, mortgages, lines of credits, business loans, credit cards, international banking services, insurance, and so on). In the 1980s, most banks did not consolidate this information, and so it was difficult to determine if serving a given customer was profitable or not. Today many banks use “profitability software” to consolidate information on each customer. Many banks have found to their surprise that the incremental costs for serving many of their customers are larger than the incremental revenues. Fleet Bank, for example, found that as many as one-half of their customers were unprofitable. Armed with this information, banks work hard to maintain high-profit customers, while they either eliminate or alter services to unprofitable customers. For example, at many banks profitable customers are given special designations, such as “Gold Customer Status,” and the banks extend special services to them. Preferred customers are frequently given special toll free lines; branch managers are furnished with their names and are instructed to meet and greet them when they visit a branch. They are assigned personal bankers, who call and introduce themselves. Customers are assigned profitability codes, for example, so employees can know whether they are dealing with a 5, 4, 3, 2, or 1 type customer (five being most profitable). When the loans for unprofitable customers come up for renewal, they are renewed at a higher rate, to try to nudge them into profitability, or possibly to get the customers to take their business elsewhere. In contrast, loan applications by customers in the 4 and 5 categories are quickly processed and given special attention. Banks provide but one example of how firms are making increased use of information technology to do more sophisticated marginal analysis—devoting their efforts to customers and products where the incremental revenues are greater than the incremental costs and eliminating and avoiding unprofitable activities.

Source: A. Hughes (2014), “How Banks Use Profitability Analysis,” Database Marketing Institute, www.dbmarketing.com/ articles/Art195.htm.

5To keep this example simple, we abstract from several issues. We ignore any pleasure Mary receives from the process of selling. Also, selling effort today is likely to have some effect on her future professional progress. Finally, if Mary values a tennis game at 9 A.M. and one at 7 P.M. equally, she will sell during the business day and postpone tennis to the evening.

18 Part 1 Basic Concepts

$6,000. Since the marginal costs exceed the marginal benefits, Ludger would be bet- ter off rejecting the contract than accepting it. This example illustrates that in calcu- lating marginal costs, it is important to use the opportunity cost of the incremental resources, not their historic (accounting) cost.

Opportunity Costs

Because resources are constrained, individuals face trade-offs. Using limited re- sources for one purpose precludes their use for something else. For example, if Larry Matteson takes four hours to play golf, he cannot use that same four hours to paint his house. The opportunity cost of using a resource for a given purpose is its value in its best alternative use. The opportunity cost of using four hours to play golf is the value of using the four hours in Larry’s next best alternative use.

Marginal analysis frequently involves a careful consideration of the relevant op- portunity costs. If Larry starts a new pizza parlor and hires a manager at $30,000 per year, the $30,000 is an explicit cost (a direct dollar expenditure). Is he better off man- aging the restaurant himself, since he can avoid the explicit cost of $30,000 by not paying himself a salary? The answer to this question depends (at least in part) on the opportunity cost of his time. If he can earn exactly $30,000 in his best alternative job, the implicit cost of self-management is the same as the explicit cost of hiring an out- side manager: He forgoes $30,000 worth of income if he manages the parlor himself. Both explicit and implicit costs are opportunity costs that should be considered in the analysis. Suppose that Larry’s gross profit from the pizza parlor, before paying the manager a salary, is $35,000 and that he can earn $40,000 in an outside job. Hiring a manager for $30,000 yields a net profit of $5,000 from the pizza parlor. He also earns $40,000 from the outside job, for total earnings of $45,000. If he manages the pizza parlor himself, he earns only $35,000. In this example, it is better for him to work at the outside job and hire a manager to run the restaurant.6

Creativity of Individuals7

Within this economic framework, individuals maximize their personal satisfaction given resource constraints. Indeed, people are quite creative and resourceful in min- imizing the effects of constraints. For instance, when the government adopts new

MANAGERIAL APPLICATIONS

Opportunity Costs and V-8 The Campbell Soup Company used the idea of an opportunity cost to create a successful ad campaign for its V-8 vegetable juice. Upon finishing a soft drink, the fellow in the ad would look into the camera, slap his forehead, and exclaim: “Wow—I coulda had a V-8.” Since one is unlikely to drink both a soft drink and a V-8, the opportunity cost of the soft drink is the forgone V-8—a cost that these commercials sought to convince the viewing audience is quite high.

6Again, to keep the example simple, we assume there is no difference in personal satisfaction between Larry’s outside job and managing the pizza parlor. We also postpone the discussion of consequences for the success of the pizza parlor from hiring a manager versus self-management until Chapter 10.

7This section draws on W. Meckling (1976), “Values and the Choice of the Model of the Individual in the Social Sciences,” Schweizerische Zeitschrift für Volkswirtschaft und Statistik 112, 545–560.

Chapter 2 Economists’ View of Behavior 19

taxes, almost immediately accountants and financial planners begin developing clever ways to reduce their impact. Some self-employed individuals were able to re- duce the impact of recent tax increases by changing their status from a proprietorship to a corporation.

As another example, a 33-year-old Brazilian farm hand recently retired with full social security benefits after he satisfied social security auditors that he had been

ANALYZING MANAGERIAL DECISIONS: Marginal Analysis

You own a business that services trucks. A cus- tomer would like to rent a truck from you for one week, while you service his truck. You must decide whether or not to do this.

You have an extra truck that you will not use for any other purpose during this week. This truck is leased for a full year from another company for $300/week plus $.50 for every mile driven. You also have paid an annual insurance premium, which costs $50/week to insure the truck. The truck has a full 100-gallon fuel tank.

The customer has offered you $600 to rent the truck for a week. This price includes the 100 gal- lons of fuel that is in the tank. It also includes up to 500 miles of driving. The customer will pay $.50 for each additional mile that he drives above the 500 miles. You anticipate that the customer will

bring back the truck with an empty fuel tank and will have driven more than 500 miles. You sell fuel to truckers at a retail price of $4.00/gallon. Any fuel you sell or use can be replaced at a wholesale price of $3.25/gallon.

The customer will rent a truck from another company if you do not accept the proposed deal. In either case, you will service his truck. You know the customer and are confident that he will pay all charges incurred under the agreement.

1. Should you accept or reject the proposed deal? 2. Would your answer change if your fuel sup-

plier limited the amount of fuel that you could purchase from him at the wholesale price? Explain.

MANAGERIAL APPLICATIONS

Creative Gaming of the System The U.S. Government in 2009 promoted the sales of presidential and Native American $1 coins by offering free shipping on any order made to the U.S. Mint (which sold the coins at face value). Enthusiasts of frequent-flyer mileage programs saw a creative way to “game” the government’s offer. Many credit cards are tied to the frequent- flyer programs of major airlines—for every dollar charged on the card, a mile is credited to the relevant frequent-flyer program. Several hundred “mile-junkies” responded by purchasing thousands of dollars worth of coins from the U.S. Mint using their credit cards. Once they received the coins, they deposited the money in their bank accounts to pay off their credit card charges before any interest costs were incurred. For example, Patricia Hansen, a San Diego retiree who loves to travel, ordered $10,000 in coins earning 10,000 miles toward free and upgraded travel. Her husband took the coins to the bank, as soon as they arrived, so that their credit card bill could be paid. The U.S. Mint eventually figured out what was going on and stopped the program that had resulted in increased costs for them, credit card companies, banks, and airlines. This example illustrates an important general point. People often respond to economic incentives in creative ways. Managers and government officials need to craft incentives thoughtfully.

Source: S. McCartney (2009), “Miles for Nothing: How the Government Helped Frequent Fliers Make a Mint,” The Wall Street Jour- nal (December 7), A1.

20 Part 1 Basic Concepts

working since he was three years old. Because Brazil doesn’t specify a minimum re- tirement age, the average Brazilian retires at age 49.8

Similarly, when hackers and corporate spies continue to develop more sophisticated schemes to steal information from Web sites or networks, software tools that detect break-ins also have grown in popularity and sophistication. This intrusion-detection soft- ware was about a $100 million industry in 1999 and is now estimated at over $2 billion.9

Understanding this creative nature of individuals has important managerial impli- cations that we discuss later in this chapter, as well as throughout the book.

Graphical Tools Economists often employ a set of graphical tools to illustrate how individuals make choices. These tools distinguish between the preferences (level of satisfaction) that the individual associates with each potential opportunity and the set of feasible op- portunities that an individual faces. We use these tools throughout this book. They also are used in other courses within the typical business school curriculum, such as in finance, human relations, and marketing courses. Our intent is to introduce these tools so that the reader is comfortable using them in basic business applications. We subsequently apply the tools to analyze the problems at Merrill Lynch. Appendix A provides a more detailed development of the economic theory of individual choice (commonly called the “Theory of Consumer Choice”).

Individual Objectives

Goods are things that people value. Goods include standard products like food and clothing, services like haircuts and education, as well as less tangible emotions such as love of family and charity. The economic model of behavior posits that people ac- quire goods that maximize their personal satisfaction, given their resource con- straints (such as a limited income). Economists traditionally use the term utility in re- ferring to personal satisfaction.

To provide a more detailed analysis of how people make choices, economists repre- sent an individual’s preferences by a utility function. This function expresses the rela- tion between total utility and the level of goods consumed. The individual’s objective is to maximize this function, given the resource constraints.10 This concept can be il- lustrated most conveniently through a simple example where an individual cares about only two goods. The insights from this two-good analysis can be extended readily to the case of additional goods such as food, housing, clothing, respect, and charity.

Suppose that Dominique Lalisse values only food and clothing. In general form, his utility function can be written as follows:

� �

Utility � F(Food, Clothing) (2.1)

8P. Fritsch (1999), “In Brazil Retirement Has Become a Benefit Nearly All Can Enjoy,” The Wall Street Journal (September 9), A1.

9J. D’Allegro (1999), “Intrusion Detection Matures,” National Underwriter (March 8), 9; and Frost and Sullivan (2007), “World Intrusion Detection and Prevention Markets,” www.frost.com

10Clearly, most individuals do not actually consider maximizing a mathematical function when they make these choices. However, this formulation can provide useful insights into actual behavior to the extent that it approximates how individuals make choices. Mathematicians have shown that if an individual’s behavior is consistent with some basic “axioms of choice” (comparability, transitivity, nonsatiation, and willingness to substitute), the individual will make choices as if he or she were trying to maximize a mathematical function.

Chapter 2 Economists’ View of Behavior 21

Dom prefers more of each good—thus, his utility rises with both food and clothing. In Dom’s case, his specific utility function is

Utility � Food1�2 � Clothing1�2 (2.2)

For instance, if Dom has 16 units of food and 25 units of clothing, his total utility is 20 (that is, utility � 161�2 � 251�2 � 4 � 5 � 20). Dom is better off with 25 units of both food and clothing. Here, his utility is 25 (utility � 251�2 � 251�2 � 5 � 5 � 25).

Utility functions rank alternative bundles of food and clothing in the order of most preferred to least preferred, but they do not indicate how much one bundle is preferred to another. If the utility index is 100 for one combination of food and clothing and 200 for another, Dom will prefer the second combination. The second bundle does not nec- essarily make him twice as well off as the first bundle.11 Neither does this formulation allow one person’s utility of a bundle to be compared to another person’s utility.

Indifference Curves

Preferences implied by the utility function can be illustrated graphically through indifference curves. An indifference curve pictures all combinations of goods that yield the same utility. Given his utility function in Equation (2.2), Dom is indifferent between either 16 units of food and 25 units of clothing or 25 units of food and 16 units of clothing. Both combinations yield 20 units of utility, and hence are on the same indifference curve. Figure 2.1 shows two of Dom’s indifference curves. For example, if given a choice between any two points on curve 1, Dom would say that he does not care which one is selected—in either case, he obtains 8 units of utility.

Figure 2.1 Indifference Curves

These indifference curves picture all combinations of food and clothing that yield the same amount of utility. The specific utility function in this example is U � F1�2 � C1�2, where F is food and C is clothing. Northeast movements are utility-increasing. Indifference curve 2 represents all combinations of food and clothing that yield 20 units of utility, whereas curve 1 pictures all combinations that yield 8 units of utility. Other indifference curves could be drawn for different levels of utility.

4 16 25 C

4

16

25

F

Quantity of clothing

Q ua

nt ity

o f

fo od

Increasing utility

1: U = 8

2: U = 20

11This is like rankings on a test—an individual who scores in the 80th percentile is not twice as smart as one from the 40th.

22 Part 1 Basic Concepts

The slope at any point along one of Dom’s indifference curves indicates how much food he would be willing to give up for a small increase in clothing (his utility remains unchanged by this exchange).12 Standard indifference curves that illustrate trade-offs between two goods have negative slopes. If Dom obtains a smaller amount of one good such as clothing, the only way he can be equally as well off is to obtain more of another good like food. If at a point along an indifference curve the slope is 22, Dom is willing to give up 2 units of food to obtain 1 unit of clothing. Alterna- tively he is willing to give up 1�2 unit of clothing to obtain 1 unit of food. This willingness to substitute has important implications, which we discuss later.

Movements up and to the right in graphs like Figure 2.1 are utility-increasing. Holding the amount of food constant, utility increases by increasing clothing (a rightward movement). Holding the amount of clothing constant, utility increases by increasing the amount of food (an upward movement). Thus, in Figure 2.1, Dom would rather be on indifference curve 2 than on 1. He obtains 20 units of utility rather than 8.

Economists typically picture indifference curves as convex to the origin (they bow in, as in Figure 2.1). Convexity implies that if Dom has a relatively large amount of food, he would willingly exchange a relatively large quantity of food for a small amount of additional clothing. Thus, the indifference curves in Figure 2.1 are steep when the level of food is high relative to the level of clothing. In contrast, if he has a relatively large amount of clothing, he would be willing to substitute only a small amount of food for additional clothing. Correspondingly, the indifference curves in Figure 2.1 flatten as Dom has less food and more clothing. The behavior implied by the convexity of indifference curves is consistent with the observed behavior of many individuals—most people purchase balanced combinations of food and clothing.

Opportunities and Constraints

Dom would like more of both food and clothing. Unfortunately, he faces a budget constraint that limits his purchases. Suppose that he has an income of I and the prices per unit of food and clothing are Pf and Pc, respectively. In this single period analysis, we assume that Dom spends all his income on food and clothing. In a multiperiod context, Dom might want to save part of his income or borrow against future income. We examine these possibilities in Appendix B at the end of this chap- ter. Since he cannot spend more than I, his consumption opportunities are limited by the following constraint:

I � Pf F � PcC (2.3)

where F and C represent the units of food and clothing purchased. This budget con- straint indicates that only combinations of food and clothing that cost no more than I are feasible. Rearranging terms, this constraint can be written as

F � I�Pf � (Pc�Pf)C (2.4)

12Recall that the slope of a line is a measure of steepness, defined as the increase or decrease in height per unit of distance along the horizontal axis. Slopes of curves are found geometrically by drawing a line tangent to the curve at the point of interest and determining the slope of this tangent line. The slope at a point along one of Dom’s indifference curves indicates how the quantity of food changes for small changes in the amount of clothing in order to hold utility constant. Since by definition Dom is indifferent to this exchange (he remains on the same indifference curve), he is willing to make the exchange.

Chapter 2 Economists’ View of Behavior 23

Figure 2.2 depicts these consumption opportunities—frequently called a budget line. All combinations of food and clothing on or below the line are attainable. Com- binations above the line are infeasible given an income of I. The F intercept (on the vertical axis) of the line I�Pf indicates how much food Dom can purchase if his en- tire income is spent on food (no clothing is purchased). The C intercept is corre- spondingly I�Pc. The slope of the line �Pc�Pf is �1 times the ratio of the two prices. The ratio Pc�Pf is the relative price of clothing in terms of food. It represents how many units of food he must forgo to acquire a unit of clothing: It is the oppor- tunity cost of clothing. For example, if the price of clothing is $8 and the price of food is $2, the relative price of clothing is 4. To keep total expenditures constant, 4 units of food must be given up for every unit of clothing purchased. The relative price of food is Pf�Pc (in this example, 0.25); 1�4 unit of clothing must be given up for each unit of food purchased.

The constraint changes with changes in Dom’s income and the relative prices of the two goods. As shown in Figure 2.3, changes in income result in parallel shifts of the constraint: Its slope is unaffected. An increase in income shifts the constraint out- ward (up and to the right), while a decrease in income shifts the constraint inward. The slope of the constraint changes with the relative prices of the two goods. As shown in Figure 2.4, if the price of clothing increases relative to the price of food, the constraint becomes steeper. If the price of clothing falls relative to the price of food, the constraint becomes flatter.

Individual Choice

Within this economic framework, Dom’s goal is to maximize utility given his op- portunities. Utility is maximized at the point of tangency between the constraint and

Figure 2.2 Opportunities and Constraints

The constraint reflects the feasible combinations of food and clothing that are attainable given the person’s income (I ). The vertical and horizontal intercepts, respectively, show the amounts of food and clothing that can be purchased if no income is spent on the other good. The slope of the constraint is equal to �1 times the ratio of the prices of the two goods. For instance, if the price of clothing is $8 and the price of food is $2, the slope will be �4. This slope implies that 4 units of food must be given up for 1 unit of clothing. If both goods have the same price, the slope will be �1.

I Pf

I Pc

C

Pf

Pc

F

Combinations above line are unaffordable

Combinations on/below line are affordable

Q ua

nt ity

o f f

oo d

Quantity of clothing

–

24 Part 1 Basic Concepts

an indifference curve.13 Figure 2.5 portrays the optimal choice. Dom could choose points like b and c on indifference curve 1. However, point a on curve 2 yields greater satisfaction (utility) and thus is preferred. Dom would prefer to be at any point on curve 3. Yet, these points are unattainable given his income.

Figure 2.3 Income Changes

This figure shows that there is a parallel shift in the budget constraint when income changes. The slope of the constraint does not change because there is no change in the prices of the two goods. The slope is �1 times the ratio of the prices.

I Pc

I Pf

C

F

Lower income

Original consumption opportunities

Higher income

Quantity of clothing

Q ua

nt ity

o f f

oo d

IHI

Pc

ILO

Pc

Figure 2.4 Price Changes

This figure shows how his consumption opportunities change with changes in the price of clothing. The slope of the line is �(Pc�Pf). Thus, an increase in the price of clothing (from Pc to PcHI) produces a steeper line, while a decrease (from Pc to PcLO) produces a flatter line. Changes in the price of food also affect the slope of the line.

C

I Pf

F

Increase in the price of clothing

Original consumption opportunities

Decrease in the price of clothing

Quantity of clothing

Q ua

nt ity

o f f

oo d

I Pc

I Pc

LO I

Pc HI

13For simplicity, we ignore the possibility of corner solutions—the points where the budget constraint intersects the axes. With corner solutions, the individual spends all income on only one good.

Chapter 2 Economists’ View of Behavior 25

This graphical solution to Dom’s choice problem has a simple intuitive interpre- tation. At the point of tangency, the indifference curve and the constraint have equal slopes. Recall that the slope of the indifference curve represents Dom’s willingness to trade food for clothing, whereas the slope of the constraint represents the terms of trade available in the marketplace. At the optimal choice, the willingness and ability to trade are equal. At other feasible combinations of food and clothing, Dom’s util- ity could be increased by making substitutions. For instance, if Dom were at a point where he was willing to trade 5 units of food for 1 unit of clothing and if the relative price of clothing were 4 units (the slope of the indifference curve is steeper than the constraint), Dom would be better off purchasing less food and more clothing. (He is willing to trade 5 units of food for 1 unit of clothing, but only must forgo 4 units of food to obtain 1 unit of clothing in the marketplace.) Alternatively, if Dom were at a point where he was only willing to forgo 1 unit of food for 1 unit of clothing (the slope of the indifference curve is flatter than the constraint), he would be better off purchasing more food and less clothing—since he receives 5 units of food for each unit of clothing forgone.

Earlier in this chapter, we discussed how marginal analysis is the cornerstone of modern economics. It is important to understand that the graphical tools presented in this section depict marginal analysis. In marginal analysis, individuals take actions as long as their incremental benefits are greater than their incremental costs. Our graphical analysis of individual choice corresponds to this decision rule. The relative price ratio, PC�PF, is the marginal cost of a unit of clothing, expressed as units of food—the units of food that are forgone is the opportunity cost of an additional unit of clothing. Similarly, the opportunity cost of an additional unit of food is PF�PC units of clothing. The slope of the indifference curve reflects the marginal benefit of an additional unit of clothing expressed as units of food. For example, if Dom is will- ing to trade 5 units of food for 1 unit of clothing (slope of the indifference curve � �5), his marginal benefit of one additional unit of clothing must equal the utility

Figure 2.5 Optimal Choice

The individual is best off by choosing point a where the constraint is tangent to indifference curve 2. This optimal combination of food and clothing, F* and C*, yields higher level of satisfaction (utility) than other feasible alternatives (e.g., points b and c). The individual would prefer points on indifference curve 3, but these points are infeasible given his consumption opportunities.

C *

F

F *

b

a

c 1

2

3

Quantity of clothing

Q ua

nt ity

o f f

oo d

C

26 Part 1 Basic Concepts

from 5 units of food. Similarly, his marginal benefit of a unit of food is equivalent to .2 units (1�5) of clothing. If Dom is not at the point of tangency between the indif- ference curve and the budget line, the marginal benefit of trading one good for the other must be greater than the marginal cost. Suppose Dom is willing to trade 5 units of food for 1 unit of clothing, but only has to trade 2 units of food for 1 unit of cloth- ing in the marketplace. In this case, Dom should trade food for clothing since the marginal (incremental) benefit is greater than the marginal (incremental) cost. At the optimum (point of tangency) the marginal benefit of consuming 1 more unit of either good is equal to the marginal cost and there is no reason to make additional trades.

Changes in Choice

Dom’s consumption opportunities will change whenever prices or income change. Consequently, he will make different choices. Recall that changes in relative prices alter the slope of the constraint. When the relative price of a good increases, individ- uals typically choose less of that good.14 Figure 2.6 shows how Dom will purchase less food as its relative price increases—food is more expensive and so less attractive than it was at a lower price. Generally, the amount of clothing purchased can go either up or down; it depends on the location of the new tangency point. (Given the particular utility function assumed in this example, the amount of clothing purchased remains unchanged.) Even though the price of clothing is relatively more attractive, the increase in food prices can limit available income so as to reduce the amount purchased of both goods. Changes in Dom’s income cause parallel shifts in the

Figure 2.6 Optimal Choice and Price Changes

This figure shows how the optimal choice changes with an increase in the price of food. In this example, the individual chooses less food (F1* rather than F0*). This is the typical case—usually, an individual will purchase less of a good when its price increases. Due to the particular utility function used in this example, the amount of clothing purchased remains unchanged (C*). More generally, the amount of clothing purchased can go either up or down. It depends on the location of the new tangency point.

C * C

F

F0

Consumption opportunities after increase in price of food

Original consumption opportunities

Quantity of clothing

Q ua

nt ity

o f f

oo d

*

F1*

14Although in principle some individuals might purchase more of a good if its price increases, this outcome is rarely observed.

Chapter 2 Economists’ View of Behavior 27

constraint and will change his optimal choice. In Chapter 4, we examine in more detail how changes in income and prices affect consumption choices. Appendix A contains a more detailed analysis of the effects of price changes on individual choice and illustrates how this basic graphical analysis can be used to study inter-temporal choices, such as the choice between current consumption and savings.

Choices also change if preferences change. Now changes in preferences undoubt- edly occur. (Do you really believe that Toys ‘R’ Us will have any difficulty satisfying the demands for toys that were highly popular in past years, such as Teenage Mutant Ninja Turtle action figures, Tomaguchi virtual pets, Tickle-Me-Elmo dolls, or Poke- mon Cards next Christmas?) Yet, economists rarely focus on such explanations. Eco- nomics has little theory to explain what might cause preferences to change. And since a large premium is placed on operationalism in managerial economics, preference- based explanations generally are appealed to only after other potential explanations are exhausted. In a sense, these preference-based explanations are too easy—they work too well. Virtually any observed behavior could be explained by appealing to prefer- ences: Why did the consumption of frozen yogurt increase relative to that of ice cream? People’s preferences changed so that more frozen yogurt and less ice cream was demanded. But an observed reduction in consumption could have been “explained” just as readily. Without a deeper understanding of why preferences change, one is left “explaining” everything but with an analysis that allows you to predict nothing.

Ultimately, the managerial usefulness of this analysis comes from its power to identify policy instruments that have a predictable impact on the problems at hand. Across a broad array of problems, assuming that underlying preferences are reasonably stable and analyzing the impact of changes in opportunities and constraints regularly will yield important managerial insights and identify productive managerial tools.

ANALYZING MANAGERIAL DECISIONS: Consumer Choice and Graphical Tools

You are a manager for a company that bottles and sells wine in two different countries. You charge the same price for a bottle of wine in both coun- tries. Yet, your wine sales are much higher in one country than the other. Your boss asks you to de- velop an explanation for the differences in wine sales between the two countries and to develop a plan to sell more wine in the country with low wine consumption.

Population sizes and family incomes in the two countries are very similar. You also know that each country imposes a per bottle tax on wine.

Begin by providing a plausible economic expla- nation (focusing on constraints) for the differences in wine sales in the two countries. Illustrate your explanation by using indifference curves and bud- get lines for representative consumers from the two countries. What data would you want to determine

if your explanation is likely to be correct? Are there other plausible explanations for the differences in wine consumption? Are there ways to determine which of these explanations is most likely to be dri- ving the differences in consumption? 1. Suppose that your economic explanation is

likely to be correct and that your company will not allow you to lower the price per liter that you charge for wine in the two countries. Discuss at least two potential actions that you might take to sell more wine in the country with low demand.

2. Now provide a potential preference-based ex- planation for the differences in wine sales. Suppose that this explanation is correct. Dis- cuss whether there are likely to be feasible policies that you could use to increase wine sales in the country with the low demand.

28 Part 1 Basic Concepts

Motivating Honesty at Merrill Lynch Often, economists focus on consumption goods such as food and clothing. This focus is natural given the interests economists have in understanding consumer behavior. Yet this analysis can be extended easily to consider other goods that people care about, such as love and respect.15 Such an extension can be used to analyze the problem at Merrill Lynch.

Suppose that Susan Chen, like other analysts at Merrill Lynch, values two goods—money and integrity. Her utility function is

� � Utility � F (Money, Integrity) (2.5)

Money is meant to symbolize general purchasing power; it allows the purchase of goods such as food, clothing, and housing. Integrity is something Sue values for its own sake—being honest in her dealings with other people provides Sue with satis- faction and she values it for that reason.

Suppose that integrity can be measured on a numerical scale with Sue preferring higher values. For example, 5 units of integrity provide more utility than 4 units of integrity. (In actuality, measuring a good like integrity on a numerical scale might be quite difficult. Yet this complication does not limit the qualitative insights that we can derive from the analysis.)

Merrill paid its stock analysts an annual bonus that was based partly on the ana- lyst’s contribution to the investment banking side of the business (e.g., the firm’s un- derwriting activities). If Sue were completely honest and rated a company as a poor investment, the management of that company might take its investment banking business to another firm. The resulting loss in Merrill’s investment banking revenue would reduce Sue’s annual bonus. This bonus scheme thus confronts Sue with a trade-off. She can be honest and derive satisfaction from maintaining her integrity, or she can be dishonest in her rating of the stock and obtain a higher bonus. (She also might consider the future effects on her income from developing a good or bad rep- utation as an investment analyst. However, the analysis in this chapter is framed in a simple one-period context and does not consider monetary returns from developing a good reputation. In subsequent chapters we extend the analysis and consider such multiperiod effects.)

Figure 2.7 depicts Sue’s implied opportunities. This constraint shows the maxi- mum combinations of income and integrity that are feasible given the compensa- tion plan and conditions at the company.16 If Sue sacrifices all integrity, she earns $max a year. If she is scrupulously honest in her investment recommendations, she earns less (there is a positive floor on her income, $min, since her base salary does depend on the amount of investment banking business and her analysis undoubt- edly will suggest recommending some of Merrill’s clients’ stocks). Intermediate options along the constraint are possible. While Sue would like to earn more than $max, higher income is not feasible in this job.

15G. Becker (1993), “Nobel Lecture: The Economic Way of Looking at Behavior,” Journal of Political Economy 101, 385–409.

16For simplicity, we draw the constraint as linear. Linearity is not necessary for our analysis. Also, we want to emphasize that we put dollars on the vertical axis only because it is a convenient general indication of value, not because money is more important than other things. We could illustrate Sue’s willingness to trade integrity against anything else Sue values, such as Big Macs, pianos, or pairs of jeans.

Chapter 2 Economists’ View of Behavior 29

Sue chooses the combination of integrity and income that places her on the high- est attainable indifference curve. This choice occurs at the point of tangency between her indifference curve and the constraint. Sue ends up selecting relatively low amounts of integrity because the bonus plan adopted by Merrill’s management has made integrity expensive. If Sue were to choose more integrity, she would forfeit a relatively large amount of income.

Management can alter the opportunities Sue and her colleagues face by chang- ing its compensation plan. In the Merrill case, reducing the emphasis of investment banking revenue in determining the annual bonus reduces the gains from dishonest advice and thus flattens the constraint. Changes in the slope of the constraint result in a different tangency point and hence a different choice. Figure 2.8 shows how Sue’s optimal choice changes when the emphasis on investment banking revenue is decreased.17 The result is more honest behavior. In essence, Sue “purchases” more integrity because it now is less expensive. Consistent with this analysis, Merrill, in its settlement with the State of New York, agreed to change the way it evaluated and compensated its analysts. Bonuses now are based on the quality of investment advice—not tied to its investment banking business.

Figure 2.7 Nature of Opportunities Facing an Analyst at Merrill Lynch

The constraint depicts the maximum amounts of money and integrity that are possible for the analyst given the bonus plan and conditions at the company. If the analyst sacrifices all integrity and recommends stocks even if they are poor investments, the employee earns a maximum of $max a year. Investment banking business is lost if the analyst gives objective advice and rates certain stocks as poor investments (selects a higher level of integrity). Income is lower since the analyst is paid a bonus based on investment banking revenues. Ic represents complete honesty. Ic

I

$

$max

$min

Quantity of integrity

In co

m e

(in d

ol la

rs )

17We have altered the compensation scheme in a manner that places Sue on the same indifference curve. Our rationale for doing this is as follows: Merrill Lynch must provide Sue with sufficient job satisfaction (utility) to retain her at the firm. Below this level of utility, Sue will quit and work elsewhere. Merrill Lynch is unlikely to want to pay Sue more than this minimum utility because it reduces firm profits. Thus, Merrill Lynch has an incentive to adjust compensation in a manner that keeps her on the same indifference curve. Sue’s indifference curve in Figure 2.8 can be viewed as this “reservation” utility. These issues are covered in more detail in Chapter 14.

30 Part 1 Basic Concepts

Managerial Implications This analysis illustrates how the economic framework can be used to analyze and ad- dress management problems. Managers are interested in affecting the behavior of in- dividuals such as employees, customers, union leaders, or subcontractors. Under- standing what motivates individuals is critical. The economic approach views individual actions as the outcomes of maximizing personal utility. People are willing to make substitutions (e.g., less leisure time for more income) so long as the terms of trade are advantageous. Managers can affect behavior by appropriately designing the opportunities facing individuals. The design of the opportunities affects the trade- offs that individuals face and hence their choices. For example, management can mo- tivate employees through the structure of compensation plans or customers through pricing decisions.

The outcome of individuals making economic choices is a function of both op- portunities and preferences. Individuals try to achieve their highest level of satisfac- tion given the constraints they face. Our discussion of management implications, however, intentionally focuses on opportunities and constraints, not preferences. As a management tool, the usefulness of focusing on personal preferences often is lim- ited. It is difficult to change what a person likes or does not like. Moreover, prefer- ences rarely are observable, and (as we noted earlier) virtually any observed change in choice can be “explained” as simply a matter of a change in personal tastes. For instance, a preference-based explanation as to why employees were dishonest at Merrill Lynch is that these employees gained personal satisfaction from being dishonest (or compared to employees at other firms, Merrill Lynch employees were willing to trade large amounts of personal integrity for small financial rewards). This

Figure 2.8 Optimal Choices of an Analyst at Merrill Lynch under Two Different Compensation Plans

Case 1 reflects the original compensation plan. In this case, compensation includes a high bonus based on investment banking revenues and the constraint is relatively steep. In Case 2, the firm reduces the emphasis on investment banking revenues in compensating analysts. The slope of the constraint is flatter. The result is that the individual chooses a higher level of integrity in Case 2 than in Case 1.

$

$1*

I1* I2*

Case 2

Case 1 I

In co

m e

(in d

ol la

rs )

Quantity of integrity

$2*

Chapter 2 Economists’ View of Behavior 31

explanation is not very helpful in giving management guidance on how to address the problem. It suggests that Merrill Lynch might try to fire dishonest employees and replace them with employees who care more about personal integrity. But the diffi- culty of observing personal preferences limits the feasibility of this approach. It would be difficult for Merrill Lynch to know if, as a group, its new hires would be any less dishonest than the old employees. You cannot just ask applicants if they are honest—if they are not, they will have no qualms about claiming that they are.

The fact that individuals are clever and creative in limiting the effects of con- straints greatly complicates management problems. Changing incentives will affect employee behavior, though sometimes in a perverse and unintended manner. Con- sider two of the Soviet Union’s early attempts to adopt incentive compensation to motivate employees. To discourage taxi drivers from simply parking their cabs, they were rewarded for total miles traveled; to encourage additional production, chande- lier manufacturers were rewarded on total volume of production—measured in kilo- grams. In response to these incentive plans, Moscow taxi drivers began driving empty cabs at high speeds on highways outside the city and chandelier manufactur- ers started producing such massive fixtures that they literally would collapse ceil- ings. (It is less costly to make one 100-kilo chandelier than five 20-kilo chandeliers; manufacturers also substituted lead for lighter-weight inputs.) Merrill Lynch initially adopted bonuses to motivate analysts to work harder and cooperate across business units. The deceitful behavior was a side effect that potentially was unanticipated when the plan was adopted.

In summary, the economic approach to behavior has important managerial impli- cations. The framework suggests that a manager can motivate desired actions by es- tablishing appropriate incentives. However, managers must be careful because set- ting improper incentives can motivate perverse behavior.

It is worth noting that economic analysis is limited in its ability to forecast the pre- cise choices of a given individual because individual preferences are largely unob- servable. The focus is on aggregate behavior or on what the typical person tends to do. For example, an economist might not be very good at predicting the responses of individual employees to a new incentive plan. An economist will be successful in

MANAGERIAL APPLICATIONS

More to Life than Money Should you hire a housekeeper or clean your house yourself? Should you mow your own lawn or hire the kid next door? People confront these types of questions everyday. Spending money on housekeepers, gardeners, etc. provides extra time to use for other activities, but it comes at the cost of having less money to purchase other things. People vary in their attitudes when it comes to time versus money. In a recent survey conducted by LearnVest and Chase Blueprint, 54 percent said they would like more money rather than more time, while 46 percent they want more free time relative to more money. It is not uncommon to see people in well paid positions retiring early to spend more time with family or to pursue other personal interests. For example, Kelly Malson was the CFO of World Acceptance Corp. and had an annual pay package valued at $4.8 million in 2013. During the summer of 2013, one of her college friends died of Lou Gehrig’s disease at 46. Kelly, who was only 43, decided to quit her job to pursue her dreams while she still could, which included traveling to all 50 U.S. states and pursuing a graduate degree. Kelly, as well as most other people, clearly value things other than just money and regularly make choices that trade off money for other things that they value.

Source: C. Oakley (2013), “Would You Rather Have More Time or More Money?” Forbes (12/20) and M. Murphy (2013), “More CFOs Choose to Retire Early,” The Wall Street Journal (December 10).

32 Part 1 Basic Concepts

predicting that the typical employee will work harder—and thus output for the group will rise—when compensation is tied to output, than when a fixed salary indepen- dent of performance is paid. Managers typically are interested in structuring an or- ganizational architecture that will work well and does not depend on specific people filling particular jobs. Individuals come and go, and the manager wants an organiza- tion that will work well as these changes occur. In this context, the economic frame- work is likely to be useful. To solve management problems where the characteristics of a specific individual are more important, other frameworks may be more valuable. For example, if the board is interviewing a potential new CEO, insights into that in- dividual’s behavior derived from psychology might be extremely useful.

Alternative Models of Behavior18 We have shown how the economic view of behavior can be used in managerial deci- sion making. We now discuss four other models that are commonly used by man- agers (either explicitly or implicitly) to explain behavior. Our discussion of each of these models is simplified. The intent, however, is to capture the essence of a few of the more prominent views that managers have about behavior and to illustrate how managerial decision making is affected by the particular view. We contrast these

MANAGERIAL APPLICATIONS

Medicare Creates Perverse Incentives for Doctors Doctors do not care about money but are motivated by concerns about providing the best care for patients—right? Apparently many doctors and the major drug company employees do not think so. Perverse incentives among physicians arguably have contributed to the problem of spiraling health care costs in the United States.

For years, Medicare (federal health program for the elderly) reimbursement policies allowed individual doctors to make hundreds of thousands of dollars a year in extra profits from the drugs they administered to patients in their offices (the doctors would buy the drugs themselves and bill Medicare, rather than having the patients get them directly from pharmacies). For example, many cancer doctors earned over $1 million per year on drug sales alone. Because the profits on different drugs varied enormously, doctors had incentives to prescribe medications with the highest profit margins. Some physicians have acknowledged that they performed treatments that got them the best reimbursements, “whether or not the treatments benefited patients.”

Drug companies were well aware of the Medicare policies and calculated the profits that doctors received from prescribing specific drugs “down to the penny.” For example, in 1998 Schering-Plough told its sales representatives that its drug for the treatment of bladder cancer could produce a profit for a physician of $2,373.84 per patient. Sales representatives in turn made sure that doctors were well aware when their drugs were in the high-profit category. For instance, a sales representative for AstraZeneca wrote in a letter to Arizona urologists, “DO THE MATH.”

Medicare changed its reimbursement policies in 2005 and reduced the profits that physicians could make on drug sales. At least some physicians have responded by shifting from drug intensive treatments to other treatments that have higher profit margins. To quote one doctor, “People go where the money is, and you’d like to believe it’s different in medicine, but it’s really no different . . . as long as oncologists continue to be paid by the procedure instead of spending time with patients, they will find ways to game the system.”

Source: A. Berensen (2007), “Incentives to Limit Any Savings in Treating Cancer,” nytimes.com (June 12).

18This section draws on W. Meckling (1976).

Chapter 2 Economists’ View of Behavior 33

alternative views with the economic view and argue why the economic framework is a particularly useful tool for managers.

Only-Money-Matters Model

Some people believe that the only important component of the job is the level of monetary compensation. But as we have already suggested, people have an incredi- bly broad range of interests, extending substantially beyond money. And these inter- ests are reflected in a diverse array of activities. As examples, much of the work through the Red Cross is undertaken by unpaid volunteers; people frequently choose early retirement, forgoing a regular paycheck to enjoy additional leisure time; riskier occupations command higher pay in order to attract people into those jobs.

Some of this confusion can result from a misinterpretation of standard economic analysis. Central to economics is the study of trade-offs (recall our discussion of in- difference curves illustrating trade-offs between food and clothing). Economists fre- quently use money as one of the goods being considered. But in these cases, money is merely a convenient unit of value: It simply represents general purchasing power. Its use does not suggest that only money matters.

Happy-Is-Productive Model

Managers sometimes assert that happy employees are more productive than un- happy employees. Managers following this happy-is-productive model see as their goal the designing of work environments that satisfy employees. Psycholog- ical theories, such as Maslow’s and Herzberg’s, are frequently used as guides in ef- forts to increase job satisfaction.19

MANAGERIAL APPLICATIONS

Happy Is Productive versus Economic Incentives—The Affordable Care Act The Affordable Care Act, better known, as “ObamaCare,” has generated significant controversy since it was signed into law in 2010. The Congressional Budget Office (CBO) conducts economic analysis for Congress and is “widely revered by both Democrats and Republicans alike as the gold standard for economic analysis.” In 2014, the CBO reported that it expected the equivalent of 2.5 million Americans, who were otherwise willing and able to work before ObamaCare, to work less or not at all as a result of the law by 2024. The projection contrasts dramatically with earlier forecasts made by proponents of ObamaCare, who projected a resulting increase in employment. These positive forecasts were based in part on an implicit assumption of the Happy is Productive Model of Behavior. The logic is as follows. Most people want to work because being productive leads to greater happiness. Bad health, however, can prevent people from working. ObamaCare by promoting a healthier population will increase the number of employed people. This argument, however, ignores economic incentives. ObamaCare imposes a stiff economic cost on unemployed people who take jobs—they lose all or part of their government subsidies for purchasing health insurance. Economist Casey Mulligan sums up the economic incentives created by ObamaCare succinctly, “when you pay people for being low income, you are going to have more low-income people.” While this is but one effect in evaluating the merits of ObamaCare, it would appear to be a potentially important one.

Source: J. Rago (2014), “The Weekend Interview with Casey Mulligan,” The Wall Street Journal (February 8), A15.

19F. Herzberg, B. Mausner, and B. Snyderman (1959), The Motivation to Work (John Wiley & Sons: New York); and A. Maslow (1970), Motivation and Personality (Harper & Row: New York).

34 Part 1 Basic Concepts

A manager adhering to the happy-is-productive model might suggest that the problem at Merrill Lynch was motivated by disgruntled employees who took out their frustrations on customers. This view implies that Merrill Lynch could reduce the problem by promoting employee satisfaction through such actions as designing more interesting jobs, increasing the rates of pay, and improving the work environ- ment. Happier employees would be expected to provide customers with better in- vestment advice.

The economic and happy-is-productive models do not differ based on what peo- ple care about. The economic model allows individuals to value love, esteem, inter- esting work, and pleasant work environments, as well as more standard economic goods such as food, clothing, and shelter. The primary difference in the models is what motivates individual actions. In the happy-is-productive model, employees exert high effort when they are happy. In the economic model, employees exert effort because of the rewards.

To contrast the two models, consider offering an employee guaranteed lifetime employment plus a large salary, which will be paid independent of performance. The happy-is-productive model suggests that the employee will be more productive, because the high salary and job security are likely to increase job satisfaction. The economic model suggests that the employee would exert less effort—since the em- ployee receives no additional rewards for working harder and will not be fired for ex- erting low effort.

Good-Citizen Model

Some managers subscribe to the good-citizen model. The basic assumption is that employees have a strong personal desire to do a good job; they take pride in their work and want to excel. Under this view, managers have three primary roles. First, they need to communicate the goals and objectives of the organization to employees. Second, they must help employees discover how to achieve these goals and objec- tives. Finally, managers should provide feedback on performance so that employees can continue to improve their efforts. There is no reason to have incentive pay, since individuals are interested intrinsically in doing a good job.

MANAGERIAL APPLICATIONS

Culture and Behavior In Tokyo, lost cell phones, umbrellas, and cash regularly find their way to the Tokyo Metropolitan Police Lost and Found Center—the Japanese are scrupulous about turning in found articles. In 2002 the center handled $23 million in cash and 330,000 umbrellas. Scrupulous behavior of this type is far less common in New York City and many other cities around the world. What accounts for this “cultural difference?” The historic and current behavior of the Japanese can be explained at least in part by economic incentives.

The system traces its roots to a code written in 718. Lost goods, animals, and servants had to be handed over to a government official within five days of being found. Not handing over found objects was severely punished. In 1733 two officials who kept a parcel of clothing were led around town and executed. Current law gives the finder seven days to turn in found goods. If the item is reclaimed, the finder is entitled to a reward (5 to 20 percent). If the item is not reclaimed within six months, the finder can claim it.

The most commonly reclaimed item is a cell phone—about 75 percent are returned. The least reclaimed are umbrellas at 0.3 percent.

Source: N. Onishi (2004), “Never Lost, but Found Daily,” New York Times (January 8), A1.

Chapter 2 Economists’ View of Behavior 35

This view suggests that the problems at Merrill Lynch occurred because employ- ees misunderstood what was good for the company. Employees might have thought that increasing investment banking revenues was in the company’s best interests, even if it required a certain amount of dishonesty. Under the good-citizen view, the management of Merrill Lynch could motivate employee honesty by clearly commu- nicating to its analysts that Merrill Lynch would be better off in the long run if they did not deceive their customers. Managers might be instructed to hold a series of an- alyst meetings to stress the value of honesty and objective investment advice.

In the good-citizen model, employees place the interests of the company first. There is never a conflict between an employee’s personal interest and the interest of the company. In contrast, the economic model posits that employees maximize their own utility. Potential conflicts of interest often arise. The economic view predicts that pleas from Merrill Lynch management that analysts be more honest would have little effect on behavior unless they also changed the reward system to make it in the interests of analysts to be more honest.

Product-of-the-Environment Model

The product-of-the-environment model argues that the behaviors of individuals are largely determined by their upbringings. Some cultures and households encourage positive values in individuals, such as industry and integrity, whereas others promote negative traits, such as laziness and dishonesty. This model suggests that Merrill Lynch had dishonest analysts. A response would have been to fire these employees and replace them with honest analysts from better backgrounds.

Which Model Should Managers Use? Behavior is a complex topic. No behavioral model is likely to be useful in all con- texts. For example, the economic model is unlikely to be helpful in predicting whether a given individual will prefer a red shirt to a blue shirt (selling at the same price). But our focus is on managerial decision making. In this context, there are rea- sons to believe that the economic model is particularly useful.

Managers are frequently interested in fostering changes in behavior. For example, managers want consumers to buy more of their products, employees to exert more effort, and labor unions to accept smaller wage increases. In contrast to other mod- els, the economic framework provides managers with concrete guidance on how to alter behavior. Desired behavior can be encouraged by changing the feasible oppor- tunities facing the decision maker. For example, incentive compensation can be used to motivate employees, and price changes can be used to affect consumer behavior.

There is ample evidence to support the hypothesis that this economic framework is useful in explaining changes in behavior. The most common example is that con- sumers tend to buy less of a product at higher prices. The evidence suggests that the model is also useful in explaining aspects of behavior in many other contexts, in- cluding voting; the formation, dissolution, and structure of families; drug addiction; and the incidence of crime.20

20G. Becker (1993).

36 Part 1 Basic Concepts

The good-citizen model appears less successful in predicting behavior in busi- ness settings. Management would be an easy task if employees would work harder and produce higher-quality products simply on request. The happy-is-productive model also has material limitations. Most importantly, the existing evidence sug- gests that there is little relation between job satisfaction and performance (see Scott’s “Criticisms of the Happy-Is-Productive Model” in the accompanying box). Happy employees are not necessarily more productive. Sometimes, managers might want to follow the implications of the product-of-the-environment model and fire employees with undesirable traits. Yet, this approach is of limited use in solving most managerial problems. Also, given laws that limit discrimination, this approach can subject the firm to potentially serious legal sanctions.

The Economic Framework and Criminal Behavior Criminals often are viewed as psychologically disturbed. Evidence, however, suggests that criminal behavior can be explained, at least in part, by the economic framework. This framework predicts that a criminal will consider the marginal costs and benefits of a crime and will commit the crime only when the benefits exceed the costs. Under this view, increasing the likelihood of detection and/or the severity of punishment will reduce crimes. In a pioneering study, Issac Ehrlich examined whether the incidence of major felonies varied across states with the expected punishment. He found that the incidence of robberies decreased about 1.3 percent in response to each 1 percent increase in the proportionate likelihood of punishment. The incidence of crime also decreased with the severity of the punishment. Since Ehrlich’s study, scholars have conducted extensive research on this topic. In general, the results support the conclusion that the economic model plays a useful role in explaining criminal activity.

Source: I. Ehrlich (1973), “Participation in Illegitimate Activities: A Theoretical and Empirical Investigation,” Journal of Political Economy 81, 521–565.

ACADEMIC APPLICATIONS

Criticisms of the Happy-Is-Productive Model W. Richard Scott summarizes some of the major concerns about the happy-is-productive model (sometimes referred to as the human-relations movement):

Virtually all of these applications of the human-relations movement have come under severe criticism on both ideological and empirical grounds. Paradoxically, the human-relations movement, ostensibly developed to humanize the cold and calculating rationality of the factory and shop, rapidly came under attack on the grounds that it represented simply a more subtle and refined form of exploitation. Critics charged that workers’ legitimate economic interests were being inappropriately deemphasized; actual conflicts of interest were denied and “therapeutically” managed; and the roles attributed to managers represented a new brand of elitism. The entire movement was branded as “cow sociology” just as contented cows were alleged to produce more milk, satisfied workers were expected to produce more output.

The ideological criticisms were the first to erupt, but reservations raised by researchers on the basis of empirical evidence may in the long run prove to be more devastating. Several decades of research have documented no clear relation between worker satisfaction and productivity.

Source: W. R. Scott (1981), Organizations: Rational, Natural and Open Systems (Prentice Hall: Englewood Cliffs), 89–90.

ACADEMIC APPLICATIONS

Chapter 2 Economists’ View of Behavior 37

Behavioral Economics The traditional economic model of behavior assumes that individuals are rational, in that they employ marginal analysis in decision making—they balance the incremen- tal costs and benefits to arrive at choices that maximize their personal happiness. One, however, does not have to look far to observe people making choices that by this def- inition appear economically irrational. For example, how many of us have eaten all the food served on a plate, even when we are not hungry and want to lose weight? Do we have some vague notion that we are not wasting food by eating more than we re- ally need or want? How many of us might volunteer to help a distressed person change a flat tire for free, but feel insulted if they offered to pay us for the work?

Simple behavioral observations, as well as more formal evidence from experiments, suggest that people do not always behave rationally. A somewhat new field called Behavioral Economics has emerged that covers a wide range of attempts to extend the standard economics framework to account for potentially relevant features of human behavior that are not included in standard analysis21. While

ANALYZING MANAGERIAL DECISIONS: Interwest Healthcare Corp.

Interwest Healthcare is a nonprofit organization that owns 10 hospitals located in three western states. Cynthia Manzoni is Interwest’s CEO. Vijay Singh, Interwest’s CFO, and the administrators of the 10 hospitals report to Manzoni.

Singh is deeply concerned because the hospital staffs are not being careful when entering data into the firm’s management information system. This data involves information on patient intake, treat- ment, and release. The information system is used to compile management reports such as those relat- ing to the costs of various treatments. Also, the sys- tem is used to compile reports that are required by the federal government under various grant pro- grams. Singh reasons that without good informa- tion, the management and government reports are less useful and potentially misleading. Moreover, the federal government periodically audits Inter- west and might discontinue aid if the reports are deemed inaccurate. Thus, Singh is worried about the managerial implications and the potential loss of federal funds.

Singh has convinced Manzoni that a problem exists. She also realizes the importance of an accu- rate system for both management planning and

maintaining federal aid. Six months ago, she invited the hospital administrators and staff members from the corporate financial office to a retreat at a resort. The purpose was to communicate to the hospital ad- ministrators the problems with the data entry and to stress the importance of doing a better job. The meeting was acrimonious. The hospital people ac- cused Singh of being a bureaucrat who did not care about patient services. Singh accused the hospital staffs of not understanding the importance of accu- rate reporting. By the end of the meeting, Manzoni thought that she had a commitment by the hospital administrators to increase the accuracy of data entry at their hospitals. However, six months later, Singh claims that the problem is as bad as ever.

Manzoni has hired you as a consultant to ana- lyze the problem and to make recommendations that might improve the situation.

1. What are the potential sources of the problem? 2. What information would you want to analyze? 3. What actions might you recommend to in-

crease the accuracy of the data entry? 4. How does your view of behavior affect how

you might address this consulting assignment?

21See Behavioral Economics and Its Application (2007), edited by P. Diamond and H. Vartiainen (Princeton University Press, Princeton and Oxford) for a collection of papers that summarize behavioral research on a variety of economic topics.

38 Part 1 Basic Concepts

behavioral economists do not argue that economic incentives are unimportant, they tend to focus more on the cognitive, emotional, and social factors that affect individ- uals in making economic decisions. The ultimate objective of this research is to provide a better understanding of both aggregate market and individual economic behavior than we can get from the standard analysis alone.

The assumptions used in any type of scientific modeling, however, are never en- tirely realistic. Indeed, the purpose of a model is to simplify the analysis to make it tractable. For instance, a physical scientist might assume “unrealistically” that there is a perfect vacuum to derive a scientific formula. The test of her model, however, should not be based on the realism of her assumptions, but on how well the model helps us to predict or understand real-world phenomena. By this criterion, standard economic analysis has stood the test of time. For many decades, it has proven useful in helping managers to understand their competitive environments better and for im- proving their decision making and performance. This book presents the standard economic framework and focuses on the many managerial insights that it provides. A detailed study of Behavioral Economics, while potentially interesting, is beyond the scope of this book.

The need for more “realistic” assumptions in a model depends in part on the pur- pose of the model. For example, suppose that your boss has to go to Chicago for a business meeting and wants you to provide directions on how to drive to the specific location. You have at least two choices: (1) you might download a satellite photo- graph of the Chicago area or (2) you might get a map. Although the satellite photo would certainly include more realism, for this purpose, the map would be more useful. Most of the additional realism in the photograph is extraneous for your par- ticular purpose. The map abstracts from these unimportant aspects of the area to highlight those facets that are important. It is precisely this sense in which within this book, we employ models that abstract from an array of aspects of reality to high- light those things that are important for the particular issue at hand. On a few occa- sions, particularly in the chapters on organizational architecture, we analyze issues for which behavioral economics provides particularly relevant insights for managers. In these cases, we present both the standard economic analysis of the problem, as well as discussion of the implications from the behavior research.

Decision Making under Uncertainty Throughout this chapter, we have considered cases where the decision maker has complete certainty about the items of choice. For instance, Dom Lalisse knew the exact prices of food and clothing, and Sue Chen knew the precise trade-off between integrity and compensation at Merrill Lynch. Decision makers, however, often face uncertainty. For instance, in choosing among risky investment alternatives (such as stocks and bonds), an individual must forecast the likely payoffs. Even so, there can be significant uncertainty about the eventual outcomes. The analysis presented in this chapter can be extended readily to incorporate decision making under uncer- tainty.22 A detailed analysis of decision making under uncertainty is beyond the scope of this book. This section introduces a few key concepts that we will use later in this book.

22For example, E. Fama and M. Miller (1972), The Theory of Finance (Dryden Press: New York), Chapter 5.

Chapter 2 Economists’ View of Behavior 39

Expected Value

Taylor McClure sells real estate for RealCo. He receives a sales commission from his employer. For simplicity, suppose that Taylor has three possible incomes for the year. In a good year, he sells many houses and earns $200,000, whereas in a bad year he earns nothing. In other years, he receives $100,000. Probability refers to the likeli- hood that an outcome will occur. In this example, each outcome is equally likely, and thus has a probability of 1�3 of occurring. The expected value of an uncertain payoff is defined as the weighted average of all possible outcomes, where the probability of each outcome is used as the weights. The expected value is a measure of central tendency—the payoff that will occur on average. In our example, the expected value is23

Expected value � (1�3 � 0) � (1�3 � 100,000) � (1�3 � 200,000) (2.6) � $100,000

Variability

Although Taylor can expect average earnings of $100,000, his income is not certain. The variance is a measure of the variability of the payoff. It is defined as the ex- pected value of the squared difference between each possible payoff and the ex- pected value. In this example, the variance is

Variance � 1�3(0 � 100,000)2 � 1�3(100,000 � 100,000)2 (2.7) �1�3(200,000 � 100,000)2

� 6.7 billion

The standard deviation is the square root of the variance:

Standard deviation � (6.7 billion)1�2 � $81,650 (2.8)

Variances and standard deviations are used as measures of risk. It does not really mat- ter which we use, since one is a simple transformation of the other (higher standard de- viations correspond to higher variances). In this example, we focus on the standard deviation—in part because the standard deviation is expressed in the same units as the mean, dollars (the units for the variance would be dollars squared). Higher standard deviations reflect more risk. An event with a definite outcome has a standard deviation of zero.

Risk Aversion

Like most people, Taylor is risk-averse: Holding the expected payoff fixed, he prefers a lower standard deviation. He, therefore, gains utility from an increase in expected value, but he experiences a reduction in utility from increases in standard deviation. Figure 2.9 shows three of Taylor’s indifference curves. Each curve shows all combinations of expected value and standard deviation that give Taylor equal

23Note that the expected value need not equal one of the possible outcomes. As a weighted average, it can be a value between outcomes. In this example, it happens to correspond to one of the possible outcomes, $100,000.

40 Part 1 Basic Concepts

utility. In contrast to our previous analysis, here one of the objects of choice is a “bad”—Taylor dislikes risk. Thus, in this figure, the indifference curves have posi- tive slopes, and upward and leftward movements are utility-increasing (recall in the standard analysis that the curves have negative slopes, and upward and rightward movements are utility-increasing). The slopes of the indifference curves indicate Taylor’s degree of risk aversion. Steeper slopes translate into higher risk aversion. (If the slopes of the indifference curves are steep, Taylor must receive a relatively large increase in expected value for each additional unit of risk to maintain a con- stant level of utility.) If his indifference curves were totally flat, he would be risk- neutral. A risk-neutral person cares only about expected value and is indifferent to the amount of risk. Indifference curve 3 is associated with the highest level of util- ity, whereas curve 1 is associated with the lowest utility. Taylor is currently on curve 2. Given a choice among compensation plans with different expected payoffs and risk, Taylor will choose the combination that places him on the highest attain- able indifference curve.

Certainty Equivalent and Risk Premium

Figure 2.9 indicates that Taylor is indifferent between the risky commission scheme, which has an expected payoff of $100,000, and a certain income of $80,000. The $80,000 is Taylor’s certainty equivalent for the risky income stream—he is willing to trade the uncertain income of $100,000 for a certain income of $80,000. The dif- ference between the expected value of the risky income stream and the certainty equivalent is called the risk premium. This $20,000 premium, which comes in the form of a higher expected payoff, must be paid to keep Taylor indifferent between the risky income stream and his certainty equivalent.

Figure 2.9 Indifference Curves for Expected Value and Standard Deviation

This figure displays three indifference curves for a risk-averse individual. The individual prefers higher expected value but lower standard deviation. Standard deviation is a measure of risk. Since risk is a “bad,” the indifference curves are positively sloped. Upward and leftward moves are utility-increasing. Currently, the individual has a compensation package that has an expected value of $100,000 and a standard deviation of $81,650. The certainty equivalent of this package is $80,000. The risk premium is $20,000.

$

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(in d

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3

2

1 Risk premium = $20,000

Standard deviation (in dollars)

81,650

80,000

100,000

Increasing utility

$

Chapter 2 Economists’ View of Behavior 41

Suppose that Taylor receives a job offer from a competing real estate company that would pay him a fixed salary of $90,000 per year. Taylor considers the new job to be the same as his current job in all dimensions other than the compensation plan. Taylor’s current compensation plan will not be sufficient to motivate him to continue to work for RealCo. Even though his current plan has a higher expected payoff, he would prefer the certain $90,000 to RealCo’s risky commission plan. If RealCo wants to retain Taylor, it must offer him a compensation package that provides the same level of utility as the $90,000 for certain.

Risk Aversion and Compensation

Diversified shareholders, who invest in portfolios of companies, own much of the stock of large firms. Managers are often ill-diversified, having much of their human and financial capital invested in one firm. As we will discuss later in this book, this difference in diversification can lead to managers being overly risk averse in their investment decisions relative to those shareholders would prefer. Shareholders can induce managers to undertake more risky investment by adopting compensation plans that reward good outcomes, but that do not penalize bad outcomes heavily. The top management of Enron (see Chapter 1) arguably went too far in this direc- tion, inducing their managers to take too much risk (effectively transforming their behavior from risk averse to “risk loving”).24 We expand on this issue later in the book.

ANALYZING MANAGERIAL DECISIONS: Risk Aversion versus Risk Taking

Lauren Arbittier decides to bet $2,000 on number 35 of the roulette wheel in a Las Vegas casino. Almost immediately she starts to question her decision. Lauren normally is a risk avoider who hardly ever gambles. But she works at Trilogy Software where the CEO understands that taking risks and suffering the consequences are critical to the firm’s success. The CEO wants to develop peo- ple who take chances. “You don’t win points . . . for trying.” Lauren is participating in Trilogy’s three-month training program for all new recruits. It educates employees about, among other things, how to evaluate risky projects, not just to immedi- ately accept or reject the project because it is risky. The program also suggests to employees that they will not be rewarded at Trilogy unless they take

risks. Thus, although Lauren does not like taking risks, working for Trilogy, she has economic in- centives to do so.

There are at least three ways in which the Tril- ogy training program might be effective: (1) It changes employees’ preferences regarding risk bearing. (2) It more effectively identifies individu- als with the risk tolerances that Trilogy desires. (3) It better communicates the consequences to Trilogy employees of undertaking risky ventures. Discuss the likely importance of these three mecha- nisms.

SOURCE: E. Ramstad (1998), “High Rollers, How Trilogy Software Trains Its Raw Recruits to Be Risk Takers,” The Wall Street Journal (September 21), A1.

24Most managers have risk-averse preferences (utility functions). Managerial actions, however, are a function of both preferences and constraints. Thus risk-averse preferences can be offset or reinforced by the design of the compensation plan. Compensation plans that limit the upside potential but not the downside induce less risky choices, whereas plans that limit the downside but not the upside induce more risky choices.

42 Part 1 Basic Concepts

Summary In this chapter we summarize the way economists view behavior. In the economic model, individuals are seen as having unlimited wants but limited resources. They rank alternative uses of limited resources in terms of preference and choose the most preferred alternative. Individuals are clever in figuring out ways of maximizing their satisfaction (utility) in the face of resource constraints. Individuals are not necessar- ily selfish in the sense that they care only about their personal wealth: They also care about charity, family, religion, and society. They are not infallible supercomputers.

The opportunity cost of using a resource is the value of the resource in its best al- ternative use. For example, the cost of having a manager use five hours to work on a project is the value of the manager’s time in working on the next best alternative pro- ject. Economic decision making requires careful consideration of the relevant oppor- tunity costs.

Marginal costs and benefits are the incremental costs and benefits that are associ- ated with a decision. In calculating marginal costs, it is important to incorporate the opportunity costs of the incremental resources. For example, in deciding whether to purchase a new laptop computer, the marginal cost is its price and the marginal ben- efit is the value that the person places on the new computer. It is the marginal costs and benefits that are important in economic decision making. Action should be taken when the marginal benefits are greater than the marginal costs. Sunk costs that are not affected by the decision (e.g., unrecoverable funds previously spent on computers) are not relevant.

A utility function is a mathematical function that relates total utility to the amounts that an individual has of whatever items the individual cares about (goods). Preferences implied by a utility function are pictured graphically by indifference curves. Indifference curves depict all combinations of goods that yield the same level of utility. Individual choice involves maximizing utility given resource constraints. Graphically, the constraint depicts all combinations of goods that are feasible to ac- quire; it defines the feasible consumption opportunities. The optimal choice is where the indifference curve is tangent to the constraint. At this point, the individual is at the highest level of utility possible given the feasible opportunities.

Changes in opportunities result in changes in the optimal choice. An important implication is that managers can affect behavior by affecting constraints and opportunities. Managers, however, have to be careful. Individuals are clever at max- imizing their utility, and establishing disfunctional incentives can have perverse consequences.

We contrast the economic model with other models of human behavior that man- agers often use. We argue that the economic model is often more useful than alter- native models in managerial decision making.

The analysis in this chapter can be extended to the case where the decision maker faces uncertainty about the items of choice. An example of decision making under uncertainty is choosing among risky investment alternatives. One concept on which we will rely later in this book is risk aversion. When confronted with both a risky and a certain alternative having the same expected (or average) payoffs, a risk-averse per- son always will choose the certain outcome. A risk premium must be offered to en- tice the person to choose the risky alternative.

Throughout this chapter, we focus primarily on how managers might use this eco- nomic view to analyze and influence the behavior of employees. As we will see, the economic view is quite powerful and useful in explaining behavior in a variety of different contexts.

Chapter 2 Economists’ View of Behavior 43

G. Becker (1993), “Nobel Lecture: The Economic Way of Looking at Behavior,” Journal of Politi- cal Economy 101, 385–409.

M. Jensen and W. Meckling (1994), “The Nature of Man,” Journal of Applied Corporate Finance 7, 4–19.

2–1. Suppose there are only two goods that Bob cares about—(1) material welfare and (2) leisure time that he “buys” from the outside world at $40 per unit and $20 per hour, re- spectively. He currently lives and works in Atlanta, has a budget totaling $1,000 per week for these two goods, and consumes 11 units of material welfare and 28 hours of leisure time. a. Show Bob’s consumption choice on a graph using the actual budget line and a hypothet-

ical indifference curve. (Label the axes and show the x and y intercepts.) b. How will Bob’s optimal consumption choice change if the government imposes a

$10/unit tax on the material welfare good? c. Suppose Bob has a chance to move (at zero cost) to Saint Louis where material welfare

and leisure time cost $50 and $10, respectively. His budget remains the same as before and the government has decided not to impose a tax on the material good. Would Bob move to Saint Louis? Why or why not? Explain.

2–2. Amiko is an investor in the stock market. She cares about both the expected value and stan- dard deviation of her investment. Currently she is invested in a security that has an expected value of $25,000 and a standard deviation of $10,000. This places her on an indifference curve with the following formula: Expected Value � $15,000 � Standard Deviation a. Is Amiko risk-averse? Explain. b. What is Amiko’s “certainty equivalent” for her current investment? What does this mean? c. What is the risk premium on Amiko’s current investment?

2–3. You have won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $5025

Solutions to Self-Evaluation Problems 2–1. Individual Choice

a.

b. The $10 tax increases the price of material welfare from $40 to $50. Refer to Figure 2.6 to see the effects of a price increase on optimal consumption (replace food with material

B1

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l w el

fa re

u ni

ts

5028

11

25

Leisure time (hours)

Self-Evaluation Problems

Suggested Readings

25Suggested by R. Frank (2005), “The Opportunity Costs of Economics Education,” New York Times (September 1), C2.

44 Part 1 Basic Concepts

welfare on the vertical axis and clothing with leisure time on the horizontal axis). Bob is likely to reduce his consumption of material welfare due to the price increase. His con- sumption of leisure time could either go up, down, or stay the same depending on the exact nature of his adjustment. The change in relative prices (reflected in the flatter bud- get line) will work in the direction of motivating Bob to substitute units of material wel- fare for more leisure time. However, Bob’s new budget line will not allow him to stay on the same indifference curve as before (it rotates inward). His consumption of leisure time will depend on the exact location of the new tangency point on a lower indifference curve in the graph. Bob was spending $560 to purchase 28 hours of leisure time. Whether Bob consumes more or less leisure time after the price increase depends on how much money he has left over after buying fewer units of material welfare at the new higher price. For example, if he only reduces his consumption of material welfare from 11 to 10 units, he will have less money to spend on leisure time than before ($500 versus $560). Alterna- tively, if he reduces his consumption of material welfare to 8 or fewer units he will have more money than he had before to spend on leisure time. Which option he chooses de- pends on his specific utility function.

c. Bob would want to move to Saint Louis. In Saint Louis, his current consumption bundle only costs $830. This leaves $170 to spend on other goods. Since more is better than less, he can always do better in Saint Louis than he is currently doing in Atlanta.

2–2. Decision Making Under Uncertainty a. Yes, Amiko is risk-averse. She is willing to take on more risk only if it is associated

with a sufficiently higher expected return. b. Amiko’s certainty equivalent is $15,000. She would be willing to accept a certain return

of $15,000 (the vertical intercept of her indifference curve) in lieu of her current risky investment that has an expected return of $25,000 and a standard deviation of $10,000.

c. The risk premium on Amiko’s current investment is $10,000. This is the difference in the expected return of her risky investment and the risk-free investment (certainty equiv- alent). The $10,000 risk premium is what it takes in expected return to make her indif- ferent between the risk and risk-free investments.

2–3. Opportunity cost is a subtle concept that requires careful analysis to implement. Even trained economists can make mistakes if they are not careful to include all relevant costs in the analysis. Two researchers from Georgia State University (P. Ferraro and L. Taylor) posed the question to 200 professional economists at an annual meeting.

A careful application of the definition of opportunity costs yields a clear answer—$10. The next best alternative use of your time, going to the Bob Dylan concert, produces a net benefit of $10 (the $50 value you place on the Dylan concert minus the $40 to purchase the ticket). Marginal analysis implies that you should go to the Clapton concert as long as you obtain at least $10 worth of happiness from the concert. For example, if you value the Clapton concert at $15, you are $5 better off going to the Clapton concert than the Dylan concert, which yields only $10 of net value. Interestingly, only 21.6 percent of the profes- sional economists surveyed chose the correct answer, a smaller percentage than if they had chosen randomly. Additional surveys revealed that the incorrect answers were driven by faulty analysis and not by the specific wording of the question. College students who had taken a course in economics did even worse.

The lesson is that managers, students, and even economists should be careful to include all of the relevant explicit and implicit opportunity costs in their analyses. Missing a hypo- thetical question on opportunity costs is inconsequential. Managers can destroy significant value if they make mistakes in evaluating opportunity costs in their decision making.

2–1. Which costs are pertinent to economic decision making? Which costs are not relevant?

2–2. A noted economist was asked what he did with his “free time.” He responded by saying that “time is not free.” Explain this response.

Review Questions

Chapter 2 Economists’ View of Behavior 45

2–3. The Solace Company has an inventory of steel that it originally purchased for $20,000. It currently has an offer to sell the steel for $30,000. Should Solace’s management agree to sell? Explain.

2–4. Suppose that you have $900 and want to invest the money for one year. There are three ex- isting options. a. The city of Rochester is selling bonds at $90 per unit. The bonds pay $100 at the end of

one year when they mature (no other cash flows). b. Put the money under your mattress. c. The one-year interest rate of saving in the Chase Bank is 7 percent.

Which one will you choose? What is the opportunity cost of your choice? Explain.

2–5. Suppose Juan’s utility function is given by U � FC, where F and C are the two goods avail- able for purchase: food and clothing. a. Graph Juan’s indifference curves for the following levels of utility: 100, 200, and 300. b. Are these curves convex or concave to the origin? What does this shape imply about

Juan’s willingness to trade food for clothing? c. Suppose Juan’s budget is $100 and the prices of F and C are both $5. Graph the budget

constraint. d. How many units of food and clothing will Juan purchase at these prices and income?

Show graphically. What is his corresponding level of utility? e. The Johnson Company is the sole producer of clothing. What can the company do to in-

duce Juan to purchase more clothing? Show graphically. (The graph does not have to be exact.)

2–6. Suppose that Bob’s indifference curves are straight lines (as opposed to being convex to the origin). What does this imply about Bob’s willingness to trade one good for the other? Give examples of goods where this type of behavior might be expected?

2–7. Suppose that Bob’s indifference curves are perfectly L-shaped with the right angle occurring when Bob has equal amounts of both goods. What does this imply about Bob’s willingness to trade one good for the other? Give examples of goods where this type of behavior might be expected?

2–8. a. Briefly describe the five models of behavior presented in this chapter. b. What are the implications of these models for managers attempting to influence their

employees’ behavior?

2–9. Employees in a plant in Minnesota are observed to be industrious and very productive. Employees in a similar plant in southern California are observed to be lazy and unproduc- tive. Discuss how alternative views of human behavior and motivation might suggest differ- ent explanations for this observed behavior.

2–10. Employees at a department store are observed engaging in the following behavior: (a) they hide items that are on sale from the customers, and (b) they exert little effort in designing merchandise displays. They are also uncooperative with one another. What do you think might be causing this behavior, and what might you do to improve the situation?

2–11. One of the main tenets of economic analysis is that people act in their own narrow self- interest. Why then do people leave tips in restaurants? If a study were to compare the size of tips earned by servers in restaurants on interstate highways with those in restaurants near residential neighborhoods, what would you expect to find? Why?

2–12. Several school districts have attempted to increase teacher productivity by paying teachers based on the scores their students achieve on standardized tests (administered by outside testing agencies). The goal is to produce higher-quality classroom instruction. Do you think that this type of compensation scheme will produce the desired outcome? Explain.

2–13. A company recently raised the pay of employees by 20 percent. Employee productivity remained the same. The CEO of the company was quoted as saying, “It just goes to show that money does not motivate people.” Provide a critical evaluation of this statement.

46 Part 1 Basic Concepts

2–14. One physician who worked for a large health maintenance organization was quoted as saying:

One day I was listening to a patient’s heart and realized there was an abnormal rhythm. My first thought was that I hoped that I did not have to refer the patient to a specialist.

Indeed, HMO physicians have been criticized for not making referrals when they are war- ranted. How do you think the physician was compensated by the HMO? Explain.

2–15. Insurance companies have to generate enough revenue to cover their costs and make a normal profit—otherwise, they will go out of business. This implies that the premiums charged for insurance policies must be greater than the expected payouts to the policyholders. Why would a person ever buy insurance, knowing that the price is greater than the expected payout?

2–16. Critically evaluate the following statement: “Risk-averse people never take gambles.”

2–17. Suppose that an investment can yield three possible cash flows: $5,000; $1,000; or $0. The probability of each outcome is 1�3. a. What is the expected value and standard deviation of the investment? b. How much would a risk-neutral person be willing to pay for the investment? c. How much would a risk-averse person be willing to pay for the investment?

2–18. In order to spur consumer spending in 1998, the Japanese government considered an $85 bil- lion voucher system whereby every Japanese consumer would receive a shopping voucher that could be used to purchase Japanese products. For simplicity, assume the following: Each consumer has wealth of 1 million yen, consumers must allocate this wealth between con- sumption now (c1) and consumption later (c2), the interest rate is zero, the voucher is worth 100,000 yen, and it can be spent only in the current period. If it is not spent, it is lost. a. Plot a budget line for a representative consumer both before and after the voucher pro-

gram (c1 and c2 are on the axes). b. Do you expect that current consumption of a typical consumer will increase by the full

100,000 yen of the voucher? Explain. c. How does the impact of this 100,000-yen voucher differ from simply giving the individ-

ual 100,000 yen?

2–19. People give to charity. a. Is this action consistent with the “economic view of behavior”? Explain. b. Suppose there is a big drop in charitable giving. At the same time there has been no de-

cline in per capita income or total employment. Using the economic model, what poten- tial factors might have led to this decline in giving?

c. How might the decline in giving be explained by the product-of-the environment model?

2–20. The Japanese are very good at returning lost property to local police stations. If you lose a wallet filled with cash in Japan it is likely to be turned into the police. This is true even though the person finding it could keep it without anyone else knowing. This behavior is not what you would find in New York City. a. Does this observation about Japan imply that the economic model does not explain be-

havior in Japan? Explain. b. Police stations in Japan are filled with lost umbrellas. It used to be that the typical

Japanese would make a trip to the local police station to search for a lost umbrella. Now they don’t. Explain this behavior using the Economic Model.

c. Do you think that the typical Japanese is more likely to come to a police station to find a lost cell phone or a lost umbrella? Explain using the Economic Model.

2–21. Some states in the United States allow citizens to carry handguns. Citizens can protect them- selves in the case of robberies by using these guns. Other states do not allow citizens to carry handguns. Criminals, however, tend to have handguns in all states. Use economic analysis to predict the effects of handgun laws on the behavior of the typical criminal. In particular: (1) Do you think criminals will commit more or fewer robberies in the states with the laws? (2) How do you think the laws will affect the types of robberies criminals commit? Be sure to explain your economic reasoning.

2–22. Discuss the following statement: “Sunk costs matter. People who pay $20,000 to join a golf club play golf more frequently than people who play on public golf courses.”

Chapter 2 Economists’ View of Behavior 47

2–23. Jenny is an investor in the stock market. She cares about both the expected value and stan- dard deviation of her investment. Currently she is invested in a security that has an expected value of $15,000 and a standard deviation of $5,000. This places her on an indifference curve with the following formula: Expected Value � $10,000 � Standard Deviation. a. Is Jenny risk averse? Explain. b. What is Jenny’s “certainty equivalent” for her current investment? What does this mean? c. What is the risk premium on her current investment?

2–24. Accounting problems at Enron ultimately led to the collapse of the large accounting firm Arthur Andersen. When the Enron scandal first became public, Andersen’s top management blamed one “rogue partner” in the Houston office who they claimed was less honest than other partners at the firm. They fired the partner and asked that people not hold the remain- ing partners accountable for “one bad apple.” What model of behavior was Andersen’s man- agement using when it analyzed the source of the problem? According to the economic view of behavior, what was the more likely cause of the problem?

2–25. According to a recent article in The Atlanta Journal-Constitution (January 29, 2004), “ma- terialism, not necessity, gave birth to dual-income families.” In supporting the argument, the author cites the following figures from the Department of Commerce: In 1970 the average wage per job was $6,900, which in 2001 dollars (adjusting for inflation) amounts to $31,500. In 2001, the average wage per job was $35,500. The main thesis of the article is that dual-income families are a result of a shift in consumer preferences toward consump- tion as opposed to leisure time/time spent with the family. a. Assume the average person worked 250 days during a year both in 1970 and 2001, and

that, as reported in the article, only one person worked in the average family in 1970, while both parents did in 2001. Provide a graphical analysis of the typical family’s choice between family income and combined parent leisure time that supports the au- thor’s argument, relying on the tools presented in class. Be careful in labeling your graph(s), and provide a clear and concise explanation for your graph(s). Note that there are 365 days in a year so that the total parent leisure time that is possible is 730 days (assuming neither spouse works). Assume it is possible for each family member to work anywhere from 0 to 365 days a year (at the going salary rate) if they choose to do so.

b. Assume that in 1971 the average single person worked 220 days per year, while the same person worked 260 days per year in 2001. Moreover, suppose the average daily wage in 2001 dollars was $125 in 1970 and $140 in 2001. Show graphically how the au- thor’s argument would not necessarily apply to the average single person (i.e., assume preferences are unchanged). Explain clearly and concisely why the average worker may be choosing to work more in 2001 and carefully label your graph.

2-26. Russell and Joe have hired Maria to help cook in their restaurant. Maria had previously owned her own breakfast business. Her speed in cooking was well-known. Russell and Joe have been surprised that her productivity has fallen significantly since she became their paid employee. Use the economic view of behavior and marginal analysis to provide a potential explanation for Maria’s reduced productivity.

2-27. Michael is a fan of the Rhinos—the local professional soccer team. At the beginning of the season, he purchased nonrefundable season tickets to their 10 home games for a total of $100. Michael places equal value on each of the home games. His value for any given game is independent of how many other games he attended during the year. Michael would be willing to stay at home, which he derives no benefit from, and miss an individual game, if he could sell the ticket for one game for $20 or more.

Michael has attended three out of the last five home games. The sixth home game of the season is tomorrow night. Michael’s friend Fred has offered to sell him an extra ticket to a sold-out concert for $50 that happens to be on the same night as the game. Normally, Michael would be willing to pay $70 to attend the concert. There is no way that Michael can attend both the Rhinos’ game and the concert. Looking online, Michael finds that he can sell his ticket for tomorrow night’s Rhinos’ game for $5. a. What type/types of cost is the $100 that Michael paid for the season tickets? Explain why. b. Which event will Michael decide to attend? Explain why.

48 Part 1 Basic Concepts

c. How much would Fred have to charge Michael for the concert ticket in order to make Michael not care which event he attended? Explain why.

2-28. An entrepreneur quits his job as a banker and invests $100,000 of his savings in a new busi- ness venture that he will manage. Discuss the two most obvious opportunity costs that he will incur from this decision.

2-29. In one hour, John can assemble either 20 telephones or 10 answering machines. It takes Sally two hours to assemble either 20 telephones or 10 answering machines. Does either person have an absolute advantage in assembling either product? What about a competitive advantage? Explain (make sure you define absolute and competitive advantage and provide the opportunity costs for each person). Draw the combined production possibilities curve for the two people assuming that they work eight hours. Put answering machines on the horizontal axis.

2-30. You are trying to decide whether to fly or drive from Rochester to Boston during your sum- mer visit. The trip is approximately 400 miles. You can purchase a round-trip nonstop flight for $230. The duration of each flight is 3.5 hours (seven hours in total). If you drive, it will take you approximately seven hours each way (14 hours in total). Your car gets 32 miles to the gallon and you expect gas will cost $3/gal. Tolls are $15 each way. You value your time at $15 per hour. a. Calculate the total cost of driving to Boston and back. b. Under these conditions, will you drive or fly? c. What if you value your time at $20, rather than $15, per hour? d. You are offered a deal for $180 total airfare if you take a flight with a one hour layover

in NYC (total flying time does not change). Do you take the deal? Will this change your flying versus driving decision? (Use the $15 per hour value of time in the calculation.)

e. What are some other costs you may want to consider in this analysis? f. If you were expecting a snow storm, how might this change your analysis? What are

some other costs you may want to take into consideration?

2-31. The school is having a happy hour on Friday. If you go, you will get two free drink tickets and snacks, for which you would normally pay $15. However, you will have to pay $10 for the cab fare home. You also have a free student ticket to the local profession team’s soccer game. There is no resale value, as free tickets are still available. a. What is the opportunity cost of going to the soccer game? b. If you would not normally pay to go to the soccer game, which will you choose?

2-32. Bill and Chris produce balls and bats. In one hour, Bill can produce two bats or four balls, while Chris can produce one bat or three balls. They each work 10 hours a day. a. Which of the following, if any, is true? Explain why.

1. Chris has an absolute advantage producing balls and a comparative advantage producing balls.

2. Chris has an absolute advantage producing balls and Bill has a comparative advantage producing balls.

3. Bill has an absolute advantage producing balls and a comparative advantage producing balls.

4. Bill has an absolute advantage producing balls and Chris has a comparative advantage producing balls.

b. If Chris and Bill each split their time evenly between producing balls and producing bats, what is the total number of bats and balls that will be produced in one day?

c. Can the combined production of balls be increased while holding the number of bats produced constant? How?

d. Graph the combined production possibilities frontier for Bill and Chris. Place Bats on the vertical axis and Balls on the horizontal axis. [The graph would show the maximum com- bined amount of bats that could be produced by Bill and Chris for each feasible combined amount of balls that could be produced.]

Chapter 2 Economists’ View of Behavior 49

Appendix A: The main text of this chapter provided a simple graphical analysis of individual choice. Consumer It introduced utility functions, indifference curves, and budget lines. It depicted the op-

Choice timal choice as the tangency between an indifference curve and the budget line where the willingness and ability to trade are equal. This simple analysis explained how the optimal choice changes with changes in relative prices or income. This economic framework has important implications since managers often want to influence and/or predict the behavior of individuals, such as customers and employees.

This appendix extends the economic framework of individual choice (commonly called consumer choice). Its intent is to provide a deeper and richer understanding of this important model of behavior. This appendix also discusses how this model re- lates to an important topic that is covered in more detail later in this book—demand functions.

Marginal Utility A utility function expresses the relation between a person’s total utility and the level of goods consumed. Utility functions can take many forms. For illustration, suppose that Tom Morrell values only food and clothing and that his utility function is

U � FC (2.9)

where F is the units of food and C is the units of clothing that Tom consumes within the period. Notice, this simple utility function is multiplicative in both food and clothing. If Tom has no clothing, then no matter how much food he has, he has utility of zero. Likewise, if he has no food, then no matter has much clothing he has, his utility again is zero. If Tom’s consumption bundle consists of 20 units of both food and clothing his utility is 400, while his utility is only 100 if he has 10 units of both goods. Tom prefers the first bundle, but he is not necessarily four times happier when he has 20 units, rather than 10 units, of each good. The utility function provides an ordinal ranking of consumption bundles—not a cardinal rank- ing where “absolute” comparisons can be made.

Marginal utility measures the additional utility that is obtained by consuming one additional unit of a good, while holding all other goods constant. Marginal utility is an important concept in economic analysis since optimizing individuals focus on the mar- ginal (incremental) benefits and costs in making consumption choices. Figure 2.10 graphs Tom’s utility as a function of food, while holding clothing constant at 10 units. The equation for this graph is

U � 10F (2.10)

The marginal utility of food in this example is 10—for each additional unit of food that Tom consumes he receives 10 additional units of utility. More generally for any given quantity of clothing, C, the marginal utility of food is C (given Tom’s utility function). Similar logic implies that the marginal utility of clothing is F.26 We denote the marginal utilities for food and clothing by MUF and MUC , respectively.

26Note for the mathematically inclined: The marginal utility of any good X is equal to the partial derivative of the utility function with respect to X. In this example, the partial derivative with respect to F is C, and with respect to C is F. In this example, the marginal utility of each good is constant. More realistically, the marginal utility of a good will eventually decline as the consumer continues to receive more of the good. We employ this utility function only to simplify the presentation.

50 Part 1 Basic Concepts

Slope of an Indifference Curve Now that we have defined marginal utility, we can derive the slope of an indifference curve. Consider Tom’s indifference curve for U � 100. The equation for this indif- ference curve, which is pictured in Figure 2.11, is F � 100�C.27 Because all points on the indifference curve generate 100 units of utility, the total gain in utility

0

U til

ity

50

100

150

200

250

300

350

400

1 3 5 7 9 11

Slope = 100/10 = 10

13 15 17 19 21 23 25 27 29 31 33 35 Food (F )

1

10

Figure 2.10 Tom’s Utility as a Function of Food with Clothing Held Constant at 10 Units (U � 10F )

This figure displays Tom’s utility as a function of food with clothing held constant at 10 units. Marginal utility measures the additional utility that is obtained by consuming one additional unit of a good, while holding all other goods constant. The marginal utility of F in this example is 10 (the slope of the line)—for each additional unit of F that Tom consumes he receives 10 additional units of utility.

27The decision to place food on the y-axis is arbitrary. If we had placed clothing on the y-axis the equation for the indifference curve would be C � 100�F.

5 10 20 Quantity of clothing

5

10

20

Q ua

nt ity

o f

fo od

Indifference curve for 100 units of utility

A (5, 20): MRS = 4

B (10, 10): MRS = 1

C (20, 5): MRS = .25

Figure 2.11 Slope of One of Tom’s Indifference Curves: �(MUC/MUF)

This figure displays an indifference curve for 100 units of utility from Tom’s utility function: U � FC. The equation for the indifference curve is F � 100�C. The slope of an indifference curve at any point is �(MUC�MUF). The slope at a point is defined as the slope of the tangency line at that point. The tangency lines at points A and C are two examples. In this example, the slope at any point is �(F�C). The absolute value of the slope, which is called the Marginal Rate of Substitution (MRS), declines continuously along the curve. This property implies that Tom becomes less willing to trade F for C as C increases relative to F.

Chapter 2 Economists’ View of Behavior 51

associated with an increase in C must be balanced by an offsetting decline in utility from reduced consumption of F (as Tom moves along the curve):

MUC (�C ) � MUF (�F ) � 0 (2.11)

where �F and �C represent the changes in food and clothing. The first term in Equa- tion (2.11) represents the change in utility from changing the amount of clothing, while the second term represents the change in utility from changing the amount of food. These terms are equal in magnitude and of opposite sign along an indifference curve, and so total utility remains unchanged.

The slope of the indifference curve for a small change in C is given by (�F��C ). Rearranging Equation (2.11):

(�F��C ) � �(MUC�MUF) (2.12) Slope of the indifference curve � �(MUC�MUF)

In the example where U � FC, the slope of the indifference curve is �(F�C ) since MUC � F and MUF � C. For example, at the point where F � 5 and C � 20 the slope is �.25. The intuition for this result is as follows: If a marginal unit of clothing yields five units of utility, while a marginal unit of food yields 20 units of utility, food can be traded for clothing at a rate of .25 units for one unit, and utility will remain the same (for small changes in the two goods).

The absolute value of the slope of an indifference curve is called the Marginal Rate of Substitution (MRS). The MRS reflects the individual’s willingness to trade at a point on an indifference curve (in this example, trading food for clothing). Consider Tom’s willingness to trade when he has a consumption bundle of 10 units of both goods. The slope at this point is �(10�10) � �1. The MRS, which is equal to one, implies that Tom is willing to give up a small quantity of food to receive an equal number of units of clothing. (If Tom were to increase his con- sumption of C by 1 unit he would have to reduce his consumption of F by ap- proximately 1 unit to keep his utility the same.) The MRS declines along the con- vex curve indicating that Tom becomes less willing to trade food for clothing as the amount of clothing increases relative to food.28

Individual Choice Recall that the equation for the budget line is

F � (I�PF) � (PC�PF)C (2.13)

The absolute value of the slope, (PC�PF), reflects the consumer’s ability to trade in the market place. For example, when the price of clothing is $2/unit and the price of food is $1/unit, two units of food must be given up to consume one additional unit of clothing (PC�PF � 2). The intercept (I�PF) indicates how many units of food could be purchased if the entire budget is spent on food.

At the optimal consumption bundle the budget line is tangent to an indifference curve (which is the highest attainable indifference curve given the budget constraint).

28The slope of a curve is defined at a point on a curve and the slope changes along the curve. The slope of �1 at the point [10,10] reflects Tom’s willingness to trade for very small changes in C. For a full unit change in C, the decline in F is only approximately (as we reduce the size of the exchange—.1 unit of food or .01 unit of food—the change in utility approaches zero) equal to one. A one unit increase in C and a one unit decrease in F produce a consumption bundle with 99 units of utility. This value is approximately equal to the starting point of 100.

52 Part 1 Basic Concepts

This condition implies that the MRS is equal to the ratio of the prices at the optimum. Since the MRS is equal to the ratio of the marginal utilities for the two goods:

MUC�MUF � PC�PF (2.14)

The left side of Equation (2.14) represents the willingness to trade, while the right side reflects the ability to trade. At the point where the consumer is maximizing his utility (the optimum), the two are equal.

We can rearrange Equation (2.14) as follows:

MUC�PC � MUF�PF (2.15)

Equation (2.15) is an important and familiar result in consumer theory. It says that the consumer’s utility is maximized when the budget is allocated among goods so that the marginal utility per dollar of expenditure is the same for each good. At any combination where this condition does not hold, the consumer can be made better off by making feasible changes in the consumption bundle. For example, suppose Tom has an initial bundle where the marginal utility per dollar for clothing is 10 and for food is 20. Since he is getting more utility per dollar from food, he should spend less money on clothing and more on food. As he trades clothing for food, his marginal utility of clothing increases while his marginal utility of food decreases. Tom will eventually reach the optimal consumption bundle where the marginal utility-to-price ratios are equal. Equation (2.15) reflects a condition known as the equal marginal principle—the marginal utility per dollar is the same for all goods at the optimum.29

This principle reappears in various forms in the economic analysis of both consumer and producer behavior.

Solving for the Optimal Consumption Bundle Suppose that Tom has a budget of $100 and the prices of food and clothing are $1 and $2, respectively. How much of each good will he buy? This problem is straightforward since it involves two unknown variables (F and C ) and two independent equations. One equation is the optimality condition Equation (2.14); the second is the budget line Equation (2.13).

At Tom’s optimal choice, the MRS must equal the price ratio (i.e., MUC�MUF � PC�PF). Substituting the values for Tom’s marginal utilities yields

F�C � 2 (2.16) C � F�2

Tom must also satisfy his budget constraint:

F � 100 � 2C (2.17)

We can solve for the amount of food that Tom will purchase by substituting Equation (2.16) into Equation (2.17):

F � 100 � 2 (F�2) F* � 50

C* � 25 is found by substituting F* � 50 into Equation (2.16). At the optimal consumption bundle, Tom obtains 1,250 units of utility (25 � 50).

He can increase his consumption of clothing by purchasing 26 units of clothing and

29This condition is also referred to as the “equimarginal principle.”

Chapter 2 Economists’ View of Behavior 53

48 units of food (26 � $2 � 48 � $1 � $100). However, this bundle would yield only 1,248 units of utility (26 � 48). Alternatively, he could decrease his consump- tion of clothing by one unit and increase his consumption of food by two units (C � 24; F � 52). This bundle also would produce only 1,248 units of utility. Indeed any feasible alternative bundle would yield less than 1,250 units of utility.

The equal marginal principle holds at Tom’s optimal consumption bundle—the marginal utility per dollar of expenditure (MUi�Pi) is 25 for both goods. This condition implies that Tom has no incentive to shift expenditures from one good to the other since both goods yield the same marginal utility per dollar of spending.

The marginal utility of income is defined as the additional utility that the con- sumer receives from one additional dollar of income. It can be shown that at the op- timum, the marginal utility-to-price ratio for all goods is equal to the marginal utility of income. For example, if Tom’s income increases by $1, he could increase his util- ity by 25 units by purchasing additional quantities of either good.

Demand Functions A demand function expresses the mathematical relation between the quantity de- manded for a product (how many units consumers will purchase) and the factors that determine consumer choice (such as prices and income). In a more general setting than our simple example, the demand for clothing is likely to be affected by the price of clothing, consumer income, the prices of other products, and other variables (such as advertising expenditures). Managers care about consumer choice since a good under- standing of the demands for their products is important for making productive invest- ment, pricing, advertising, and other decisions. In subsequent chapters, we focus on ag- gregate demand for a product (total demand across all consumers in the market) without directly tying the analysis back to individual consumer behavior as analyzed in this chapter. Nevertheless, it is useful to recognize that aggregate demand for a given product can conceptually be derived from the framework presented in this appendix.

The derivation of Tom’s demand function for either food or clothing is particu- larly easy (given his utility function). Tom’s optimal consumption bundle is where his MRS equals the price ratio. In Tom’s case, this condition is

F�C � PC�PF (2.18) Tom’s total expenditures on either food or clothing is equal to the quantity purchased of the good times its price. By cross-multiplying Equation (2.18) we see that Tom’s expenditures on food and clothing are always equal:

(F � PF) � (C � PC) (2.19)

Equation (2.19) implies that Tom will always spend half his income on each good (this result is driven by his particular utility function). It follows that Tom’s total ex- penditures on clothing are (C � PC) � I�2. Solving for C produces Tom’s demand function for clothing:

C � I�(2PC) (2.20) This demand function implies that Tom will purchase more clothing as his income rises and less clothing as his income falls. His clothing purchases vary inversely with the price of clothing.

In our example, Tom had an income of $100 and PC � $2/unit. Consistent with Equation (2.20), we found that he consumed 25 units of clothing. The demand func- tion implies that if Tom’s income were to increase to $200 (holding price constant)

54 Part 1 Basic Concepts

he would purchase 50 units of clothing. In contrast, his clothing purchases would fall to 12.5 units if PC increased to $4 (holding income constant at $100). Tom is only one consumer who purchases clothing. The total (aggregate) quantity demanded for clothing at a given price is equal to the sum of the purchases made by all consumers in the market.

Since Tom always spends half his income on clothing, the amount of clothing that he purchases is not affected by the price of food. This is a special case, which does not hold for many other utility functions. Consider Anne George whose utility func- tion is U � C .5 � F.5. Anne’s demand for clothing is C � I�[(P2C�PF) � PC].30 This function indicates that Anne’s clothing purchases increase with income and the price of food, but decrease with the price of clothing. For example, at the initial prices and income (PF � $1, PC � $2, and I � $100) Anne purchases 16.67 units of clothing. If the price of food were to increase from $1 to $2, her demand for clothing increases to 25 units. When the prices for food and clothing are equal she spends half her in- come on each good. As relative prices change, Anne spends a higher percentage of her income on the relatively less-expensive good.

Income and Substitution Effects Equation (2.20) indicates that Tom’s demand for clothing decreases with the price of clothing. Figure 2.12 displays the example where the price of clothing increases from $2 to $4 (holding income constant at $100 and the price of food at $1). Remember, Tom’s utility function is U � CF. The price increase causes the budget line to rotate inward. The new budget line, B 2 is steeper than the original line, B1 (slopes of �4 and �2, respectively).

The inward shift of the budget line implies that Tom has less purchasing power than he had prior to the price increase. The area between the two budget lines con- tains consumption bundles that he could have purchased when PC � $2 that he can no longer afford. The reduced consumption possibilities imply that Tom has effec- tively less purchasing power than he had prior to the price increase. Thus, an increase in the price of clothing has two effects. One is to increase the price of clothing rela- tive to the price of food (i.e., PC�PF increases); the other is to reduce Tom’s effective income (purchasing power). As we will see, both effects influence Tom’s response to the price increase.

Tom purchased 25 units of clothing and 50 units of food when PC � $2, PF � 1, and I � $100. This choice, which is at the point of tangency between the original indifference curve, I1, and budget line, B1, is labeled as t1 in Figure 2.12. His optimal consumption bundle following the price increase, consisting of 12.5 units of clothing and 50 units of food, is pictured by the point of tangency, t2, between the indifference curve, I2, and the new budget line, B2. The decline in the quantity demanded for clothing from 25 units to 12.5 units represents the total effect of the price change (a decrease of 12.5 units). The total effect can be decomposed into a substitution effect and an income effect.

The substitution effect is the change in the quantity demanded of a good when its price changes, holding the prices of other goods and utility constant. To hold utility constant, Tom must be compensated for the price increase by receiving enough addi- tional income to maintain his previous level of utility of 1,250 units (U � FC � 25 � 50 � 1,250). Without this increase in income, he could not afford any of the bundles

30For practice, derive the demand function from Anne’s utility function (for this utility function: MUC � .5C (�.5) and MUF � .5F (�.5)).

Chapter 2 Economists’ View of Behavior 55

on the original indifference curve at the new prices. To focus on the effect of changes in relative prices (versus changes in effective income), we examine what Tom would do if he actually received this hypothetical income increase. This hypothetical situa- tion is depicted by an imaginary budget line, B in Figure 2.12—which is parallel to the new budget line, B2, and tangent to the original indifference curve, I1, at t . The resulting combination of 70.6 units of food and 17.7 units of clothing is the least expensive bundle that Tom can purchase at the new prices that yields 1,250 units of utility.31 Since the cost is $141.40, Tom’s income would have to increase by $41.40 to afford this combination. Thus, if he were to receive enough additional income to compensate for the price increase, he would respond by purchasing 7.3 units less of clothing and 20.6 units more of food than when the price of clothing was only $2. This substitution between clothing and food occurs because clothing is relatively more expensive. Figure 2.12 depicts the 7.3 unit decline in Tom’s clothing purchases with an arrow labeled “substitution effect.” The convexity of the indifference curves implies that the substitution effect is positive.

70.6

100

F oo

d

50

12.5 25 50 Clothing

17.7

Substitution effect: 25 – 17.7 = 7.3

Income effect: 17.7 – 12.5 = 5.2

Total effect = (7.3 + 5.2) = 12.5

I1 (utility = 1,250 units) I2 (utility = 625 units)

t1

B1

B2

t

t2

B

Figure 2.12 Income and Substitution Effects

This figure illustrates income and substitution effects. Tom’s original budget line and indifference curve are denoted by B1 and l1; here he chooses 25 units of clothing and 50 units of food as denoted by t1. An increase in the price of clothing from $2 to $4 causes the budget line to rotate inward as pictured by B2. At the new optimum, t2, Tom purchases 12.5 units of clothing and 50 units of food. The 12.5 unit decline in the demand for clothing is the total effect of the price change, which is the sum of the substitution and income effects. The substitution effect is 7.3 units. It is pictured by Tom’s optimal choice, t , which assumes that Tom has received additional income to keep him on the original indifference curve. The income effect of 5.2 units is the additional decline in demand due to the fact that Tom does not actually receive the hypothetical increase in income. The hypothetical increase is used to isolate the “pure price effect” from the effect of reduced purchasing power due to the price increase.

31This consumption bundle is found by solving two equations simultaneously. One equation is for the indifference curve containing bundles that yield 1,250 units of utility (F � 1,250�C); the second equation is that the slope of the indifference curve and the new budget line are equal at the point of tangency (F�C � 4).

56 Part 1 Basic Concepts

The hypothetical $41.40 increase in income is used to isolate the “pure effect” of the change in relative prices. Since Tom does not actually receive this extra income, he will not be able to purchase 70.6 units of food and 17.7 units of clothing (his ac- tual income is still $100). The decline in purchasing power from the price increase has an additional effect on Tom’s demands for clothing and food. The income effect is the change in the quantity demanded of a good because of a change in purchasing power, holding prices constant. The parallel shift in the budget constraint from B to B2 in Figure 2.12 captures Tom’s effective decrease in income. As Tom’s budget de- creases from the hypothetical level of $141.40 to the actual level of $100, he con- sumes 5.2 fewer units of clothing (17.7 � 12.5 � 5.2). The 5.2 unit reduction in quantity demanded is depicted in Figure 2.12 with an arrow labeled “income effect.”

The total effect is that Tom’s quantity demanded for clothing drops by 12.5 units (25 � 12.5 � 12.5) due to the price increase. The total effect, which is the sum of the substitution and income effects, is pictured by an arrow labeled “total effect.” The final result is that Tom purchases 12.5 units of clothing and 50 units of food and ob- tains 625 units of utility (50 � 12.5):

Total Effect � Substitution Effect � Income Effect 12.5 � 7.3 � 5.2

The substitution effect is always positive—changes in relative prices motivate sub- stitutions toward the relatively less-expensive good. The income effect for a normal good is also positive. As income decreases (increases) total consumption must decrease (increase); thus, on average the demand for goods must move in the same di- rection as the income change. Nonetheless, for some goods the income effect is nega- tive. For example, in contrast to a normal good the demand for canned meat products is likely to vary inversely with income (wealthy people are likely to shun canned meat and purchase fresh meat, such as steak). We call goods with demands that vary in- versely with income inferior goods. A positive income effect reinforces the substitu- tion effect and increases the magnitude of the response, while a negative income effect mitigates the substitution effect and reduces the magnitude of the response. In Tom’s case the 7.3 unit substitution effect is reinforced by the 5.2 unit income effect. For most goods, the income effect is small relative to the substitution effect, and thus the total effect usually is in the same direction as the substitution effect.

The income effect in Tom’s case is relatively large (42 percent of the total effect). This is due to the assumption that Tom can only purchase two goods. Since Tom spends half his budget on clothing, he experiences a large drop in purchasing power when the price of clothing doubles. In contrast to this simple example, most con- sumers purchase many goods and spend a relatively small percentage of their bud- gets on any one good (e.g., salt, toothpaste, apples, and so on). Thus, a change in the prices of the typical good does not have an important effect on the purchasing power of the consumer. This observation implies that for many products the substitution ef- fect is much more important than the income effect. For example, suppose that your nearby grocery store raises the price of cucumbers by $1/pound. Conceptually, your income (purchasing power) is lower than it was before since you can no longer pur- chase as many potential consumption bundles. This small decline in effective in- come, however, is not likely to be the driving force behind your response to the price change. The relative increase in the price of cucumbers might motivate you to use more tomatoes and fewer cucumbers in your next salad. However, this decision is driven by the change in relative prices of cucumbers and tomatoes—not by the small change in your purchasing power.

Chapter 2 Economists’ View of Behavior 57

Some goods, such as housing or transportation, constitute a relatively large propor- tion of the typical consumer’s budget. For these goods, income effects can be more important. Since these goods are the exception rather than the rule, we can safely ignore income effects in many applications. Correspondingly, we tend to concentrate on sub- stitution effects in analyzing the effects of changes in relative prices. The reader, how- ever, should be aware that other applications exist where income effects are important.

One prominent case where income effects can be important is the supply of labor. Figure 2.13 depicts Ralph Kramden who is choosing between work and leisure time. Ralph is a bus driver whose employer allows him to choose the number of hours he works each week. Ralph has a total of 100 hours per week that he divides between work and leisure activities (the remaining hours are used for sleeping, etc.). At a wage rate of $10 per hour, Ralph chooses to work 60 hours per week and has a total income of $600; the other 40 hours are used for leisure activities. The budget line ro- tates outward when the wage rate is increased to $20/hr. The new budget line is flat- ter than the original line (slope is 1�20 versus 1�10). The reduced slope captures the increase in the opportunity cost of leisure—leisure now costs Ralph $20/hr. The sub- stitution effect works in the direction of motivating Ralph to reduce his leisure time and to work more hours. The substitution effect in this example, however, is out- weighed by the income effect. At the higher wage rate, Ralph chooses to work only 40 hours per week; his total income is $800, which is $200 more than he made work- ing 60 hours at $10/hr. At an income level of $800, Ralph values an additional hour of leisure time at more than the $20 he could make from using the hour for work. At the lower level of income ($600) he placed a smaller value on an extra hour of leisure time (he had to work more hours to provide basic support for his family).

Magnitude of the Substitution Effect Economists typically assume that indifference curves are convex to the origin. Con- vexity is consistent with the behavioral observation that a person’s willingness to

$600

40

60

100

Le is

ur e

tim e

(h r)

Total income $1,000 $2,000

Budget line for wage = $20/hr.

Budget line for wage = $10/hr.

Figure 2.13 Income Effects in the Supply of Labor

This figure displays Ralph Kramden’s choice between work and leisure. Ralph has a total of 100 hours per week that he divides between work and leisure activities (the remaining hours are used for sleeping, etc.). At a wage rate of $10/hr., Ralph works 60 hours/week and has a total income of $600. At a wage rate of $20/hr., he chooses to work fewer hours (40) and to consume more leisure time (60 hours). While the increase in the wage rate increases the opportunity cost of leisure time, the income effect is larger than the substitution effect. At the higher income level ($800), Ralph places greater value on leisure time and works 20 fewer hours than when the wage rate was $10/hr.

58 Part 1 Basic Concepts

trade one good for the other generally declines as the relative amount of the second good increases (i.e., the MRS declines as the good on the horizontal axis increases). While Tom is willing to trade a large amount of food for a unit of clothing when he has lots of food and little clothing, his willingness to trade food for clothing declines as he reduces his food stock relative to his supply of clothing.

The substitution effect is always positive with convex indifference curves. An in- crease in the relative price of one good motivates substitution away from that good to- ward other goods (holding utility constant). The magnitude of the substitution effect, however, varies depending on the convexity (curvature) of the indifference curve.

Figure 2.14 compares the typical indifference curve with the two extremes. The first extreme is the case of perfect complements where the indifference curve is shaped as a right angle. In this case, the two goods are used in fixed proportions. An individual receives no additional utility from receiving more units of just one of the goods. For utility to increase, the quantity of both goods must increase. An example is shoes. The typical individual requires both a left and right shoe. Utility is not in- creased if the individual receives a right shoe unless it is matched with a left shoe.

The other extreme is perfect substitutes, where the indifference curve is a straight line. In this case, the MRS does not change as the person receives more of one good relative to the other. For example, a person’s willingness to trade $10 bills for $20 bills remains at 2 for 1 regardless of the relative supply of the two goods.

While most goods are neither perfect complements nor perfect substitutes, the con- vexity of indifference curves varies among products. Some indifference curves have sig- nificant curvature (tend to be closer to right angles), while others are relatively straight. The substitution effect is smaller when the indifference curve is more convex (closer to perfect complements). For example, a small increase in the price of left shoes will not motivate consumers to purchase fewer left shoes and more right shoes. In contrast, a small price change can motivate large shifts from one good to another when they are

G oo

d Y

Good X

G oo

d Y

Good X

G oo

d Y

Good X

Normal Case Perfect SubstitutesPerfect Complements

Figure 2.14 Convexity of Indifference Curves

This figure compares the typical indifference curve with the two extremes. The first extreme is the case of perfect complements where the indifference curve is shaped as a right angle. In this case, the two goods are used in fixed proportions. An individual receives no additional utility from receiving more units of just one of the goods. The other extreme case is perfect substitutes, where the indifference curve is a straight line. In this case, the MRS does not change as the person receives more of one good relative to the other. The substitution effect in response to a change in relative prices is larger when the two goods are close substitutes than when they are close complements.

Chapter 2 Economists’ View of Behavior 59

close substitutes. For instance, a small price change can motivate a consumer to switch from one brand of orange juice to another if the consumer is largely indifferent between the two brands (i.e., they are viewed as close substitutes). Geometrically, as the convexity of an indifference curve increases, the consumer does not have to move as far from the initial optimum to reach the new optimum as relative prices change (higher convexity implies that the slope of the indifference curve is changing more rapidly along the curve).

Additional Considerations Our analysis has focused exclusively on interior solutions where the consumer opti- mally purchases positive quantities of both goods. This focus is justified because it is the usual case with convex indifference curves. Nevertheless, there are special cases where it is optimal for the consumer to spend the entire income on only one of the goods. This outcome is known as a corner solution. For example, in the case of perfect substitutes it is optimal for the consumer to purchase only one of the goods unless the budget line and straight-line indifference curve have the same slopes, in which case the consumer is indifferent between purchasing either of the two goods (and thus might purchase positive quantities of both goods). For instance, you might be relatively in- different between holding your cash as $5 bills or $10 bills at an exchange rate of two for one. However, you will hold only one type of bill at other exchange rates. If you have the ability to trade one $10 bill in the marketplace for three $5 bills you should clearly do so. Similarly, while you might be indifferent between purchasing two simi- lar brands of orange juice when they sell for identical prices, you will quickly shift to buying only one brand if that one goes on sale.

For simplicity we have focused on an example based on only two goods. When there are more than two goods in the marketplace, an increase in the price of one good can motivate a reduction in the demand for other complementary goods. For example, an increase in the price for playing golf can reduce the demand for golf equipment. The substitution effect constitutes movement away from golf-related goods to other goods, which are now relatively less expensive. We examine comple- mentarity and substitutability of products in greater detail in Chapter 4.

Calculus Derivation of Equal Marginal Principle The equal marginal principle states that the marginal utility to price ratio is equal for all goods at the consumer’s optimal consumption bundle. At any combination where this condition does not hold, the consumer can be made better off by making feasi- ble changes in the consumption bundle. This section provides a calculus-based de- rivation of this principle.

The utility function for the two-good case takes the following general form:

U � f (xi, xj) (2.21)

To find the slope of an indifference curve, we totally differentiate Equation (2.21). We set this differential equal to zero, since utility does not change along an indifference curve:

dU � [�U��xidxi] � [�U��xjdxj] � 0 (2.22) The slope of the indifference curve is defined by dxi�dxj (when good i is placed on the y-axis). Thus the

slope of the indifference curve � �(�U��xj)�(�U��xi) (2.23) � �MUj�MUi (2.24)

60 Part 1 Basic Concepts

This expression has a straightforward interpretation. For illustration, assume that at some fixed combination of xi and xj, the marginal utility of good i is 1 and the mar- ginal utility of good j is 2. This means that 2 units of i can be given up for 1 unit of j and utility will stay the same. This is true by definition, since j has twice the mar- ginal utility of i.

At a consumer’s optimum the slope of the budget line (–Pj�Pi) is equal to the slope of the indifference curve:

�MUj�MUi � �Pj�Pi (2.25)

Rearranging this expression yields the Equal Marginal Principle:

MUj�Pj � MUi�Pi (2.26)

This principle immediately generalizes to utility functions with more than two goods.

ANALYZING MANAGERIAL DECISIONS: Consumer Choice

1. Define the following terms: marginal utility, ordinal utility, marginal rate of substitution, equal marginal principle, demand function, substitution effect, income effect, normal good, inferior good, perfect complement, and perfect substitute.

2. Susan Pettit’s preferences for coffee (by the pound) and doughnuts (by the dozen) can be characterized as follows:

MUcoffee � MUx � y2

MUdoughnuts � MUy � 2xy

a. If the ratio of relative prices is (Px�Py) � 6�3 � 2, and Susan’s income is $90 per period, what combination of pounds of coffee and dozens of doughnuts will she choose?

b. Now let the ratio of coffee to doughnut prices decline to unity (�1), holding the price of doughnuts constant. How does Susan respond to the reduction in the relative price of coffee?

c. Redo parts (a) and (b) for the case of income of $60 per period.

d. Derive Susan’s demand function for coffee. e. Is coffee a normal or inferior good for this

consumer? f. Does Susan consider coffee and doughnuts

to be either perfect complements or perfect substitutes? Explain.

3. Susan’s demand function for coffee in the previ- ous problem includes only the price of coffee and income. Thus, changes in the price of doughnuts do not affect the demand for coffee. Does this imply that there is no substitution effect between the two goods? Explain.

4. (More challenging problem) Mario Casali is a TV newscaster who gets an annual clothing allowance to buy suits that he must wear during his televised forecasts. He allocates the allowance each year between expensive Italian suits and cheap American suits. Mario’s utility function for suits is SA.5 where S is the number of Italian suits bought and A is the number of American suits bought. Last year, Mario bought two Italian suits and four American suits. [Note: MUS � A.5 and MUA � .5SA (�.5)] a. If Mario was maximizing his utility last

year, what was the ratio of the price of an Italian suit to the price of an American suit (PS�PA)?

b. What was Mario’s clothing allowance last year if the price of an Italian suit was $1,000?

c. If Mario has the same allowance this year as last year, and American suit prices have not changed, how high would the price of Italian suits have to rise in order for Mario to want to buy exactly one Italian suit this year?

Chapter 2 Economists’ View of Behavior 61

Appendix B: Introductory economics generally concentrates on single-period problems. For ex- Inter-Temporal ample, how does a consumer choose to spend her income within a single period? Decisions and How much should a firm produce in a single period to maximize its profits? What

the Fisher prices should it charge for this output?

Separation The frameworks introduced in this book, however, also are used to analyze

Theorem multiperiod problems. Indeed, this is what the modern study of finance is largely about. How does an individual choose between consumption today versus saving for the future? How does a firm choose between paying cash dividends now versus in- vesting to earn higher future profits?

This appendix provides a simple example of how the consumer choice frame- work presented in this chapter can be used to analyze inter-temporal consumption decisions. It also provides a brief introduction to the important problem of a firm deciding on whether to pay higher cash dividends now or to invest the cash to earn higher profits in the future. In so doing, we introduce an important concept that is the starting point of the modern study of finance—the Fisher Separation Theorem.

Simple Example of Inter-temporal Choice Mary Donaldson graduated from college five years ago and has been working as an entry-level employee at a bank. She has taken leave from her job to enter a one-year, full-time MBA program, which begins today. The bank has paid for her tuition, books, and basic room and board. It has also promised to promote her when she com- pletes the program. While Mary earns no salary from the bank while she is in the pro- gram, the bank has promised to pay her $75,000 per year in her new position. Mary currently has $25,000 in savings.

Mary can borrow money from a bank at a 5 percent interest rate if she wants to consume more while she is in school than she can buy with her $25,000. For exam- ple, she might want to rent a better apartment than the one she has been provided. She also might want to travel internationally on her school breaks or to upgrade her music system or automobile. Alternatively, Mary might want to save all or part of her $25,000 so that she can consume more in the future. She knows that she will likely want to buy a house once she starts her new job. She will also have moving and other expenses that will not be covered by her company. She earns 5 percent interest on her savings.

Mary’s problem is to decide how much to consume today versus how much to consume in the future given her current savings, future income, and the market in- terest rate. The key insights that arise from analyzing this problem can be illustrated most conveniently by assuming that Mary cares only about consumption at two points in time: today and one year from today. (This simplification is similar to our earlier focus on only two goods—food and clothing.) To simplify the analysis fur- ther, we assume that there is no uncertainty about Mary’s future income of $75,000 and that she pays no taxes on her interest or job income.

If Mary saves all $25,000 over the next year, she will have (1.05 � $25,000) � $26,250 at the end of the year in her account. Added to her $75,000 salary, the max- imum sum she could have to spend next year is $101,250. Mary, however, might want to increase her current consumption at the cost of not being able to consume as much next year. If Mary wants to spend more than $25,000 today, she will have to borrow to do it. The bank will not loan Mary more money than she is able to pay

62 Part 1 Basic Concepts

back (with interest) given her future income of $75,000. The maximum (B) that she can borrow is

(1.05) B � $75,000

B � $75,000/1.05 � $71,428

Adding the maximum borrowing of $71,428 to the initial $25,000 gives Mary a max- imum of $96,428 to consume today, assuming she consumes nothing next year.

Mary is highly unlikely to want to consume all of her funds in just one period. Rather she is likely to want consume at least something in each period. We refer to her $25,000 in current savings and the $75,000 she will receive next year in income as her endowment. One option is for Mary to consume her endowment at the time it is received. In this way, she neither saves nor borrows. Depending on her prefer- ences, however, Mary might want to borrow something from the bank to consume more today or to save part of her $25,000 to consume more in the future.

The solution to Mary’s decision problem can be pictured using the graphical framework introduced in this chapter. Figure 2.15 displays Mary’s inter-temporal budget line. The variable on the y-axis is Mary’s consumption next year (c2); the

100 20 70 Consumption today (C1) in $000’s

Mary is a net saver

Mary is a net borrower

Mary’s inter-temporal budget line slope = –(1.05)

Endowment

0

C on

su m

pt io

n in

o ne

y ea

r (C

2) in

$ 00

0’ s

30 40 50 60 80 90 100 110 120 130

10

20

30

40

50

60

70

80

90

100

110

120

130

Figure 2.15 Mary’s Inter-Temporal Consumption Choice

Mary’s initial endowment consists of $25,000 in current savings and $75,000 in future income. The interest rate for borrowing and lending is 5 percent. The inter-temporal budget line shows all feasible combinations of consumption today and consumption next year, given Mary’s endowment and the interest rate. Mary’s optimal choice is where the budget line is tangent to an indifference curve. The figure depicts two possible optima that assume different preferences for Mary. The one on the left is the case where she is a net saver. She saves part of her initial $25,000 so that she can increase her consumption in the second period. The one on the right shows the case where she borrows against her future income to increase her current consumption. The actual outcome depends on Mary’s particular preferences.

Chapter 2 Economists’ View of Behavior 63

variable on the x-axis is her consumption today (c1). The budget line goes through her endowment and shows all the feasible alternatives that Mary has, given her en- dowment and the 5 percent interest rate. The y-intercept of $101,250 is the maximum amount she can consume next year if she chooses to consume nothing today. The x-intercept of $96,428 is the maximum she can consume today if she chooses to consume nothing next year. The slope of the budget line is �1.05, which more generally can be expressed as �(1 � r), where r is the interest rate. Note that a change in the interest rate will change the slope of the budget line. An increase would make the line steeper, while a decrease would make it flatter. In all cases the line would include the endowment point.

Mary’s preferences can be pictured with standard indifference curves. All combi- nations of c1 and c2 along a given indifference yield the same level of utility. Mary’s optimal consumption choice occurs at the point of tangency between her budget line and an indifference curve (assuming an interior solution). Mary would like to be on an even higher indifference curve, but this is the best she can do, given her endow- ment and the interest rate of 5 percent. Whether Mary decides to borrow or save de- pends on her preferences. Figure 2.15 depicts two possibilities. The tangency on the left occurs at a point where Mary is a net saver (she saves part of her $25,000 to in- crease next year’s consumption); the tangency on the right shows the case where Mary is a net borrower (she borrows to consume more today at the cost of not being able to consume as much next year). Which of these, if either, that she will choose depends on Mary’s particular preferences for inter-temporal consumption.

Exercise for the Reader. As previously noted, a change in the interest rate will change the slope of the budget line. This, in turn, will change Mary’s optimal choice. Use the standard choice diagram depicted in Figure 2.15 to demonstrate each of the following: If Mary is a borrower when the interest rate is 5 percent, she will also be a borrower if the interest rate falls to 3 percent. However, if Mary is a borrower at 5 percent and interest rate rises to 7 percent, she may still be a borrower, but she might decide to switch to being a lender. Now suppose that Mary is a lender at the initial 5 percent rate. What will she do if interest rates rise? What if they fall?

Terminology. The maximum that Mary can borrow, given her future income of $75,000, is $71,428 at the 5 percent interest rate. In the business world, the $71,428 is referred to as the present value of the $75,000 future cash flow. It is the amount that Mary would need today to obtain $75,000 in one year investing at the market in- terest rate of 5 percent. The ability to earn 5 percent on her savings implies that Mary would be indifferent between receiving $71,428 today or $75,000 one year from now (since she could reproduce the $75,000 future cash flow with $71,428 today). The process of transforming future cash flows into present values is called discounting. The present value in this example was obtained by dividing the $75,000 by 1.05. More generally the present value of a cash flow, C, occurring one year in the future is C/(1 � r), where r is the annual interest rate.32 The $75,000 cash flow in this ex- ample is the future value of the $71,428.

32Calculating present vales is a bit more complicated when expected future cash flows occur at multiple dates in the future and when they vary in their riskiness. However, the basic concept is the same. A dollar today is worth more than a dollar in the future (since you could obtain the same dollar in the future by investing a smaller amount today).

64 Part 1 Basic Concepts

Fisher Separation Theorem Now consider an inter-temporal investment decision by a firm. Deon and Ramona each own 50 percent of the firm. The firm has $100,000 in cash that it could distrib- ute to the owners as cash dividends. This would give Deon and Ramona additional cash today. Alternatively the firm could use the funds to invest in a project that would allow it to pay higher future dividends to its owners.

Our previous example suggests that individuals can differ in their inter-temporal consumption preferences (some might want to save for the future, while others might want to spend more on current consumption). An important question is whether the managers of the firm should consider Deon and Ramona’s time preferences in de- ciding whether to invest in the project. The somewhat surprising answer is that under certain assumptions the answer is no.

Modern finance courses typically start with the assumption of perfect capital mar- kets, which are characterized by zero transaction costs, no taxes, and perfect infor- mation. In a perfect market, Deon and Ramona will unanimously agree that the firm should invest in the project if it increases the present value of the firm’s cash flows, even if they have quite different time preferences. This important result is one part of what is known as the Fisher Separation Theorem—named after the economist Irving Fisher. The other implication, which focuses on how the project is financed, will be addressed later in this appendix.

The basic logic for why the firm’s investment decision can be separated from its owners’ preferences is as follows. If the firm invests the $100,000 today it will re- ceive $110,000 as a cash inflow in one year. For simplicity, assume the firm makes this investment, then (1) the investment is riskless (the firm will receive the $110,000 for sure) and (2) the firm will discontinue operations at the end of the year and dis- tribute $55,000 each to Deon and Ramona. Alternatively, the firm might forgo the investment, discontinue operations and pay $50,000 to each of the owners in cash dividends today. We assume for this analysis that the firm, Deon, and Ramona can all borrow or lend at a market interest rate of 5 percent (subject to having the funds to pay back loans with interest).

If the firm decides to liquidate and pay $100,000 in cash dividends, the present value of the firm’s cash flows is by definition $100,000 (since the cash flows occur at the present time). The present value of $110,000 received in one year is $110,000/1.05 � $104,762. According to the Fisher Separation Theorem, both Deon and Ramona will want the firm to invest regardless of their inter-temporal preferences for consumption since it increases the present value of the firm’s cash flows.

To see why, suppose that Deon wants to consume all he can today, while Ramona wants to save all she can today to consume more in the future. If the firm invests in the project, it will be able to pay $55,000 to each owner in one year. Deon can bor- row $52, 381 from a bank using his future $55,000 as collateral ($52,381 � 1.05 � $55,000). In contrast if the firm does not make the investment, Deon will only have the current dividend of $50,000 to consume today—a loss of $2,381 in current con- sumption. Ramona, in turn, could borrow nothing today and have $55,000 to spend next year if the firm decides to invest. If instead the firm discontinues operations today, she will only have (1.05) � $50,000 � $52,500 to consume next year—a loss of $2,500 in future value. The difference is due to the fact that the firm can earn 10 percent on its investment, compared to the 5 percent that Ramona earns from per- sonal savings. The conclusion is that Deon and Ramona will both want the firm to invest even though they have dramatically different time preferences.

Chapter 2 Economists’ View of Behavior 65

Large corporations often have thousands of shareholders. The basic result illus- trated in this simple two-person example, however, readily extends to many joint owners. In a perfect capital market, all owners will unanimously agree that the firm should invest in any project that will increase the present value of its cash flows. The owners, in turn, can use their own borrowing and lending in capital markets to meet their individual inter-temporal preferences.

Financing Decision. The second part of the Fisher Separation Theorem focuses on the firm’s financing decision. According to the Fisher Separation Theorem, the fi- nancing decision does not affect value in a perfect capital market and is therefore ir- relevant. In other words, the firm’s financing decision can be separated from its in- vestment decisions. The investment decision should be based on present value, while the financing decision is irrelevant in a perfect market. In our current example, this implies that it would not matter whether the firm forgoes its current dividend and uses the $100,000 to finance the investment (as analyzed above) or pays the $100,000 in current dividends and borrows $100,000 to finance the investment.

The logic for this result can be illustrated by comparing how Deon and Ramona would fare if the firm were to borrow to finance the investment in the case analyzed earlier, where the project was financed by forgoing current dividends. If the firm pays the $100,000 it has on hand in current dividends and borrows $100,000 to fund the investment, it will have to pay $105,000 back to the lender in a year. Since its cash flow from the project is $110,000, it will have $5,000 leftover to distribute to Deon and Ramona in one year as dividends. If Ramona invests the initial $50,000 cash dividend at 5 percent, she will have $52,500 at the end of the year in savings plus the $2,500 dividend that she will receive at that time. The total of $55,000 is ex- actly the same as when the firm paid no dividends and used its own cash to fund the project. Thus, Ramona is indifferent as to how the project is financed. Similarly under the second option, Deon could borrow $2,500/(1.05) = $2,381 to finance cur- rent consumption (using his future dividend of $2,500 as collateral). Added to the $50,000 current cash dividend, he will have $52,381 to spend today—the same amount that he would have if the firm financed the investment with cash and paid no current dividends. Deon is also indifferent as to which of the two financing options the firm chooses.

Modern finance theory starts with this perfect capital market analysis. The as- sumptions of zero transaction costs and perfect information are then relaxed to ex- amine under what circumstances the Fisher Separation Theorem breaks down. The analysis focuses on whether there are “real-world” circumstances where the owners of the firm can disagree on a firm’s investment decisions or where the financing de- cision affects firm value? The answer to these questions is yes, but answering them is beyond the scope of this book.

chapter

3 C H A P T E R O U T L I N E

Goals of Economic Systems Property Rights and Exchange in a Market Economy

Dimensions of Property Rights Gains from Trade

Basics of Supply and Demand The Price Mechanism Shifts in Curves versus Movements along Curves Using Supply and Demand Analysis for Qualitative Forecasts Linear Supply and Demand

Supply and Demand— Extended Analysis

Price versus Quantity Adjustments Short-Run versus Long- Run Effects Industry Cost Increases and Price Adjustments

Prices as Social Coordinators Efficient Exchange and Production Measuring the Gains from Trade Government Intervention Externalities and the Coase Theorem

Markets versus Central Planning

General versus Specific Knowledge Knowledge Creation Specific Knowledge and the Economic System Incentives in Markets

Contracting Costs and Existence of Firms

Contracting Costs in Markets Contracting Costs within Firms

Managerial Decisions Summary Appendix: Shareholder Value and Market Efficiency

M uch of the world’s economic activity occurs within “free mar- kets” where individual decisions are coordinated through the price mechanism. For example, four of the countries with the largest gross domestic products (GDPs) in 2012 (the United

States, Japan, Germany, and France) all have developed market systems. China with the second largest GDP has made increased use of markets since the 1990s. Prior to that time it had been a centrally planned economy with an extremely low per capita GDP.

On closer inspection, however, it is evident that a substantial amount if not most of the production in modern economies takes place inside firms, where multimillion dollar resource allocation decisions (e.g., on what to produce and how to produce it) are made by managers without the use of market transactions. The monetary size of the world’s largest firms exceeds that of many economies. For instance, the 2012 GDPs of Peru, Kenya, and Portugal were $205 billion, $41 billion, and $212 billion, respectively; the 2012 net sales of ExxonMobil, Walmart, and Chevron were $453 billion, $447 billion, and $246 billion, respectively.

Exchange and Markets

L E A R N I N G O B J E C T I V E S

1. Illustrate the concept of Pareto efficiency. 2. Explain the role of alienable private property rights in markets and why

voluntary trade takes place.

3. Define and apply the concept of comparative advantage. 4. Explain the difference between demand and supply functions versus demand

and supply curves.

5. Distinguish between movements along supply and demand curves and shifts in the curves.

6. Explain the forces that move prices and quantities toward their equilibrium lev- els in a competitive market.

7. Explain why long-run demand and supply curves are generally more elastic than short-run curves.

8. Predict (qualitatively) the relative changes in price versus quantity when demand or supply changes in applied settings.

9. Define and interpret consumer and producer surplus; define and interpret dead- weight loss in terms of the value of foregone gains from trade.

10. Explain the effects of price controls both within the supply and demand model and in real-world terms.

Chapter 3 Exchange and Markets 67

To be effective, managers must have a working understanding of both markets and firms. In this chapter, we contribute to this understanding by examining five impor- tant questions: Why do most people actively participate in market exchanges? How do market systems work? What is supply and demand analysis and how can it be used by managers? What are the relevant advantages of using market systems com- pared to central planning in large economies? Why do we observe so much economic activity conducted within firms in market economies?

Answers to these questions are particularly important to managers for two rea- sons. First, an understanding of how markets work helps managers make appropriate strategic and operational decisions (e.g., input, output, and pricing decisions). The supply and demand analysis that we introduce in this chapter is especially useful in many management applications. Second, understanding the relative advantages and disadvantages of markets, central planning, and firms is directly relevant to under- standing firm-level issues such as which decision rights to be decentralized to employees and whether to make or buy each of the firm’s inputs. The basic tools and concepts introduced in this chapter are used to analyze these specific management decisions in more depth in subsequent chapters.

Goals of Economic Systems Every economic entity—be it a national economy, firm, or household—is confronted with three basic issues:

• What to produce • How to produce it • How to allocate the final output

Economic entities can be organized in alternative ways to address these issues. For instance, national economies can rely on either central planning or free markets. Similarly, firms and households can use centralized decision making, where the CEO or head of household makes all major decisions. Alternatively, other people in the firm or household can be granted substantial decision-making authority.

Given the alternatives, what is the best way to organize economic activities? To answer this question, we need some criterion for comparing alternative systems. Un- fortunately, uniform agreement over such a criterion is unlikely. For instance, you might argue that an ideal system would produce your preferred mix of products and give them all to you—although your neighbor would certainly disagree. Given these differences in opinion, economists generally focus on a relatively uncontroversial but narrow criterion for comparing the effectiveness of economic systems: Pareto efficiency.1 The production and distribution of goods and services in an economy is said to be Pareto-efficient if there exists no alternative that keeps all individuals at least as well off but makes even one person better off. If an economic system is not producing or distributing goods efficiently, it is conceptually possible to make its members better off by adopting Pareto-improving changes (thus benefiting some members without hurting others).

To illustrate the concept of Pareto efficiency, suppose that an economy can pro- duce two goods: desktop and tablet computers. Currently the economy is producing

1The term is named after Vilfredo Pareto, 1848–1923, an Italian economist and sociologist.

68 Part 1 Basic Concepts

1,000 desktops and 2,000 tablets. The two goods are being produced efficiently only if it is impossible to increase the production of one of the goods without decreasing the production of the other (given existing technology and resources). In contrast, suppose that some of the firms that are currently producing desktops are wasting raw materials due to suboptimal production methods (e.g., the firms could be scrapping more metal than necessary because of the way they cut metal sheets into final parts). In this case, the firms could increase their production of desktop computers by choosing more effective production methods without having any effect on the num- ber of tablets that are being produced. Doing so would be a Pareto improvement. The distribution of desktops and tablets (once they are produced) among consumers in this economy is Pareto efficient if there is no alternative distribution that keeps all individuals at least as well off but makes even one person better off.

As example of inefficient distribution, suppose that John owns a tablet but prefers a desktop, while Gunter owns a desktop and is indifferent between owning a tablet or a desktop. The current allocation is not Pareto efficient since John would be made better off if he and Gunter were to exchange the two products, while Gunter would be no worse off. The trade would be Pareto improving. If a change in the allocation of the two goods in the economy adversely affects even one person, the move would not be Pareto-improving and an economist would have little formal basis to conclude whether the move would be good or bad for society at large.2

Within centrally planned economies, government officials decide what to pro- duce, how to produce it, and who obtains the final output. In free markets, these de- cisions are decentralized to individuals within the economy. At least in concept, a central planner could order any feasible production and distribution of goods. Thus, any allocation of resources that could be achieved by a market economy also could be achieved by a centrally planned economy—at least in principle. We begin by dis- cussing how market systems work and how they can produce a Pareto-efficient allo- cation of resources. We then discuss why in large economies a market is more likely to produce an efficient resource allocation than central planning.

Property Rights and Exchange in a Market Economy A property right is a legally enforced right to select the uses of an economic good. A property right is private when it is assigned to a specific person. Private property rights are alienable in that they can be transferred (sold or given) to another individ- ual. For example, if Valerie Fong owns an automobile, she can use the automobile as she sees fit (within limits set by traffic laws). Valerie can restrict others from using her vehicle. She also can sell the automobile (transfer to another person whatever property rights her ownership confers in the vehicle). The government maintains police and a court system to help enforce these property rights.

An important feature of a market economy is the use of private property rights. Owners of land and other resources have the legal rights to decide how to use these re- sources and frequently trade these rights to other individuals. They are free to start new

2Therefore, economics does not address the question of which of the many possible efficient resource allocations is best for a society. Producing your preferred set of products and giving them all to you is efficient (the allocation cannot be changed without making you worse off). However, others will argue that the allocation is not fair or equitable. Economists have no special training in resolving these fairness or equity issues. Thus, we focus our attention on efficiency, which most people will agree is a laudable objective— given limited resources it is good not to waste them.

businesses and to close existing businesses. In contrast, in centrally planned economies, property tends to be owned by the state; government officials decide how to use these resources.

Dimensions of Property Rights

Ownership involves two general dimensions: use rights and alienability rights. These aspects of ownership are not always bundled together. You own your body in the sense that you can decide what activities to pursue. Yet, there are significant legal restrictions on alienability. For instance, you cannot enter a legally enforceable con- tract to sell one of your kidneys, despite the fact that you have two, can live com- fortably with one, and might value your second kidney much less than a wealthy in- dividual who is dying from kidney failure. This restriction eliminates the possibility of a free market in kidneys. In some transactions, it is possible to sell use rights while retaining alienability rights. For instance, in a rental contract, the renter obtains the rights to use an apartment, but does not own or have the right to sell the unit. Con- versely, the landlord has the right to sell the apartment, but does not have the right to use it during the term of the lease. (Rental, lease, and franchise agreements separate alienability and use rights; we examine these contracts in a later chapter.)

MANAGERIAL APPLICATIONS

Patent for Priceline.com Government-enforced patents better define property rights in new inventions. Patents in the United States are awarded for processes, machines, manufacturers, or compositions of matter that are considered useful, novel, and not obvious. Patents protect the intellectual property rights of the inventor and thus protect the common good by providing incentives to innovate novel and not obvious inventions.

Priceline.com received a patent for the world’s first buyer-driven e-commerce system where users can go to the Internet to name their price for goods and services. Expedia.com challenged whether Priceline.com’s process is really novel and not obvious. In 2001, the parties settled. Internet businesses where consumers can name their own price have to pay Priceline.com a royalty. This royalty is a tax on all Internet consumers. Awarding a patent for something that is obvious lowers incentives for future innovations that use this process.

Source: J. Gurley (1999), “The Trouble with Internet Patents,” Fortune (July 19), 118; L. Flynn (2002), “The Web World Watches Closely as British Telecommunications Stakes a Patent Claim on a Now-Ubiquitous Function: Hyperlinking,” New York Times (March 11).

Chapter 3 Exchange and Markets 69

MANAGERIAL APPLICATIONS

Property Rights Insecurity in Colombia Colombia has a continuing stream of impoverished farmers who are leaving the countryside and migrating to cities. They live in shantytowns that breed crime and violence. Yet Colombia has substantial arable land—an area equivalent in size to North Dakota. And only about 20 percent is used for agriculture. These seemingly inconsistent facts are both by-products of Colombia’s more than four decades long conflict between the government and a paramilitary force that is deeply involved in drugs. The resulting violence induces many to flee. But others are forced off their land or intimidated into selling at bargain-basement prices.

Source: J. Forero (2004), “Colombia’s Landed Gentry: Coca Lords and Other Bullies,” New York Times (January 21), A4.

70 Part 1 Basic Concepts

Gains from Trade

To understand how a market economy works, we must understand the motives for trading property rights. Why do people buy and sell? The basic answer is to make themselves better off.

Within the economic framework, people order their preferences and take actions that maximize their level of satisfaction (utility). Trade takes place because the buyer places a higher value on the item than the seller. The corresponding gains from trade make both parties better off—voluntary trade is mutually advantageous. For example, if José Coronas is willing to pay up to $26,000 for a particular automobile and Rochester Motors is willing to sell the automobile for as little as $20,000, the poten- tial gains from trade are $6,000 ($26,000 � $20,000). If the automobile trades at $23,000, both parties are $3,000 better off. José gives up $23,000 to buy something that he values at $26,000, while Rochester Motors obtains $23,000 for something it values at only $20,000. At other prices between $20,000 and $26,000, the total gains are still $6,000 but they are not split evenly. For example, at a price of $25,000, José gains $1,000 in value, while Rochester Motors gains $5,000.3

From where do these gains from trade come? One source is differences in prefer- ences. The buyer and seller simply may place different values on the traded item. For

3Sometimes, individuals regret a trade after the fact. For instance, José might be unhappy after he purchased a particular automobile from Rochester Motors. But given the information he had at the time of the transaction, he must have expected it to be advantageous to purchase the automobile or else he would not have done so (at least from Rochester Motors). José’s ability to say no limits the extent to which he can be exploited in any voluntary trade.

MANAGERIAL APPLICATIONS

While Animosity between the Governments of Venezuela and the United States Grows, So Does Trade Former Venezuelan President Hugo Chavez predicted that “capitalism will lead to the destruction of humanity.” In turn he worked hard to redirect his nation’s trade away from the United States to what he considered “more like-minded nations,” such as China and Iran. Washington has also taken steps to limit trade with Venezuela, such as halting American weapon sales to Venezuela.

The potential gains from trade between Venezuela and the United States, however, are large. For example, Venezuela is a leading producer of oil that is in high demand in the United States, while U.S. manufacturers produce automobiles and other products that are in high demand in Venezuela. Meanwhile many Venezuelans place lower value on an array of products produced by the like-minded nations, such as Chinese cars.

Despite the acrimony between the Venezuelan and U.S. governments, trade between the two countries continues to soar. Venezuela is the fourth largest oil supplier to the United States, while non-oil exports to the United States increased 116 percent during the first three months of 2006. Meanwhile, General Motors and Ford have been striving to meet soaring demand in Venezuela, with automobile sales up over 28 percent between July 2005 and 2006. General Motors, as Venezuela’s largest car manufacturer, indicated that it planned to invest $20 million to expand its output in the country by 30 percent, adding 600 new workers.

Trading partners are made better off through exchange. There are strong incentives to engage in trade. This example illustrates that these incentives are not easily thwarted by political rhetoric. Trade continues to thrive even though companies and individuals face potential government actions that could affect their trading relationships and corresponding investments.

Source: S. Romero (2006), “For Venezuela, as Distaste for U.S. Grows So Does Trade,” nytimes.com (August 16).

example, some people value new automobiles more than other people do. Another im- portant source of gains is that the seller may be able to produce the item more cheaply than the buyer and thus has a comparative advantage in its production. In advanced economies, individuals specialize in producing goods where they have a comparative advantage; they then trade to acquire other goods. Specialization greatly enhances the standard of living of a society. Imagine that you had to be completely self-sufficient, making your own clothing, growing your own food, building your own house, and producing your own vehicles for transportation. Your overall standard of living would be dramatically lower than it is living in a modern, specialized economy.

Table 3.1 presents a numerical example of comparative advantage. Donna Meyers and Mario Santini each produce their own food and drink through hunting and brew- ing beer. Panel A shows how many hours it takes for them to produce 1 pound of meat and 1 quart of beer. Panel B shows their allocation of time and resulting output work- ing independently prior to their meeting and trading. Both work 30 hours per week.

A. Time it takes for Donna and Mario to produce meat and beer

Meat (1 lb) Beer (1 quart)

Donna 1 hour 2 hours Mario 6 hours 3 hours

B. Allocation of time (30 hours per week) and output prior to specialization and trading

Meat Beer

Donna 18 hours; 18 lbs 12 hours; 6 quarts Mario 18 hours; 3 lbs 12 hours; 4 quarts Total production 21 lbs 10 quarts

C. Production with specialization

Meat (lbs) Beer (quarts)

Donna 30 0 Mario 0 10 Total production 30 lbs 10 quarts

D. One possible allocation after trading

Meat (lbs) Beer (quarts)

Donna 23 6 Mario 7 4

Table 3.1 Comparative Advantage

This table provides an example of comparative advantage. Panel A shows how many hours it takes for Donna and Mario to produce 1 pound of meat and 1 quart of beer. Donna and Mario each work 30 hours per week. Panel B shows their allocation of time and resulting output prior to meeting and trading. While Mario is less productive than Donna in an absolute sense for both goods, he has a comparative advantage in making beer (opportunity cost of 1⁄2 pound of meat for 1 quart of beer compared to Donna’s opportunity cost of 2 pounds of meat). Donna has a comparative advantage in producing meat. Panel C illustrates how total production can be increased by having both people specialize in the activity where they have a comparative advantage. Panel D displays a possible final allocation after Donna and Mario trade. Specializing and trading produce real gains for both people.

Chapter 3 Exchange and Markets 71

72 Part 1 Basic Concepts

Donna spends 18 hours per week hunting and 12 hours per week making beer, pro- ducing a total of 18 pounds of meat and 6 quarts of beer. Mario spends 18 hours hunt- ing and 12 hours making beer, producing a total of 3 pounds of meat and 4 quarts of beer. Their total production prior to meeting is 21 pounds of meat (18 � 3) and 10 quarts of beer (6 � 4).

Donna has an absolute advantage over Mario in making both goods—it takes her fewer hours to produce either a pound of meat or a quart of beer. Mario, however, has a comparative advantage (lower opportunity cost) for producing beer. Mario’s op- portunity cost for producing 1 quart of beer is 1⁄2 pound of meat (he could have pro- duced 1⁄2 pound of meat with the 3 hours he uses to produce a quart of beer), while Donna’s opportunity cost is 2 pounds of meat. Conversely, Donna has a comparative advantage in hunting. Donna’s opportunity cost for producing 1 pound of meat is 1⁄2 quart of beer, while Mario forgoes 2 quarts of beer to produce a pound of meat.

Panel C shows how total production can be increased by having each person spe- cialize in producing the product for which they have a comparative advantage. Donna can produce 30 pounds of meat by spending all 30 hours on hunting, while Mario can produce 10 quarts of beer by focusing exclusively on beer production. This specialization maintains total beer production at 10 quarts and increases the production of meat by 9 pounds.4 By specializing and trading, both parties can be made better off—there are gains from trade. The final allocation depends on the spe- cific bargain reached by Donna and Mario. One possible outcome is presented in Panel D, where both parties have the same amount of beer as before but more meat. Specializing and trading results in a Pareto improvement relative to working in isolation.

MANAGERIAL APPLICATIONS

Strategic Business Planning: Ignoring Economics of Trade During the 1970s, many firms adopted a particular form of strategic business planning. The idea behind this process is to treat the projects of a firm like stocks in a portfolio. Through systematic analysis, winners are to be kept and losers sold. Specifically, all projects of the firm are ranked based on growth potential and market share. Projects with high growth potential and high market share are called stars, while projects with low growth potential and market share are referred to as dogs. Dogs are sold, while stars are kept. Funding for the stars comes from cash cows, projects with high market share and low growth potential. Thus, money is invested in the winners to enhance the firm’s competitive advantage.

Although the idea might sound intriguing, its underpinnings are inconsistent with the basic economics of trade— sell if, and only if, you can get a price that exceeds the value of keeping the item yourself. This principle implies that, contrary to the process, dogs should be kept unless they can be sold at sufficiently high prices. Moreover, stars should be sold if the price is sufficiently high.

By the 1980s, many firms found that violating the basic economics of trade had led them to accumulate suboptimal collections of projects. Large increases in stock prices were observed as these firms reshuffled plants, divisions, and subsidiaries through sell-offs, spin-offs, and divestitures.

Source: (1984) “The New Breed of Strategic Planner,” BusinessWeek (September 17), 62–68.

4In this example, Donna and Mario completely specialize and produce only one product. More generally, at least one of the two people will specialize in producing one product. The other person might allocate some time to producing the same product (the one for which he does not have a comparative advantage) if additional gains are derived from producing more of the product than can be produced by the first person.

Figure 3.1 provides a graphical analysis of Mario and Donna’s gains from spe- cialization and trade. A Production Possibilities Frontier (PPF) shows all combina- tions of the two goods that can be produced with efficient production. Recall, with efficient production it is not possible to increase the production of one good without decreasing the production of the other. The figure pictures Mario and Donna’s indi- vidual PPFs, as well as their combined PPF that assumes appropriate specialization. The individual PPF ’s picture Donna and Mario production choices when each work independently with no trade. As drawn, Donna can produce both more beer and more meat than Mario if there is no trade.

The absolute value of the slope of Mario’s PPF, 1⁄2 lb. meat/qt. beer, is his oppor- tunity cost for producing beer. The absolute value of the slope of Donna’s PPF,

350 5 10 15 20 25 30

35

0

5

10

15

20

25

30

Beer (quarts)

M ea

t ( lb

s. )

No trade combined total

Com bined production possibilities

curve (PPF)— efficient production

Mario's production possibilities (PPF)

Donna's production

possibilities (PPF)

Donna with specialization

and trade

Mario with specialization

and trade

Example of complete specialization (Depending on their preferences they may want to locate somewhere else on the combined PPF)

No trade

No trade

G ai

n

G ai

n

G ai

n

Figure 3.1 Comparative Advantage

This figure displays the example of comparative advantage presented in Table 3.1 graphically. Donna and Mario’s Production Possibilities Frontiers (PPFs) show the combinations of the two products that each can produce individually, working 30 hours per week with no trade. The absolute value of the slope of Mario’s PPF, 1⁄2 lb. meat/qt. beer, is his opportunity cost for producing beer. The absolute value of the slope of Donna’s PPF, 2 lb. meat/qt. beer, is her opportunity cost for producing beer. Mario’s lower opportunity cost implies that he has a comparative advantage in beer production. The combined PPF shows combinations of meat and beer production that are possible if they divide the work based on comparative advantage. Any point on the combined PPF is efficient in the sense that the output of one good cannot be increased without decreasing the output of the other good, given their productive capacities. The y-intercept of 35 is the maximum meat that can be produced if they produce no beer. Moving from there, the slope of the PPF is initially �1/2, which assumes Mario will produce the beer because of his comparative advantage. The kink in the PPF occurs where Mario reaches his maximum production of 10 beers. Donna must produce any desired beers beyond that point, and she has a higher opportunity. The combined and individual gains from specialization and trade are also pictured.

Chapter 3 Exchange and Markets 73

74 Part 1 Basic Concepts

2 lb. meat/qt. beer, is her opportunity cost for producing beer. Mario’s lower oppor- tunity cost implies that he has a comparative advantage in beer production. The ini- tial production choices with no trade are pictured on the respective PPFs. The com- bined PPF shows combinations of meat and beer production that are possible if they divide the work based on comparative advantage. The y-intercept of 35 is the maxi- mum amount of meat that can be produced jointly if they produce no beer. Moving from there to positive beer production, the slope of the PPF is initially �1⁄2, which assumes Mario is assigned the task of producing beer because of his comparative advantage.

The kink in the PPF occurs where Mario reaches his maximum production of 10 beers for the week. Donna must produce any additional beers beyond that point, and she has a higher opportunity cost. The slope of the PPF from that point on is �2. Ar- rows showing the increased amount of meat that goes to each person (without re- ducing the beer they receive) picture the combined and individual gains from spe- cialization and trade. These gains are based on the assumption of complete specialization and Donna trading Mario 7 lbs. of meat for six beers. Where the two will actually produce on the PPF depends on their preferences for beer and meat. In simple two good examples of this type with linear PPFs, it is never optimal for both people to produce both goods. It, however, can be optimal for one person to be com- pletely specialized and the other person to produce some of both goods, depending on the demand for the two products.

While it is possible to have an absolute advantage in producing all goods, it is im- possible to have a comparative advantage in all activities.5 Specialization and trading are common features in economies throughout the world. Comparative advantage also arises in many management situations. For example, while a top-level manager might be able to perform many activities more effectively and in less time than a lower- level employee, the manager should not try to do all activities himself (make sales calls, work on the manufacturing line, change lightbulbs, answer phones, and so on). More value will be created if managers concentrate on activities for which they have a com- parative advantage.

5Note for the mathematically inclined: Donna’s opportunity cost for producing 1 pound of meat is 1⁄2 quart of beer (1 qt. beer/hr.)/(2 lb. meat/hr.) � 1⁄2 qt. beer/lb. meat. The reciprocal of this ratio, 2 lb. meat/qt. beer, is Donna’s opportunity cost for producing beer expressed in pounds of meat. If Donna’s ratio is smaller than Mario’s ratio for one product, the reciprocal of Mario’s ratio must be smaller than the reciprocal of Donna’s ratio. Thus Donna has a comparative advantage in producing the first product, while Mario has a comparative advantage in producing the second product. It is a mathematical impossibility for one person to have a comparative advantage in producing all products.

Gains from Trade In 1880, the United States was about to become the world’s most efficient economy. Yet labor productivity varied substantially among states. North Carolina, the least productive state, was only 18 percent of Nevada, the most productive. (In 1880, Nevada’s productivity was high because many had migrated there to work in the mines.) In 2002, New Mexico, the poorest state, had a per capita income that was almost 60 percent of Connecticut, the richest state. As a giant free-trade zone, incomes in the United States have converged to similar standards. Although there are still differences, those differences have fallen substantially—and not at the expense of the rich states.

Source: V. Postrel (2004), “A Case Study in Free Trade: American Incomes Converge, but Not at the Bottom,” New York Times (February 24), C2.

ACADEMIC APPLICATIONS

A common misconception is that trade takes place because people have too much of some goods—people sell to others what they cannot use themselves. This view, however, does not explain why individuals sell houses, cars, jewelry, land, and other resources that they value highly and have in short supply. The economic explanation for trade argues that trade takes place not because people have too lit- tle or too much of a good. Rather, trade takes place because a person is willing to pay a higher price for a good than it is worth to its current owner. While you might love your new sports car, you would still sell it if someone offered you a high- enough price. And winning bidders of collectibles auctioned on eBay are fre- quently individuals with collections of related items.

It is important to recognize that trade is an important form of value creation. Trading produces value that makes individuals better off. Gains from trade also pro- vide important incentives to move resources to more productive uses. If George Nichols can make the most productive use of a piece of land, he will be willing to pay a higher price for the land than other potential users. The current owner, Jody Crowe, has the incentive to sell the land to George, because she gets to keep the pro- ceeds from the sale. It is these incentives that help to promote a Pareto-efficient al- location of resources in a market economy. After all mutually advantageous trades are completed, it is impossible to change this allocation without making someone worse off.

Basics of Supply and Demand Gains from trade explain why individuals buy and sell. But what coordinates the sep- arate decisions of millions of individuals in a market economy to prevent chaos? Why are there not massive surpluses of some goods and huge shortages of other goods? What restricts the amounts demanded by the public to the amounts supplied? Answers to these questions come from an understanding of the market price system.

ANALYZING MANAGERIAL DECISIONS: Comparative Advantage in the Workplace

You are a manager of a division of a company that is responsible for the final assembly of two com- puter products, modems and keyboards. You man- age two employees, Julio and Chenyu, who each work 8 hours per day. Currently you have assigned both Julio and Chenyu to spend the first 7 hours of the day assembling keyboards and the last hour as- sembling modems. Julio can assemble 2 modems per hour and 14 keyboards per hour. Chenyu is more highly skilled in both activities. She averages 3 modems per hour and 15 keyboards per hour.

1. How many modems and keyboards are being assembled under the current work assign- ments?

2. What are Julio’s opportunity costs for assem- bling modems and keyboards? What are Chenyu’s? Does either employee have a comparative advantage in assembling one of the products?

3. Devise a way of reassigning the work activi- ties between the two employees that keeps the number of modems being assembled the same as before but increases the number of keyboards.

4. What are potential reasons why you might not want to change the work assignments (assume that more assembly of either or both products is desirable)?

Chapter 3 Exchange and Markets 75

76 Part 1 Basic Concepts

The Price Mechanism

The basic economics of a price system can be illustrated through standard supply and demand diagrams. Figure 3.2 displays a supply and demand diagram for a particular model of personal computer—for example, a Pentium dual-core machine with standard quality and features. The vertical axis on the graph shows the price for a PC, and the horizontal axis shows the total quantity of PCs demanded and supplied in the market for the period (e.g., a month).

The market includes all potential buyers and sellers of this type of PC. Suppose that in this market there are many buyers and sellers and that individual transactions are so small in relation to the overall market that the price is unaffected by any single sale or purchase. In this case, no buyer or seller has market power: All trades are made at the going market price. We label this type of market as competitive.

The demand curve depicts how many total PCs consumers are willing to buy at each price (holding all other factors constant). The demand curve slopes downward because consumers typically buy more if the price is lower. For example, consumers are likely to buy more PCs if the price is PLO (say, $900) than if the price is PHI (say, $1,500).

The supply curve depicts how many PCs producers are willing to sell at each price (holding all other factors constant). The curve slopes upward: At higher prices, pro- ducers are able and willing to produce and sell more units. For example, at a price of $900, many potential producers cannot cover their costs, and thus they refrain from entering production. At a price of $1,500, more units are manufactured and brought to market.

P ric

e (in

d ol

la rs

)

Demand

Supply

Q

Surplus

Shortage

P HI

P *

PLO

Q*

$

Quantity of PCs

Figure 3.2 Supply and Demand in the PC Industry

The demand curve shows the number of PCs that consumers want to purchase at each price. The supply curve shows the number of PCs that producers want to sell at each price. Equilibrium occurs where the two curves intersect. Here, the quantity supplied equals the quantity demanded. If the price is above the market-clearing price of P*, say at PHI, there is a surplus of PCs. Producers supply more PCs than consumers want to purchase, and inventories build. If the price is below the market-clearing price, say at PLO, there is a shortage. Producers supply fewer PCs than consumers want to purchase and inventories shrink. Surpluses and shortages put pressure on prices and quantities to move to equilibrium levels of P*.

The two curves cross at the market-clearing price P* and quantity Q*. At the mar- ket-clearing price, the quantity of PCs demanded exactly equals the quantity sup- plied. Here, at a price of $1,200, the market is said to be in equilibrium.

There are strong pressures within markets that push prices and quantities toward their equilibrium levels. To see why, suppose that the market price is above the equi- librium price, such as PHI in Figure 3.2. At this higher price, there is a surplus of PCs—suppliers produce more PCs than consumers are willing to purchase. As inven- tories of unsold PCs build, this surplus places downward pressure on prices as suppli- ers compete to try to sell their products. As prices fall, fewer PCs will be produced and more will be demanded, thus reducing the surplus. In contrast, if the price is below the market-clearing price, such as P LO in Figure 3.2, inventories dwindle and back orders accumulate—there is a shortage of computers. Here, consumers will bid up the price of PCs as they compete for the limited supply. As prices rise, producers increase their output and consumers demand fewer PCs, thus reducing the shortage. When the mar- ket is in equilibrium, there is no pressure on prices and quantities—the quantity de- manded exactly equals the quantity supplied. Inventories are stable at their desired levels, and the market price is stable at this point.

Supply and demand diagrams like that in Figure 3.2 are snapshots at a point in time. As time passes, both the supply and the demand curves are likely to change. Figure 3.3 shows the effects of a shift in the demand curve in the PC market. The left panel depicts an increase in demand. Here, there is a shift in the demand curve to the right, since at each price, consumers demand more PCs. Demand for PCs might increase for a variety of reasons, including an increase in the purchasing power of consumers or a decline in the prices of supporting software. These types of changes motivate consumers to purchase more PCs at any given price. After the demand shift at the old equilibrium price, inven- tories shrink and there is a shortage of PCs. This shortage places upward pressure on prices; higher prices in turn stimulate more production. The end result is a higher equi- librium price and quantity. The right panel shows that the opposite effect occurs with a reduction in demand. This shift to the left in the demand curve also can be caused by a variety of factors (e.g, a recession that causes businesses to reduce their purchases of PCs or an increase in personal tax rates that reduces consumers’ purchasing power).

Chapter 3 Exchange and Markets 77

Q

Initial demand

Initial demand

$

P ric

e (in

d ol

la rs

)

$

Increase in demand Decrease in demand

Q

S0 S0

D1

D2 D0

Q0 Q0Q1 Q2

D0

Quantity of PCs Quantity of PCs

*

P1*

P0*

* **

*

P0

P2

*

Figure 3.3 The Effects of a Shift in Demand on the Equilibrium Price and Quantity of PCs

The initial equilibrium is where the demand curve, labeled D0, intersects the supply curve, labeled S0. The left panel shows the effects of an increase in demand. The result is a higher equilibrium price and quantity. The right panel shows the effects of a decrease in demand. The result is a lower equilibrium price and quantity.

78 Part 1 Basic Concepts

Figure 3.4 depicts the effects of a shift in supply in the PC market. The left panel displays a shift in the supply curve to the right. A rightward shift implies an increase in supply, because at each price producers make and offer more PCs. Many factors might cause an increase in supply. For example, a decline in the prices of labor and other inputs used for manufacturing PCs will make PC production more profitable and increase supply. Supply also might increase because of changes in technology that allow for less expensive, more efficient production. After the supply shift at the old equilibrium price, inventories accumulate and there is a surplus of PCs. This sur- plus places downward pressure on prices, which in turn increases the quantity of PCs demanded. The end result is a lower equilibrium price and higher equilibrium quantity. The right panel shows that the opposite effect occurs when supply shifts to the left.

Initial supply

P ric

e (in

d ol

la rs

)

Initial supply

Q

P *1

D0

S0 S2

S1 S0

D0

P *0

Increase in supply Decrease in supply

P *2

P *0

Q

$ $

Quantity of PCs Quantity of PCs

Q0 Q0Q1 Q2* * **

Figure 3.4 The Effects of a Shift in Supply on the Equilibrium Price and Quantity of PCs

The initial equilibrium is where the demand curve, labeled D0, intersects the supply curve, labeled S0. The left panel shows the effects of an increase in supply. The result is a lower equilibrium price and an increase in equilibrium quantity. The right panel shows the effects of a decrease in supply. The result is a higher equilibrium price and a lower equilibrium quantity.

MANAGERIAL APPLICATIONS

Shifts in Demand, Quantity, and Price at the PGA Tournament The PGA Tournament features competition among the world’s top golfers. In 2013, the PGA was held at Oak Hill Country Club in Rochester, New York. The event attracted over 30,000 spectators a day. Many of these spectators were from outside the Rochester area.

A significant number of these visitors were avid golfers who wanted to play while they were in Rochester. Rochester has several courses that are open to the public. However, many courses in the area are private (only members and their guests can play). Facing this dramatic temporary increase in the demand for public golf courses, several of the private courses decided to become public during the week of the PGA. These courses charged high fees ranging from $150 to $350 per round (their normal guest fees were approximately $75). This example highlights that shifts in demand motivate increases in the quantity supplied and the price of a product (in this case, golf times).

Chapter 3 Exchange and Markets 79

Shifts in Curves versus Movements along Curves

Demand and supply curves depict the quantities that will be demanded and supplied at each possible price, holding all other relevant variables constant. The price observed in the market determines the specific quantity demanded and quantity supplied in the marketplace (i.e., the price determines the relevant points on the two curves).

We have provided examples of how a change in an important non price variable can cause either the demand and/or supply curve to shift. It is common to refer to a rightward shift in the demand curve as an increase in demand and a leftward shift as a decrease in demand. Similarly, a rightward shift in the supply curve is referred to as an increase in supply (higher quantity is supplied at any given price) and a left- ward shift as a decrease in supply.

A movement along a given demand or supply curve is caused by a change in price (holding other variables constant). The change in price is said to result in a change in the quantity demanded or quantity supplied.

It is important to be able to distinguish between shifts in demand and supply curves (changes in demand or supply) and movements along a given curve (changes in quantity demanded or quantity supplied). For example, reconsider the increase in supply pictured on the left in Figure 3.4. As we have discussed, this increase would have been motivated by a change in some relevant variable other than the price of the product, such as a decline in the hourly wage paid to labor. The rightward shift in supply indicates that producers will supply more of the product at any given price. The demand curve has not changed, so there is no change in demand. However, there is a change in the quantity demanded when supply increases—at the lower equilib- rium price consumers purchase more of the product.

Note that a change in supply or demand is motivated by a change in a relevant variable other than the price of the good. On the other hand, a change in the quantity demanded or quantity supplied is caused by a change in the price of the good, in- duced by a shift in the other curve, holding all other variables that affect the position of the curve constant.

Using Supply and Demand Analysis for Qualitative Forecasts

Consulting firms, large companies, and governmental agencies use formal statistical analysis to develop quantitative estimates of demand and supply to use in analyzing specific markets. Managers, analysts, the media, and others, however, often use sup- ply and demand analysis on a much less formal basis simply to forecast the direction of changes in prices and quantities in the marketplace.

For example, suppose that Mr. Fan owns a restaurant chain in the United States that features a menu of specialty beef dishes. Fan has just read in his morning news- paper that there have been newly reported cases of “Mad Cow Disease” in the United States. Several people who ate contaminated beef died recently from the disease. Fan recalls that Japan, South Korea, and other countries immediately stopped importing American beef when the first case of Mad Cow disease was reported in the United States a number of years ago. Among other things, Fan wants to know what effect the scare will have on the price that he will have to pay for beef over the upcoming months.

Fan can use supply and demand analysis to forecast the directional effect that the Mad Cow scare will have on beef prices. First, he needs to consider whether it will

80 Part 1 Basic Concepts

affect the demand for beef, the supply of beef or both. He is fairly confident that the scare will cause demand to decrease. As pictured in Figure 3.3, a decrease in demand is expected to result in a lower price for beef. However, Fan should not forget supply. For example, what if the government immediately ordered the slaughter and disposal of 90 percent of all cows in the United States to protect consumers from the disease? He needs to take both effects into account, unless he has good reason to assume that one of the effects is not likely to be important.

For practice, suppose that you are Fan and use supply and demand analysis to forecast the directional change in the price beef. Start by drawing a standard supply and demand diagram, as pictured in Figure 3.2 to depict the beef market prior to the scare. Draw the projected shifts in supply and demand caused by the scare. Note that the shifts in both curves have the same directional effect in reducing the equilibrium quantity. The effects on price, however, are in opposite directions. In such cases, you need to ask yourself, which effect is likely to be larger? Sometimes it is hard to fore- cast. Suppose in this case, Fan is relatively confident that the short-term supply of beef will not change very much. The government is unlikely to order the mass de- struction of cows due to a few reported cases of the disease. If so, he might assume that the demand effect is likely to dominate and the near-term effect is likely to be a decline in beef prices. In the longer run, the cost of cattle ranching and beef process- ing could increase due to new government regulations, additional testing for Mad Cow disease, and so on. Thus the longer run effects are harder to forecast. For addi- tional practice, what affect do you think the scare will have on the price of chicken products?

Fan is also likely to be interested in how the scare will affect customer demand for his beef dishes. Demand for products is the subject of the next chapter.

Linear Supply and Demand

Throughout this book we use linear demand and supply curves (as pictured in Fig- ures 3.2 to 3.4). Linearity simplifies the analysis and is often a reasonable approxi- mation in actual applications (at least over the range of actions being considered). This section provides a numerical example of supply and demand analysis using lin- ear supply and demand curves.

Suppose that the supply function for apples is

Qs � 30 � 0.2Pa � 3W (3.1)

where Qs is the quantity supplied of apples in millions of pounds, Pa is the market price for apples in cents, and W is the hourly wage rate paid to agricultural workers. The supply function indicates that farmers will produce more apples as either the market price of apples rises or the wage rate for workers falls. Farmers produce more apples when the wage rate falls since production costs are lower. Currently the wage rate is $10. Substituting this value in Equation (3.1) and solving for Pa produces the current supply curve6:

Pa � 5Qs (3.2)

6Recall that when graphing the supply and demand curves, the convention is to place price on the vertical axis.

Chapter 3 Exchange and Markets 81

Supply curves show the relation between price and quantity supplied holding all other factors constant (in this case the wage rate for agricultural workers).

Suppose that the demand function for apples is

Qd � 20 � 1�3Pa � 0.002I (3.3)

where I � per capita income. The demand function indicates that consumers will purchase more apples as the price falls and/or as income increases. Currently income is $10,000. Substituting this value into the demand function and solving for Pa pro- duces the current demand curve:

Pa � 120 � 3Qd (3.4)

In equilibrium, the quantity supplied equals the quantity demanded: Qs � Qd � Q* where Q* denotes the equilibrium quantity. Substituting Q* into the supply and demand curves (Equations [3.2] and [3.4]) and setting them equal (since there is one equilibrium price) allows us to find the equilibrium quantity, Q*:

5Q* � 120 � 3Q* (3.5) Q* � 15

The equilibrium price of 75 cents is found by substituting the equilibrium quantity of 15 into either the demand or supply curve Equations ([3.2] or [3.4]).7

ANALYZING MANAGERIAL DECISIONS: Ethanol and Pork Prices

Over the past decade, the federal government has taken significant steps to encourage the develop- ment of ethanol and other fuels made from plants as a partial replacement for gasoline. These actions have been undertaken by politicians in the midst of public concerns about the dependence on foreign oil, war in the Middle East, and global warming. The primary input for ethanol production is corn. In 2011, the 13.9 billion gallons of ethanol pro- duced in the United States consumed over 20 per- cent of the domestic corn supply.

Suppose that the government has just passed new legislation mandating increased annual pro- duction of corn ethanol. You manage the Hog Heaven restaurant chain. Your restaurant chain, which has about 300 outlets throughout the United States, specializes in barbecue pork dishes but also

offers chicken, beef, and vegetarian meals. Cur- rently about 80 percent of your revenue comes from your pork dishes. The price of pork has a major impact on your costs. You are concerned that the federal promotion of ethanol might have an impact on pork prices and the profitability of your restaurant chain. Feed cost is typically about 50 to 60 percent of the total cost of production of pork producers. About 80 percent of the feed that hogs consume is corn.

1. Use basic supply and demand analysis to illus- trate the likely effect of the government’s man- dated increase of ethanol production on (1) corn prices and (2) pork prices.

2. What actions might you consider given the results of your analysis?

7We could have found the equilibrium price by setting the demand and supply functions (Equations [3.1] and [3.3]) equal after substituting for the current values of W and I. The equilibrium quantity then could be found by substituting the equilibrium price into either Equation (3.1) or (3.3). We took the extra steps of solving for the demand and supply curves to illustrate how they are derived from the underlying demand and supply functions. We elaborate on this derivation in the case of the demand curve in the next chapter.

82 Part 1 Basic Concepts

Note that changes in the wage rate shift the supply curve, while changes in income shift the demand curve. See if you can find the new equilibrium price and quantity if income increases to $20,000. Answer the problem before looking in this footnote for the answer.8

Determining the equilibrium in simple numerical supply and demand problems can be summarized as follows. Begin by inserting the current values for variables other than price into the supply and demand functions and solve the functions for P to get the demand and supply curves. Equate the supply and demand curves and solve for the equilibrium quantity, Q*. Put Q* into either the supply or demand curve equations and solve for the equilibrium price, P*.

To consider the effect of a change in a non price variable, replace the original value with the new value and repeat the above steps to obtain the new equilibrium. It is a good idea to graph these kinds of problems on a standard supply and demand diagram, which shows the original equilibrium, as well as the shift in the relevant curve and the new equilibrium. Graphical analysis can often provide a more intuitive understanding of a problem. It also can be helpful as a check for arithmetic errors that can arise in purely algebraic solutions to the problem.

Supply and Demand—Extended Analysis This section uses supply-and-demand framework to analyze other issues of manage- rial interest. It begins by considering whether a change in supply or demand is likely to have a greater impact on the equilibrium price or quantity. This analysis is followed by a related discussion of short-run versus long-run responses to changes in the marketplace. The section ends by considering under what circumstances a per- unit cost increase in an industry can be passed on to consumers through higher prices.

Price versus Quantity Adjustments

We have seen that the equilibrium price and quantity typically change when either the demand or supply curves shifts. Forecasting the direction of price and quantity changes in a market can be very useful to managers. However, it is even more useful to be able to forecast whether most of the impact of the change will be on price or quantity.

To analyze this question, we need to introduce the concept of demand and supply elasticities. Elasticities, which are defined more precisely later in this book, measure the sensitivity of quantity demanded and supplied to price changes.9 The left panel of Figure 3.5 depicts two extreme demand curves—one is vertical and the

8An increase in income in this example shifts the demand curve to the right, resulting in both a higher equilibrium price and quantity (see Figure 3.2). More specifically, shifting the income from $10,000 to $20,000 results in an equilibrium quantity of 22.5 million pounds and an equilibrium price of $1.125 (112.5 cents).

9The responsiveness of consumption and production decisions to price changes varies across products. For example, consumers tend to be relatively responsive to price changes when it comes to restaurant meals but pay little attention to changes in the price of toothpaste. Similarly, the supply decisions of producers can be greatly affected by price in some cases and vary little in others (in the latter case consider a farmer who has grown a fixed quantity of a highly perishable commodity that must be sold before rots).

other is horizontal. The right panel displays similarly sloped supply curves. A ver- tical curve indicates that the quantity demanded or quantity supplied is the same regardless of price. Vertical supply and demand curves are referred to as perfectly inelastic. The horizontal curves depict the extreme opposite case where no quantity is demanded at prices above P*, and no quantity is supplied at lower prices. Horizontal supply and demand curves are referred to as perfectly elastic. Typically industry demand curves and supply curves are less extreme—industry demand curves typically slope downward, while industry supply curves typically slope up- ward. At a given price and quantity, demand and supply curves with more vertical slopes are referred to as relatively more inelastic (since the relative change in quantity to a price change is small), while flatter curves are termed relatively more elastic.

In extreme cases, a change in demand or supply will result in only a price or quantity change—the other variable will remain unchanged. Figure 3.6 depicts these cases for an increase in demand. When supply is completely inelastic, an in- crease in demand increases price, but has no effect on quantity. For example, con- sider land in central New York City. Its supply is inelastic and the price for the land is determined by demand. The higher the demand, the higher will be the price. In contrast, when supply is perfectly elastic the increase in demand will cause an increase in quantity but no increase in price. Later in this book, we will discuss why horizontal long-run supply curves are reasonably common in certain types of industries.

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Figure 3.5 Perfectly Inelastic and Elastic Demand and Supply

This figure displays perfectly inelastic and elastic demand and supply curves. When demand (supply) is perfectly inelastic the quantity demanded (supplied) does not change with price. With perfectly elastic demand (supply), a small increase (decrease) in price relative to $5 in this figure will reduce the quantity demanded (supplied) to zero.

Chapter 3 Exchange and Markets 83

84 Part 1 Basic Concepts

Figure 3.7 depicts the two extreme cases for an increase in supply. The effects are similar to what we saw for the increase in demand. An increase in supply will be fully reflected in price when demand is perfectly elastic and fully in quantity when demand is perfectly elastic. In the next chapter, we will examine in more detail the determinants of demand elasticities.

We have focused on increases in demand and supply. The effects are the same but in the opposite direction for decreases in supply and demand. While we have focused our attention on the extremes, the results generalize to more common in-between cases. If the supply curve is relatively inelastic, a change in demand will primarily affect the price of the product. In contrast, if the supply curve is relatively elastic a change in demand will primarily affect the quantity. Similarly, if the demand curve is relatively inelastic a shift in supply will be reflected primarily in price; if the demand curve is relatively elastic it will primarily affect the quantity.

Short-Run versus Long-Run Effects

Supply and demand curves tend to be relatively more inelastic in the short run than the long run. To see why, consider how consumers might respond to a large increase in the price of gasoline. Consumption of gasoline might not change very much in the

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Figure 3.6 Increase in Demand with Perfectly Inelastic or Elastic Supply

This figure displays the effect of a demand increase on the equilibrium price and quantity when supply is either perfectly inelastic or elastic. The original equilibrium price and quantity are $5 and 4 units respectively. When demand increases, only the equilibrium price changes when supply is perfectly inelastic (from $5 to $7). With perfectly elastic supply, only the equilibrium quantity changes (from 4 to 6). If demand were to decrease back to D1, the same general effects would happen in reverse.

first weeks after the price increase. People have to get to work, school, and other places. The locations of people’s homes and the types of automobiles they drive are largely fixed in the short run. All of these factors make the short-run demand rela- tively inelastic. With more time to adjust, however, consumers can reduce their con- sumption of gasoline by forming car pools with others to commute to work, pur- chasing vehicles that get better gas mileage, and so on. In the even longer run, they can relocate moving closer to their jobs, change jobs to work at locations closer to home, and so on. A similar analysis holds on the supply side of the market. Supply curves tend to be relatively more inelastic in the short run than the long run because suppliers have more flexibility to make changes over the longer run. Figure 3.8 depicts supply curves and demand curves for the so-called short run, medium run, and long run. Focus on the intersection point of the three curves as the initial starting price and quantity. Notice how a change in price is met with a greater change in quantity in the longer run, since the curves are more elastic.

We previously discussed how a shift in demand or supply will have a greater ef- fect on price when the other curve is relatively inelastic and a greater effect on quan- tity when it is relatively elastic. Because demand and supply curves are likely to be more inelastic in the short run than the long run, shifts in demand and supply will tend to be reflected in price changes in the short run and in quantity changes in the long run.

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This figure displays the effect of a supply increase on the equilibrium price and quantity when demand is either perfectly inelastic or elastic. The original equilibrium price and quantity are $5 and 4 units respectively. When supply increases, only the equilibrium price changes when demand is perfectly inelastic (from $5 to $3). With perfectly elastic demand, only the equilibrium quantity changes (from 4 to 6). If supply were to decrease back to S1, the same general effects would happen in reverse.

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Prices communicate important information to consumers and suppliers. For exam- ple, price increases signal to consumers to reduce their consumption of a product and to producers to figure out how to supply more of it. Ultimately, these responses trans- late into less extreme price changes and greater quantity changes in the longer run. In a sense, the large price changes in the short run help to motivate the output and con- sumption changes in the long run.

Industry Cost Increases and Price Adjustments

John MacDonald manages a company in a competitive industry that bottles and sells healthy juices to consumers. The current market price for juices in his industry is $5 per bottle. The government has just announced a new $2 per bottle tax that it is going to impose on suppliers in this industry. John wants to know whether he will be able to pass this cost increase on to consumers, for example, by charging $7 per bot- tle. Since his firm operates in a competitive industry he has no power to set the price. His hope is that the market price will increase to $7 to offset the cost increase. The question is will it? It turns out that the answer depends on the relative elasticities of supply and demand curves in the industry.

Figure 3.9 displays a graphical analysis of this example where the absolute values of the slopes of the demand and supply curves are roughly the same. The $2 per unit

MANAGERIAL APPLICATIONS

Decrease in Supply of Pilots Results in Reduction of Flights and Small Increases in Pilot Wages In August 2013, the Federal Government increased the minimum experience required for commercial airline pilots from 250 hours to 1,500 hours. This reduced the supply of entry-level pilots materially. The primary employer of entry- level commercial pilots are the smaller regional airlines. Before this change, the starting salary paid at 14 U.S regional carriers averaged about $22,400 per year.

Supply and demand analysis suggests that this decrease in the supply of pilots would either decrease the number of pilots employed by the airlines, increase pilot wages, or some combination of both. Many of the routes flown by the regional airlines were only marginally profitable, and the airlines had only limited power to increase ticket prices to cover the increased costs for hiring pilots. These conditions imply that their demand for pilots would have been relatively elastic. The supply and demand framework predicts that the primary effect of a decrease in supply with relatively elastic demand would be a decline in the number of flights by these smaller regional airlines. Consistent with this forecast, many of the regional airlines cut their number of flights and hired fewer pilots, rather than raising wages of entry-level pilots. In the first quarter of 2014. Silver Airways announced that it was cutting its flights by 13 percent. Republic Airways, one of the nation’s largest regional carriers announced due to the limited lumber of qualified commercial pilots, it was removing 27 of their 243 aircraft from operation. Great Lakes Aviation Ltd. stated that it was reducing the number of pilots from 300 in 2013 to about 100. However this reduction in the supply of qualified pilots, also resulted in small increases in pilot wages by 2014. For example, Silver Airways, a Florida-based airline with 35 planes, offered its current pilots salary increases of 5 to 10 percent and promised a $6,000 bonus if they continued to work for the company for one year.

Consistent with the economic view of behavior, some regional airlines responded “creatively.” Because the new federal rules only required 250 hours of experience for commercial pilots flying planes with fewer than 10 seats they could hire pilots with this lower level of experience by removing 10 seats from a 19-seat airplane. Since these pilots were more plentiful, they were less expensive to hire.

Source: J. Nicas and S. Carey (2014), “What Can New Pilots Make? Near Minimum Wage” The Wall Street Journal (February 12).

cost increase causes the supply curve to shift upward by $2. Suppliers have to pay $2 per unit to the government and thus require $2 more per unit to induce them to bring any specific quantity to the market, relative to the original supply curve. For example, suppliers were willing to bring 6,000 units to market at a price of $5. Now they require $7 to induce them to produce the same quantity. Note that the decrease in supply (upward/leftward shift in the curve) causes the price to increase to $6. Thus, suppliers are able to pass on half the cost to consumers. John and the other producers collect $6 for each unit sold. However, they only net $4 after paying the tax to the government. Each side of the market is $1 per unit worse off.10

More generally the sharing of a per-unit cost increase depends on the relative elas- ticities of the demand and supply curves. In the previous example, the supply and de- mand elasticities were about the same, so each side of the market bore about one-half the cost. When the two elasticities are not the same, the side of the market with the less elastic curve bears the larger share of the cost increase. Figure 3.10 depicts the two extreme cases for the demand curve. If the demand curve is perfectly inelastic, quantity remains unchanged and the price increases by the full amount of the cost

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This figure displays the typical pattern observed for supply and demand curves in the short, medium, and long run. Both demand and supply tend to be more elastic in the longer run than the short run because consumers and producers have more time to make adjustments in quantities when price changes.

Chapter 3 Exchange and Markets 87

10Aside from paying the increase costs on units transacted, consumers and producers also experience lost gains from trade due to the reduction in quantity transacted. Their combined loss due to the reduction in trade is pictured by the deadweight loss (DWL) triangle in the graph. The tax does not only transfer money from consumers and producers to the government, but also causes a reduction in quantity and gains from trade. These losses are not offset by gains to others and so are commonly referred to as “deadweight losses.”

88 Part 1 Basic Concepts

increase. Here the entire cost increase is passed on to consumers. In contrast, when demand is perfectly elastic the price remains the same and the quantity adjusts. In this case, none of the cost increase is passed on to consumers. Similarly, it can be shown that if supply is perfectly inelastic, producers bear all the costs. If supply is perfectly elastic all the cost is passed on to consumers. When neither side of the

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Figure 3.9 Passing on Part of a Cost Increase to Consumers

This figure displays an example where suppliers face a new $2 per unit tax. The original equilibrium price and quantity were $5 and 6,000, respectively. The tax causes the supply curve to shift upward by $2. The new equilibrium price and quantity are $6 and 4,000 units, respectively. Consumers pay $6, but producers only net $4 after tax. Each side of the market is $1per unit worse off than before the tax. The government collects $8,000 in taxes. The shaded rectangles reflect the sharing of this cost. Each side of the market bears $4,000, so the cost increase is evenly split. The even split is due to the fact that the absolute values of the slopes of the supply and demand curves in this example are equal. More generally, the side of the market with the relatively less elastic curve will bear a greater share of a per unit cost increase. The deadweight loss triangle represents the lost gains from trade due the quantity reduction due to the tax.

MANAGERIAL APPLICATIONS

Supply of Online Résumés Bogs Down Employers The Internet has reduced significantly the cost of submitting résumés to would-be employers. Job seekers no longer must print their résumés on high-quality paper, address, stamp, and mail an envelope. A click of the mouse and the résumé is gone. Some companies have thousands of résumés dumped into their e-mail boxes each day. During 1999 there were almost 5 million résumés on the Internet—200 times more than in 1994. When the cost of producing a good (like submitting a résumé) falls, its supply increases.

Source: S. Armour (1999), “Online Résumés Bogging Down Employers,” Democrat and Chronicle (July 19), 1F.

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Figure 3.10 Sharing of a Cost Increases at the Extremes

This figure shows the effects of a $2 per unit cost increase with perfectly inelastic and perfectly elastic demand. When demand is perfectly inelastic, the entire cost increase is passed on to consumers through a higher price and quantity does not change. With perfectly elastic demand the entire cost is borne by suppliers (none can be passed on). Price does not change and quantity falls.

MANAGERIAL APPLICATIONS

Elastic Demand Limits Steelmakers’ Abilities to Pass through Cost Increases Higher prices for inputs, such as iron ore and coking coal, were expected to force up steel prices during 2011. Analysts, however, predicted that steelmakers would be unlikely to be able to raise steel prices enough to pass on the full increase in costs. Theory suggests that the ability of producers to pass through cost increases depends on the elasticity of demand. Analysts argued that weaker demand from the construction industry and the expectation that China might tighten its monetary policy due to concerns about rising inflation implied that steel makers would have difficulty in maintaining higher prices throughout the year. A UBS analyst summarized the basic economics of the situation as follows, “While mills can easily pass through higher input costs when demand is strong, unfortunately the current environment is less supportive.”

Source. D. Maylie (2010), “Steelmakers Grapple with Price-Increase Pressures,” The Wall Street Journal (December 28)

Chapter 3 Exchange and Markets 89

market is at one of the extremes, the cost is split. The side of the market with the rel- atively more elastic curve bears a smaller share of the cost.

Sometimes a cost increase is imposed on consumers, rather than on suppliers. For ex- ample, some states impose taxes on consumers when they purchase bottles of liquor at a store. While we do not do so here, it is relatively easy to show that the sharing of a cost increase does not depend on which side of the market initially incurs it. When a cost in- crease is imposed on consumers, the demand curve shifts downward, while the supply curve stays the same. The resulting price change results in the same net outcome for both parties as when the tax is imposed on suppliers. What matters in both cases are the relative elasticities of the supply and demand curves.

90 Part 1 Basic Concepts

Prices as Social Coordinators The equilibrium of supply and demand highlights the crucial role that prices play in coordinating the consumption and production decisions of individuals. For example, if too few PCs are being produced, inventories will shrink and dealers will raise prices. High-prices signal would-be producers to shift from producing lower-valued products to producing computers. Because property rights are private, individuals reap the reward from redirecting their efforts and therefore have strong incentives to shift production. Higher prices also motivate consumers to reduce the quantity of PCs demanded. The end result is that the quantity demanded equals the quantity supplied. This is what Adam Smith referred to as “the invisible hand.”

Efficient Exchange and Production

If everyone trades in a competitive marketplace and all mutually advantageous trades are completed, the price system results in a Pareto-efficient resource allocation.11

No government intervention or central planning is required. Rather, consumers and producers, acting in their own self-interest, react to price signals in a manner that produces an efficient resource allocation. Prices act to control and coordinate the many individual decisions made in the economy. After trading is completed, the output mix and final distribution of products cannot be changed without making someone worse off.

The basic logic for efficiency in a competitive economy is straightforward. At equilibrium prices, the quantity supplied equals the quantity demanded for all goods and there are no shortages or surpluses. Everyone who wants to make trades has done so, and all gains from trade have been exhausted. In making supply decisions, firms have strong private incentives to adopt the most efficient production methods and the value-maximizing output mix (these production choices maximize their profits). No changes in either production or distribution can be made without making someone worse off.

Measuring the Gains from Trade

In some applications it is useful to have measures of the gains from trade that are in units, such as dollars, that are independent of individuals’ subjective utilities. Con- sumer surplus and producer surplus display this property and are commonly used to measure the gains from trade and the effects of specific actions and events on con- sumers, producers, and society as a whole.12

Figure 3.11 displays supply and demand curves for a market in which the equilib- rium price and quantity are $10 and 10 units. The demand curve indicates that some

11These conditions will be met in a competitive market when trading costs are sufficiently low. Later, we will discuss factors that can motivate inefficiency in a market economy.

12Technically, consumers must have a specific type of utility function for consumer surplus to be an exact measure of their gains from trade in a market. However, it is generally a good approximation whenever consumers allocate their expenditures across many goods, which most do. The measure is widely used and accepted by most economists.

consumer would be willing to pay $19 to obtain the first unit of the product; how- ever, the consumer only has to pay the market price of $10. The $9 “surplus” is a measure of the consumer’s gains from trade from purchasing the first unit. The sum of the surplus at all points along the demand curve up to the equilibrium quantity of 10 units represents the aggregate difference between what consumers would be will- ing to pay for the product and what they have to pay given the market price. We call this difference, consumer surplus and display it graphically in Figure 3.11 by Triangle A. In this example, the consumer surplus is $50 (1�2 � 10 � 10). Note that in the aggregate, consumers would be willing to pay up to $150 dollars to obtain the 10 units (Triangle A � Triangle B � Triangle C), but only have to pay $100 (Trian- gle B � Triangle C). Their gains from trade from participating in this market are $50.

The same idea is used for measuring the net gains to producers. Later in this book, we show that the area under the supply curve represents the incremental costs that producers incur to produce the output. In this example, the incremental costs are $50 (Triangle C). Producers are willing to supply 10 units as long as the incremental rev- enue is at least equal to the incremental costs of $50. Producers, however, receive $100 (Triangle B � Triangle C). The extra $50 (Triangle B) represents the gains to trade for producers and is called producer surplus.

The total gains from trade produced in the market are measured by the sum of consumer and producer surplus. In this example, the total gains from trade (surplus) are $100 (Triangle A � Triangle B). We use the concepts of producer, consumer, and total surplus in several places in this book to measure the effects of various actions on consumers, producers, and “social welfare.”

Government Intervention

We have discussed how a well-functioning price system can produce an efficient al- location of resources without government intervention or central planning. Nonetheless, governments sometimes intervene to establish caps or floors on

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In this figure, consumers pay $100 to obtain 10 units of the product ($10 � 10 units). They would have been willing to pay an additional $50 to obtain the 10 units. This $50 (Triangle A) represents the gains from trade to consumers and is called consumer surplus. Producers receive $100 of revenue, but would have been willing to supply the product if they had covered their incremental production costs of $50 (Triangle C). The extra $50 (Triangle B) is the gains from trade to producers and is called producer surplus.

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prices. This section examines the economic effects of these actions (in an otherwise well-functioning market).

Price Controls The average retail price for gasoline in the United States was about $1.15 per gallon in 2003. Gasoline prices increased dramatically over the period 2004–2008 due to factors such as the increased demand for oil in China and India, the war in Iraq, and Hurricane Katrina. Gasoline prices, which averaged $1.60 per gallon in 2004, broke the $2.00 per gallon barrier in July of 2005. In August 2005, gasoline supply was dis- rupted by Katrina, the devastating storm that hit the Gulf Coast. Gasoline prices surged to over $3.00 per gallon. In subsequent months gasoline prices were volatile, rising from a low of $2.10 per gallon in November 2005 to a high of $3.20 per gallon in May 2007. In 2008 the price was above $4.00 per gallon. Consumers expressed fear and outrage over the high gasoline prices. Some groups asked the U.S. government to implement price controls to protect consumers from “unfair” gasoline prices.

Figure 3.12 displays the economic effects of a cap on the price of gasoline. The free market equilibrium price is $3.00 per gallon. However, suppose that the government passes a law that does not allow stations to charge more than $2.00 per gallon. At the $2.00 price, the quantity demanded, QD, is greater than the quantity supplied, QS— there is a shortage of gasoline. The excess demand implies that gasoline must be al- located through nonprice mechanisms. One mechanism is to serve customers in the order that they arrive until the supply is exhausted. This mechanism is likely to

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The free market equilibrium price in this figure is $3 per gallon. The government does not allow stations to charge more than $2 per gallon. At the $2 price, the quantity demanded is greater than the quantity supplied— there is a shortage of gasoline. The excess demand implies that gasoline must be allocated through nonprice mechanisms, such as waiting in line. Triangles A and B represent the lost gains from trade to consumers and producers (consumer and producer surpluses), respectively, induced by the price cap. Rectangle C represents a transfer of surplus from producers to consumers (ignoring other costs imposed on consumers). The price cap can also distort incentives of consumers to reduce consumption of gasoline, for example, by moving closer to work or buying smaller automobiles.

produce long lines and waits for gasoline. Also, customers who place the highest value on the gasoline (e.g., due to the importance of their travel) do not necessarily re- ceive the product. The quantity supplied falls as a result of the price cap, resulting in lost gains from trade (total surplus). The reduction in consumer surplus and producer surplus is pictured by Triangles A and B, respectively. The consumers who obtain the gasoline for $2.00 potentially benefit from the cap at the expense of the gasoline deal- ers, the gasoline distributors, the gasoline refiners, and the individuals who own the mineral rights and receive a lower price for the quantity sold (unless the gains are off- set by costs such as having to wait in line). Rectangle C pictures the transfer from pro- ducers to consumers (ignoring other costs).

During the 1970s, there was a severe shortage of gasoline in the United States due to an oil embargo and price controls. People still remember the long gas lines and substantial inconveniences experienced during that period. Some gas stations served customers based on their license plate numbers—odd numbers one day and even numbers the next. Customers also were limited in the number of gallons that they could purchase. These inconveniences have rarely been observed since the elimina- tion of price controls in the early 1980s.

Consumers responded to higher gasoline prices during the 2004–2007 period in a variety of ways. Some reduced their travel plans, while others shifted to less expen- sive forms of transportation (e.g., carpooling, buses, and bikes). Some moved closer to work, while others purchased more fuel-efficient automobiles. Price controls not only produce shortages, but also distort incentives to take actions that reduce the consumption of the product.

Price Floors A prominent example of a price floor is a minimum wage law. In the United States, the Fair Labor Standards Act (FLSA) requires employers to pay employees at least a minimum wage (in 2014, $7.25 per hour) for all hours they work. If a state has a min- imum wage that is higher than the federal minimum, employers are obligated to pay the higher rate to employees working in that state. For example, the minimum wage in the State of Washington was $9.32 per hour in early 2014.

Figure 3.13 displays the economic effects of a minimum wage law. The market clearing price for unskilled labor in this example is $6.00 per hour. However, em- ployers are not allowed to pay wages below $7.25 per hour. At $7.25, the quantity supplied of labor, QS, is greater than the quantity demanded, QD —there is unem- ployment. Firms would hire more workers at $6.00 and fewer people would enter the labor market; at $6.00, the quantity supplied equals the quantity demanded, Q*, and there is no unemployment.13

The QD people who are employed at the minimum wage of $7.25 benefit from the law at the expense of their employers who have to pay higher wages (unless the employees incur offsetting costs to obtain and keep their jobs). Rectangle C pictures the transfer of surplus from employers to employed workers. In contrast, the people between QD and Q* are hurt by the law. These people are willing to work for as lit- tle as $6.00 per hour and would obtain jobs in a free market. However, they are un- employed due to the minimum wage law. Overall, there is a reduction in the total gains from trade in the labor market. The lost surpluses for firms and labor are

Chapter 3 Exchange and Markets 93

13In reality, measured unemployment would not be zero absent minimum wage regulation. There are always going to be individuals changing jobs or searching for better jobs. We abstract from these considerations in this example.

94 Part 1 Basic Concepts

pictured by Triangles A and B, respectively. These triangles depict the lost surplus from not allowing companies and unemployed workers to enter into mutually beneficial employment relations below the minimum wage. In January 2014, the unemployment rate among teenagers in the United States was 22.6 percent com- pared to 6.8 percent for adults. One potential reason for the high unemployment rate among teenagers is the minimum wage.14

Minimum wage laws can also affect how people are paid. For example, suppose that prior to a new minimum wage law unskilled workers are paid $6.00 per hour plus health benefits. One likely effect of forcing employers to pay higher cash wages is a reduction in health benefits. Employees who prefer the health benefits to higher cash wages are worse off after the law.

14The U.S. government has tried to reduce the effects of the minimum wage law on teenagers by exempting them from the law for their first 90 days of employment. During this period, teenagers must be paid at least $4.25 per hour. Note that the amount of unemployment caused by the minimum wage laws depends on the slopes of the supply and demand curves (see Figure 3.13). Although most economists would agree with the direction of the effect, there is disagreement as to its magnitude. Many economists believe this effect is large, but some disagree. For example, D. Card and A. Krueger (1995), Myth and Measurement: The New Economics of the Minimum Wage (Princeton University Press: New Jersey).

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$

Q

Figure 3.13 Economic Effects of Minimum Wage Laws

This figure displays the supply and demand for unskilled labor. The free market equilibrium is a $6.00 wage rate and Q* people being hired. The government has imposed a minimum wage of $7.25 that results in an excess supply of labor (unemployment). The QD people who are employed at the minimum wage of $7.25 benefit from the law (unless they incur offsetting costs to obtain and keep their jobs). Rectangle C represents the transfer of surplus from employers to employed workers. In contrast, the people between QD and Q* are hurt by the law. These people are willing to work for as little as $6.00 per hour and would obtain jobs in a free market. However, they are unemployed due to the minimum wage law. Overall there is a reduction in the total gains from trade in the labor market. The lost surpluses from reduced trade for firms and labor are pictured by Triangles A and B, respectively.

Externalities and the Coase Theorem15

Externalities exist when the actions of one party affect the well-being or production possibilities of another party outside an exchange relationship. Externalities can pre- vent a free market from being efficient. If a firm emits pollution into the air, it can adversely affect the welfare of the firm’s neighbors. If the firm does not bear these

15This section draws on R. Coase (1960), “The Problem of Social Cost,” Journal of Law and Economics 3, 1–44.

The Coase Theorem and the “Fable of the Bees” A prominently discussed case of externalities is the so-called “Fable of the Bees.” Beekeepers provide pollination services for the surrounding fruit growers, and the growers, in turn, provide nectar for the bees. Many economists would consider this to be a classic case of externalities. If beekeepers and growers do not receive compensation for the benefits they bestow on other parties, they will underinvest in their activities (from a social standpoint).

The Coase Theorem suggests that beekeepers and growers can privately negotiate to overcome this externality problem. This is exactly what is done. Beekeepers and growers often enter into contracts. Fruit growers hire beekeepers to supply hives of bees for pollination of those trees that give little suitable nectar, while the beekeepers pay growers for the privilege of “grazing” their bees on high nectar-producing trees. Given these payments, beekeepers and growers have incentives to consider the effects on the other party when they make their investment decisions. Through this process, beekeepers and growers can reach efficient levels of investment without help from the government.

Source: S. Cheung (1973), “The Fable of the Bees: An Economic Investigation,” Journal of Law and Economics 16, 11–34.

ACADEMIC APPLICATIONS

Chapter 3 Exchange and Markets 95

CBO Estimates Effects of Proposed Increase in the Federal Minimum Wage The Federal Minimum wage was $7.25 per hour in 2014. The President and various members of Congress supported proposed legislation that would have increased it to $10.10 per hour. They argued that $7.25 was not a “living wage” and that raising the minimum wage would lift many out of poverty. Opponents argued that by decreasing the number of jobs and thus increasing unemployment, such an increase would hurt many of the people who it was designed to help.

Economic theory argues that a binding minimum wage will decrease the number of jobs and increase unemployment. It also predicts that the people who find jobs at the higher rate will potentially be better off (it depends in part on how costly it was for them to find employment). The Congressional Budget Office (CBO) is a highly respected agency that conducts bipartisan economic analysis for Congress. In February 2014, the CBO issued a report projecting the impact of the proposed increase in the minimum wage. Consistent with economic theory, they predicted that the proposed hike would cause a loss of about 1�2 million jobs. They further predicted that 16.5 million workers would experience wage increases. About 900,000 of them would be lifted out of poverty.

The higher wages paid to workers will have to be paid by someone—there is no “free lunch.” As discussed in this chapter, the ultimate payers are not necessarily the companies that are required to pay higher wages. At least some of this cost increase is likely to be passed to consumers in the form of higher prices. Moreover, many employees currently hired at the minimum wage are entry-level workers with limited work experience and education. The increase in the quantity of labor supplied at the higher wage rate is likely to include suburban middle-class teenagers and others who have some more prior work experience. Given the limited number of jobs openings relative to people seeking work at the higher wage rate, the prospects of a minority, high-school dropout finding work could be even more bleak.

Source: E. Morath, D. Paletta, and C. Lee (2014), “Wage-Rise Report Sees Fewer Jobs, Less Poverty” The Wall Street Journal (February 20).

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96 Part 1 Basic Concepts

costs, it is likely to select an inefficient level of pollution (i.e., to overpollute). In choosing how much to invest in pollution control equipment, the firm’s managers will consider only its own costs and benefits. Efficient investment would require them also to consider costs and benefits imposed on neighbors (the efficient level of investment is where the total marginal costs of additional investment equal the total marginal benefits—not just those incurred privately by the firm).

Economists used to think that externalities surely would prevent a market system from producing an efficient allocation of resources. Government intervention seemed to be required to enhance efficiency. For example, the traditional recom- mendation was to tax firms based on their levels of pollution. Such a tax would give firms incentives to reduce pollution.

In 1960, Nobel Prize winner Ronald Coase presented a compelling argument that exchange in a free market is more powerful in producing efficient results than had been thought previously. As long as property rights can be traded, there is an incen- tive to rearrange these rights to enhance economic efficiency. The often-recom- mended government intervention might be unnecessary and in many cases undesir- able. Suppose that a firm has the legal right to pollute as much as it wants. Its neighbors always can offer to pay the firm to reduce its pollution level. Thus, the firm faces a cost for polluting (if the firm pollutes, there is an opportunity cost of not receiving compensation from its neighbors). The firm will pollute only if the pollution is more valuable to the firm than the costs it imposes on its neighbors. This efficient solution is obtained without a pollution tax. The same level of pollu- tion can occur even if the neighbors have the legal right to stop the firm from emit- ting any pollution as opposed to the firm’s having the legal right to pollute as much as it wants. In this case, the firm can pay its neighbors for the right to pollute. Re- gardless of whether the firm or the neighbors have the legal right, the gains from trade are exhausted when the marginal benefit to the firm of polluting is equal to the sum of the marginal costs imposed on its neighbors plus those that the firm bears.

Coase’s argument convinced most economists that externalities were less of a problem than previously thought. It also implied that the distribution of property (legal) rights might have less of an effect on the ultimate use of resources than it has on the distribution of income—as long as these rights can be exchanged. In our ex- ample, the firm might emit the same amount of pollution regardless of who initially is assigned the property right. However, the party with the property right obtains more wealth (since it is the one receiving or avoiding payments).

Nonetheless, as Coase points out, market exchange will not always solve the problem of externalities. The transactions that are necessary to overcome this

problem are not free: There are contracting costs. These costs in- clude search and information costs, bargaining and decision costs, and drafting, policing, and enforcement costs.16 These costs can pre- vent a preferred outcome from occurring. In our example, the firm might limit its pollution for a payment that is far lower than the col- lective damage imposed on its neighbors. Nonetheless, the costs of bargaining with the firm and the costs of reaching agreement on how the neighbors should split the payment can prevent this mutually ben- eficial agreement from being reached. Generally, the costs of reaching an agreement increase with the number of bargainers. In our example,

16C. Dahlman (1979), “The Problem of Externality,” The Journal of Law and Economics 22, 148–162.

The Coase Theorem The ultimate resource allocation will be efficient, regardless of the initial assignment of property rights, as long as contracting costs are sufficiently low and the property rights are assigned clearly, are well enforced, and can be exchanged readily.

the likelihood of reaching an efficient agreement is highest if the firm only has to bar- gain with a single neighbor who owns all the surrounding property.

It also is important that property rights be clearly assigned, enforced, and ex- changeable. Suppose there were no legal system to enforce property rights. Neigh- bors would be reluctant to pay a firm not to pollute—they do not obtain an enforce- able property right to prevent the firm from polluting. After collecting the payment, the firm could renege on its promise to reduce pollution and the neighbors would have no recourse.

This discussion suggests that market economies will tend to produce an efficient resource allocation whenever property rights are clearly assigned and contracting costs of exchanging them are sufficiently low. When these conditions are met, effi- ciency will occur regardless of the initial distribution of property rights. This general principle is often referred to as the Coase Theorem.

The driving force behind the Coase Theorem is gains from trade: Individuals have incentives to search out and undertake mutually advantageous trades. This principle has important managerial implications. Even if a manager does not have all the prop- erty rights necessary to undertake a particular project, it does not mean that the pro- ject cannot be undertaken. If the proposed project creates enough value, the manager often can acquire the necessary property rights from their current owners. Suppose the Watts Construction Company can create substantial value by developing a shop- ping center on a site that currently is zoned for residential housing. Surrounding property owners might support a change in the zoning requirement, as long as they share in the value creation. Watts might be able to increase this support by offering to develop a new neighborhood park near the shopping mall.

Chapter 3 Exchange and Markets 97

MANAGERIAL APPLICATIONS

Property Rights Help Make Niger Greener Niger in northern Africa historically ha