MANAGERIAL ECONOMICS

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MANAGERIAL ECONOMICS
BOOK | SECOND SEMESTER

CHAPTER 2: THE ONE LESSON OF BUSINESS

CREATING WEALTH
Voluntary transactions create wealth by moving assets • The buyer and seller must agree to a price that
from lower to higher-valued uses splits surplus between buyer and seller. Here,
$128,000
• capital goods → translate to something profitable • The buyer and seller both benefit from this
• diamond = nominal and sentimental value transaction:
• jewelry at face value = profit → valuable • Buyer surplus = buyer’s value minus the price
• value = maximize the thing $130,000 - $128,000 = $2,000 buyer surplus
• Seller surplus = the price minus the seller’s value
Anything that impedes the movement of assets to higher- $128,000 - $120,000 = $8,000 seller surplus
valued uses, like taxes, subsidies, or price controls, • Total surplus = buyer + seller surplus = difference
destroys wealth in values
$2,000 + $8,000 = $10,000 → $130,000 -
Economic analysis is useful to business for identifying $120,000 = $10,000
assets in lower-valued uses $10,000 are the gains from trade

The art of business consists of identifying assets ub low- • Which assets do these transactions move to
valued uses and devising ways to profitably move them to higher-valued uses?
higher-valued ones o Factory owners, real estate agents,
investment bankers, corporate raiders,
A company can be thought of a series of transactions. A insurance salesman
well-designed organization rewards employees who • Discussion: How does eBay create wealth?
identify and consummate profitable transactions or who • Discussion: Which individua; has created the
stop unprofitable. most wealth during your lifetime
• Discussion: How do you create wealth?
SUPPOSE YOU WANT TO MOVE FROM DETROIT TO
NASHVILLE DO MERGERS FOLLOW THE WEALTH-CREATING
ENGINE OF CAPITALISM? DO THEY MOVE ASSETS
1. First, you would try a two-way trade TO A HIGHER-VALUED USE?
2. Failing that, you’d try three-way connection with
another city • Our largest and most valuable assets are
3. Need to find correct trades with correct timing = corporations
difficult! • Ex: Dell-Alienware merger:
4. Like with kidney transplants, compatibility problems o In 2006, Dell purchased Alienware, a
lead to inefficiency manufacturer of high-end gaming
computers
To identify money-making opportunities, you must first o Dell left design, marketing, sales and
understand how wealth is created (and sometimes support in Alienware’s hands
destroyed). o Dell took over manufacturing though,
using its expertise to build Alienware’s
• Key note: Wealth is created when assets are computers at much a lower cost
moved from lower to higher-valued uses o However, many mergers and
• Definition: value = willingness to pay acquisitions do not create value
Desire + income = you want something + you can ▪ if they do, value creation is rarely
pay for it so clear
• Key note: Voluntary transactions, between o To create value, the assets of the
individuals or firms, create wealth acquired firm must be more valuable to
Meaning, people create wealth by pursuing self- the buyer than to the seller
interest
GOVERNMENT’S ROLE IN WEALTH CREATION
A HOUSE IS FOR SALE
• Enforcing property rights and contracts legal tools
• The buyer values the house at $130,000 that facilitate wealth creating transactions
(buyer’s top dollar – willingness to pay) • Ensures that buyers and sellers keep gains from
• The seller values the house at $120,000 trade
(This is the seller’s bottom line – won’t accept less)
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WHY ARE SOME COUNTRIES POOR?

• In other words, make money by identifying
• No property rights unconsumed wealth-creating transactions and
• No rule of law devise ways to profitably consummate them.
• Much of the justification for government intervention
comes from the assertion that markets have failed. DESTROYERS OF WEALTH
One money manager scoffed at this idea. “The
markets are working fine, but they’re giving people Anything that stops assets from moving to higher valued
answers that they don’t like, so people cry market uses is destroying wealth.
failure.”
1. Taxes destroy wealth – by deterring wealth-creating
transactions-when the tax is larger than the surplus
WHEN ECONOMY IS EFFICIENT of a transaction

• An economy is efficient if all assets are employed in 2. Taxes create a profit opportunity – 1983 Sweden Tax
their highest-valued assets
3. Subsidies destroy wealth – flood insurance
encourages people to build in areas that they
• This is an unattainable, but useful benchmark
otherwise wouldn’t
• The one lesson of economics
4. Subsidies create opportunity – health insurance
o Art of economic consists in looking not merely
5. Price controls destroy wealth – rent control price
at the immediate but at the longer effects of any
(price ceiling) in NYC deters transactions between
act or policy; it consists in tracing the
owners and renters.
consequences of that policy not merely for one
group but for all groups.
6. Price controls create opportunity – Regulation Q. &
Euro dollars
o Must look at the intended and unintended
effects of policies to understand their efficiency.
Which assets end up in lower-valued uses?
o The economist’s solution to inefficient outcomes
COMPANIES
is to argue for a change in public policy.

o Business person’s solution to try to make • Companies = a collection of transactions

money on the inefficiency. • They buy raw materials (capital, labor, etc.) and
create and sell higher-valued goods and services
INEFFICIENCY
• Can equate market-level problems (taxes, subsidies
• Inefficiency - implies existence of unconsumable, and price controls) with organization-level goal
wealth-creating transactions. alignment problems

• The art of business consists of identifying assets in • Ex: the overbidding form the oil company = “subsidy”
lower valued uses and devising ways to profitably paid to management for acquiring oil reserves
moving them to higher valued uses. • Allows us to use the same analysis
MANAGERIAL ECONOMICS
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CHAPTER 1: INTRODUCTION

PROBLEM SOLVING REQUIRES 2 STEPS PRACTICAL TIPS TO DEVELOP PROBLEM-SOLVING

SKILLS
i. figure out why people are making mistakes and
ii. then figure out how to prevent future ones. Think about the problem from the organization’s POV
• how does the org give employees enough
information to make good decisions and the
RATIONAL-ACTOR PARADIGM incentive to do so?

Think about the organizational design

Rational-actor paradigm
• avoid reversing the decision
• assumes that people act rationally, optimally, and • think about why the bad decision was made and how
self-interestedly, that is, they respond to incentives. to make sure it will not happen again
• suggests ways to get behavior change
• to change behavior = incentives → self-interest → What is the trade-off?
behavior • solution may solve the problem you identify, but it
• Incentives have two pieces: may cause other problems

i. performance evaluation metric (revenue, Don’t define the problem as the lack of your solution
cost, profit, or return on investment) • if you define problem as “the lack of centralized
purchasing”, then solution will be “centralized
ii. a compensation scheme to reward good (or purchasing”, regardless of whether that is the best
punish bad) performance (commission, option
bonus, raise, promotion) • Instead, define problem as “high acquisition cost”
and examine “centralized purchasing” vs
• A well-designed organization is one in which “decentralized purchasing” as potential solutions to
employee incentives are aligned with organizational the problem
goals.
Avoid jargon
• By this we mean that employees have: • most people misuse it
• use simple language and communicate precisely
i. enough information to make good decisions
and NAR AND TV REPORTER CASE ANALYSIS
ii. the incentive to do so.
In 2006, an investigative news program sent a TV reporter
YOU CAN ANALYZE ANY PROBLEM BY ASKING with a perfectly good car into a garage owned by National
THREE QUESTIONS Auto Repair (NAR). The reporter came out with a new
muffler and transmission—and a bill for over $8,000. After
the story was aired on national TV, consumers began
Q1: Who made the bad decision?
avoiding NAR, and profit plunged. What is the problem,
Q2: Does the decision maker have enough information to
and how do you fix it?
make a good decision?
Q3: Does the decision maker have the incentive to make
Let’s run the problem throught our problem-solving
a good decision?
algorithm:
ANSWERS TO THESE QUESTIONS WILL SUGGEST
Q1: Who made the bad decision?
ONE OF THREE SOLUTIONS
The NAR mechanic recommended unnecessary repairs.
S1: Let someone else make the decision, someone with Q2: Did the decision maker have enough information to
better information or incentives. make a good decision?
S2: Give the decision maker more information. Yes, in fact, the mechanic is the only one with enough
S3: Change the decision maker’s incentives. information to know whether repairs are necessary.

Q3: Did the decision maker have the incentive to make a

good decision?
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No, the mechanic receives bonuses or commissions tied

to the amount of repair work, which rewards the mechanic Solution:
for making needless repairs.
1. Ask whether the new decision maker had enough
Although answers to the three questions clearly point to information to make good decisions and incentive to
the source of the problem, solving it proved much more do so
difficult. 2. Keep original organizational design + performance
metric based on mystery shopper evaluation
NAR tried two different solutions, but both failed. 3. Fire or penalize mechanics who recommend
unnecessary repairs
The company reorganized into two divisions:
ETHICS AND ECONOMICS
1. One responsible for recommending repairs = flat
salary To control unethical behavior, understand why it occurs.
2. Other responsible for doing them = paid based on It helps to anticipate opportunistic behavior and design
amount of work did organizations

Deontologists – judge actions as good or ethical by

whether they confirm to set of principles
Consequentialists – judge actions by consequences

PAUSE HERE AND TRY TO FIGURE OUT WHY THIS Professor Holt – objects on principle to the practice of
CHANGE DID NOT SOLVE THE PROBLEM. raising prices in times of shortage

Mechanics in the two divisions began colluding. In Spider Man Principle: with great power comes great
exchange for recom- mending unnecessary repairs, the responsibility
service mechanic shared his incentive pay with the
recommending mechanic. The unnecessary repairs Laws of capitalism allow corporations to amass significant
continued. power and in turn, society should demand high level of
responsibility from them
NAR used single mechanic again who both recommend
and perform repairs but replaced the incentive pay with
flat salary.

It removes incentive to do unnecessary repairs and to

work hard = shirking
MANAGERIAL ECONOMICS
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CHAPTER 3: BENEFITS, COSTS, AND DECISIONS

COSTS, VARIABLE, FIXED COSTS BACKGROUND: TYPES OF COSTS

• Costs – associated with decisions not activities ● Fixed costs - do not vary with the amount of output.
• Opportunity cost – profit gave up for the
alternative ●Variable costs - change as output change
• Relevant costs and benefits of a decision
o Consider all costs and benefits that vary
with the consequences of a decision
o Only those costs and benefits that vary
with the consequences of the decision
• Fixed costs – do not vary with the amount of
output
• Variable cost – changes as output changes
o Decisions that change output will change
only variable cost • The cost of the factory is fixed.
• Employee pay and cost of ingredients are
BIG COAL POWER COMPANY
variable costs
Big Coal Power Co. switched to a 8400 coal when the
price fell 5% below the price of 8800 coal
• 8400 coal generates 5% less power than 8800
• The manager was compensated based on the
average cost of electricity, and expected this
move to save money Instead – company profit
reduced
• Why? What happened?
o Discussion: Diagnose the problem. Are these costs fixed or variable?
o Discussion: Come up with a proposal to 1. Payments to your accountants to prepare your
fix it.
tax returns.
Three questions for analysis 2. Electricity to run the candy making machines.
Fees to design the packaging of your candy bar.
1. Who is making the bad decision? 3. Costs of material for packaging.
- The plant manager made the switch to
the lower-priced 8400 coal. REAL EXAMPLE: CADBURY (BOMBAY)
2. Did he have enough information to make a good
decision?
- Yes, presumably he knew that this would Beginning in 1978, Cadbury offered managers free
reduce his output. housing in company owned flats to offset the high cost
3. Did he have the incentive to make a good of living.
decision?
- No, because he was evaluated based on In 1991, Cadbury added low-interest housing loans to its
the average cost of electricity produced
benefits package. Managers moved out of the company
at his plant.
housing and purchased houses. The empty company flats
LESSON FROM COAL PROBLEM remained on Cadbury’s balance sheet for 6 years.

• The plant manager should have considered all In 1997, Cadbury adopted Economic Value Added (EVA)®
the costs of switching to the lower Btu coal Charges each division within a firm for the amount of
o Namely, the lost electricity capital it uses
• Average costs can be a poor measure of plant • Provides an incentive for management to reduce
performance
capital expenditures if they do not cover costs
• Need to align incentives of a business unit with
the goals of the parent company
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• Senior managers then decided to sell the unused • If you start with costs, you will always get
apartments after seeing the implicit cost of confused
capital o If you start with a decision, you will
never get confused
ACCOUNTING PROFIT AND ECONOMIC PROFIT • Apply it to Cadbury:
o The cost of the company of holding onto
ACCOUNTING PROFIT the apartments was the forgone
opportunity to invest capital in the
Accounting profit - recognizes only explicit costs company’s organization to earn a higher
return.
Typical income statements include explicit costs:
o Costs paid to its suppliers for product Holding on to the flats cost the company £600,000 each
inputs year.
o General operating expenses, like salaries
to factory managers and marketing • Unless the benefits to the company of holding
expenses onto the apartments were at least £600,000, the
o Depreciation expenses related to capital was not employed in its highest-valued
investments in buildings and equipment use.
o Interest payments on borrowed funds • The cost of the company of holding onto the
apartments was the forgone opportunity to
What’s missing from Cadbury’s statements are implicit invest capital in the company’s organization to
costs: earn a higher return.
• By selling the flats, the company moved the
o Payments to other capital suppliers capital to a higher-valued use
(stockholders) Stockholders expect a certain
return on their money (they could have invested RELEVANT COSTS AND BENEFITS
elsewhere)
o “Profit” should recognize whether firm is When making decisions, you should consider all costs
generating a return beyond shareholders and benefits that vary with the consequence of a
expected return decision and only costs and benefits that vary with the
decision.
ECONOMIC PROFIT
• These are the relevant costs and relevant
Economic profit - recognizes these implicit costs; benefits of a decision.
accounting profit recognizes only explicit costs • You can make only two mistakes
o You can consider irrelevant costs
OPPORTUNITY COSTS AND DECISION o You can ignore relevant ones

Opportunity cost - what you give up (forgone profit) to FIXED-COST/SUNK-COST FALLACY

pursue it
o Costs imply decision-making rules and vice-versa • Fixed-cost/sunk-cost fallacy
o Goal: make decisions that increase profit • you make decisions using irrelevant costs and
o Profit of an action > alternative = pursue it benefits
• Common fixed-cost fallacy: overhead or
IDENTIFYING COST depreciation costs influence short-run decisions
Whenever you get confused by costs, step back and ask,
“What decision am I trying to make?”
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Football game: SUBPRIME MORTGAGES

• You pay $20 for a ticket. At halftime, you’re team
is losing by 56 points. The subprime mortgage crisis of 2008 is a good example
• You say you’ll stay to get your money’s worth, of the hidden-cost fallacy.
but you can’t get your money’s worth! • Credit-rating agencies failed to recognize the
• The ticket price does not vary whether you stay higher costs of loans made by dubious lenders.
or leave – it’s a sunk cost and irrelevant. o Example: Long Beach Financial
Launching a new product: o Gave loans out to homeowners with bad
• You are in a new products division and will be credit, asked for no proof of income,
able to distribute a new product through your deferred interest payments as long as
existing sales force possible.
• You will be forced to pay for a portion of the sales • Credit ratings didnt reflect the hidden costs of
force risky loans
• If you believe this “overhead” is big enough to • As a result, many Wall Street investors
deter an otherwise profitable product launch, purchased packaged risky loans and eventually
then you’ve committed the sunk-cost fallacy went bankrupt when the debtors defaulted.

HIDDEN COST FALLACY HIDDEN COST OF CAPITAL

Hidden cost fallacy • Recall that accounting profit does not necessarily
• ignoring relevant costs (costs that vary with the correspond to economic profit.
consequences of your decision) when making a • Discussion: Economic Value Added
decision o EVA®= net operating profit after taxes
• Common hidden-cost fallacy: ignore the minus the cost of capital times the
opportunity cost of capital when making amount of capital utilized
investment or shutdown decisions. o Makes visible the hidden cost of capital
• The major benefit of EVA is identifying costs. If
Example: Football game (again) you cannot measure something, you cannot
• You buy a ticket for $20 control it.
• Scalpers are selling tickets for $50 because your o Those who control costs should be
team is playing cross-state rivals responsible for them.
• You go to the game, saying, “These tickets cost
me only $20.” WRONG INCENTIVES AND EVA
• The tickets really cost you $50 because you give
up the opportunity to scalp them by going EVA® - measure of financial performance that makes
• Unless you value them at $50, you are sitting on visible the hidden cost of capital.
an unconsummated wealth-creating transaction
• Rewarding managers for increasing economic
EXAMPLE: should you fire an employee? profit increases profitability, but evidence
suggests that economic performance plans work
The revenue he provides to the company is $2,500 per no better than traditional incentive
month compensation schemes based on accounting
● His wages are $1,900 per month measures.
● His office could be rented out $800 per month
● YES, you are only making $600 a month from this • Goal alignment: “By taking all capital costs into
employee but could make $800 a month from renting his account, including the cost of equity, EVA shows
office the dollar amount of wealth a business has
created or destroyed in each reporting period. …
EVA is profit the way shareholders define it.”
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Discussion: can you make mistakes using EVA? either performer. Based on this information, what is the
o Does it help avoid the hidden cost fallacy? opportunity cost of seeing Eric Clapton?
o Does it help avoid the fixed cost fallacy?
A. $0 B. $10 C. $40 D. $50
DOES EVA WORK?
You won a free ticket to see an Eric Clapton concert
• Adopting companies of EPP’s (+ four years) (which has no resale value). Bob Dylan is performing on
o ROA from 3.5 to 4.7% the same night and is your next-best alternative activity.
o operating income/assets from 15.8 to Tickets to see Dylan cost $40.
16.7%
• Indistinguishable from non-adopters On any given day, you would be willing to pay up to $50
o Bonuses increase 39.1% for EVA® firms to see Dylan. Assume there are no other costs of seeing
But 37.4% for control group either performer.
• Interpretations
o Selection bias? Based on this information, what is the minimum amount
o NO, cheaper to use existing plans (in dollars) you would have to value seeing Eric Clapton
o Goal alignment, YES. for you to choose his concert?
• EVA® is no better or worse
o Rival EPP’s A. $0 B. $10 C. $40 D. $50
o Bonus plans
o Discussion: Why?
Not enough information or bad
incentives are not the only causes for
business mistakes. Often psychological
biases get in the way of rational decision
making.

PSYCHOLOGICAL BIASES

1. Endowment effect means that taking ownership

of item causes owner to increase value she
places on the item.
2. Loss aversion – individuals would pay more to
avoid loss than to realize gains.
3. Confirmation bias – a tendency to gather
information that confirms your prior beliefs, and
to ignore information that contradicts them
4. Anchoring bias – relates the effects of how
information is presented or framed
5. Overconfidence bias – tendency to place too
much confidence ion the accuracy of your
analysis

You 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
MANAGERIAL ECONOMICS
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CHAPTER 4: EXTENT (HOW MUCH DECISIONS

Do not confuse average and marginal costs. ● He committed the fixed-cost fallacy by
● Average cost (AC) is total cost (fixed and looking at average cost, which include
variable) divided by total units produced. costs that do not vary with the decision.
• Average cost is irrelevant to an extent ● If he had ignored fixed costs, he would
decision. have seen that increasing the number of
● Marginal cost (MC) is the additional cost deliveries would increase profit.
incurred by producing and selling one more unit.
● Marginal revenue (MR) is the additional revenue AVERAGE COST
gained from selling one more unit.
● Sell more if MR > MC; sell less if MR < MC. If MR ● Definition: Average cost (AC) is simply the total
= MC, you are selling the right amount cost (TC) of production divided by the number of
(maximizing profit!). units produced (Q).
• AC = TC/Q
● The relevant costs and benefits of an extent ● Average costs often decrease as quantity
decision are marginal costs and marginal increases due to presence of fixed costs (FC)
revenue. If the marginal revenue of an activity is • AC = (VC + FC)/Q
larger than the marginal cost, then do more of it. • FC does not change as Q increases
● An incentive compensation scheme that ● Key note: Average costs are not relevant to
increases marginal revenue or reduces marginal extent decisions
cost will increase effort. Fixed fees have no
effects on effort.
● A good incentive compensation scheme links pay
to performance measures that reflect effort.

US FINANCIAL CRISIS

● The financial crisis began in the subprime

housing market, where government policies
encouraged lenders to extend credit to low-
income borrowers (by lowering lending standards) MEMORIAL HOSPITAL REVISITED
● These high-risk loans, or mortgages, were being
packaged into securities by lenders and sold to
investors. ● Memorial made 500 deliveries originally
• Fixed cost: $1,000,000
● If the risk had been recognized investor demand
• Variable cost: $3,000/delivery
would have been low, but rating agencies were
• Total cost: $1,000,000 + ($3,000 x 500)
too liberal with AAA ratings, increasing demand
• Average cost: total costs/# of deliveries
for loans.
● Average costs fall as you increase output, but the
● The result? A credit “bubble”
variable costs remain constant
● How did this lending crisis arise?
● Marginal cost is only $3,000 at Memorial
Hospital
AVERAGE COST CAUTION
MARGINAL COST & MARGINAL REVENUE
● Memorial Hospital’s CEO conducted
performance reviews of the hospital departments.
● Definition: Marginal cost is the additional cost
● During this process, the chief of obstetrics to make and sell one additional unit of output (Q)
proposed an increase in the number of babies MC = TCQ+1 – TCQ
being delivered in his department.
● Marginal cost is often lower than average cost
● The CEO wondered why since the cost of (due to fixed costs) but not always
delivering babies was higher than the revenues
● Marginal costs are what matter in extent
brought in.
decisions
● The CEO’s mistake: He began with the costs
● Definition: Marginal revenue (MR) is the
instead of the decision.
additional revenue gained from producing and
selling one more unit.
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EXTENT DECISIONS • by comparing marginal effectiveness of

different media
● Examples of extent decisions:
• Should you change the level of COMPETING STRATEGIES AND MARGINAL
advertising? ANALYSIS
• Should you increase the quality of
service? ● Example: Compare TV advertising to telephone
• Is your staff big enough, or too big? solicitation
• How many parking spaces should you • The opportunity cost of spending one
lease? more $ on TV advertising is the forgone
● For extent decisions, we break the decision into opportunity to spend $ on telephone
small steps solicitation
• If taking a step provides more benefit • Say you recently cut telephone (PH)
than cost, take a step forward budget by $10,000 and lost 100
If not, step backward customers
Estimated MCPH = $100= ($10,000 / 100)
● This analysis tells you direction of change but not • So, to get one more customer costs $50
the distance. for TV and $100 for phone
• You can only measure MR and MC at the MCPH > MCTV so shift ad dollars from phone to TV
current level of output – make a change ● Advice: make changes one-at-a-time to gather
and re-measure valuable information about marginal
● If the benefits of selling another unit (MR) are effectiveness of each medium
bigger than the costs (MC), then sell another unit.
● Maxim: TEXTILE PRODUCTION EXAMPLE
• Produce more when MR>MC
• Produce less when MR<MC ● A textile company with manufacturing plants in
Profits are maximized when MR=MC Latin America uses SAH=“Standard Absorbed
Hours” a measure of textile factory output
MEMORIAL HOSPITAL MARGINAL ANALYSIS • Allows managers to compare factories
making different items, e.g. t-shirt = 1
● As we mentioned, the MC of a delivery was SAH while dress=3 SAH
$3,000 ● Suppose Factory A has costs of $30 per SAH
● The MR was $5,000 while Factory B has cost of $20 per SAH. How
can you profitably use this information?
● Therefore, MR>MC so the hospital was not
delivering enough babies ● Should you move production to cheaper factory?
• Make sure you are not including fixed
● This explains why the CEO was wrong
costs in the analysis
• Marginal costs matter, not average costs!
Answering the “How much advertising?” question
• If the $20 and $30 rates are good MC
● A $50,000 increase in the TV ad budget brings in proxies, shift some production from
1,000 new customers Factory A to Factory B
● Estimated MCTV is $50 (the cost to get one more INCENTIVE PAY
customer)
$50,000 / 1,000 = $50
If the marginal revenue generated by this customer is ● Discussion: Royalty rates vs. fixed fee contracts
greater than $50, do more advertising. ● How hard to work is an extent decision so you can
design incentives to encourage hard work by
● You know the direction (do more), but you do using marginal analysis
not know how far to go ● Example: You receive two bids to harvest 100
● You have to take a step and re-compute marginal trees on your land
cost and benefit to see if you should continue in • $150/tree or $15,000 for the right to
the direction your analysis originally pointed harvest all the trees.
you in • On your tract there are pines (worth $200)
and fir (worth $100).
● Also, even if we do not know the marginal
• Which offer should you accept?
revenue, we can still use marginal analysis to
• Hint: consider the effects of the
make extent decisions
two bids on the incentives of the
logger.
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TREE HARVESTING ANSWER

AMERICAN EXPRESS EXAMPLE
● The bids have the same face value, but are very
different in terms of logger’s incentives ● American Express offers a Platinum Card to
• Fixed fee: the logger will ignore the affluent customers
$15,000 because it doesn’t vary with the ● In 2001, there were approximately 2,000
decision to cut down trees. Platinum cardholders in the Japanese market.
• The logger will end up cutting Numbers had been limited to ensure high quality
down all trees that are profitable customer service
to ● With customer service technology advances, the
cut down, MR>MC company considered expanding number of card
• Royalty Rate: The logger will only cut holders
down trees trees that generate profit of ● How many more should be added?
$150, MR>MC+150 • As more members are acquired, average
• Mix of $200- and $100-value spending per card member decreases
trees – logger will harvest only because the financial threshold for
the $200 membership is lowered
• The landowner receives less • Costs of customer service rise for each
money since the logger only additional member added, and growing
harvests one type of tree beyond a certain point would require
• Royalties deter some wealth- building and operating an additional call
creating transactions as fir trees center
are not harvested • After analyzing the costs and benefits,
SALES COMMISSION EXAMPLE American Express realized that it should
expand its offering to only 15,000 more
Platinum Card members
Motivating salespeople:
● We call this an “extent” decision, because the
● Expected sales level: 100 units @
company needed to decide “how many” platinum
$10,000/unit=$1M
cards to provide. In this chapter, we show you
• Option 1: 10% commission
how to make profitable extent decisions.
• Option 2: 5% commission + $50,000
salary
• Hint: consider incentives for
salespeople
● Use Option 1 because MR=$1000/sale >
$500/sale, the MR under Option 2
● The sales force responds to larger marginal
benefits of selling with more effort
• Lower sales effort under option 2 is called
“shirking”

TIE PAY TO PERFORMANCE

● A consulting firm COO received a flat salary of

$75,000
• After learning about the benefits of
incentive pay
in class, the CEO changed COO
compensation to
$50K + (1/3)* (Profits-$150K)
• Profits increased 74% to $1.2 M
• Compensation increased $75Kg$177K
● Discussion: What are the disadvantages to
incentive pay?