GSBS6410

Economics of Competitive Advantage

Week 1
Economic Decision Making
An Introduction
 OUTLINE

1. Readings and Introduction

2. Economic Problems & Problem Solving
3. Market Economy
4. Questions for Discussion

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 GSBS6410
Readings for this lecture
• Froeb Luke M., Brian T. McCann, Michael R. Ward and Mike Shor
(FMWS) 2018, Managerial Economics, Fifth edition, Cengage
Learning US, Chapters 1 and 2, and
• Relevant chapters in any intermediate microeconomic textbook,
especially one of the following
• Arnold, Roger A., (2016) Microeconomics, 12th Edition, Cengage.
Chapters 1 & 2 (if you think our textbook is too simple).
• Layton A, Robinson T, and Tucker I. (2016) Economics For Today,
Fifth Asia Pacific Edition, Cengage Learning Australia, Melbourne.
Chapters 1 & 2 (if you think our textbook is too hard).
• Sloman, Norris, and Garratt (2011), Principles of Economics, Pearson
Australia, Sydney. Chapter 1.
 Introduction to Course
• In the dynamic global economy, managers are
increasingly faced with multifaceted problems
where a working knowledge of economic principles
can provide useful insights.
• This course develops economics skills and
competencies for problem solving by offering
Exampleperiential analysis of the challenges that
managers face and by demonstrating how the
application of economic principles informs
managerial decision-making.

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 Introduction to Course
• Students are encouraged to use the insights
provided by this course - with its emphasis on
concepts of competitive advantage and the
economics of strategy - to investigate how
competitiveness is created.
• Students develop an understanding of
microeconomic principles and their practical
application, and use this knowledge to analyse
various issues including the impacts of government
regulation and policies, and production and pricing
decisions within an international business
environment.
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Course Objectives and Learning Outcomes
At the conclusion of this course students will be able to:
1. Demonstrate basic knowledge of the assumptions, tools,
theories, models and the language of microeconomics.
2. Identify recent developments in applied microeconomics,
especially concepts about competitive advantage and
strategy, and contemporary policy debates.
3. Apply the microeconomic concepts, theories and models
to case studies.
4. Develop and present a critically reflective, well written
case analysis.
5. Access and analyse on-line microeconomic data sources.

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 Economic Problems & Problem Solving

• Problem solving requires two steps:

1) figure out what’s causing the problem
2) figure out how to fix it
• For both steps, predict how people behave
• Rational-actor paradigm: assumes that
people act rationally, optimally, and self-
interestedly.
• Simply put, people respond to incentives.

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 Economic Problems & Problem Solving

• Good incentives come from rewarding good

performance.
– Example: commission on sales
• A well-designed organization aligns employee
incentives with organizational goals.
• Specifically, employees have enough
information to make good decisions, and the
incentive to do so.

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 Economic Problems & Problem Solving
• Three questions to find the source of the problem:
1) Who is making the bad decision?
2) Does the decision maker have enough information
to make a good decision?
3) Does the decision maker have the incentive to make a good
decision?
• Answers to these questions will suggest solutions:
1) Letting someone with better information or incentives make
the decision
2) Giving the decision maker more information
3) Changing the decision maker’s incentives.

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 Problem: Over-bidding OVI gas tract
• A young geologist was preparing a bid
recommendation for an oil tract in the Gulf of
MExampleico.
• The geologist knew the productivity of nearby
tracts also owned by the company.
• Knowing this, he recommended a bid of $5 million.
• Senior management bid $20 million – far over the
nExamplet highest bid of $750,000.
• What, if anything, is wrong?

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 Problem solving
• The goal of this lecture is to provide tools to
help identify and solve problems like this.
• Two distinct steps:
1) Figure out what’s wrong
• i.e., why overbidding occurred
2) Figure out how to fix it

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 Model of Behavior
• Both steps require a model of behavior
– Why are people making mistakes?
– What can we do to make them change?
• Economists use the rational-actor paradigm to
model behavior.
• The rational actor paradigm states:
– People act rationally, optimally, self-interestedly
– Meaning, they respond to incentives – to change
behavior you must change incentives.
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 Answer to Overbidding Problem
• Answer the three questions:
1) Senior management made the bad decision to overbid.
2) They had enough information to make the right decision.
3) They didn’t have the incentive to do so.
• A bonus system created incentives to over-bid.
– Senior managers were rewarded for acquiring reserves
regardless of their profitability.
– They had the young geologist “do what he could” to
increase the size of estimated reserves.
– Bonuses also created an incentive to manipulate the
reserve estimate.

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 Solution to Overbidding Problem
Now that we know what is wrong, how do we fix it?
• Let someone else decide? NO
• Change information flow? NO
• Change incentives? YES
– Change performance evaluation metric
• Exampleample: Increased profitability as measurement of
success instead of increased acquired reserves
– Reward scheme
• Exampleample: Make bonuses tied to profitability, not
acquired reserves

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 National Auto Repair Problem
• In 2006, a TV reporter was sent into a
National Auto Repair (NAR) shop with a
perfectly good car
• The reporter came out with a new muffler
and transmission – and a bill for over
$8,000
• The news story badly hurt NAR’s profits
• How do you solve this problem?

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 Problem-Solving Algorithm
1) Who is making the bad decision?
– The mechanic recommended unnecessary repairs.
2) Does the decision maker have enough
information to make a good decision?
– Yes, in fact, the mechanic is the only one with
enough information to know whether repairs are
necessary.

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 Problem-Solving Algorithm
3) Does the decision maker have the incentive
to make a good decision?
– No, the mechanic is evaluated based on the
amount of repair work he does, and receives
bonuses or commissions tied to the amount of
repair work.

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 National Auto Repair Solution
• There was an incentive issue
• NAR tried two solutions
1) reorganized into two division – led to colluding
2) adopted flat pay – led to less incentive to work hard
• Suggested resolution: add an additional performance
evaluation metric to original commission scheme
– Exampleample: Sporadically send in “secret shoppers”
like the news reporter
• This shows the trade-offs you face when creating
solutions

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 Ethics and Economics
• The rational-actor paradigm can make
students uncomfortable
– It seems to disregard personal ethics the guide
behavior.
• You have to understand why unethical
behavior occurs to fix it though
– Be able to anticipate opportunistic behavior to
know how to avoid it

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 Value System
• Debates about ethics and economics really are about
different value systems
• Deontologists: actions are good or ethical if they
conform to a set of principles (Exampleample: The
Golden Rule)
• Consequentialists: actions are judged based on
whether they lead to a good consequence
• Economics is more consequentialist
– Uses analysis to understand the consequences of
different solutions
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 Market Economy
• Voluntary transactions or market create
wealth by moving assets from lower- to
higher-valued uses.
• Anything that impedes the movement of
assets to higher-valued uses, like taxes,
subsidies, or price controls, destroys wealth.
• Economic analysis is useful to business for
identifying assets in lower-valued uses.

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 Market Economy
• The art of business consists of identifying
assets in low-valued uses and devising ways to
profitably move them to higher-valued ones.
• A company or firm can be thought of as a series
of transactions in market, or
• A well-designed organization rewards
employees who identify and consummate
profitable transactions or who stop
unprofitable ones.
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 Capitalism 101
To identify money-making opportunities,
you must first understand how wealth is created
(and sometimes destroyed).
• Key note: Wealth is created when assets are moved
from lower to higher-valued uses
• Definition: Value = willingness to pay
Desire + Income = You want something + you can pay for it
• Key note: Voluntary transactions, between individuals
or firms, create wealth.
– Meaning, people create wealth by pursuing self-interest.
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 Housing Example
A house is for sale:
• The buyer values the house at $130,000
– This is the buyer’s top dollar – willingness to pay
• The seller values the house at $120,000
– This is the seller’s bottom line – won’t accept less
The buyer and seller must agree to a price that
“splits” surplus between buyer and seller. Here,
$128,000.

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 Surplus
The buyer and seller both benefit from this
transaction:
• Buyer surplus = buyer’s value minus the price
$130,000 - $128,000 = $2,000 buyer surplus

• Seller surplus = the price minus the seller’s value

$128,000 - $120,000 = $8,000 seller surplus

• Total surplus = buyer + seller surplus = difference in

values
$2,000 + $8,000 = $10,000  $130,000 - $120,000 = $10,000
$10,000 are the gains from trade

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 Wealth-Creating Transactions
• Which assets do these transactions move to
higher-valued uses?
• Factory Owners • Corporate Raiders    
• Real Estate Agents • Insurance Salesman
• Investment Bankers        
• Discussion: How does eBay create wealth?
• Discussion: Which individual has created the
most wealth during your lifetime?
• Discussion: How do you create wealth?
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 Do Mergers Create Wealth?
• Do mergers follow the wealth-creating engine of capitalism?
Do they move assets to a higher-valued use?
– Our largest and most valuable assets are corporations.
• Exampleample: Dell-Alienware merger:
– In 2006, Dell purchased Alienware, a manufacturer of high-
end gaming computers.
– Dell left design, marketing, sales and support in Alienware’s
hands.
– Dell took over manufacturing though, using its
Examplepertise
to build Alienware’s computers at a much lower cost.
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 Do Mergers Create Wealth?
• However, many mergers and acquisitions do
not create value
– If they do, value creation is rarely so clear

• To create value, the assets of the acquired

firm must be more valuable to the buyer
than to the seller

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 Does Government Create Wealth?
• Discussion: What’s the government’s role is wealth creation?
– Enforcing property rights and contracts legal tools that facilitate
wealth creating transactions
– Ensures that buyers and sellers keep gains from trade
• Discussion: Why are some countries so poor?
– No property rights
– No rule of law
• Discussion: Much of the justification for government
intervention comes from the assertion that markets have failed.
One money manager scoffed at this idea. “The markets are
working fine, but they’re giving people answers that they don’t
like, so people cry market failure.”

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 The One Lesson of Economics
• Definition: An economy is efficient if all assets are employed in their
highest-valued assets.
– This is an unattainable, but useful benchmark
• The One Lesson of Economics: The art of economics consists in
looking not merely at the immediate but at the longer effects of any
act or policy; it consists in tracing the consequences of that policy
not merely for one group but for all groups.
• Must look at the intended and unintended effects of policies to
understand their efficiency
• The economist’s solution to inefficient outcomes is to argue for a
change in public policy.
• Business person’s solution is to try to make money on the
inefficiency
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 The One Lesson of Business
• Definition: Inefficiency implies the Example existence
of unconsummated, wealth-creating transactions
• The One Lesson of Business: The art of business
consists of identifying assets in lower valued uses
and devising ways to profitably moving them to
higher valued uses.
• In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.

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 Destroying Wealth
Anything that stops assets from moving to higher valued uses is
destroying wealth.
– Taxes Destroy Wealth:
• By deterring wealth-creating transactions – when the tax is
larger than the surplus for a transaction.
– Subsidies Destroy Wealth:
• Example: flood insurance encourages people to build in areas
that they otherwise wouldn’t
– Price Controls Destroy Wealth:
• Example: rent control (price ceiling) in New York City deters
transactions between owners and renters
• Which assets end up in lower-valued uses?
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 Profiting from Inefficiency
• Taxes create a profit opportunity
– Discussion: 1983 Sweden tax

• Subsidies create opportunity

– Discussion: health insurance

• Price-controls create opportunity

– Discussion: China’s dual track price system in the
1980s
– Discussion: What about ethics?
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 Wealth Creation in Organizations
• Companies = a collection of transactions
• They buy raw materials (capital, labor, etc.) and
create and sell higher-valued goods and services
• Can equate market-level problems (taxes,
subsidies and price controls) with organization-
level goal alignment problems
– Example: The overbidding from the oil company =
“subsidy” paid to management for acquiring oil
reserves
• Allows us to use the same analysis
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 Questions for Discussion
1. Identify an unconsummated wealth-creating transaction
(or a wealth-destroying one) created by some tax, subsidy,
price control, or other government policy, and then figure
out how to profitably consummate it (or deter it). Estimate
how much profit you would earn by consummating (or
deterring) it.

2. I recently sold my used car. If no new production occurred

for this transaction, how could it have created value?

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