Introduction: What This Book is About

1. Introduction: What This Book is About

2. Summary of Main Points • Problem solving requires two steps: First, figure out why mistakes are being made; and then figure out how to make them stop. • The rational-actor paradigm assumes that people act rationally, optimally, and self-interestedly. To change behavior, you have to change incentives. • Good incentives are created by rewarding good performance. • A well-designed organization is one in which employee incentives are aligned with organizational goals. By this we mean that employees have enough information to make good decisions, and the incentive to do so.

3. Summary of Main Points (continued) • You can analyze any problem by asking three questions: • Who is making the bad decision?; • Does the decision maker have enough information to make a good decision?; and • the incentive to do so? • Answers to these questions will suggest solutions centered on • letting someone else make the decision, someone with better information or incentives; • giving the decision maker more information; or • changing the decision maker’s incentives.

4. Problem: Over-bidding OVI gas tract • A young geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico. • With knowledge of the productivity of neighboring tracts also owned by company, the geologist recommended a bid of $5 million. • Senior management, though, bid $20 million - far over the next highest-bid of $750,000. • What, if anything, is wrong? • The goal of this text is to provide tools to help diagnose and solve problems like this.

5. Problem solving • Two distinct steps: • Figure out what’s wrong, i.e., why the bad decision was made • Figure out how to fix it • Both steps require a model of behavior • Why are people making mistakes? • What can we do to make them change? • Economists use the rational actor paradigm to model behavior. The rational actor paradigm states: • People act rationally, optimally, self-interestedly • i.e., they respond to incentives – to change behavior you must change incentives.

6. ANSWER: Manager bonuses for increasing reserves • The bonus system created incentives to over-bid. • Senior managers were rewarded for acquiring reserves regardless of their profitability • Bonuses also created incentive to manipulate the reserve estimate. • Now that we know what is wrong, how do we fix it? • Let someone else decide? • Change information flow? • Change incentives? • Performance evaluation metric • Reward scheme