Business Economics: Behavior, Ethics, and Strategy
Economist’s View of Behavior
Business economics should provide a framework for analyzing problems. Darwinism: the fittest survive. People have unlimited wants; how to allocate resources, trade-offs (compensación). Limited resources, costly and imperfect information. Marginal analysis and cost-benefit analysis. Sunk Cost. Nature of opportunity costs: Explicit costs, implicit costs.
Decision Making Under Uncertainty
Lottery (uncertain outcome) probability. Key descriptive statistics: expected value EV=Pr(A)xA+… (centrality) variance Var: Pr(A)·(A-EV)^2+… (dispersion) 0-1. Attitudes to risk: loving, averse, neutral. Asymmetric information, moral hazard, and adverse selection. Individuals protect themselves against risk and opportunistic behaviors. Insurance premium increasing on the riskiness. Risk premium, fairly priced insurance.
Economist’s View of Behavior
Individuals decide rationally comparing marginal… thinking at the margin, the nature of opportunity costs… sunk costs… Other models: happy is productive, good citizens, only money matters.
Applications: Ethics and Corporate Governance
Ethics
Business ethics is an elusive concept. If the corporation is to survive, it needs to maximize value to its owners. Corporate social responsibility, managerial implications, ethic programs, codes of conduct, corporate policy setting, mechanisms for encouraging behavior, ethics and policy implementation. The company’s reputation is part of its brand-name capital. It’s not about changing employees’ performance, it’s about setting the right incentives. Even if the ethic program fails, good communication and education add value to the firm.
Corporate Governance
Corporations have the legal standing of an individual. Some corporations are privately held, and others are publicly traded. Raising capital from investors is the primary reason why firms go public. The main elements in US corporate governance are: 1) shareholders, 2) board of directors, 3) CEO and top management, and 4) external parties. Corporate governance (organization structure), corporate structure (legal capacity of a person), corporate ownership in publicly traded corporations, separation of ownership and control. CEO: chief executive officer: most decisions, acquire more info, decentralize decision making to individuals with better information.
Incentive Conflicts and Contracts
Market and Organizations
Prices coordinate individual actions and resource allocation and also generate useful information. Efficiency. Property rights. Market transactions. Markets use prices to allocate resources, and firms use managers, which creates managerial conflicts. Managers are focused on their own utility, and shareholders on the firm’s value. The Coase theorem: if property rights are assigned and transaction costs are low, markets are efficient. Transaction costs = contracting costs = costs involved (searching, testing, comparing)…
Incentive Conflicts and Contracts
A firm is the center of a network of contracts. Contracts need to be enforceable with their employees, owner-manager, buyer-supplier. They have fundamental assumptions. Breach of contract (incumplimiento). Monitoring costs. Large firms are more bureaucratic and difficult to manage and control: delegation is necessary (overinvestment=sobreinversión).
Contracting Costs
Costly contracting, asymmetric information, opportunistic behavior. Agency relationship is the main form but has problems: pre-contractual (bargaining failures: asymmetric information)(bonding costs). Post-contractual (monitoring and bonding costs) — OWNER VS MANAGER: salaries and perquisites, work hard or shirk (effort is costly), risk aversion (owners risk neutral, managers risk averse), different time horizons, overinvestment. OTHER CONFLICTS: free ride or not, management versus labor, buyer-supplier conflicts. Reputational concerns and implicit contracts are very important.
Economics of Strategy
Strategy is a long-term vision of how to create and capture value. Created: introducing new products or services, reducing transaction costs (know-how) = innovation, reduce transaction costs, organizational knowledge. Capture: market power (rivalry, threats of substitutes, threats and opportunities in general, power of supply and demand). Cooperation between firms. Diversify with related or unrelated industries.
Organizational Architecture
Vertical Integration and Outsourcing
Production of own goods and services (inputs) is organized by a vertical chain, from raw materials at the top. Market discipline is the main reason for on-spot transactions. Reasons in favor of vertical integration: avoid contracting costs, including incomplete contracting, to avoid hold-up problems for specific assets. The adverse thing is externalization: non-specific assets, better technology and communication. The current tendency is between vertical integration and externalization, it’s in long-term contracts. Backward integration, forward integration (commercialization). Spot market. Transaction in the market: spot market, transactions outside the market: vertical chain or long-term contracts. Reasons for non-market transactions: quality, fewer externalities, specific assets, coordination, market power, and taxes and legislation. Vertical integration vs. long-term contracts are expensive and prone to opportunism.
Organizational Architecture and Decision Rights
Allocation of decision rights “who decides what.” Fundamental problem: decision-makers and relevant information, appropriate incentives. The environment (technology, markets, regulation) determines strategy and the architecture of the firm. Main debate: centralization: better coordination but overloads the center. Appropriate form for calm environments and standardized production. Decentralization: better use of local info but overloads the center, motivation, senior managers have a bigger cost of opportunity. All this is very expensive. Monitoring and coordination costs. Better for changeable environments and varied production. Decision management and control need to be separated. Pyramid: business environment (tech, markets, regulation), strategy, organization architecture, incentives and actions, firm value.
Incentive Conflicts and Performance Evaluation
Incentive conflicts exist within firms because principals and agents have different goals, and the principal cannot observe agents’ actions. The incentive problem: incentives from ownership, optimal risk sharing. Effective incentive contracts: basic principal-agent problem. Performance evaluation. The optimal compensation should strike a balance between risk sharing: reduce the risk of the agent, and incentive provision: induce the agent to exert effort. In general, apply the “informativeness principle”: a group of employees do the same tasks and give information on how the work is and, in effect, how the recompense should be… = relative performance evaluation. Individual performance evaluation (output): ratchet effect, relative and subjective. Divisional performance: cost, expense, revenue, profit, investment.
Employee Motivation
People are guided by four basic emotional drives: acquire (goals), bond (connections), comprehend (satisfy our curiosity), defend (external threats). Give employees financial services. Motivation is measured by engagement (energy), satisfaction, commitment, and intention to quit. Drive to acquire: our sense of well-being. Drive to bond: make the employee feel proud. Comprehend: challenged. Defend: clear goals and intentions and allow people to express their ideas and opinions. Organizational levels of motivation: the reward system, culture, job design, performance-management, and resource allocation processes.
Outsourcing Analytics
It can offer benefits but requires a carefully constructed relationship. Addressing capability gaps, how analytically sophisticated companies view outsourcing, creating successful analytics partnerships.
Reinventing Your Business Model
Three steps to determine when you should: articulate what makes your existing model successful, watch for signals that your model needs changing, decide whether reinventing your model is worth the effort. A successful model has three components: customer value proposition (prediction), profit formula (the model generates value for your company), key resources and processes (people, tech, products, facilities..)
Initial Public Offering (IPO)
Going public is one of the biggest decisions; pay attention to market timing and assembling the right management team, watch out for who is your buyer, especially if it’s a bank. Benefits: more expensive equity base, more diversified equity, the chance to cash in, raised market. Risks: agency problems, costs, change of culture. Tips: underwriters teams, preserve the best of your corporate culture, consider issuing shares.
Conflict Management
Managers get truly effective collaboration only when they realize that conflict is natural and necessary. Challenge for managers: how to get people in your organization to work together across internal boundaries. It works best when the parties included are equipped to manage it themselves. Strategies: devise and implement a common method for resolving conflict, provide people with criteria for making trade-offs.
Ultimate Marketing Machine
Most marketing organizations are stuck in the last century. Strategies that were developing a few years ago are obsolete. New approaches are appearing every day. Big data, deep insights. Purposeful positioning. Experience. Growth. Inspiring. Focusing. All employees have to know about marketing, it’s very important. New marketing roles. Building capabilities. Technology.
Exporting to Grow
Grew up in different parts. Rich countries had already developed the necessary technology, fundamental deficiency. Some countries’ growth depends on exports. The elusive search for growth. Is more capital the key to growth? Organizational capital. How the early developers built organizational capital. The strategy of late developers (nations that became independent just after WWII), the commanding heights (consider first the strategy of creating state-owned enterprises. Favoring the few. Missing the turn. Some exporters get rich, very rich, Germany and Japan.
8 Traps in Decision Making
Before making important decisions, prudent managers evaluate the situation confronting them. Optimistic and overconfident, others too cautious.
Anchoring Trap
Disproportionate weight to the first information. Antidote: different perspectives, consult, be open-minded.
Status Quo Trap
Biases that influence the choices we make. Antidote: reminding yourself of your objectives, never thinking as the only alternative.
Sunk Cost Trap
Antidote: listen carefully to other people, don’t give importance to the influence, admit your mistakes, don’t cultivate failure-fearing.
Confirming Evidence Trap
Avoiding other information that is not in line with your point of view. Antidote: examine all with equal rigor, be honest to yourself about your motives.
Framing Trap
How you frame a problem (el enfoque).
Overconfidence Trap
Prudence Trap
Recallability Trap
Faced with high stakes, just be on the safe side. Antidote: discipline to making forecasts and judging probabilities.