people have done it.
Has anyone in this class worked it out already?
Great, I see a thumbs up, so you can
go through there. If you have any issues, let
me know, reach out to me, and yeah, I can
help you out with that. Also, for those of
you who checked, I uploaded a redacted
version of this lecture on Brightspace,
so if you're someone who likes to
look at the lecture slides before class
or use it as a guide within class,
you have that there. And also, I did
have a chat with the McGraw-Hill
people this morning and it turns
out regarding my homework policy it
might not be able to be implemented in that
way so the re-attempts can only be done for
the entire homework not for individual
questions so what will happen is let's say
there are 20 questions you solve it all and
you get 16 right you can do it again you don't
have to redo the ones you got correct but
you can redo the four that you got wrong
so I can't take of 5% per question what I can
do is remove a total amount so if you got
16 right which is 80% you can take the
80% or you can take a deduction let's say
of 5% overall and try and get the other four
right so if you get everything right the
second time around you'll end up with 95% so
I'm still figuring out the best way to
do this given it is different to how I wanted
to implement it if a 5% total deduction overall
is still appropriate or will I move to
something like 2 or 2.5% so you'll have
unlimited attempts and you can figure out
what is best for you once again this is meant
to be a way to help incentivize you to
like do the homework rather than outsource
it to try and just get it all correct I
want you to learn with it so I might lower
this down this happened this morning
I've been teaching since so I haven't been
able to think of the best way to incentivize
it yet but I want to be transparent
where I'm at so you all know, and you can
reach out to me once again if you've got
questions about that. And finally, it does
look like we have a TA for the course. I
will update the syllabus so you can see where
their office hours are, and it'll be on
Tuesday, Thursday, because mine are Monday,
Wednesday, Friday. Any questions
regarding any of this? Right, so let's jump
into it. So the way I want to teach this
course is I do want to follow the textbook
closely, and this is for your, I in benefit so
when you're studying for exams and stuff you
have the source material right there but
sometimes in the textbook they'll spend one
sentence or one paragraph on something that I think
is really interesting or really important
and as you'll see today I'll like expand
upon that maybe tangent a little bit whereas
some other things I think are less interesting
so I'll spend less time on it but I'll
show it here so you have reference to it and
it'll be less likely to appear on the exam as
well so at the start of chapter one they have
these seven principles of effective managerial
decision making. And we're going to
end up finishing up with understanding
incentives today. So identifying goals
and constraints, recognizing the nature and importance
of profits, understanding
incentives. So I'll spend a lot of
focus on that for the last 20
minutes of today. Understanding markets, recognize the time
value of money. This course is something
really weird. We usually don't really talk about
inter-temporal choice or discounting in
these early on courses, but they put this in
in chapter one, which I think is good.
I don't like their definition of how they
go about it, but I think it is cool that they
included it in here. Use marginal analysis,
and as an experimentalist, I'm very into
evidence-based policy, so they've got this
little section on making data-driven decisions,
which is important. So the first of these
principles is identifying goals and constraints.
So for anyone, not just a firm or a
manager, your goals must be well-defined so
you know what you're actually trying to
optimise, what you're trying to maximise. So in
the firm's case, it's their goal to maximise
profits, make the most amount of profit
possible, but for us these goals can be anything
from, you know, being as successful as we can
in our marks, in our managerial econ class,
to optimising how much fun we can have on
a Saturday night. All these things are goals
and once you have a goal there are ways
to optimize for those goals what stands in the
way of this optimization process is constraints
and constraints make it difficult to
achieve goals so there's only a limited amount
of technology that we have that can limit
your business model so for example imagine
if we had you know teleporters available
uber eats would probably be a lot cheaper to run
than having to pay a whole bunch of drivers
to go around that doesn't exist so they're
limited by the technology available to them,
and then also the prices of inputs using
production. So we'll talk about an example
in a second of someone running a lemonade stand,
but if you're selling lemonade, you need
to buy lemons, sugar, have water, maybe
employees as well, all these things
cost money, these are input costs
which lower your profitability. So these
are the constraints that you need to
take into account when you want to
maximize your profit. So as we said, the
firm's overall goal is to maximize their
profit or max this this this this pie function
here which is just the total revenue
that you get minus the total cost nothing new
nothing groundbreaking so for example our
good old friend lamar runs a lemonade stand
and he sold 50 cups of lemonade for three
dollars each he spent forty dollars on his
inputs cups lemons sugar water he didn't
hire anyone to do anything what is his
profit his profit is equal to the total revenue
minus the total cost, and he sold 50
cups of lemonade at $3 each, which is $150
revenue minus the $40 on input costs, so that
equals $110 profit. So this is our
accounting profit, we've probably all
seen this before, either in high
school, earlier econ courses, or in your
other business courses as well, and it's
just our total revenue minus the
total explicit cost. However, our
definition of economic profit differs from
accounting profit. We have the same two
terms, total revenue minus total explicit
cost, but we have this third thing.
We also take into account, we minus
total implicit cost. And given that implicit
costs are often more than zero, pretty
much most of the time, economic profit
is going to be less than the
accounting profit. So, for example, let's think about these
implicit costs. So, let's say after
class, it's probably a bit too late for
lunch now, but, okay, imagine before class
on Friday at 1 o 'clock, I offer you to
come with me to Bistro 811, you can order
whatever you want and I will pay for it.
Is this a free lunch? So, you over there in the Adidas hoodie,
what's your name? Michael. Michael,
I invite you out to lunch 1 o'clock or
12 o'clock on Friday, You can order
whatever you want, and I'll pay for it.
Is this lunch free? No. Why is it not free? Because I was going
to do something else for lunch. What else
would have you done rather than hear me throwing
on and on about economics for an hour
and a half over lunch? Literally anything
else. That's great. So there's a very famous
saying in economics that there's no such
thing as a free lunch. And this is because
we always face trade -offs due to scarcity.
In this case, even though I'm paying for
Michael's meal, he has limited time and he's
spending that hour with me over lunch
rather than literally doing anything else.
He could have given up an hour of wages by
putting off work. He could have been studying
for class. He could have been playing
some flag football. Literally anything.
This set of options that Michael could do is
essentially infinite. So trade-offs consist
of this entire set of other things
we might have done. And And as we know,
trade-offs are a part of life, so let's see
if the sounds work. Navigation over me. Maps, get up here. Pay more for data
limits. Introducing T -Mobile One. Unlimited
data for everyone. Get four ads,
just 35 bucks. So the first thing
that I love about this ad is that
in these American ads, you can name
your competitor. So T-Mobile specifically
called out Verizon. I've never really seen
that anywhere else. But we can talk about
trade-offs here, that the driver has a scarce
resource, such as the amount of data they
have left and they've got to make a decision
what they want to use that data on. Is
it to listen to Ariana Grande or is it to
navigate themselves home? And T-Mobile is
offering this plan of unlimited data,
removing that scarcity, but there's still other
scarcity that could happen here. Our
phones have limited battery. If you have 2
% battery left, you kind of probably got to
decide what apps to have on and run in and
you end up in similar situations as well. So
given all the things that we can do with
our phones, listen to music use maps you know
call someone probably not message while
driving but I guess you can do that as
well these are all the other possible things
that you could be doing compared to listening
to music so the economic profit takes
into account these total implicit costs
remember time itself doesn't enter into the
explicit cost it's just a cost of our inputs
but there are always other things you can
be doing with your limited time as Michael
clearly pointed out. So in economics we
think about these types of implicit costs as
opportunity costs. So the opportunity cost
is the value of the best alternative which
equals what we're spending to do what
we're doing right now, our explicit costs,
plus the implicit cost, the foregone opportunity
or our best value alternative, our best
foregone opportunity. So in Michael's case
we established he could do lots of things
but we can rank how much utility or how
much money each of these alternatives
bring him. So let's say the best alternative
was the $17 he could have made for working
for an hour rather than coming to lunch with
me. The opportunity cost is whatever you
know explicit cost there is it might be
zero dollars in this case plus the $17 the
foregone opportunity. Importantly we
don't consider sunk costs as part of
opportunity costs. Some costs are something
that you've paid for. The money's
gone no matter what. It shouldn't influence
your future decision. And I'll talk a
bit more about that in a second because
it is something a lot of people fall
for a lot of the time. So an example of
opportunity costs, let's say you decide to study
abroad for the summer. Your explicit costs
could include things like your plane ticket,
other travel, your tuition fees for the
summer abroad, etc. And your implicit cost is
what else you could have done without time
over the summer. how much you could have made
by doing an internship rather than going
on the study abroad. But what about things
like spending on food? Suppose you spend
30 days, $30 per day on food in either
scenario, how should we evaluate this? And
this is arguably a sunk cost, it shouldn't
enter our calculations. So a quick detour
into this realm of sunk cost, imagine
that you bought a concept ticket a few
weeks ago for $50. Beyond the cost you're
super excited. All of your friends will be
in attendance and the band playing is your
all-time favourite band. However on the
day of the concert you feel pretty sick and
it's raining or snowing outside classic Midwest
cold weather and you know that traffic
will be worse because of the rain, it will
take you longer to get there, longer to get
home and that you risk getting sicker by going
to the concert. So imagine your own
favorite band you've paid fifty dollars it's
probably a bit cheap let's say a hundred
dollars for this ticket are you still going to
this concert hands up if you think you'd still
go in this situation great you over there
what's your name kevin why would you
still go to this concert because i spent a
hundred dollars you spent a hundred dollars
and you feel like you're wasting a
hundred dollars by not going what would you
what would happen if rather if you spent
a hundred dollars on the concert
someone had given you a free ticket to the
concert before same situation everything's
the same, do you think you'd go or
you'd stay at home? I'd probably
stay at home, though. Great,
you'd probably stay at home. Perfect
illustration. Thank you so much,
Kevin. This is known as the sunk
cost fallacy. This is a perfect
example of it. You've spent $100
on the ticket. No matter what
happens, that $100 is gone. You shouldn't
let it differ in your evaluation of
how much happiness you get from going
versus not going. So, this cost is sunk
because it cannot be recovered no matter
what. Whether you go, you've lost $100. If
you don't go, you've also lost or spent
$100. So optimally, we should ignore the sunk
cost. When making this decision, you should
only take into account the marginal benefit
of going to this concert, how much you'd
enjoy it, and the marginal cost, which would
be the traffic, the probability of getting
even sicker, the cold weather, etc. But
as Kevin, you know, illustrated, and he's
definitely not the early one, this is very
common, people do honour sunk costs all the time.
You feel like you're wasting money or
there's something wrong about not going if you
paid for the ticket. And this is known as
a sunk cost fallacy. And as we said, people
use these reasons to make decisions all
the time. And there's literally a saying, in
for a penny, in for a pound. Once you spend
that penny, you should spend the whole pound.
But from what we just said, no, if it's not
beneficial to spend the remaining 99 cents
don't go in for the pound keep it for
yourself so here are a few other examples so
hopefully drive home this idea of sunk costs and
the sunk cost fallacy an entrepreneur has
invested 50 grand in a failing restaurant
over two years despite clear signs that this
won't succeed they invest another 20 grand
and they reason they do this because i can't
waste everything i put into this this
happens a lot of the time putting good money
after bad money because people feel like it's
a waste since they've already spent this
amount. They don't see the $50,000 as sunk, even
though they should. Also, not just
money, but time and identity as well play
into this. If you've spent three, four
years on a startup, your identity is
going to be wrapped up in that. And
you might make bad decisions to continue
to pursue how successful it is
because of that. In fact, there's a lot
of research that shows we stick a lot to the
status quo. We don't like moving on to new
things. And, in fact, there's a paper that
has a really cool, you know, experiment
where they find that people are happier,
essentially, once they leave, you know, jobs
that they've been in for a while that they don't
like, or relationships that they're thinking
whether to leave or not. If they make
the decision to leave in those situations
where they're not sure what to do, they're
happier six months on. So this idea of not taking
into account what's sunk in the past can
make you better off. Yeah? If you invest
those $20,000, can't you, like,
recover the $50,000 and they're not
really wasted anymore? Because you're trying
to invest back and trying to get them back.
But if you don't do anything, they're for
sure wasted. Sure. But, I mean, there are
potentially threshold things you can talk
about, but it's like, what benefit can I get from
spending this $20,000 now? So you take
that into account. If spending $20,000 makes
you $70,000, let's say, that's your marginal
benefit of spending the $20,000. the $70,000.
But there could be other things you could
be doing with the $20 ,000 as well. So you
only want to calculate how much you can make
from that point on. You shouldn't be
saying, you know, I have an extra $5,000 of
cost in this situation and not the other. So
it's just about evaluating my future prospects.
So yeah, you may be able to recover it,
but that's a future prospect of recovery.
Like an extra $50,000 made is different to
the fifty thousand dollars spent if that
makes sense another example is let's say you
pay $15 for a movie ticket after 30 minutes
you realize it's awful but you stay for the
remaining 90 minutes because you paid for
the movie ticket you should see it out and
I'm someone who actually falls for this one
all the time I don't think I've ever walked
out of a movie early have people here walked
out of movies early before do you remember
what movie well it wasn't like I think
it was Into the Woods. Okay. Not good?
Not a musical fan? Yeah, we were not
musical fans. Okay, fair enough. So
you did the right thing. You're like,
why did I throw this? My time is
valuable. There are better things
that you can do. And interestingly, now with things
like Netflix, we're not paying anything
to watch an individual movie. Yes, there's
subscription fees. So you'll get halfway
through, and you're probably much more likely
to be like, no, this is crap. I'm going to
change than you would if you were in the
cinema. So this is the idea of sunk cost
influencing our decisions. And Michael Lewis,
who wrote the books Moneyball and The Big
Short, you might be familiar with them, they would
turn into movies, he wrote another great
book called The Undoing Project, which is
about the lives of Amos Tversky and Danny
Cunnaman, who essentially founded behavioural
economics. And this is a quote about Amos.
He said, if he didn't like a movie, he'd
simply walk out. They've already taken my money,
should I give them my time as well? So
this is the mindset we should be in when trying
to make decisions. Don't acknowledge
these sunk costs. And finally for
you sports fans there, a lot of
organizations succumb to sunk
costs all the time. So an NFL might not
cut a player simply because they spend a
high draft pick on them and they see that cost
is not sunk. So you know there are teams
that spend, you know, a first-round pick on
a player. The player clearly sucks. If
they didn't have that first-round tag on
them, they'd probably give up on them. but
because they have that tag they pursue them
with it they persist with them for a few
more years same thing when they hand out
big contracts as well so this is something
that occurs all the time the realm of sports
so this is a pretty dumb comic to drive
the point home this person's with a gun don't
move and this person's like why would I
move I paid $50 for this concert when
clearly the best course of action is probably
to get out of the way so let's go back to
our lemonade example. So let's say Lamar uses
his labor to produce and sell lemonade. He
might spend a couple of hours doing that.
That was not available for other uses. So
there's no opportunity cost of the ingredients.
So the lemons and the sugar, let's just say
they're perish. He can't repurpose them.
So we only take into account Lamar's labor
and the opportunity cost. If his best
alternative is to play, let's say, a
video game like Madden, this would
have generated enjoyment which
he values at $30, then we need to
include this as part of the cost
of producing lemonade for his
economic profit. So our economic profit
will be our revenue, total revenue, which
is the same, 50 times 3, minus our explicit
cost, the inputs, which is $40, minus
the opportunity cost, the best alternative
of what he could do with his time and
resources, which is $30. And this gives
us an economic profit of $80,
which is less than the accounting
profit of $110. So we can look at
this for your decision to go to college as
well. So if you go to college for four
years, you'll spend $10 ,000 in tuition and
$12,50 in books each year and give up your
opportunity cost, a job that would
have, let's say, paid you $40,000 a year
straight out of college. So what is your
opportunity cost here? What you're giving
up, so your explicit cost here, is the
tuition and the books. So $10,000 times
four is $40,000. The books is $12,50 times
four is $5,000. So $45,000 in these
explicit costs, and the amount of wages you're
for going by coming to college and not
taking this other job is $40,000 times
four, so $160,000. So the total
opportunity cost of going to college
is $205,000. Like for you, there's
a ton of evidence that suggests going to
college significantly increases your
wages in the future. So you will definitely
get that back and more. We're only
looking at these four years and what the
opportunity cost is. yeah so they have
this um probability profitability framework
which they call the five forces so they have
these five things to consider with how
profitable a business or a firm can be so they
talk about entry power of buyers power of
sellers industry rivalry and substitutes and
compliments and we'll break each of them down
this is just the the tagline for each one
and in the textbook and in the redacted
slides i have this this is their yeah like
framework and with with all the things here.
There's a lot going on here, it's really messy,
but you can access it. I prefer to make
dumb memes instead. My favorite show
growing up as a kid was Captain Planet, and
these are the five rings of power in
Captain Planet, as you can see, the five
things that, you know, the five forces that
affect profitability, and combined we get
Captain Planet or Captain Profitability.
So that's my preferred way of making images
compared to theirs. But let's get
to the content, which is more
important here. So the first thing
to take into account is entry. And by entry,
we mean can firms and businesses enter
the market easily. Lower barriers to entry,
so the easier it is for other companies
to start up and enter, reduces the
sustainability of profit in
the long run. The easier a market
industry is to enter, the harder it is to
sustain this profit. So some examples, so
like food trucks are relatively easy to
start. You don't need to invest that much
capital. You need the truck. You can get a
lease on the truck. you need some ingredients
but it's easy to get to you know local
farmers markets and fairs and start competing
with others and selling when you have a food
truck you're really like the only food
truck around usually see a lot more it's
quite competitive and it's easy for this
competition to appear because other people
can enter it as well on the other hand creating
new technologies or entering into these
industries and have new technologies is
much harder so imagine wanting to start a business
that sells computers how are you gonna
enter this and do better than these
other firms. You don't really have a pattern
to technology that you can do, there's a lot
of research that needs to go to start it up,
much harder to do. And I wasn't really
sure about this one so I want to put it out
to you to have a think and let me know what
your perspective is. So with content creation
there's you know a lot of money going
around on YouTube and Twitch these days. Do
you think starting a YouTube channel is
relatively easy or relatively hard. Do you think
there are high or low barriers to entry
to become a YouTuber? Low. You said that,
sorry? Yeah, why would you say low? Because it is really
easy to make it on your own. The hardest
part is actually getting subscribers
and actually becoming a quote unquote
YouTuber is quite easy. It's just like how
popular you're going to get, that's the hard
part. Yeah, you need a laptop, you need a
webcam, you need a microphone, and you can
make YouTube videos. I don't even know if you
need to actually subscribe to YouTube or not to
monitorize it. Did you have a different
opinion over there, or were you going to say
the same thing? Yeah, I was going to say
the same. Okay, great. So the one thing I've
taken into account is, like, is the entry
point starting that channel, or is it getting
your first viewer? Because the way the
YouTube algorithm works is it's more likely to
recommend, you know, more famous content
creators, There's high watch videos and high
subscribe channels, et cetera. There are a
ton of people who want to start out and they
can't even get their foot off the ground.
So that's why it might be considered not
that easy to start up depending on where you
draw the line of entries. As soon as you make
the channel, once you get your first
viewer, I think this is slightly more gray than
maybe we're thinking. Yeah? So I had a
question about the second line. When it says
lower barriers to entry, you reduce the
sustainability of profit in the long run. Does
the opposite also hold true? if there are
higher barriers to entry does it increase
sustainability yeah yeah it just means
there's no one that can come in and take your
business and when you're planning for the
future this is important so for a lot of these
things we're going to say um it reduces
sustainability of profit and you can flip
it around like pretty much all the time
i don't want to say every time in case
there's a counter example but yeah that's the
way to think about it okay the power of your
input suppliers so in lamar's case you
know he's paying for for lemon sugar etc
let's say there's only one seller of lemons
in the entire world they can probably
charge a lot for lemons which means Lamar would
be paying a lot more for his inputs than
he would be if it was you know a competitive
market with lots of different lemon sellers
so the more power your suppliers have
the more that they will charge for your inputs
and this is going to reduce profit in
the long run and once again vice versa the
more competitive the market is the less power
your input suppliers have, the more
profitable you'll be in the long run, you can
be confident that your inputs will stay low
in terms of price. The other one is with
another input which we haven't really
discussed yet, we've talked about capital
inputs, but there are also labour
inputs as well. Lamar could decide to hire
an employee to help you make and sell the
lemonade. However, if labour union power
increases, that means workers will have more
power to negotiate wages. in states
that have low minimum wage they could argue
or they could ask for a lot more or not
work which means they have to pay more for
labour or Lamar would have to pay more
for labour and this reduces profits,
increases costs. So the amount of power your
suppliers, whether they're capital inputs or
labour inputs have, is going to affect
your profitability. The power of buyers
also matters. More concentration
of power among consumers reduces
sustainability of profit in
the long run. Essentially, if
switching costs from your product to another
product are low, this gives buyers
more power to choose another product.
In other words, you can't really piss them
off as much because they can easily
switch. And I think a really good example
of this is Ryanair. Has anyone flown
Ryanair before? I see a hand up the
back there. Where did you fly Ryanair?
Do you remember? Barcelona in
Europe. Barcelona in Europe. Did you have
a good experience? It was fine. It was
fine. But why did you choose Ryanair
in the first place? It's cheap. It is
dirt cheap, one of the cheapest airlines in
the world. If not the cheapest, you can get
a flight from, I don't know, Barcelona to,
let's say, Budapest for like $7 sometimes.
We're talking really cheap. But the trade
-off here is that the service is non-existent
and they sometimes treat you pretty
badly. As you can see here, Stephen McKenna
flew Ryanair and said, excellent view as
usual, there's no window even here. They really
maximise efficiency. And the Ryanair
Twitter account, their social media, is known
for being a bit sassy and dunking on their
customers a bit. So they say, we sell seats,
not windows. And they can get away with
this because there's not really much
competition for that low, low price air flights.
But if there was, you might see a change in
strategy because the buyers, the consumers,
will have lower switching costs. They
can choose other airlines who aren't being
assholes to them. So maybe that would change
Ryanair's strategy. The point of this
is saying that the more direct competitors
you have, the more opportunity
buyers have to switch. Another example of
the power of buyers is in a lot of these
electricity markets. So I think Texas
is a really interesting
example. Is anyone here from Texas,
by any chance? No. So in Texas,
there's an absolute free -for-all in the electricity
market, but in a lot of other states,
there's only one supplier. So buyers don't have
any power in these markets, if you're
that one supplier they have to kind of go with
you for electricity whereas in these other
markets yeah they have a lot more concentration
of power yeah next is industry rivalry i
don't know if anyone's been watching hated
rivalry on netflix but this is my one
chance to use this in a meme the more intense
rivalry between firms the less ability to
sustain profit in the long run this is due to
driving down each other's prices going into
advertising wars etc so things like low
price guarantee so this is something that you
know places like Best Buy and Walmart do all
the time it's like hey if you find a price
somewhere else that's lower we'll beat it by
10% this has a negative impact on prices and
a negative impact on profitability
especially when both these firms are trying to
do the same thing also the less differentiated
your product is from others this is going to
make this competition a lot harder so an
example this is with McDonald's and Burger
King as we can see here in the photo if you
see them as completely different entities if
they're not substitutes for you Then this
rivalry wouldn't be as competitive But they
see themselves as selling kind of the exact
same product So they'll go into these advertising
laws promotion laws like with Happy
Meals and McDonald's giving out all these
sort of things And this essentially reduces
company profit as well Another example
of this the industry rivalry
is selling our gas or petrol as we call
it back in Australia. There's really
interesting data, I didn't put it in here,
but I'll maybe try and find it for a later
lecture, that shows a lot of these gas
companies collude. So they start off
by setting this high price together, but
over time they start undercutting each
other until they get all the way to this
low price, and then there's some point where
they start colluding again. But this
industry rivalry is what putting these
pressures on, undercutting each other and
lowering the price. Finally, going back to our first year micro, or our high school
econ, and that actually reminds me,
a few people reached out after class,
saying things like, hey, I got credit
for first year micro, I haven't taken econ
in like four years, this is my first
class, do I have anything to worry
about? No, not really. The first couple of
weeks here is kind of rehashing old things
in a way, and if we ever get to a point
where you think we've just jumped away you
know too far ahead let me know come to my
office hours I can help you catch up to
the rest of the group. So substitutes are
defined as goods that can be used in
place of each other. So butter and margarine
can be substituted for one another. There
are many different streaming services. You
could argue that they have you know unique
content on them but at the same time some
people might only have enough money to choose
one and then they'll make decisions to
choose like Netflix or Hulu. And when it comes
to certain products there are many different
subsets of that product so with apples
you have pink lady you've got red gala
royal delicious so on and so forth so the more
substitutes in consumption there are the less
abilities to sustain profit in the long
run you just have more competition in terms
of what other people can choose to buy on the
other hand complements the goods that are
used or consumed together so something
like fries and dipping sauce if you sell you
know dipping sauce if there's an increase
in the amount of fries being purchased you
can assume there's probably there's going
to be an increase in the amount of dip in source
purchase as well. And shoes and socks
is pretty trivial, but it's the
same thing there. And finally, an
institution of going to the cinema is
buying popcorn. So the fact that
not many people go to the cinemas
these days can't be a good thing for
popcorn sellers. So the less complementaries
they are, the less ability to sustain
long-run profit. So some examples, let's
say you make a video game console, but
game makers don't make many games that work
on your console. there's a low amount
of complementary tiers, that means your profit is going to be lower. And it's the other way
around as well. And, you know, sometimes
companies do this to incentivise purchasing,
you know, new consoles. So what they
usually do is, like, PlayStation will release,
you know, the PS5. For a year, they'll
keep making games on the PS4, but then they'll
only make games that are available on the
PS5. So if you want to play the new games,
you've got to buy the complement, which is
the new PlayStation. Also, Netflix started
as the only streaming service. you know 15
years ago there were no substitutes now
there are so many you probably have different
ones um i'm thinking of actually getting
rid of netflix i was really disappointed by
the the end of stranger things i thought it
was complete slop and there isn't i think
many good things on netflix right now so
i'm going to stick to like hbo prime disney
that's that's my bag but yeah you can all
probably make different decisions okay so
for the remainder of the class i want to
talk about incentives. So incentives can be both
positive or negative, the carrot or the
stick, and they usually influence our actions
in predictable ways. And I've made the
predictable ways bolded and in red because
there's a strong caveat here. To be predictable,
we need to actually understand what
motivates people. If we misunderstand the
motivations, incentives can backfire and even make
the problem worse. So another common
saying or platitude in econ is that
incentives matter. What do we mean by that? People will do things if their marginal benefit, if the happiness
they get is greater than the
marginal cost, how much cost it
takes to the user. So let's start
with a simple example in more
of the managerial framework, so
sales commissions. So workers may
exert some amount of effort. You're the
manager. you want to get people to put in more
effort, make more sales, that increases
your profit. And a way to do this is
sales commissioners, give them some
percentage of the sale. What this means is
the more effort they exert, which increases
their marginal cost, but the more they
exert, the more likely they are to
sell more, which increases their
marginal revenue. So if you design
the incentives in a way that more
effort will make them better off
in the long run, they'll respond to
this in a good way. But if you design
it in a bad way, you make it too hard
to get, it might put off people
entirely and they can actually exert less
effort which is a common situation
with incentives and another random
situation to consider is policing behaviour
so something that's a discourse on Twitter or
on X at the moment is a lot of people evading
subway fares in New York City just jumping
over the railings etc and there are ways to
police this more to disincentivise this
behaviour so for example when I lived in Germany
for a year I feel like every time I went on
the train there would be some you know ticket
inspector coming on checking tickets like
95 percent of the time it was just a poor
economic decision not to purchase a ticket because
there's a 95 chance you'll get a hundred
dollar fine whereas let's say if they only
came on let's say one percent of the time
or two percent of the time it's probably a
good decision for me not to buy a ticket and risk
getting that fine in the long run i'll be
better off so the amount of deterrence you
put in place is an incentive for people to
buy or not buy tickets. So within a firm
the way you design incentives impact how
resources are used and how hard workers
work. So as a manager like you need to think
hard about incentives and I'll get into a
few things now that may be a little bit
surprising to you. So an unplanned result
or usually negative and unwanted result
of an incentive is not really take into account
what people's motivations are so here we see
that the university or the city has spent
money designing this pathway so this is the
human design they've spent money on this
but the human action is to not use the pathway
here but to take the the you know how diagonal
because it's shorter so we have an incentive
to exert the least amount of effort
possible to achieve the goal so a lot of people
are walking on the pathway so if you took
that into account when designing it you could
have built the pathway slightly different
and And since this is a managerial course, and
that I'm a millennial, I feel an obligation
to show you office clips because they're
very relevant. So this is one from a latter
season, which aren't as good, but this is
when Andy is the boss and he's trying to
incentivize his workers to work harder. And keep
in mind what things kind of go wrong in
Andy's incentive schemes. Thanks for coming in,
guys. You don't have to thank us for coming
in. It's our job. Well, I never got
thanked for coming into a meeting.
I always wanted to be so I'm going
to thank you. What's under the blanket? This is what's
under the blanket. We don't get it.
These are incentives. It's how we're going
to double growth. Now you're
probably all asking yourselves, well,
how does this work? Seems like a basic
reward system where you give us points, and
then we redeem those points for prizes.
You're exactly right. And you get a point. Well,
is that a vibrator? 20 points. How does
one get a point? I've outlined the
exact parameters in an email, You
can also check your spam folder, but
basically, you do your job better,
you get points. So, collect 15
points and redeem them for this polar bear. Why is it all
kid stuff in a vibrator?
It's so gross. There's lots of stuff. John Irving, collect
works, 22 points. Or, you can pool
your points and redeem 55 for this
maternity shirt. How about you
want us to wear part of AS4? I
can't. This point system is really
insulting. Ooh, well, I didn't mean
to offend you, and I hope you'll forgive me,
because I have very, very, sorry, 16 points.
It's a tablecloth. What if we went all
the way up to 500 points? Yeah, that's
a crazy amount of points. But what if?
Well, what do you want? I don't know. I'm
such a crazy number, I'd like to say
I'm pretty crazy. All right, for
500 points, I will wear a
dress to work. That's pretty good.
What about for 1,000 points? I'll run
naked through the parking lot with a
donut on my ding-dong. Yeah, you like that? Alright, for 5
,000 points, I will let you tattoo
whatever you want on this third of the
old S.S. Bernard. Alright, alright,
and you are totally serious. Swear to
God, hope to die. Now let's get to work.
Wait, but you did say we could pool
our points, right? In that case, let's
get to work. Yeah! Yeah! Yeah! Good, guys. How are you doing? I think we'll have a team by the beginning
next week. All right. Thank
you very much. Phyllis Bracken Otto. Yes. We're down on
insurance bananas. Okay. Two-bag bone. Andrew. Hold on one second. You can file that.
I'm just a little bit of a mood shift.
You're out here. No, I'm not saying
that. really because I sat next to
Stanley for years and this is nap time.
Open eye nap time. It balances the
bone on the shoulder and the power is
down. Now with me, you've got to unleash the power of the pyramid. You think it
has something to do with that
incentive program? Oh, 100%. We don't
want to send that to your ass. I
think people are, I was kidding when
they said that. No, you definitely
weren't kidding. I came across loud
and clear. Oh, by the way, I want
him to listen. 120 points? Yeah. Big sale. Don't worry
about it, though. I don't care
about the points. I would like to find
a receipt, though. Hey! Yes, this is Jim
Halpert calling for Donald. Can you hold
on for one second? Thank you very much. Can we talk to
Maggie at Kauffman's? And I'm back. How are you, sir? I think you can
squeeze a couple more golf games
in, right? Hey, Kevin, what are you doing? Don't talk to me. Hi, Professor Frank. Andy Bernard, class of 95. Hey there. I'm a huge fan of
your management book. Management? Quick question. I may be missing a chapter here. Deincentivizing. What
are your strategies? Looking for real
blue and morale. Why? Well, um, I guess you could say
I'm in one of those classic ass tattoo
incentive situations. Thanks. Okay, so
it goes on a little bit more, but
I think there's a few juicy nuggets
in there for our conversation
about incentives. First of all, like,
originally when he offered these crappy
little prizes and this point system,
you know, Stanley and others found it
kind of offensive, and that can obviously
reduce effort. then he makes a
mistake of kind of going overboard and
probably incentivizing people too much.
So he probably didn't need to go
that strong in terms of saying that
Hitattoo is behind, but we'll get into
that a little bit more here in a second. And
the way the episode plays out is that
they achieve it all in one day, all 5
,000 points, so that incentive didn't
really boost, you know, effort in the long run,
it was only one day. So these are all
things you need to kind of take into account
when thinking about incentives and moving
from the more I think fun and pop culture
form of it to the study version, Nisi and
Rastachini in 2000 ran two very important
studies that I think shed a lot of light on
poor incentive design. So in this one here,
there were daycare centres and they had a problem
that parents would sometimes pick up their
kids like. So they introduced this
intervention where they introduced a fine of
$5, so this stick, this disincentive for parents
who picked up their kids late and they
reasoned that if people you know come late they'll
pay a fine they don't want to pay a fine
it's more costly to pay the fine so they'll
pick up their kids on time and what they did
as you can see is they had two groups so they
had a group or a bunch of day cares where
they had the fine and a group where they
didn't have the fine so for the first five
weeks of the study they didn't introduce the
fine so neither group, or neither parents in each
group got fined for picking up their kids
late and we can see that around 10% of parents
were picking up their kids late in both
groups. Then at week 5, in the fine group they
introduced the fine. So according to our
standard understanding of incentives, what
would you predict happens in both these groups?
Yeah? I would predict that the group with
the fine actually increases in the amount
of late arrivals just because I'm assuming
that they're already paying for their kids
to be at kindergarten or wherever it is,
just daycare, and I'm guessing that paying
only $5 for having more time to keep their
kids there is probably incentive for them just
to leave them there. What's your name, sorry?
Ivan. Ivan, you kind of hit the nail on
the head, but you're also jumping the gun a
bit. So in our traditional model of incentives,
we're just thinking if you increase the
marginal cost, people should be less likely
to do the bad thing. so we'd expect it to
reduce but as you say something weird is going
to happen here what we find is that in the
group with the fine late pickups double
and it's for the reason that you said once
the fine is removed it actually stays at that
level and this is because a fine is a price
once a price always a price people are already
paying for their kids to be at daycare and
they feel some sort of social responsibility
they feel guilty if they don't pick up their
kids on time because they're a daycare
workers you know that spend their time over
time making sure the kids get picked up safely
but once you introduce the fine it changes
elements of this transaction you no
longer see it as a social responsibility you view
this fine as a price and daycare I mean I don't
have kids but daycare can be pretty expensive
from my understanding so if you leave your
kid in the daycare for an extra hour
extra hour and pay a $5 fine that's a really
good deal and a lot of parents felt this way
in the group with the fine as you can see it
doubled and even after they removed it you've
distorted motivations they no longer feel
guilty you change people's expectations
as a result these late pickups continue so Ivan
you know hit the nail on the head there
that people think of things in different ways
so introducing incentives especially when they're
too low like only $5 can crowd out these
other motivations. So people aren't motivated
by doing the right thing now, they're
motivated by the fine but the fine is too low
to actually you know change behavior in
the way that you want. Similarly they had
this other paper so QJE is a top five
economic journal and so is the other paper
they published in and the way academia works
in econ back then if you had one top
five publication you're pretty much
assured of getting tenure. So they had a really
good year 2000. In this study they want
to look at the effects of monetary incentives
on performance in a simple intelligence
test. So they had 160 students at the University
of Haifa and they were asked to answer
a set of 50 questions taken from an IQ test,
so a bunch of multiple choice questions.
And they randomized these participants in
the four groups and each group had different
incentives. So in the first group they could
just answer the questions as they could, there
was no extra bonus. Group 2 got 10 extra
cents for each correct answer group three got
one dollar and group four got three dollars
so here are our four groups down here
our uh you know no bonus group 10 cents one
dollar three dollars so prediction from our
normative model of incentives in which
group would we predict is the lowest amount of
correct answers and which group would we predict
is the highest amount of correct answers
and we want to take a I feel like
10 cents would probably be the
lowest. Why do you think it would
be the lowest? It sounds like it's
just a small value. I feel like you hear
that and like honestly just don't care. And
you think it's all about good. Anyway, and then
I think highest will either be zero or
three bucks. Okay, so why do you think zero
is highest? Because if we're thinking about
traditional incentives, 10 cents per correct
answer is more than zero, so shouldn't
I exert more than 10 cents than zero? Why do
you disagree with that? The same thing as
before. because it's the zero that you don't
even know there could be a price attached.
So you're just getting asked questions. It's
kind of normal human behavior if you want
to get them right. Correct. And I think,
I don't know, it would be higher than three.
Because three bucks is enough where it's
like, that's a decent amount. Yeah. It's 50
-50 whether the three bucks made them nervous
and they got them wrong. I don't know.
That's actually a great point. I didn't
consider that. But yeah, once again, like, I kind
of like led you into it. If we went into
this blind, maybe we got more wrong answers.
But you're 100% correct. So you can see
when there's no price attached to correct
answers, There's no bonus. People got around
30 questions, right? People still have
motivation to get questions, right? You have kind
of some pride in how intelligent you are,
you want to do well. But as you can see, when the 10
cent incentive per question
was introduced, it drops by around seven correct answers
on average. And this is because
10 cents for some people can be seen as
insultingly low. And that means you're
focusing on the price incentive of correct
answers, rather than this motivation
to do well. so you actually exert less
effort than you would have otherwise. And
we can see that here, less effort, people
are doing worse. However, once we
up it to a dollar, people actually jump
not only back to the baseline level,
but significantly higher as well, around
34, 35 questions. So high incentives
here, or high enough incentives,
does increase effort. However,
interestingly, when you triple that to
$3, it doesn't actually improve
correct answers. That could be
because we're at the frontier of how
much effort people can exert. There
could be constraints of intelligence
or other reasons. But it's important
to keep in mind when designing incentives
that you don't want to go overboard like
Andy did by getting the tattoo on his ass.
He could have probably done something a lot
less expensive to motivate his workers.
Because let's say you offered your workers
a $3 incentive for every correct answer
they got. You make profit based on the
correct answers they get. You would have
achieved the exact same goal if you offered
the $1 incentive. You're just paying
two extra dollars per answer, which reduces
your profitability. Finally for
today, Alex Simas, up at the University
of Chicago, has a really cool
paper where he wants to see if people exert
more effort when the incentives are for
themselves or for other people, in this case a
charity. So he designs a clever two-by-two
experiment where people do a task where they
have to squeeze this hand dynamometer for
like a minute and squeeze it as hard as
possible. The harder they squeeze it, the
more rewards they get. and they either
receive the money for themselves or the money
goes to the charity and the other manipulation
is sometimes they'll have a high incentive
so they'll get paid a lot for this or the
charity will get paid a lot or it will be
really low and what he finds is really
interesting so first let's look at the
incentives for self this dotted line here you
can see people put in a low effort when the
incentive is lower and a much higher effort
when the incentive is high so So this is
a case where higher rewards motivate people
to exert more effort. So the incentive works. But really interestingly
here, there's two observations to
make. If we look at for others, there's no
difference between the low incentive and
the high incentive. And the other
observation of interest is in the low
incentive condition, people exert more
effort, significantly more effort, when
the money's going to the charity than
for themselves. Why is this the case?
the quick I guess reason is when it comes to
giving for charity we don't necessarily
care about maximizing the good or maximizing
the amount the charity gets we give for
other reasons such as feeling good and it
doesn't matter if it's you know five dollars or
ten cents go to the charity if you're all
the one that gets that money for the charity
you'll feel pretty good about yourself so that's
why effort remains the same in both cases
and why people will exert more effort
when incentives alone you're doing it because
you feel good, rather than some maximisation
problem, whereas incentives for yourself,
you care more, you're probably calculating
how much you'll make for each sale or how much
you'll squeeze, so we find it can actually
differ behaviour a lot there and that's, I
guess, a few different ways to think about
incentives, especially for those of you
involved in, like, groups and clubs here that
are running things for charity you can leverage
this to your advantage when getting people
to volunteer, etc. We covered a lot
today, we're going to talk about perverse
incentives starting next week, then
we'll Thank you.