Corporate Social Responsibility

Cobra Effects
pparently, the officials of the British government were terrified by a large number of venomous cobra snakes in the
city. To solve the problem, someone came up with a brilliant idea of an exchange offer to the people of Delhi. Money
for dead cobras.

Guess what happened next? Soon, the enterprising Delhiites were breeding cobras. When the government found out,
they scrapped the bounty scheme, whereupon the cobra breeders set the snakes free. And the cobra population went
up, not down.

Why did both situations backfire? Because well-intentioned people who created the bounty schemes didn’t think
about second order effects. They didn’t pause, reflect and ask how people will respond to their brilliant-sounding idea.

It’s fascinating to observe how this problem keeps on repeating over and over again. One variant is called “you get
what you measure.” For instance, if hospitals are asked to publish their mortality rate, the ones with the highest
mortality rates are incentivised to turn away terminally ill patients.

If someone is paid on a cost-plus basis (e.g. for generating electricity), you can be confident that there will be plenty
of gaming in the form of cost padding. Businesses which pay their m ..

Thinking about first order effects is easy. Thinking about second or higher order effects is hard. But just because it’s
harder, doesn’t mean one shouldn’t do it. Indeed, the practice of routinely thinking about second and higher order
effects by asking “and then what?” should not be limited to chess players and regulators. It should be adopted by
investors as well.

the answer is by constantly re-assessing the solutions and improvements you’ve

made/are making to your life. It’s not enough to identify a problem and come up with
a solution (although that’s an important first step!); rather, you should implement your
plan, give it a trial run, and then take a step back to see if this approach is having the
effects you intended.

Discarded Kidneys

Auctioning off parking spaces

Market for corporate control.

Chapter 2

Wealth is created by moving assets from lower to higher values uses.

• Voluntary transactions move assets to higher-valued uses.

• Wealth (or value) is destroyed by impediments to the movement of assets to higher-valued

uses, like taxes, subsidies, or price controls.
 • The art of business consists of identifying assets in low-valued uses and devising ways to
profitably move them to higher-valued ones.

• Economic analysis is useful to business for identifying assets in lower-valued uses.

• A company can be thought of as a network of transactions. Design your organization to reward

employees who identify and consummate profitable transactions or who stop unprofitable ones.

Chapter 3

• Costs <==> Decisions

• Opportunity cost is the value of what you give up

• To consider all costs, identify hidden costs; do not commit the hidden cost fallacy

• To consider only the relevant costs, identify sunk costs; do not commit the sunk cost fallacy

• Fixed costs do not vary with output, variable costs do

• Accounting profit (costs) usually differ from Economic profit (costs) in how they treat durable
assets

• Retrospective versus Prospective

Chapter 1:

One thing that unites economist is their use of ration-actor program paradigm.

People acts rationally, optimally and self-interested.

To change behavior, you have to change one self-interest, do that by chaging incentive

You would have to find a way to better align managers incentive with company goals. By rewarding
management for increasing profitability not just acquiring reserves.

Not easy typically hard to measure employee contributeion to company profitability

Problem solving

Who? made bad decision- figure out why people hbehave rationally, optimally, self-interstedly, bad
occurs for 1 of 2 reasons

1. Did not have enough info

2. Lack incentive to do so

Way to fix solution

1. Let someone else—better info, incentive—make decision

2. Give more info to current decision
3. Change current decision maker incentive
 - Help develop problem solving skills
o Think about problem in point of view of organization.
 Avoid temptation to think about porblemm from employee’s point of view you
will miss fundamental problem of incentive alignment or goal alignment.
o Think about organizational design
 Avoid temptation to solve problem by simply reverse decision. Think about why
bad decision was made and make sure similar mistakes wont be made in future.
o What is trade-off
 Your solution may solve the problem u identify but may cause other problem
o Don’t define problem as lack o solution
 This might cause you to miss the best solution.
o Avoid jargon
 Most ppl misuse. Force urself to spell out what exactly you mean in simple
language. Will help u think clearly and communicate precisely.

Ethics and Economics.

Economics in job interview.

Summary
- Rational-actor paragigm model of behavior that which assumes ppl act rationally, optimally, and
self-interestdly that is they respond to inceitives.

Chapter 2

How to exploit inefficiency as an opportunity to make money.

How wealth is created and destroyed

- Wealth is created when assets move from lower- to higher-valued users.

- Individual’s value for a good or service is measured as amount of money he or she is willing to
pay for it.
o Value of a good mean that you want it and can pay for it.
- Biggest advantage of capitalism is that it creates wealth by letting ppl follow their self-interest.
- A buyer willingly buys if the price is below his value and seller sell for same selfish reason.
- Both buyer and seller gain otherwise they would not transact
o Voluntary transactions create wealth.
- Different btw the agreed-on price and seller’s value is called seller surplus. Buyer surplus is
buyer value minus the price.
- Total surplus, or gain from trade created by transaction is sum of buyer and seller surplus, the
different btw buyer top dollar and seller bottom line.
- Zero sum fallacy—the voluntary nature of trade require both parties gain, otherwise transaction
would not occurs. Assuming if someone wining, someone else must necessary be losing. Often
uses to justify limit of profitability, price or trade.

Does gvt create wealth?

 - Pay critical role in wealth creating process by enforcing property right and contacts– legal
mechanism that facilitates voluntary transactions.
- . By make sure buyers and seller gain from trade, legal system make trade money more likely,
contributes to America enormous wealth creating ability,
- Conversely, absence of property rights contributes to poverty. Reasons are simple, without
property and contract enforcement wealth creating transaction are less likely to occurs.
o Ironically, poor countries survive largely on wealth created in the so called
underground—black market economy, transaction are hidden from gvt.

Hidden cost fallacy

- Hidden-cost fallacy—when you ignore rerlevant costs, those costs that do vary with the
consequences of your decision.

Final warning

- It is not much of stretch to predict that you will make some of same mistakes, and for same
reasons, either you will lack information necessary to make good decision or you don’t have
incentive to do so.
- When struggling with decision—remember
o 1st recognize relevant benefit and costs of decision—shard to do because easy to get
lost in data. Decision get distracted by irrelevant number and forget why they are
analyzing the numbers.
o 2nd consider the conequences of decision from your organization point of view.

Summary

- Cost associated with decision

- Opportunity cost—alternative is the profit you give up to oursue it
- Consider all cost and benefits that vary with consuequences of decision and only costs and
benefits that vary with consequences of decision. These are relevant costs and benefits of
decision.
- FC do not vary with amount of outpot.
- VC changes as out put changes.
- Decision change output change only VC.
- FC fallacy or sunk cost fallacy—you consider irrelevant costs. Common FC fallacy is to let OH
depreciation costs influence the short term decision.
- Hidden cost fallacy occurs when you ignore relevant costs. Common is to ignore opportunity
costs of capital when making investment or shutdown decision.
- If you begin look at the cost you always get confuse. If you begin with decision you are
considering, you will never get confused.
 Chapter 17: making decision with undertainty

Intro

Random variables and probabilities

- Random variables- take account of what we don’t know.

- E(x) = p * x1 + (1-p) *(x2)

Price discrimination

- Risk – uncertainty that can be modeled with random variables

- Uncertainty—refer to outcomes that we cannot foresee or whose probabilities we cannot
estimates.
- Risk can be quantified priced and traded
- It can even be hedged w large pool of assets.
- Uncertainty—much more difficult to deal with. And mistaking risk for uncertainty can have
devastating consequences because it leads to overconfidence.

Chapter 19

- Adverse selection problem I s most easily illustrated in market for insurance.

- Risk neutral—consume value lottery at its expected value. Risk averse consume value a lottery
less than its expected value.
- Insurance is wealth creating transaction that transfers risk from someone who doesn’t want it
(risk averse consumers) to someone who is willing to accepts it (risk neutral insurance company)
- Only differences from out lottery example is that riskaverse sellers face lottery over bad
outcomes instead of goods one.

Anticipating adverse selection

- Anticipate adverse selection and protect yourself against I t

- In financial markets, adverse selection arises when owner of companies seeking to sell shares to
public know more about prospects of company than do potential investor.

Summary

- Insurance is wealth creating transaction that moves risk from those who don’t want it to those
who willing to bear it for a fee
- Adverselection is problem arise from info asymmetry or hidden info. Anticipated it and if you
can figure out how to consummate the unconsummated wealth creating transation.
- Adverse selection disappear if info asymmetry disappear.
- Screen uninformed party effort to learn about info that the more informed party has. Successful
screens have characteristic that is unprofitable for bad types to mimic the behavior of goods
types.
- Signaling the informed party effort to communication her info to less informed party. Every
successful screen can also be used as signal.
- Online auction and sales sites, Ebay address adverse selection problem with authentication and
escrow services, insurance and online reputation.
 Chapter 20 problem of moral hazards

Intro

- Moral hazard—post contractual increase in risky or negative behavior. Ex: reduce incentive to
excersi care once you purchase insurance and reduce incentive to work hard once you have
been hired. Moral hazard is similar to adverse selection in that it is caused by info asymmetry; it
differs is that is caused by hidden actions rather than hidden types.

Insurance.

Moral hazard means that insured customer exercise less care because they have less incentive to do
so.

Moral hazard v. adverse selection

- Adverse selection arises from hidden info regarding of the type of person (high v. low risk) who
is purchasing insurance
- Moral hazard arise from hidden action by person purchasing insurance.
- Adverse selection is problem separating you from someone else.
- Moral hazards is problem separating the good you from the bad you.

Shrinking—type of maral hazard cauased by difficulty or cost of monitoring employee behavior after
firm has hired them. Without good info, ensure high lv effort become more difficult.

Moral hazard in lending

- Borrowers take bigger risks with other money than they would with their own money.
- To control thisi kind of moral hazard, lenders must try to find ways to better align incentives of
borrowers with goal of lenders.
- Do this by requiring borrowers put some of their own money at risk
- Investment doesn’t pay off, lenders want to maker sure borrowers share downside.
- This is why bank are much more willing to lend to borrowers who have great deal of their own
money at risk.

Summary

Moral hazard- reduced incentive to exercise care once you purchase insurance

Can be very similar to adverse selection—both arise from info asymmetry

Adverse arise from hidden info about type of individual you are dealing with.

Moral arise from hidden action

Anticipate moral hazard and if you can figure out how to consummate the implied wealth creating
transaction.

Solution to problem of moral hazard center on effort to eliminate info asymmetry

Shrinking is a a form of moral hazard

 Borrowers refer riskier investment because thye get more of the upside.

Lenders bear downside.

Borrowers who have notohing to lose exacerbate this moral hazard problem.

Chapter 4:

How extend decision

FC are irrelevant to an extent decision

- Marginal cost (MC) is th additional cost incurred by producing and selling one more unit.
- Marginal revenue (MR) additional revenue gain from selling one moroe unit
- If benefit of selling another unit (MR) is > than MC then sell another unit
- Sell more if MR>MC, sell less if MR<MC if MR=MC you are selling at the right maximum amount
(maximizing profit).
- Typically MR falls and MC rises, the more you do.

Deciding btw 2 alternative

Incentive

Summary

Do not confuse average and marginal cost

Average cost (AC) total cost (FC and VC) divided by total units produced. The FC portion of AT is
irrelevant to an extent decision

An incentive compensation scheme that increase MR or reduce MC will increase effort. Fixed fees have
no effects on effort.

A good incentive compensation scheme links pay to perf measure that reflect effort.

Chapter 5

Investment decision: look ahead and reason back

Intro

Compounding and discounting

- All investment decision involve trade off btw current sacrifice and future gain
- Before investing need to know future benefit are more than current cot
- Discounting tools allows to figure this out
- (FV, one period in future)= PV (1+r)
-
FV, k period in future e= (PV) (1+r)k
 - If you invest at a rate of return r, divide 72 by r to get number of years it takes to double your
money
-
PV= FV, k period in future/ (1+r)k
- If NPV of sum of all discounted CF is larger than 0 then the projected earns more than Cost of
capital.
- NPV illustrated link btw economic profit and investment decision.
- IRR is discount rate that sets NPV = 0

Break even analysis

- Break even analysis can give wrong answer as it ignores TVM.

- Is easy to do and generate simple intuitive ans.
- Sell more than break even quant  profitable otherwise, unprofitable
- Break even quantity is Q= F/ (P-MC)
- F is annual FC and P is price, MC is marginal cost
- Break even quant is quantity that will lead to 0 profit
- Debt constant = r/(12(1/11r)n
- Warning to avoid a very common business mistake
o Do not use break even analysis to justify higher prices or greater output
- If you shut down, you lose your revenue, but you get back your avoidable cost
- If revenue is less avoidable cost or equivalently, if price is less than average avoidable cost then
shut down.

Sunk cost and post investment hold up

Before investing, look ahead and reason back.

- Post investment hold up, sunk cost are unadvoidable even in long run. So after u incure them,
you become vulnerable to post investment hold up.

Chapter 7

Economies of scale and scope

Intro

Increasing marginal cost

- Law of diminishing of marginal returns—you try to expand output, your marginal productivity (
extra output associated with extra inputs) eventually declines.
- Several reasons DMR occurs,
o Difficulty of monitoring and motivating larger workforces
o Increasing complexity of larger systems, or fixed nature of some factos.
o Popular jargon called bottlenecks.
o Often rises when more workers, or any variable input, must share fixed amount of
complementar input. When productivity fall from bottlenecks, costs increase
- Diminishing marginal productivity implies increasing marginal cost
 - Increasing MC eventually lead to increasing average costs

Economies of scale

- Law of diminishing of marginal return is primary short run phenomenon arising from fizity of at
least one factor of product, like capital or plant size.
- In long run, increase size of plant, hire more workers, buy more machines, remove product
bottlenecks. FC become variable in long run
- If LR average cost are constant with respect to output, you have constant return of scale
- If LR average cost rise with output, u have decreasing return of scare or diseconomies of scales
- If LR average cost fall with output, you have increasing return to scale, economies of scales.
- Learning curves—characteristic of many processes. Current production lower future ecost. Look
over life cycle of product when working with product characterize by learning curves.
-

Economies of scope

- If cost of producing two products jointly is less than cost of producing those two product
separately  economies of scope btw 2 product.
- Diseconomies of scope—if cost of producing 2 product together is higiher than cost of producing
them separately

Chapter 8

- Monopoly model of pricing because involves only single firm.

- Perfect competition—seller compete to the other to sell to buyer. and many buyer come
together in market setting

Shift in demand

- Changes in price lead to changes in quantity demanded

- Movement along demand curve—change in quantity demanded in response to change in price
- Price helps to catalog the factors that affect demand into controllable and uncontrollable factor
- Price, ads, warranties, product quality, distribution speed, service quality, prices of substitutes
or complementary products owned by company – controllable facto
- Uncontrollable—income, weather, interest rate, price of substitutes and complemtanry product
owned by other companies
- Shift of demand curve—change in demand caused by any variable except price
- If demand increase ( ship up to right) consumer demanded larger quantities of good at same
prices.
- Demand decrease consumer demand lower quantities at same prices.
- Shift are caused by factor like ads, change in consumer taste, and product quality

Shift in supply

- Supply curve slope upward, higher price higher quantity supplied.

- Entry or exit firms along change in cost, technology and capacity will all result in supply curve.

Market equilibrium
 - S=D
- In market equil, no unconsummated wealth creating transaction

-
- Chapter 9 market structure and LR equil

Perfectly competitive industry—

- Firm produce product or service with very close substituts mean demand is very elastic
- Firms may have rival and no cost advantages
- Industry has no entry or exit barriers

Demand curve for output of perfectly competitive firm us flat (perfectly elastic)

- Competitive firm cannot affect price little a competitive can do except react to industry price.
- Price above MC, sell more
- Price below MC sell less.
- Competitive firm fortunes closed tied to those of industry in which it compete.
- Profit attract capital to industry, existing firm expand capacity, new entrants, come into
industry increase S decrease in price.
- Entry and capacity expansion continue, P falling until firm in industry are no longer earning
above average profit. Capital stop flowing into industry industry has reached Long run equil
- Length of SR depend on how quickly assets can move into or out of industry
- In LR, no competitive industry earn more than average rate of return.
- Competitive efirm earn + or – economic profit in SR but only until entry or exit cocurs.
- LR, competitive firms earn only average rate of return.

Indifference principle

- Economic profit include cost of capital econ profit is normally zero

 - Indifference principle—if asset is mobile then in LR equil, the asset will be indifferent about
where it is used it will make same profit no matter where it goes.
- Higher return on risky stock—risk premium, which is analogous to compensating wage
differential
- In equil, different in Rate of return reflect different riskiness of investment.
- Summary
- Profit exhibit mean reversion or regression toward the mean
- Unattractive wage differential are risky investment will pay compensating risk differential (risk
premium)
- Different btw stock return and bond yield is compensating risk premium.
- Risk premia become too small, some investor view as a time to get out of risky assets market
may ignoring risk in pursuit higher returns
- Monopoly firm earn = profit for longer period of time than cocmpetitive.
- Entry of competing firms and imitation eventually erode their profit as well.

Chapter 10

Simple view of strategy

- Firm have competitive advantages when they can

o Deliver same product or service benefit as competitors but at lower costs or
o Deliver superior product or service benefit at a similar costs.
- Firm with competitive advantage are able toe rn positive econ profit

-
- Strategy is how to increase size of profit box.
- Box get bigger firm lower its costs or raise its price.
- Strategy is about raising price or reducing cost
- Successful company manage to do both
 - Extremely successful firm do it over a long period of time reflecting a sustainable competitive
advantage

Source of econ profit

- 1st industrial organization(IO) econ perspective—locates source of adv at industry lv

- 2nd resource based view (RBV)locates at individual firm lv
- Industry (External) View
o IO perspective—essence of this paradigm is that firm perf in marketplace depends
critically on characteristics of industry environment in which it competes.
o Certain industry more attractive based don structural characteristic.
o Companies in those industry possess market power, allows them to keep price above
competitive lv and earn economic profit.
o Industry structure include – barrier to entry, product differentiation, number and size
distribution
- If industry structure is most important determinant of LR profitability key generating econ
profit is to opeprate in right industry
- Best industry characterized
o Lower buyer power
o Low supplier power
o Low threat of entry (high barriers to entry)
o Low threat from substitutes
o Low lv rivalry btw existing firm
- An industry—group of ifrm producing products that are close substites to each other to serve a
market.
- Resource (internal) view
o RBV gained favored in 1990s as explanation or these inter-firm differences
o RBV explain indi firms may exhibit sustained perf adv due to their superior resource—
where resource defined tangible and intangible assets firm use to conceive of and
implement their strategies.
o 2 primary assumption
 Resource heterogeneity and resource immobility
 Rbv view firms as possessing different bundles of resources that are immobile (
resource reisit transfer or copying)
 Immoile resource are sources of differential perf within industry
 RBV provies further guidance on when these resource ma lead to superior perf
 Superior perf is defined as firm ability to earn profit above average
- Several condition that make resource hard to imitate (inimitability)
o Flow from firm unique historical condition will be difficult for competitor to match
o Link btw resources and adv is unclear, competitor have hard time trying to recreate
particular resource that deliver adv
o Resource is socially complex (organizational culture) rival find it difficult to duplicate
resousrce

3 basis strategies
- Cost reduction
o Generate increase in LR profitability only if cost reduction is difficult to imitate
o Other easily imitate duplicate action, CR will not give you sustainable competitive
advantage
- Product differentiation
o Reduction in elasticity of demand for product
o Less elastic demand  increase in price (P-MC)/P= 1/ |e|
- Reduction in competitive intensity
o Reduce lv of competition and keep new competitors from entering, able to slow erosion
of profitability
o One easy way ask gvt to do it