Naked Economics Wheelan, Charles (books to read for 13 year olds TXT) 📖

surprise was that the program had such a significant deterrent effect on car traffic that revenues from the fee were lower than expected.9 Retailers have also complained that the fee discourages shoppers from visiting central London.

Good policy uses incentives to channel behavior toward some desired outcome. Bad policy either ignores incentives, or fails to anticipate how rational individuals might change their behavior to avoid being penalized.

The wonder of the private sector, of course, is that incentives magically align themselves in a way that makes everyone better off. Right? Well, not exactly. From top to bottom, corporate America is a cesspool of competing and misaligned incentives. Have you ever seen some variation of the sign near the cash register at a fast-food restaurant that says, “Your meal is free if you don’t get a receipt. Please see a manager”? Does Burger King have a passionate interest in providing a receipt so that your family bookkeeping will be complete? Of course not. Burger King does not want its employees stealing. And the only way employees can steal without getting caught is by performing transactions without recording them on the cash register—selling you a burger and fries without issuing a receipt and then pocketing the cash. This is what economists call a principal-agent problem. The principal (Burger King) employs an agent (the cashier) who has an incentive to do a lot of things that are not necessarily in the best interest of the firm. Burger King can either spend a lot of time and money monitoring its employees for theft, or it can provide an incentive for you to do it for them. That little sign by the cash register is an ingenious management tool.

Principal-agent problems are as much a problem at the top of corporate America as they are at the bottom, in large part because the agents who run America’s large corporations (CEOs and other top executives) are not necessarily the principals who own those companies (the shareholders). I own shares in Starbucks, but I don’t even know the CEO’s name. How can I be sure that he (she?) is acting in my best interest? Indeed, there is ample evidence to suggest that corporate managers are no different from Burger King cashiers—they have some incentives that are not always in the best interest of the firm. They may steal from the cash register figuratively by showering themselves with private jets and country club memberships. Or they may make strategic decisions from which they benefit but shareholders do not. For example, a shocking two-thirds of all corporate mergers do not add value to the merged firms and a third of them leave shareholders worse off. Why would very smart CEOs engage so often in behavior that seems to make little financial sense?

One partial answer, economists have argued, is that CEOs benefit from mergers even when shareholders are left with losses. A CEO draws a lot of attention to himself by engineering a complex corporate transaction. He is left running a bigger company, which is almost always more prestigious, even if the new entity is less profitable than the merged companies were when they were on their own. Big companies have big offices, big salaries, and big airplanes. On the other hand, some mergers and takeovers make perfect strategic sense. As an uninformed shareholder with a large financial stake in the company, how do I tell the difference? If I don’t even know the name of the CEO of Starbucks, how can I be sure that she (he?) is not spending the bulk of her day chasing attractive secretaries around her office? Hell, this is harder than being a manager at Burger King.

For a time, clever economists believed that stock options were the answer. They were supposed to be the CEO equivalent of the sign near the cash register asking if you received your receipt. Most American CEOs and other important executives receive a large share of their compensation in the form of stock options. These options enable the recipient to purchase the company’s stock in the future at some predetermined price, say $10. If the company is highly profitable and the stock does well, climbing to say $57, then those stock options are very valuable. (It is good to be able to buy something for $10 when it is selling on the open market for $57.) On the other hand, if the company’s stock falls to $7, the options are worthless. There is no point in buying something for $10 when you can buy it on the open market for $3 less. The point of this compensation scheme is to align the incentives of the CEO with the interests of the shareholders. If the share price goes up, the CEO gets rich—but the shareholders do well, too.

It turns out that wily CEOs can find ways to abuse the options game (just as cashiers can find new ways to steal from the register). Before the first edition of this book came out, I asked Paul Volcker, former chairman of the Federal Reserve, to give it a read since he had been a professor of mine. Volcker read the book. He liked the book. But he said that I should not have written admiringly about stock options as a tool for aligning the interests of shareholders and management because they are “an instrument of the devil.”

Paul Volcker was right. I was wrong. The potential problem with options is that executives can do things to goose the firm’s stock in the short run that are bad or disastrous for the company in the long run—after the CEO has sold tens of thousands of options for an astronomical profit. Michael Jensen, a Harvard Business School professor who has spent his career on issues related to management incentives, is even harsher than Paul Volcker. He describes options as “managerial heroin,” because they create an incentive for managers to seek short-term highs while doing enormous long-term damage.10 Studies have found that companies with large options grants are more