Quoted from Managerial Economics by Luke Froeb et al. Editions 2-5 (2011-2018). Introductory case studies of chapter 1
In 1992, a junior geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico. She suspected that the tract contained a large accumulation of oil because her company, Oil Ventures International (OVI), had an adjacent tract with several productive wells. Since no competitors had neighboring tracts, none of them suspected a large accumulation of oil. Be cause of this, she thought that the tract could be won relatively cheaply and recommended a bid of $5 million. Surprisingly, OVI’s senior management ignored the recommendation and submitted a bid of $21 million. OVI won the tract over the next-highest bid of $750,000.
If the board of directors asked you to review the bidding procedures at OVI, how would you proceed? Where would you begin your investigation? What questions would you ask? You’d find it difficult to gather information from those closest to the bidding. Senior management would be suspicious and uncooperative because no one likes to be singled out for bidding $20 million more than was necessary. Likewise, our junior geologist would be reluctant to criticize her superiors…
Solving a problem like OVI’s requires two steps: first, figure out what’s causing the problem; and second, how to fix it. In this case, you would want to know whether the $21 million bid was too high at the time it was made, not just in retrospect. If the bid was too aggressive, then you’d have to figure out why the senior managers overbid and how to make sure they don’t do it again.
…let’s go back to OVI’s story and try to find the source of the problem. After her company won the auction, our geologist increased the company’s oil reserves by the amount of oil estimated to be in the tract. But when the company drilled a well, it was essentially “dry,” so the acquisition did little to increase the size of the company’s oil reserves. Using the information from the newly drilled well, our geologist updated the reservoir map and reduced the estimated reserves to where they was [sic] before OVI won the tract.
Senior management rejected the lower estimate and directed the geologist to “do what she could” to increase the size of the estimated reserves. So, she revised the reservoir map again, adding “additional” (not real) reserves to the company’s asset base. The reason behind this behavior became clear when, several months later, OVI’s senior managers resigned, collecting bonuses tied to the increase in oil reserves that had accumulated during their tenure. The incentive created by the bonus plan explains both the overbidding and overestimated reserves as rational, self-interested responses to the incentive created by the bonus. Senior managers overbid because they were rewarded for acquiring reserves, regardless of the price. Their ability to manipulate the reserve estimate made it difficult for shareholders and their representatives on the board of directors to spot the mistake. To fix this problem, you would have to find a way to better align managers’ incentives with the company’s goals, perhaps by rewarding management for increasing profitability, not just for acquiring reserves. This is not as easy as it sounds because it is typically hard to measure an employee’s contribution to company profitability… In OVI’s case, we see that… senior management made the bad decision to overbid;… they had enough information to make a good bid, but… they didn’t have the incentive to do so. One potential fix… is to change the incentives of senior management so that they are rewarded for increasing profitability instead of oil reserves.
This is a ridiculous way to analyze and fix this problem which makes it a fascinating case study of Froeb’s thought processes. Unfortunately he replaced it with a more banal story in 2023 so I’ve reproduced it here for students to critique.
Medianism 