Tuesday, July 31, 2007

Business for Boneheads

I am thinking of capitalizing on the popularity of the "Dummies" series of books by publishing a book called Business for Boneheads. In the book, I'll lay out the secrets of how to create competitive advantage and become a successful business based on mountains of research I've conducted on successful companies. Wanna buy a copy?

Here's a couple of reasons why you should be suspicious of my book (and also any others that claim to tell you how to succeed easily in business). First, you can't really learn anything about what causes success unless you study both successes and failures. Say I found that all of the successful companies I studied had red product logos. Well, I can't say much about any association between red logos and company success unless I know something about how many failed companies had red logos (if none of them did, perhaps I might be on to something).

Second, as Phil Rosenzweig argues in his new book, The Halo Effect, a lot of the conclusions of such a book would likely suffer from the fact that success shapes our perceptions. Let's say I interview managers from successful and unsuccessful companies about their strategic planning process. The successful managers would probably describe their clear, well-funtioning planning process as one of the factors contributing to their success while the unsuccessful managers would likely describe their muddled, problematic process as contributing to their failure. So, clear planning processes are critical to success. But, wait. Rosenzweig's point is that we would likely see this result even if the companies followed the exact same process. His book is definitely worth a read!

The final reason you should avoid my book is that no publicly available knowledge is going to help you create a competitive advantage. Let's say I correctly discover that having a CMEO (Chief Managerial Economics Officer) in your company inevitably led to competitive advantage in companies I studied. So you, the astute reader, decide to hire a CMEO for your business and no competitive advantage follows. What happened? Well, your competitor probably heard about the CMEO "secret" as well and hired one too. Now that everyone knows about it, no advantage is possible. Competitive advantage flows from having something that competitors can't easily duplicate - you're not likely to find these on the shelves of your local bookstore.

Monday, July 30, 2007

What if there were no antitrust?

I returned from a conference in Shanghai on Asian Competition Policy where I was struck by the realization that the four fastest growing economies in the world (India[1], China[2], Singapore[3], and Hong Kong) have had, until recently, no antitrust laws. I heard tales of explicit collusion--land developer and rice-importing cartels--yet these economies are growing at double digit rates. Makes you wonder.

I would like to hear from our readers how business practices (relationships with suppliers and customers) differ in the absence of antitrust laws, and how they changed with the advent of laws.


Figure: Countries with Antitrust Laws (in red) in 2004



[ 1]. India does have an antitrust law on the books but it is not enforced at traditional antitrust targets, i.e., price-fixing, anticompetitive mergers, and abuse of dominance.

[2] China is on the verge of passing an anti-monopoly law.

[3] Singapore has only recently put an antitrust law on the books.

Managing a government agency

I sent a colleague who was appointed to a government post a copy of this essay on my attempt to actually manage after teaching the subject for over a decade. This is also in my textbook.

The government presents a unique challenge to any manager because it has ... few metrics to gauge its performance, and no sticks and only small carrots to align the incentives of employees with the goals of the organization. In addition, government employees are lifetime civil servants, with better information than the political appointees who manage them and strong ideas about what the government should be doing. They can easily outlast the appointees who seem to come and go every few years or so.

Here is my bottom-line advice:
  1. Develop goals--without them you cede control of the policy agenda to your InBox. ...Be as specific as possible with timetables and measurable benchmarks.
  2. Constantly monitor progress toward your goals.
  3. If the organizational structure is broken, fix it. Otherwise, respect the structure you have...If you jump over your managers to get involved in specific matters, you are implictly telling them that you don't think they are capable of doing their assigned jobs.
  4. Finally, manage yourself. Don’t let your InBox run your life...

Friday, July 27, 2007

Marx on change

At Stanford, I took econ 101 from Marxist professor John Gurley, and then followed up by taking his class on Marxism. The analysis never made sense to me, but I surely missed this paragraph which, except for its eloquence, could have come from a modern management text.

Constant revolutionizing of production, uninterrupted disturbance of all social conditions . . . distinguish the bourgeois epoch from all earlier ones. . . . All fixed, fast, frozen relations . . . are swept away, all newformed ones become antiquated before they can ossify. All that is solid melts into air; all that is holy is profaned . . . . KARL MARX & FREDERIC ENGELS, THE MANIFESTO OF THE COMMUNIST PARTY (1848).

Next time you buy or re-finance a house...

make your bank fill out this mortgage disclosure form. Designed by FTC staff economists Jim Lacko and Jan Pappalardo, this form is a huge improvement over the confusing ones you are likely to see.

A summary of the research is here. Don't say the government never did anything for you.

One of the surprising things to me at the FTC was the number of frauds perpetrated on poor people: credit repair, work at home scams, and diet, health, and exercise schemes. Better disclosure forms should help consumers protect themselves against deceptive lending practices.

Wednesday, July 25, 2007

Using credit history to price car insurance

The FTC's Bureau of Economics just relased their FACTA study, which concludes that:
  1. Credit scores effectively predict ... the total cost of [auto insurance] claims.
  2. Credit scores permit insurers to evaluate risk with greater accuracy, which may make them more willing to offer insurance to higher-risk consumers ... . [note: this is why you can call up GEICO, let them look at your credit report, and get an auto insurance quote over the phone].
  3. ..as a group, African-Americans and Hispanics tend to have lower scores than non-Hispanic whites and Asians.
  4. ...scores effectively predict risk of claims within racial and ethnic groups.
  5. The Commission could not develop an alternative scoring model that would continue to predict risk effectively, yet decrease the differences in scores among racial and ethnic groups.
So even though credit scores help insurance companies price insurance more accurately, point 3 implies that some groups pay more, on average, than others. The policy issue behind the study is whether the government ought to ban the use of credit history for anything but making loans. As point 4 implies, banning the use of credit scores would result in higher prices for good drivers, regardless of their race or ethnicity.

Theory tells us that in states which ban the use of credit scores to price insurance (California and Massassachusetts) insurance companies would find it more costly to distinguish high from low risks, so they may lump them together (called "pooling"), and price insurance at the average risk. Or they may be concerned that only high risks would be willing to buy high-priced insurance (what economists call "adverse selection") and price high or, if price controls prevent high prices, exit the market.

I would be curious if any of our readers know of novel uses of credit scores as a screening mechanism, or if they have developed better predictors (point 5) in a particular application, like pricing insurance or screening job applicants.

When M&A Makes Sense

Given the seeming poor performance of a lot of mergers and acquisitions, a natural question is when do these transactions create value for the acquiring firms. The answer is both simple and complex.

To create economic value for the acquiring firm, the target must be acquired at a cost lower than its value. Leaving aside any issues of bargaining skill, why would we expect that a buyer would be able to purchase a target at less than its value, especially when the target firm probably has a heck of a lot better idea of its true value than the buyer does? The simple answer is that the target firm must be more valuable to the buyer than it is to the seller (the assets of the target must be moved to a higher-valued use using the language of our book). The complex part is discovering / creating that difference in value. Words like "synergy" get tossed around pretty easily, but it's a lot easier to talk about synergy than it is to actually create it.

Even though it's nearly 20 years old, the logic from this article by Jay Barney remains solid. Whether you call it creating synergistic cash flows as Barney does or moving assets to higher-valued uses as we do, it's a necessary condition for creating economic value from mergers / acquisitions. When considering or evaluating a merger, ask the hard question - why is the target more valuable to the buyer than it is to the seller? If you can't come up with a strong case, don't expect a positive result.

Tuesday, July 24, 2007

If merger is the answer, what is the question?

McKinsey researchers surveyed 19 of the busiest and largest acquirers to find out why some acquisititions succeed (positive stock price reactions to the announcement) and some fail (negative stock price reaction). They find that executives at firms pursuuing succesful acquisitions mentioned fewer reasons for the merger than those at unsuccesful acquisitions.

I found something similar in my experience as a government antitrust enforcer:

In some mergers the value created is obvious and well documented, but for a surprising number the analysis is nothing more than a litany of excuses copied out of a corporate strategy textbook to justify the deal to the board of directors.

For a large percentage of proposed mergers, the internal analysis of the merger by the acquiring firm was surprisingly bad:

... mergers are thought to cure a variety of corporate ailments, including, but not limited to: underdiversification, high taxes, excessive overhead, limited product offerings, under-investment in R&D, and my personal favorite, ruinous competition. All that is missing is the disclaimer that the FTC requires on testimonial ads: "results may differ.”

Apparently, however, things have gotten better. Another McKinsey survey finds that in 2006, the merger premium for the acquired firms dropped from 30% to 20% and that stock price reactions were more likely to be positive following the merger announcement.

Monday, July 23, 2007

Look ahead and reason back: buying a franchise

Individual franchisees (like an individual hotel owner) pay to use the brand and business formula of the franchisor (like Best Western, Comform Inn, Days Inn, Econolodge, Hampton Inn, Holiday Inn, Ramada, or Super 8). The value of the brand to the franchisee depends, among other things, on how much "within brand" competition there is.

Unless the contract grants the franchisee an "exclusive territory," the franchisor may have an incentive to set up more franchisees in the same area. Using a ten year data set of Texas Hotels, Arturs Kalnins find that when new franchisees open up nearby, incumbent franchisees lose 2-3% of their revenue. Interestingly, there is no cannibalization when a new company-owned hotel enters near an existing company-owned hotel (e.g., La Quinta and Motel 6 own most of their own hotels).

If franchisees anticipate that future franchisees will cannibalize sales, this will reduce the amount that they are willing to pay for the franchise. If franchisees do not anticipate cannibalization, they are in for a rude awakening.

Franchisees are powerful politically (easy to organize, common purpose) and often lobby state legislatures to enact franchisee "bill of rights" giving them, among other things, right of first refusal for new franchises. In states with strong franchisee bills of rights, companies with strong brands opt for company-owned stores, which are easier to control instead of the franchisee organizational form..

Friday, July 20, 2007

The Power of P

Luke's post of yesterday regarding price discrimination reminded me of a great article on the importance of pricing to profitability. We all know that Profit = PxQ - CxQ, but too many businesses focus on either Q or C and forget about P. Think about companies you've worked for - I bet they spent more time talking about how they could sell more or about how to reduce costs and not a whole lot of time about how to raise prices.

"Pricing: The Neglected Orphan" (available at
http://www.parthenon.com/OurWork/IntellectualCapital/Documents/Parthenon-Pricing%20The%20Neglected%20Orphan_09-2004.pdf) by Roger Brinner, Partner and Chief Economist at The Parthenon Group, should be required reading for all managers and MBA students. He argues that nearly every company has the opportunity to raise effective prices. The profitability impact of price increases is dramatic. Raising price by just one percent flows directly to higher profits. He notes that with an average pre-tax profit margin of 8.6% for an S&P company, revenues would have to increase by 12% to get the same payoff.

The bottom line: don't forget the power of P.

Thursday, July 19, 2007

Only Schmucks Pay Retail

Ordinarily, price discrimination is profitable if firms can segment consumers by how much they are willing to pay. By offering discounts to low-value consumers, firms profit because they can increase sales to low-value consumers without cannibalizing (losing) sales to high-value ones.

However, recent research by colleagues Mike Shor and Rich Oliver showed that this intuition does not always hold . They studied the use of "promotional codes" on websites, an online analog to discount coupons. They found that the click-through rates on real websites that had boxes for promotional codes were so much lower as to render the promotional discounts unprofitable. They conclude that "Web sites prompting [high-value] customers to enter a 'promotion code,' ...may unwittingly be losing customers who otherwise would be willing to purchase."

Apparently, no one wants to be a schmuck.(1)

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(1) Schmuck also shmuck: n. Slang; a clumsy or stupid person; an oaf.

Wednesday, July 18, 2007

Will Resale Price Maintenance Return?

Last week, the Supreme Court removed the blanket prohibition against retail price agreements between manufacturers and retailers. PING (the golf club manufacturer) submitted an amicus brief in the case that detailed how difficult it is to prevent discount retailers from free riding on the custom fitting services of full service retailers. The discount retailers were advising consumers to visit a full-service retailer to request a custom-fitting session, and then bring the specifications for custom-made clubs back to the discounter. PING could control this kind of opportunistic behavior only by dropping dealers, a very costly option. [For an economic analysis of resale price maintenance, see the amicii brief of 24 antitrust economists--full disclosure: I am one of the 24].

Now PING has another option, minimum resale price maintenance. The federal legality of these agreements will now be determined under a rule of reason. However, it is likely that those states more inclined towards regulation, like California and New York, will try to "repeal" the Supreme Court decision with state legislation, setting up a conflict between state and federal antitrust laws.

This just in: some manufacturers are suuing retailers who sell merchandise on eBay at a discount.