Thursday, May 31, 2012

For those of you who get queasy during economics class

Economists are really good at figuring out the consequences of various policies, like selling pollution permits.  By placing a price on pollution, you also create an incentive to reduce it.  If the policy goal is less pollution, this is one of the best ways to reach it.

This kind of analysis leads naturally to the moral ethic of consequentialism, where a policy is judged "good" if its consequences are good, i.e., the ends justify the means.

So why does this rub so many people the wrong way?  Perhaps the biggest objection to consequentialism is that by using markets to allocate goods and services, we turn personal relationships based on love or affection into arms-length commercial relationships based on the pursuit of profit.  Philosophers call this "commodification."

This can make a difference if, for example, the "means" of trading pollution permits, changes how we feel about the "ends" of reducing pollution.  Specifically, by allowing people to trade pollution permits, we may reduce the stigma of pollution, and make it more acceptable.

So, if some of you get queasy during economic class, you are not alone:
What Money Can’t Buy – which must surely be one of the most important exercises in public philosophy in many years – examines a wide variety of cases in which goods that in the past were believed to be outside the market have been turned into commodities. Surrogate motherhood, paying others to queue for you to attend a Supreme Court hearing, buying the right to immigrate into a country or shoot endangered wildlife, purchasing the insurance policies of ailing and elderly people to collect death benefits and charging fees for a better class of prison cell are just a few of the examples that Sandel deals with.

The problem with this critique, of course, is that we need something to replace economic relationships. And, as the author points out, a highly pluralistic society such as ours, there is not much consensus on the content of the good life. As a result, there is little prospect of agreement on the moral limits of the market. Sandel points out: “We disagree about the norms appropriate to many of the domains that markets have invaded.”

This reminds me of something that Winston Churchill would have said, "markets are the worst way to allocate goods and services, except for every other method that has been tried."

HT:  Daniel C.

The demand for sexual misconduct insurance

A former students who works for a firm that does background checks tells me that drug users like to work in hospitals, rapists in occupations that get them into homes, and pedophiles in schools.

And now insurance agents are being told that the "target" markets for "sexual misconduct insurance" are: Religious institutions, Educational institutions, Leisure services including camps, recreation centers, outdoor activity companies, spas resorts, and Healthcare organizations and social services.

This is an interesting manifestation of adverse selection.

I don't want to think about the moral hazard.  

Friday, May 25, 2012

What can President Obama learn from Bain Capital? (iii)

Now that President Obama has begun a discussion about the role of business vs. the government in making decisions that move assets to higher (or lower) valued uses, the Washington Post has jumped into the middle of it:
Since taking office, Obama has invested billions of taxpayer dollars in private businesses, including as part of his stimulus spending bill. Many of those investments have turned out to be unmitigated disasters — leaving in their wake bankruptcies, layoffs, criminal investigations and taxpayers on the hook for billions.
Some examples:
  • Raser Technologies, $33 million in 2010. Bankrupt in 2012 and owes $1.5 million in back taxes. 
  • ECOtality. $126.2 million in 2009. Has since incurred more than $45 million in losses and “under investigation for insider trading,” 
  • Nevada Geothermal Power, $98.5 million in 2010. Now "significant doubt about the company’s ability to continue” 
  • First Solar. $3 billion. Recently “fell to a record low in Nasdaq Stock Market trading and fired 30 percent of its workforce.” 
  • Abound Solar, Inc. $400 million. Recently the company halted production and laid off 180 employees. 
  • Beacon Power. $43 million. Now bankrupt.
UPDATE: A reader correctly points out that you cannot judge a policy by looking at only its failures, you must also look at the benefits. I have blogged before about the record of the industrial policy of picking winners and losers.

Thursday, May 24, 2012

What can President Obama learn from Bain Capital? (ii)

The Economist has a profile of Mitt Romney's business career, arguing that it coincided with three big revolutions in American Business. The second revolution was the idea that a company’s purpose is to make money for shareholders. Up until the 1970's, post-war American capitalism was dominated by managers, who ruled over sprawling conglomerates with elaborate hierarchies, ornate headquarters and three-martini lunches.  Bain Capital helped change this:
But by the time Mr Romney came of age in the 1970s this comfortable world was crumbling. Post-war prosperity had given way to stagflation. The Japanese had started to run rings around slow American giants. And in 1976 a brilliant article by two business academics, Michael Jensen of Harvard and William Meckling of the University of Rochester, offered a radical diagnosis. Corporate America had a principal-agent problem, they said. Agents (ie, managers) were feathering their own nests rather than serving the interests of their principals (shareholders). The solution was to force managers to focus on shareholder value.
Not only is principal-agent conflict between shareholders and managers the topic of Chapter 21, but Jensen and Meckling's analytic framework on how to align the incentives of employees with the goals of the organization is behind the problem-solving methodology of our textbook.

Wednesday, May 23, 2012

Wax my back, please

New York is busy enforcing a prohibition on sex-based pricing.  This causes problems if serving men is more costly than serving women, or vice-versa:
At Vanilla Hair Spa, manager Oksana, who didn't want to give her last name, said the charge to wax men used to be $5 more than for women. 
"If someone's waxing a man's back and a woman's back, it's like day and night," she said. "Of course it takes longer for men. It's more labor, more product."
HT: Sarah

What can President Obama learn from Bain Capital?

Everyone makes money by moving assets to higher valued uses:  workers sell their labor to employers who place a higher value on it; real estate agents earn money by finding higher value uses for houses; and private equity firms like Bain, make money by finding higher valued uses for our largest and most valuable assets, corporations.

Assembling component pieces into single entity creates value if the single entity is worth more than the sum of its component parts. Breaking up companies and selling off the component parts creates value if the component parts are worth more than the parent company. 

In addition, the threat of taking over under-performing corporate assets serves as an incentive to managers to maximize the value of the assets. Otherwise, someone else with a better idea may buy up the company, fire the managers and or, as I like to say, "move them to a higher-valued use."

President Obama has attacked Governor Romney for his association with Bain Capital, a private equity firm involved in the business of wealth creation.   The Economist thinks that Romney's response should be telling:
If Mr Romney can't defend against Mr Obama's attempt to turn his experience at Bain into a liability, he doesn't deserve to win.

Monday, May 14, 2012

Sorting customer types by episodes

Video games are a growing segment of the class of products called "information goods." These are products with informational content like books, songs, movies, software, etc. People differ in their willingness-to-pay for the product, but so far, it has been difficult to price discriminate. Now Telltale Games has developed episode based games in which a gamer can sequentially purchase up to five episodes of a 'season' of a game. Their FAQ states:

Aside from their one-shot games like Puzzle Agent and Poker Night, Telltale makes 'episodic games'. If you buy a season, about once a month you'll get a new 2-4 hour game to play, called an 'episode'- kind of like a TV show. And just like on TV, each episode has its own plot, but the season as a whole has an overarching plot spanning all the episodes.


It is also possible to purchase the entire season at once by buying a season pass- you can download all episodes that have already been released up to that point and will get the rest as they come out. And, of course, you can buy the entire season of any game that is finished and get all the episodes at once. Many of Telltale's older episodes can be purchased individually, but most of their newer titles only come as a season pack.

One advantage of pricing by episode is that gamers with less interest will be more apt to purchase a first episode, try it out, and see if the cliff-hanger is enough to entice them to buy another.
An added benefit of several shorter games with an overarching plot is, again, the same as one would get from watching television. Water-cooler talk is always exciting on the forums, in between episodes there is always engaging discussion on what might happen next.

This version of indirect price discrimination is called "metering" in which willingness-to-pay is related to the intensity of use. Instead of charging everyone the same price, try to devise a way to measure the intensity of use and then price the usage as with a meter.

HT: Brandon Vanderford

Friday, May 11, 2012

Wouldn't a market be much simpler?

In the spring of 2011, Rick Ruzzamenti of Riverside California decided to donate his kidney to a orgnization set up to match donors and recipients. His selfless act set off a domino chain of 60 operations involving 17 hospitals in 11 different states. Donors, unable to help their loved ones because of incompatible blood types or antibodies, instead donated kidneys to those whose loved ones donated to others, and so on, until the chain ended six months later in Chicago, Illinois.

The good news is that thirty people received new kidneys, and escaped the "living hell" of dialysis. The bad news is that this complex barter system is the only legal way for Americans to get kidneys. It is so inefficient that only 17,000 of the 90,000 people on waiting lists received kidneys last year.

To understand how complex and cumbersome this process is, imagine trying to do the same things with an apartment . If you wanted to move from Detroit to Nashville, you would either have to find someone who was moving in the opposite direction or, failing that, you could find a second person moving from Nashville to Los Angeles, and a third from Los Angeles to Detroit.  Then you could swap the first apartment for the second, the second for the third, and the third for the first.

Why not simply allow people to buy and sell kidneys?

Wednesday, May 9, 2012

Grow a pony tail and cut taxes

The strategy employed by the Swedish Finance Minister seems to be working.
He continued to cut taxes and cut welfare-spending to pay for it; he even cut property taxes for the rich to lure entrepreneurs back to Sweden. The last bit was the most unpopular, but for Borg, economic recovery starts with entrepreneurs. If cutting taxes for the rich encouraged risk-taking, then it had to be done. "In most cases, the company would not have been created without the owner," he says. "There would be no Ikea without [Ingvar] Kamprad. We would not have Tetra-Pak without [Ruben] Rausing. They are probably the foremost entrepreneurs we have had in the last few decades, and both moved out of Sweden."
HT:  Carpe Diem

What happens when a company forgets about Moral Hazard and Adverse Selection?

American Airlines should read chapters 19 and 20. They sold 64 lifetime AA passes for $350,000 that allowed passengers to fly first class, anywhere, at any time.  This was a big mistake:

  • Adverse selection:  only extremely travel-inclined passengers purchased the tickets; and
  • Moral Hazard: since the marginal cost of travel was zero, they used to fly to any destination where the marginal benefit was greater than zero.  

Bottom Line:  The passes ended up costing AA over ten times as much as they sold them for.

HT:  Don Marron

Monday, May 7, 2012

How to value a stock

In this blog, we talk a lot about "value" investing, but not much about how to calculate value.  Here is an excellent set of slides from Prof Damodaran introducing the three valuation methodologies:  Discounted Cash Flow; Relative Valuation; and Option Valuation.

Friday, May 4, 2012

The point of studying game theory

Watch the first game of golden balls, and then write down the reduced form of the game (simultaneous moves) and show that it has three equilibria. Was the outcome one of the equilibria?

 Now watch this same game played by a different pair of people.  
Why was the outcome different?

 HINT: the point of studying game theory is to figure out where self-interest is likely to lead you.  If you don't like where that is, try to figure out how to change the game to your benefit.

 How would you model what Nick did in the second game.  [HINT:  sequential-moves.]