Consult an economist before buying a wedding dress

When Stephanie (her name has been changed to avoid embarrassment) went shopping for a wedding and bridesmaid dresses, she found valuable advice from an unusual source, Chapter 23 of her favorite economics text.  And it was not about sleeve options, figure flattery, or bustles.

She was puzzled that over half of the stores that sell wedding dresses do not permit photos, and do not have tags in the dresses that would identify the manufacturer and style type.  

These retail stores want to prevent customers from "free riding" on their fitting and display services:

I just spoke with someone who had all her bridesmaids sized in the store only to go online and buy them from a discount site. I would assume many of the brides are doing this as well.

Note that this is not just a problem for the store, but also a problem for the dress manufacturer: if stores cannot prevent free-riding, they will invest less in point-of-sales fitting services, and dress sales will suffer.  See our earlier post about golf club manufacturer PING, who faced a similar problem,

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.

PING wanted to set a minimum retail price (called "retail price maintenance") to address the problem.  The minimum price meant that discount retailers could not undercut full service retailers.  The antitrust laws prevented this until the Supreme Court changed the case law.

For the wedding dresses, the no-photos policy created a problem for Stephanie because she wanted to photograph her bridesmaids in each of the dresses to make sure that they choose the best dresses for the wedding. So she chose to purchase from a large retail chain, like J. Crew, BCBG, Ann Taylor, or Nordstrom’s because they had solved the free riding problem, using exclusives, where only one chain carries the style.

For an economic analysis of resale price maintenance, see the amicii brief of 24 antitrust economists (I am one of the 24.)

UPDATE:  Amazon just made free riding a lot easier.

How did Blockbuster's CEO solve the double marginalization problem?

Hal Varian's (Chief Economist at Google) tells the story of Blockbuster (a video "rentailer") and its distributors who suffered from "double marginalization" or "the double markup problem." In other words, competition between firms selling complementary products results in a price that is too high and output that is too low:

Consider, for example, video tape rental industry. Prior to 1998, distributors sold video tapes to rental outlets, which proceeded to rent them to end consumers. The tapes sold for around $60 apiece, far in excess of marginal cost. The rental stores, naturally enough, economized on their purchase, leading to queues for popular movies.

The old contractual form suffered from double marginalization, which resulted in video rental prices that were too high and output that was too low.

The Blockbuster CEO recognized this as a problem and proposed a solution:

In 1998 the industry came up with a new contractual form: studios provided video tapes to rental stores for a price between zero and $8, and then split revenue for rentals, with the store receiving between 40 and 60 percent of rental revenues.

Although the stores marginal revenue was cut in half, the marginal cost of a video went down by about 90%.  As a result,

.. these contracts increased revenue of both studios and rental outlets by about 7 percent and consumers benefitted substantially. Clearly, the revenue sharing arrangement offered a superior contractual form over the system used prior to 1998.

 This arrangement is subject of course to verification of the downstream revenue by the upstream distributor.  New "smart" cash registers at Blockbuster made this possible:

The interesting thing about this revenue-sharing arrangement is that it was made possible only because of computerized record keeping. The cash registers at Blockbuster were intelligent enough to record each rental title and send in an auditable report to the central offices. This allowed all parties in the transaction to verify that revenues were being shared in the agreed-upon way. The fact that the transaction was computer mediated allowed the firms to contract on aspects of the transaction that were previously unobservable, thereby increasing efficiency. 

More of Hal Varian's insights about economics (there are some good stories here) can be found in his popular columns.  He is most famous to MBA's for saying that "marketing is the new finance," urging the Quants, who used to go into finance, go into marketing instead.

HT:  Vlad Mares

Noisy ESG metrics lead to moral hazard and adverse selection

 

Noisy performance metrics lead to moral hazard (firms shirk on ESG efforts), and adverse selection (ESG investors more likely to invest in firms who are not ESG). 

 Link: AEA 

The cobra effect in software development

When software developers are given a bounty to find bugs, they pay fellow developers to create bugs that they then find and claim a bounty.  This is an old problem, called the "Cobra effect."

From Wikipedia:

The British government, concerned about the number of venomous cobras in Delhi, offered a bounty for every dead cobra. Initially, this was a successful strategy; large numbers of snakes were killed for the reward. Eventually, however, enterprising people began to breed cobras for the income. When the government became aware of this, the reward program was scrapped. When cobra breeders set their now-worthless snakes free, the wild cobra population further increased.[5]

Other examples:

• In 2005 the UN Intergovernmental Panel on Climate Change began an incentive scheme to cut down on greenhouse gases. Companies disposing of polluting gases were rewarded with carbon credits which could eventually get converted into cash. The program set prices according to how serious the damage the pollutant could do to the environment was and attributed one of the highest bounties for destroying HFC-23, a byproduct of a common coolant,HCFC-22. As a result, companies began to produce more of this coolant in order to destroy more of the byproduct waste gas, and collect millions of dollars in credits.

• The United States Endangered Species Act of 1973 imposes development restrictions on landowners who find endangered species on their property.a While this policy has some positive effects for wildlife, it also encourages preemptive habitat destruction (draining swamps or cutting down trees that might host valuable species) by landowners who fear losing the lucrative development-friendliness of their land because of the presence of an endangered species. In some cases, endangered species may even be deliberately killed to avoid discovery. This same perverse incentive has also been observed in other countries, including Canada and various European countries.

Why doesn't insurance cover floods, earthquakes or bed bugs?

Planet Money has another episode that is making me rethink my opposition to government subsidies for public broadcasting.  In The Fine Print, a reporter reads his homeowner's insurance policy.  In it, he discovers that the policy does not pay for:

• Floods: because floods hit all the homeowners in an area at the same time, so insurers cannot diversify the risk (called "correlated risk") so insurance companies become more risk averse, so there is less of a gain from insurance

• Earthquakes: adverse selection costs are high (only the homeowner knows if they are close to an active fault) and how likely it is that their house would withstand an earthquake; and

• Bedbugs: moral hazard costs are high (once consumers buy bedbug insurance, they engage in riskier activities, like picking furniture off the street).

A business plan built on screening out bad risks

If you can find a way to signal that you are a safe driver, you should be able to get better rates.  Here is how Progressive screens out bad drivers:

You, the consumer, agree to allow Progressive to install a monitor that plugs into your car's onboard diagnostic system. Progressive then monitors how you drive: how far, how fast, how many hard brakes and so on. If Progressive likes what it sees, you can get your bill knocked down by as much as 30% after 30 days. Six months later, you mail the device back and have the opportunity to lock in the discount — permanently. If, on the other hand, Progressive puts you in the naughty category, sorry, no discount.

HT: Micah

Which governments can get out of the way of growth?

John Cochrane reminds us to keep our eyes on the prize:

In the long run, nothing else matters. GDP buys you health, advancement of the disadvantaged, social programs, international security, and climate if you are so inclined. Without GDP, you get less of all.  Economic policy should have one central goal -- get productivity growing again, or (in my view) get out of the way of its growth. This is the one little hope that has not been let out of the policy Pandora's box, focused on everything else right now.

Macroeconomists classify two basic types of growth:  

• More inputs (labor, capital) lead to more output (GDP)
• Technological progress (Total Factor Productivity) increases output for the same level of input.

Here is a graph of the Total Factor Productivity in the US

And here is the change in Total Factor Productivity across countries.  

We have blogged about the dearth of unicorns in the EU,

   

Total Factor Productivity seems to be telling the same story.

Will Resale Price Maintenance Return?

[Orignally posted in 2007], 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 suing retailers who sell merchandise on eBay at a discount.

tit-for-tat in the New Congress

In a repeated prisoners' dilemma, [play coauthor Mike Shor's online game against 5 different players], the best strategies exhibit the following characteristics: 

• Be nice--no first strikes 
• Be provokable--retailiate immediately if your rival cheats 
• Be forgiving--don't punish cheating too much 
• Be clear--make sure your rival can interpret your moves 
• Dont be envious--focus on only your slice of the profit pie

Tit-for-tat is the winning strategy (examples)

The WSJ reports that new Republican House Speaker is doing exactly what the previous Democratic House Speaker did, in order to deter future abuses of power:

Republicans believe that if they don’t play tit-for-tat like this, Democrats will feel empowered to keep escalating. Maybe if Democrats get the same ill treatment, the GOP thinks, Democrats will revert to better form the next time they’re in the majority.

Of course, this works only in an evenly divided Congress. If one party gains the majority for a long time, it need not fear retaliation.

Play the repeated prisoners' dilemma

By playing against one of five types you learn how to sustain cooperation:

1. Be nice--no first strikes
2. Be provokable--retailiate immediately if your rival cheats
3. Be forgiving
4. Be clear--make sure your rival can interpret your moves
5. Dont be envious--focus only on your slice of the profit pie

HT: Jordan