Hedge fund managers misreport returns

In an earlier post we asked whether the "2 and 20" compensation system (2% of assets and 20% of profit) aligns the incentive of hedge fund managers with the profit goals of hedge fund owners. Colleague Nick Bollen and his student Veronika Krepely Pool have a working paper (abstract) that finds evidence of earnings manipulation by hedge fund managers to attract investors.

Hedge funds differ from mutual funds in that they are not valued every day. In addition, managers have discretion about how they value the (often illiquid) assets. Because young hedge funds find it easier to attract investors if they do not report negative returns, they choose valuation methods that avoid negative returns. Frequent auditing reduces earnings manipulation.

Can functionally organized banks see risk?

Managers of a functionally organized firm must coordinate the activities of each division. Otherwise, the divisions may end up working at cross purposes.

The incentive conflict between bank deposit and lending divisions is a classic example. The S&L crisis of the early 1980's was caused, in part, by the behavior of S&L's which borrowed short (deposits) and lent long (home mortgages). When interest rates skyrocketed in the early 1980's, S&L borrowing costs increased dramatically as depositors demanded higher rates, but revenue did not change on the 30-year, fixed-rate mortgages. Good managers would recognize the mismatch between deposit and loan maturities and use financial markets to offload some of the risk.

It seems as if something similar may be going on in today's banks. The loan originators and (mortgage brokers) are compensated mainly on volume, but not the quality of the loans they make. This leads to risky loans that may not be recognized as risky until housing prices start falling, and borrowers find it more profitable to forfeit the house to the bank. Again, good managers will recognize the incentive conflict between loan origination and servicing, and try to control it.

In an earlier post, we suggested that investors ignored risk in search of higher returns as they drove risk premia on all kinds of exotic and risky investments down to historic lows. It may be that functional specialization has been partly responsible for the failure of subprime lenders to recognize risk. When loan originators make loans that no investor wants to fund, lenders go bankrupt.

Economics in the Whole Foods merger case

Last week, a federal judge refused to grant a preliminary injunction against the Whole Foods acquisition of Wild Oats (FTC website; testimony: day1 am, day1 pm, day2 am). He ruled that "premium, natural and organic supermarkets" was a not a "relevant product market." A relevant market is one in which a hypothetical, multi-store monopolist, owning all stores in the category (and eliminating competition among them), would raise price.

In his decision, the Judge cited a break-even analysis (sometimes called "critical loss") that asks how much quantity a monopolist could afford to lose and still want to raise price. With retail margins of 40% (FTC complaint, p.21), a 5% price increase would require a quantity loss of no more than 11.1% to be profitable [11.1%=5%/(5%+40%)]. Citing marketing studies showing that customers shopped at Whole Foods as well as other grocery stores, former FTC Chief Economist and colleague David Scheffman argued that the actual quantity lost would be greater than 11.1%, presumably to stores outside the category.

University of Chicago economist Kevin Murphy criticized the break-even analysis by focusing on the incentive of the merged firm to raise price. From my favorite textbook,

When you price commonly owned products, ... your concern changes from earning profit on an individual product to earning profit on both products ... Aggregate demand for a group of substitute goods is less elastic than the individual demand for the goods that comprise the group. And with a less elastic aggregate demand, the merged firm wants to raise price.

The closer substitutes the two stores are, the bigger incentive the merged has to raise price (Murphy rebuttal report).

The heavily redacted court documents refer to entry "experiments" to determine the degree of substitution between the two merging stores. We found the following on the Whole Foods website,

If we [close the Wild Oats Store right across the street], we believe approximately 50% of the volume their store does will transfer to our store, with the other 50% migrating to our other competitors (these estimates are based on our past experience with similar situations).

It is hard to believe that the diversion ratio is this big. But even at half the size, simple models of competition would predict a big enough post-merger price increase to put the two stores into a relevant market by themselves.

Did mergers cause the fall of the Roman Empire?

I just finished listening to a book on tape, "How the Irish Saved Civilization" by Thomas Cahill, which describes the fall of the Roman Empire (about 400AD) and the subsequent rise of Ireland as St. Patrick brought Christianity to the island. Cahill claims that Ireland was the first place to embrace Christianity without bloodshed.

Cahill's description of the fall of the Roman Empire is nuanced but cohesive. Here is my economist take on what he said. As the Roman Republic turned into a corrupt Empire, politically connected citizens were able to avoid taxes. For middle class landowners who could not avoid taxes, it was more profitable to sell land to those who could (lords) and become sharecroppers (vassals) instead.

Without taxes to support the army, the Empire fell to the barbarian hordes who crossed the Rhine and Danube rivers. The fiefdoms filled the power vacuum.

I will pass on my copy of the book on tape to the first person who posts a comment.

In Defense of Smoking

One of the beauties of becoming more educated is developing an ability to defend what otherwise appears to be totally stupid behavior. Think of those poor dopes standing outside in the searing heat or huddled under an inadequate shelter during a pelting rain sucking down a nicotine fix. How could anybody be dumb enough to engage in such behavior? I mean they tell you right on the product itself that it's likely to do damage.

Well, it's quite possible that these people have engaged in a rational decision to smoke. First of all, a lot of the warnings don't even apply. Why do I care that "Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, And Low Birth Weight"? I'm not going to be popping any kids out anytime soon. So I can already start to discount the negative effects. Second, it's not like I'm definitely going to get cancer; smoking only makes it more likely. Sounds like we need to do some sort of expected value calculation. Finally, we need to consider discount rates. Perhaps people who smoke simply have very high discount rates. They value the pleasure of smoking today very highly and heavily discount the negatives they will encounter in the future. How much fun am I really going to be having during that 89th, 90th, and 91st year of my life that I might gain from quitting? Compare that to how cool and relaxed I feel today with that smoke delicately tickling my alveoli.

Apparently, government is catching on to the fact that warnings like the one above may not be as effective as they had hoped. In the United Kingdom, you can get a nice picture of a diseased lung (BBC story) with your pack of smokes. The Netherlands has another approach to affecting men's discount rates. They warn that "Roken veroorzaakt impotentie" (Smoking causes impotence).

Agents vs. principals: the strange case of Dartmouth

The purpose of corporate governance is to control the incentive conflict between principals (shareholders) and their agents (managers): principals monitor agent behavior to make sure that agents are acting in the principals' best interests.

In non-profit universities, the Board of Trustees (the principals) typically exert less control over agents (administrators and faculty) which allows agents to follow their own goals ("shirk") rather than those of the principals.

Dartmouth is unusual in that its board has recently become more actively involved in exercising control over faculty and administration. The board has prevented the administration and faculty from implementing a speech code, and from moving away from the college's historical focus on undergraduate education (faculty want more graduate students) (article). Predictably, alumni giving has increased.

But if the alumni feel better about the school, the faculty and administration do not. ACTA, a good governance group, warned that the current President is trying to change the governance structure to make it more difficult for the board to exert control,

On the basis of our review of Dartmouth’s current practices, we believe both trustees and alumni should be concerned by the President’s deep involvement in the Governance Review—and, more generally, in his selecting those who are responsible for reviewing his performance.

Credit Hazards

Let's say I am starting a new business and want to borrow some money from my friendly, neighborhood banker to finance some of my assets. Leaving aside the issue that it's probably unlikely that I will be able to borrow any money unless I have sufficient personal assets to guarantee the loan, what are some of the likely terms of the loan agreement?

Well, I can almost guarantee that the contract is going to be loaded with 1) restrictions on what I can actually do with the money and 2) enumerations of a long list of the bank's rights to monitor my behavior. These are called "covenants" (promises that you make to Mr. or Ms. Friendly Banker that he or she can live inside your shorts with you until you pay the money back).

Covenants are designed to help solve the moral hazard problem; borrowers have an incentive to change their behavior after receiving a loan to engage in more risky behavior. Banks insist on covenants in loan agreements in an attempt to monitor and prevent this type of behavior.

What happens when banks starting easing off on covenants? Daniel Gross argues, in a recent Newsweek column, that "covenant-lite" loans are at least partially responsible for some of the recent troubles with the popping credit bubble.

As risk increases, spreads widen

In October 2006, I attended a talk by Vanderbilt Treasurer Bill Spitz showing that risk premia (the extra return you receive for investing in risky assets) were very small. The differences between returns on stocks vs. bonds, low vs. high quality stocks (low debt, high and stable profit margins), and emerging market debt vs. US debt were at all time lows.

Small spreads between risky and less risky assets mean either that the world had gotten less risky, or that investors were ignoring risk in search of higher returns. Spitz thought it was the latter which motivated his investment advice:

• Avoid Riskier assets
  
• Stick with quality
• Be skeptical of the rush to alternatives
• Moderate return expectations
  
• Borrow now if you are a marginal credit
  

Well it looks like the risk has returned, or that investors are no longer ignoring it. The Volatility Index (invented by colleague Bob Whaley) which measures the implicit risk in options prices (the higher the options price, the bigger implied risk) has doubled since Spitz's talk a year ago. The expected annual change in stock prices is now 23%.


As this risk is recognized by investors and "priced" by the market, one would expect spreads to widen. For example, the spread between jumbo loans (bigger and therefore more risky) and "conforming" home loans has jumped by about 100 basis points (1%) in the last two weeks (article).

How many of us would have been able to foresee these changes a year ago? And what advice would you give now?

DVD war drags on

In an earlier post, I asked whether the European Union antitrust investigation would turn the standards war between Blu-Ray and HD DVD into a quagmire. The Economist reports that DreamWorks Animation and Paramount Pictures have switched sides--all their future high-definition titles will be released solely in the HD DVD format.

Paramount was rumoured to have received $50m and DreamWorks $100m for making the switch. ... The defection certainly levels the playing field in terms of titles released exclusively in one format or the other. In doing so, however, the confusion that’s prevailed in the marketplace—with mainstream customers staying on the sidelines until a winner emerges, or both get overtaken by events—is now set to continue for several more years.

The payments suggest that an auction between the two formats might be an efficient way out of the quagmire.

Corporate Social Responsibility: Whole Foods vs. Cypress Semiconducter

My colleague Mark Cohen pointed me to an interesting debate on Corporate Social Responsibility in REASON Magazine ("Free minds and Free Markets") between three libertarians: Whole Foods CEO John Mackay, Milton Friedman, and Cypress Seminconductor's TJ Rogers, who makes an appearance in John Stossel's intriguing "Greed" video.

Professor Friedman's classic argument is that since shareholders can contribute to charity if they want, the corporation should return as much money as possible to shareholders to let them pursue their own goals. Indeed, Mr. Rogers' employees can afford to be altruistic, partly because they have jobs at Cypress:

My company, Cypress Semiconductor, has won the trophy for the Second Harvest Food Bank competition for the most food donated per employee in Silicon Valley for the last 13 consecutive years (1 million pounds of food in 2004).

Mr. Rodgers goes on to criticize Whole Foods for donating 5% of its profit to charity by arguuing that corporations add far more to society by maximizing "long-term shareholder value" than they do by donating time and money to charity. Mr. Mackay responds by turning the usual principal-agent relationship between shareholders and managers on its head:

I believe the entrepreneurs, not the current investors in a company's stock, have the right and responsibility to define the purpose of the company. ... At Whole Foods we "hired" our original investors. They didn't hire us. .... We first announced that we would donate 5 percent of the company's net profits to philanthropy when we drafted our mission statement, back in 1985.

The most interesting, and paradoxical, argument comes from Mr. Mackay who says that one cannot maximize profit by trying to maximize profit:

...we have not achieved our tremendous increase in shareholder value by making shareholder value the primary purpose of our business. ... In the profit-centered business, customer happiness is merely a means to an end: maximizing profits. In the customer-centered business, customer happiness is an end in itself, and will be pursued with greater interest, passion, and empathy than the profit-centered business is capable of.

Blood Money

Why do crime scene cleaners make so much money? According to this article from CNN Money.com, these workers can make up to six figure salaries despite the fact that there are no difficult educational and experiential requirements.

This type of job includes what economists call a "compensating wage differential." In equilibrium, wage differences are a reflection of differences in the attractiveness of jobs. Cleaning up blood, guts, and gore is not a particularly pleasant task for the majority of the population, so crime scene cleaners receive a premium.

Interested in making a better salary than those who have similar education and skills? Pick a nasty job that no one else wants to do. Here is a Business Week article about the worst jobs with the best pay.

Business memos without all of the thinking

To proactively manage profit, our key initiative objective pushes the envelope toward systematized reciprocal capability.

Enabling continuity, enterprise optimization accelerates the movement towards third-generation contingencies.

To automatically generate sentences like these, try Mike Shor's MBA Writer, constructed using phrases from real memos.

CONTEST ANNOUNCEMENT: "Worst abuse of the English language in a business memo." Submit by commenting to this post. Prize to be determined.

Business Bureaucratese

Our analysis showed that significant cost savings could be realized by incenting your project managers to realize additional cost cutting initiatives.

I don't know what it is about MBA students that makes them write in a style that no one wants to read. This sentence on their first homework assignment inspired me to assign Fred Kahn's classic "My War Against Bureaucratese," the gobbledygook written by government bureaucrats designed to hide what they are really doing.

Professor Kahn began this war as part of his succesful effort to deregulate the airline industry. He is the hero of Thomas McCraw's Pulitzer Prize Winning book Prophets of Regulation. Interestingly, the villain of the book is Louis Brandeis for his role in creating the FTC. From a review of the book:

Brandeis…became bogged down between the constraints of his own ill-considered anti-big business ideology, his lack of understanding regarding the economic properties of industrial structure and behavior, and his reliance on the efficacy of due process legal procedures.… The ultimate result of Brandeis’s involvement was a regulatory process ripe for decay…

Be Afraid; Be Very Afraid

Economists have taken a lot of flak for supposedly imbuing students with a more cynical attitude, which somehow is supposed to be linked to the rising (?) instances of unethical and illegal behavior in corporations (see, for example, this article from a few years ago in the Washington Post).

So, what's the latest solution offered by business schools to help make students more ethical? Well, Illinois State University has instituted a dress code for its students requiring them to come to class in business casual dress. This step was taken at least in part, according to one school official, because "colleges felt pressure from corporations, which wanted to know how students were being prepared for the moral responsibilities awaiting them after graduation."

Why don't we stop here to give you a chance to go back and read that last sentence again? I have read it a bunch of times and still can't believe someone actually said that.

I am not sure I see the link between wearing Dockers instead of shorts to class and becoming a more moral or ethical individual. If you want people to behave a certain way, perhaps it would be better to look at their incentives to engage in that behavior rather than expecting revolution via khaki pants.

It's Good to Be in Demand

A July 29 New York Times article reports that many state universities have begun to charge higher tuition rates for certain majors like engineering and business. One factor mentioned by university officials in driving the increases is “ high salaries commanded by professors in certain fields.” The article quotes G. Dan Parker III, the associate executive vice president of Texas A&M. Mr. Parker said, “The salaries we pay for entering assistant [business] professors on average is probably larger than the average salary for full professors at the university. That’s how far the pendulum has swung at the business schools, and I sure wish they’d fix it.”

I am not sure who Mr. Parker thinks “they” are, but using some simple demand and supply curves can give us an idea. As shown in the adjacent graph analyzing the market for business professors in the United States over the past few years, rising pay for business professors is consistent with an increase in demand for business professors. What would then cause salaries to fall? Salaries will decrease when one of two things happens: when demand falls or when supply increases.

“They” in this case is him, Mr. Parker. Universities demand the services of business professors. So, people like Mr. Parker (although I must confess I don’t exactly know what an associate executive vice president does – I think this breaks the rule for the number of adjectives that should be placed in front of a noun) can either decrease their demand (unlikely to be a wise choice given that student demand for business education does not appear to be decreasing markedly) or they can work to increase the supply by producing more business professors. I don’t see any other “theys” out there who are going to fix the problem.

Aahh – the power of simple supply and demand analysis.

Six Big Ideas from Finance

My colleague Bill Christie just delivered a lecture entitled Six Big Ideas from Finance to our executive MBA's. Here they are

1. Discounted cash flow and Net Present Value
2. Portfolio Theory and Diversification
3. Capital Asset Pricing Model
4. Efficient Capital Markets
5. Modigliani-Miller Theorem
6. Options Pricing, e.g., Black-Scholes

Why is it so hard to pull the plug?

MBA students seem intent on building, creating, and rescuuing businesses. Even when it is the most obvious solution, they resist pulling the plug on a venture.

McKinsey has a chart summarizing the cognitive biases that make it so hard for us to shut down, exit, or divest a business unit.

When entry raises price

In simple economic models, entry by a substitute product increases the elasticity of demand for existing products, which results in a decrease in price. For example, the FTC complaint against the Whole Foods/Wild Oats grocery store merger used this logic to conclude that the merging stores are close substitutes for one another:

Entry by Whole Foods into a local market where Wild Oats currently operates causes Wild Oats sales to fall by roughtly 37%, margins to fall by 1-3%, and prices to fall by 1-2%.

This got me to thinking about the obverse question, "Does entry by a substitute product ever raise price?" I came up with two examples, pharmaceuticals and Las Vegas hotel/casinos. When a branded drug faces entry by a generic copy, it will stop promoting the brand (as that increases demand for the generic), and raise price. The brand loses its low-value (and more price-elastic) customers to the generic so that branded demand becomes less elastic. The brand responds by raising price.

The hotel entry result works through a different mechanism. When a new hotel/casino opens up in Las Vegas, it makes the Las Vegas a more attractive destination, particularly for conventions. The increase in demand for Las Vegas as a destination more than offsets the decline in demand for consumers who, once they get to Las Vegas, have more choices from which to choose.

P&G acquiring superbrands, selling "tired" ones

P&G, the biggest consumer goods company in the world, (sales of $76.5 billion), is acquiring "superbrands," like Gillette and Clairol, while selling off "tired" brands, like Sunny Delight, Jif, Crisco, Pert Plus, and Sure.

The Economist (article) reports that the superbrands are being acquired to allow the company take advantage of economies in purchasing (foodstuffs, packaging, chemicals and energy), and to improve its bargaining position with Wal-Mart, the world's largest retailer.

I suspect that the superbrands are being acquired so that P&G can plug them into its innovative supply chain. Not only does it allow P&G to get product to retailers more quickly and efficiently, sophisticated software tools allow retailers to better track customer behavior so that it knows how best to sell P&G's products (article). P&G's supply chain makes the superbrands more valuable to P&G than to current owners.

As more manufacturers develop supply chains that can capture and use information about consumers and their purchasing behavior, data aggregators like IRI and Nielsen becomes less important. Wal Mart has since dropped out of these data collection networks, so that market share data, like those we reported earlier on baby food, have to be interpreted carefully.

Also notable is that P&G has begun outsourcing its innovation activity. It has 75 "technology scouts" that travel the globe looking for new ideas ("R") that it can develop ("D").

Stock price reaction to these changes has been tepid.

Evaluating Investments: Theory and Practice

Let’s say you or your company is deciding whether to make some sort of new investment. How do you go about deciding whether it makes sense? The typical advice from economics / finance professors is to perform some sort of net present value (NPV) analysis. Project all of the proposed cash flows from the project, properly discount future cash flows to reflect the fact that a dollar received in the future is worth less than a dollar received today, and calculate the net. If the NPV is positive, you’ve got yourself a good investment. Live long and prosper.

Despite the masses of MBAs bludgeoned with the importance of NPV analysis over the years, other techniques remain in practice. In a very interesting paper that appeared in the Journal of Financial Economics, two Duke professors examined how real CFOs make decisions and found that over half of surveyed CFOs used the payback period as a technique to evaluate projects. Interesting because, as any first year MBA who has completed core Finance can tell you, the payback period technique can lead to incorrect decisions.

Theory sure is nice, but practice is often very different.

[I should add a few caveats related to NPV analysis. First, it’s not entirely clear what discount rate you should use – the standard story from finance is to use your weighted average cost of capital, but not everyone agrees on how this should be calculated. Second, real options theory would argue that simple NPV analysis misses some critical values flowing from the option nature of projects.]

Teaching Econ: abstract professors vs. concrete students

Robert Frank has an article in the NY Times on why econ professors do such a lousy job of teaching. He concludes that we simply don't know the subject ourselves. As evidence he cites research showing that most new econ PhD's flunked a simple quiz, reproduced at the bottom of this post. He recommends giving simple puzzles to students to work out on their own, like "Why do soda vending machines dispense one can at a time, while newspaper vending machines allow you to take as many newspapers as you like?" [ANSWER BELOW].

I have an alternate hypothesis, that the problem is instead caused by the general mismatch between how professors and their students think and learn (article). The solution is to tie the theory much more closely to applications. This conveniently, and shamelessly, brings me to the point of suggesting an alternate solution:

A user's manual for applying economics to the real world!!, July 19, 2007

By	TerryJ (Atlanta, GA) - See all my reviews

When I picked up this book, I thought I was going to read yet another theoretical, ivory tower text on the finer points of micro economics. In stead, I read a relevant, well written, at times amusing text on how to apply economic principles to real business problems.

I particularly found interesting the real-world examples throughout the book. This is a must have for any MBA student, business leader, or someone trying to get ahead in the management world.

----ANSWER TO VENDING MACHINE QUESTION-----
The marginal utility of another newspaper is zero. The marginal utility of another soft drink is positive.

----CAN YOU RECOGNIZE AN OPPORTUNITY COST?--

QUIZ from Ferraro and Taylor:

Select the Best Answer to the Following Question:

You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton?

A. $0
B. $10
C. $40
D. $50

Have an answer? Now try this one:

Select the Best Answer to the Following Question:You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert?

A. $0
B. $10
C. $40
D. $50

Have an answer? Scroll down.

The answer to both is (of course?) B.

A study polled PhD economists and found that only 22% got the first right, and about 40% got the second right. Year of degree, quality of school, etc., were insignificant in explaining this. Only significant finding was that micro theorists were better than all other groups, and macroeconomists were indistinguishable from undergraduates who NEVER took an econ course!

Humor

Soliciting contributions.

1. Video: the growing gap between rich and super-rich
2. Stephen Colbert on the history of AT&T
3. The standup economist on 10 principles of economics
4. Memos without all the thinking, MBAwriter
5. Satire: the subprime primer
6. Eliot Spitzer's new political ad from Late Night with Conan O'Brien
   
7. Job market in 2010
8. Anonymous philanthropist donates 200 human kidneys to hospital
9. Onion News Network: Historic video rentailing outlet
   

In praise of irrational politicians

James Buchanan won the Nobel prize for discovering that politicians are like everyone else--they respond to incentives. He found that he could explain a lot of their voting bahavior using the rational actor paradigm (rational, self interested, optimal behavior).

After his party took control of Congress, I would have expected my own Congressman, Jim Cooper, to start handing out favors to constituents in exchange for campaign contributions. Instead, he is acting...irrationally. And I am delighted. He is making it harder for his colleagues to spend our money on their pet projects.

PORKBUSTERS UPDATE: The Club for Growth has put up a Congressional Pork Scorecard tracking members' votes on all 50 anti-pork amendments that have been presented.

Highlights:

* Sixteen congressmen scored a perfect 100%, voting for all 50 anti-pork amendments. They are all Republicans.

* The average Republican score was 43%. The average Democratic score was 2%.

* The average score for appropriators was 4%. The average score for non-appropriators was 25%.

* Kudos to Rep. Jim Cooper (D-TN) who scored an admirable 98%-the only Democrat to score above 20%.

* Rep. David Obey (D-WI) did not vote for his own amendment to strike all earmarks in the Labor-HHS appropriations bill. Rep. Obey scored an embarrassing 0% overall.

* 105 congressmen scored an embarrassing 0%, voting against every single amendment. The Pork Hall of Shame includes 81 Democrats and 24 Republicans.

* The Democratic Freshmen scored an abysmal average score of 2%. Their Republican counterparts scored an average score of 78%.

A far bigger problem with the politicians' incentives is that old people vote in greater proportions than young people. This creates incentives for politicians to delay addressing our entitlement problem, likely the most pressing issue of our children's generation. Fortunately, however, our irrational Jim Cooper has been the driving force behind the adoption of accrual accounting by the US government, so we can see how badly we are screwing our kids. Each working family would have to come up with about $400,000 in today's dollars to pay off the Medicare and Social Security promises our politicians have made to old people. Before this bill comes due, teach your kids to speak Danish so they can move to a country that has addressed its entitlement problem.

Only 25% of voters approve of the job that Congress is doing--I say lets hunt down the 25% and exile them as they are obviously part of the problem.

Why Economics Isn't Totally Useless

A previous post discussed how government regulation can be an escape from the prisoners' dilemma. A comment to that post noted that the regulation came at the expense of consumers and/or the local taxpayers. This highlights the different viewpoints of economists and business people. I put myself more in the business than the economics camp, and my initial reaction to the comment was "OK, but I care about my profit not at whose expense that profit comes."

For those of you who haven't sat through a number of economics classes (should I admire you or pity you?), economists spend an awful lot of time worried about concepts like "efficiency" and "social welfare." Taking these classes with a business viewpoint, my thought was "why should I care about social welfare?" I care about making money, regardless of whether it increases or decreases social welfare. Here's a contrast: say you could find a way to become a monopoly producer. Economist say monopoly bad; business person say monopoly good.

So, why don't I think economics is totally useless for business people? Because if you understand how to increase social welfare, you also understand how to reduce it. If you understand how to identify assets not being used in their highest-valued use (inefficiency), you can probably figure out a way to make some money by moving that asset to a better use. Michael Porter of Harvard Business School got famous by taking tools from industrial organization economics and turning them on their head to advise businesses how to create strategies for competitive advantage. Economics provides very useful tools - how you choose to use those tools is up to you.

What happened after the FTC blocked the Heinz/Beech-Nut merger?

In 2000, the FTC challenged a merger between and Beech-Nut and Heinz, the second- and third-largest sellers of baby food in the US, but still much smaller than market leader Gerber. At issue in the case were the synergy claims of the merging parties (Heinz had a new factory; Beech-Nut had good brands) against the potential loss in competition. While Heinz and Beech-Nut rarely appeared together on the shelf of any given supermarket, supermarkets typically carried Gerber and one other brand, and there was competition between the two to be the other brand on the shelf.

It is harder to follow up on mergers that were challenged by the FTC because figuring out what would have happened had they been allowed to merge is much more difficult. This creates a kind of asymetry in that we can potentially catch anticompetitive mergers that were not challenged; but not pro-competitive mergers that were challenged. In the table below, we see that after their proposed merger was blocked, Heinz and Beech-Nut lost share to market leader Gerber. Since we do not know what would have happened had they been allowed to merge, it is difficult to evaluate the FTC's decision.

US Baby Food Market Shares
Firm	2000	2003	2006
Gerber	73	80	81
Beech-Nut	13	10	11
Heinz (Del Monte after 2002)	11	7	4

In 2002, Heinz exited the industry by selling its baby food brands to Del Monte. In 2006, Beech-Nut was sold to Hero AG, a Swiss firm.

Will this standards war become a quagmire?

Standards benefit consumers by encouraging coordination among producers of complementary products. But what happens when there are competing standards, like Blu-ray and HD DVD? This can be modeled as a coordination game with two equilibria where each format is trying to "steer" the game towards its preferred equilibrium.

Because of uncertainty about which format will eventually "win" the standards war, consumers are waiting to see what happens. On the Tennessean website, one reader commented "Anyone remember the Betamax? I do...never again! I'm going to wait and see who wins this battle."

So how do you win a standards war? While both formats are cutting price, they also seem to be competing for the exclusive support of content providers. For example, Spiderman 3 is available only in Blu-ray, and The Bourne Ultimatum is available only in HD DVD. Complementary service providers Target and Blockbuster have also committed to the Blu-ray standard. (See Carl Shapiro and Hal Varian on Waging a Standards War in Information Rules, HBS Press, 1998).

The European Commission has opened an antitrust investigation into whether Blu-ray "improperly" induced studios to release content exclusively in its format. HD DVD is thought to be lobbying the Commission to force movie studies to release content in both formats (article).

While this solution would benefit consumers who have already purchased a player, it may also turn the standards war into a quagmire (with no clear victor), which would hurt those who are waiting to purchase.

All this assumes that one standard will eventually emerge as the winner. But this may not be a winner-take-all war. Warner has developed a dual-format disc and said it would license the technology to other studios willing to back both formats.

Do organizations "test" the decisions they make?

When his firm decided to introduce a Christmas menu into their restaurant chain, one of my students decided to test the profitability of the change by introducing it in only half the restaurants in his territory. By comparing sales changes at these restaurants (the "experimental group") to changes at restaurants that did not introduce the menu (the "control group"), he concluded that the change did little to increase overall sales, despite the apparent popularity of the menu.

This inference was possible only because my student constructed what economists call a difference-in-difference estimate of the change. The first difference is before vs. after introduction of the menu; the second difference is between the experimental and control groups.

The difference-in-difference methodology controls for other unobserved factors that might have accounted for the change. The FTC has released a number of studies following up on merger enforcement decisions to try to figure out whether they did the right thing. For two consumated oil mergers, FTC economists Dan Hosken and Chris Taylor (article) and John Simpson and Chris Taylor (article) found that prices in cities affected by the merger did not increase relative to prices in control cities. In the time series graph below, the three lines represent gas prices of the experimental city (Louisville) relative to gas prices in three control cities (Chicago; Houston; Arlington, VA) for the Marathon Ashland gasoline merger. The vertical line represents the date of the merger. By comparing prices before and after the merger, we see the merger had no effect, or that the FTC was correct to let it through without a challenge.
FTC General Counsel (now Commissioner) Bill Kovacic coined the term "Enforcement R&D" to describe the practice of government agencies following up on their decisions to improve policy (article).

I would like to hear stories from readers about how, or if, their organizations test decisions.

Rolling Chair Prisoners' Dilemma

The Academy of Management conference I just attended was held in Philadelphia. Knowing how important it is for a researcher to be familiar with statistics and probability, I felt it would be irresponsible of me not to take advantage of the opportunity for an in-depth study at the casinos of Atlantic City located just an hour away.

One of the more unique aspects of Atlantic City is the availability of rolling chairs to transport you along the boardwalk (see a picture of a rolling chair here). I expected the price of transportation to be relatively low - it doesn't seem like it would be that hard to get into the business (low barriers to entry in econ-speak). Just buy a couple of chairs and hire some strapping young lads to push them. I expected the operators would be caught in a classic prisoner's dilemma in which the operators continue to undercut each other's prices until economic profit is driven down to marginal cost (economist's hallowed equilibrium). Instead, prices seemed relatively high, although I have no idea of the costs of rolling chair operation, so I can't really comment on whether prices are at a profitable level.

What's the solution to the prisoner's dilemma in this case? Government regulation. The city of Atlantic City regulates both the number of rolling chairs and the prices that they charge. So here's one case where regulation might actually benefit business - it can be one way to escape the prisoner's dilemma.

And, for those of you who might be interested, the casinos gave me a hard lesson in statistics and probability during our visit. Did someone say business expense?

Breadstick Blunder?

Yesterday, we were driving home from the Academy of Management conference and decided to stop for a quick bite to eat at Fazoli's. For those of who don't recognize the name, it's a fast-food restaurant offering Italian food. One feature the company has been well-known for is its free breadsticks, with a server wandering around the restaurant offering more breadsticks throughout your meal.

Well, apparently, the company is trying to rein in the breadstick bonanza. The location where we stopped now charges an extra twenty-five cents for "endless breadsticks" throughout your meal. This decision sounds like it was made by someone well trained in standard economic principles - with rising costs, this move will help them recoup some costs while avoiding an across-the-board price increase. Only those who value the extra breadsticks will have to pay. Perfect solution, right?

Well, based on the reaction of the geriatric gourmand in line in front of me, maybe not. This gluttonous granny was outraged that she had to cough up a quarter each for her and hubby to have their free bounty of breadsticks.

Not a surprising reaction to those familiar with prospect theory, an alternative to the standard expected utility theory found in most economics textbooks. How something is "framed" matters a great deal in how people react. Granny now has to lose twenty-five cents to get the right to gorge on as many breadsticks as her dentures can plow through. Prospect theory tells us that people "feel" losses more than they feel gains. So this loss frame will have a powerfule negative effect. Fazoli's may have been better off just raising all of their meal prices by a quarter and then offering a twenty-five cent discount for those who forgo the rights to the extra breadsticks.

Google, making the rules so its rivals won't

It seems as if Google CEO Eric Schmidt has been reading Richard Shell's Make the Rules or Your Rival's Will, a book of colorful stories about how firms like MSFT, Intel, and CBS have used the legal and regulatory process to further their own competitive strategies.

Google wants the FCC to mandate access rules that would turn the newly auctioned spectrum into a "third broadband pipe" (in addition to cable and DSL) that would allow Google to offer content and advertising to mobile users (article1, article2, article3). Preston McAfee in his Competitive Solutions: The Strategists Toolkit, calls this the "sixth" competitive force--the one that Michael Porter forgot--competition from complements.

The problem, of course, is that restricting use of the spectrum reduces what other firms, like Verizon (position paper) and at&t, are willing to pay for it. To counter this argument, Google has offered to bid $4.6 billion for the spectrum should the FCC madndate its version of "open access" licensing. Restrictions may also reduce the incentive to invest in innovative uses of spectrum.

Watch the stock price reactions to major FCC announcements to see who is winning this war.

From time to time, the FTC or US Department of Justice weighs in on these legislative and regulatory battles when they think consumers are being harmed. See James Cooper, Paul Pautler, and Todd Zywicki for a history of competition advocacy at the FTC.

Will negotiating teams from the same firm compete against one another?

The FTC ruled that a merger between two hospitals in Evanston reduced competition and raised prices to managed care organizations (MCO's). To see how such a merger could affect price, consult your favorite managerial economics textbook:

Suppose a managed care organization (MCO) ... puts together a network of hospitals to serve its client base. The MCO bargains with individual hospitals over whether to include them in the network and what price they’ll charge if included in the network. To get better prices, the MCO threatens to exclude one hospital in favor of a nearby substitute hospital. But if the two hospitals merge and bargain together, [the MCO's can no longer play the hospitals off against each other]. [1]

The interesting part of the FTC decision from a management point of view is the remedy requiring that the merged hospital establish separate and independent contract negotiating teams – one for each hospital – that will allow managed care organizations to negotiate separately with each hospital.

The remedy is designed to create a deliberate incentive conflict between the two negotiating teams. If insurers are able to play the two teams off against each other, then competition will be restored to pre-merger levels.
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[1] See Werden, Gregory and Luke Froeb, Unilateral Competitive Effects of Horizontal Mergers II: Auctions and Bargaining, Issues in Competition Law and Policy, W. Dale Collins (ed.), ABA Section of Antitrust Law, SSRN.

Compensating fund managers

Currently there is a debate in Congress about how to tax the compensation earned by private equity and hedge fund managers who are compensated using a "2 and 20" formula: 2 percent of the funds under management (taxed as ordinary income, i.e., at a 35% rate); and 20 percent of the profit (taxed at a 15% capital gains rate), referred to as "carried interest."

Testimony by Peter Orszag at CBO lays out the basic alternatives and tells the recent history of the industry. Reading between the lines, Dr. Orszag seems to favor the following alternative:

...one can think of carried interest as an interest-free nonrecourse loan from the limited partners to the general partner equal to 20 percent of the partnership assets, with the requirement that the loan proceeds be reinvested in the fund. ... To see how this example works, imagine a fund worth $100 million. With no direct capital investment, the carried interest entitles the general partner to the profits on $20 million (20 percent of the profits on $100 million is equivalent to the full profits on $20 million). It is therefore as if the limited partners have contributed $80 million to the fund and then lent the general partner $20 million to invest in the fund too, but without charging the general partner interest on that loan.

This implicit loan perspective would result in treating carried interest somewhere between purely capital income and purely ordinary income... this perspective would suggest that the component of carried interest attributable to implicit interest on the implied loan would be ordinary income and that the returns in excess of that implicit interest would be capital income

What interests me is whether this compensation scheme aligns the incentives of fund managers (general partners) with the goals of the fund purchasers (limited partners). And why has the industry standardized on this compensation scheme? A friend of mine raised $15 million for a "fund of funds," which he invests in other funds, and is charging "1 and 10" instead of "2 and 20."

I would like to hear some stories about how well (or poorly) this compensation scheme works to align the incentives of fund managers with the profitability goals of fund owners.

PO'd at Price Discrimination

So, I am getting ready to head to the annual conference of the Academy of Management today in Philadelphia (yes, I know you wish you could go too, but make sure to check your local news for all of the exciting highlights). I can feel myself already getting irritated. Why? Not because of anything specific to the conference but rather the experience I am sure awaits me at the hotel.

We are staying at a somewhat upscale hotel for location convenience. Amazingly to me, I know the bums are going to want to charge me extra for a wireless internet connection despite the fact that they are already soaking me for the room. Normally this wouldn't bother me - I don't necessarily mind paying for services that I value. But, what kills me is that as I drive to the conference, I will pass bunches of Super 8's and Days Inns all with big signs saying "Free Internet Access." I am paying more to get less.

Somehow, I know this makes sense to the economists. Here is Steven Landsburg's take although he really doesn't address the high-end vs. low-end comparison directly. This is another instance where price discrimination may be backfiring with its irritation to consumers.

How about it, readers? What are other price discrimination tactics that drive you mad?

Gain bargaining power by reducing capacity

To gain bargaining power, some firms reduce capacity to increase competition among their suppliers. For example, health insurers restrict the number of drugs on their formularies or the number of hospitals in their network to to increase competition among health care providers to get onto the formulary or into the network. Similarly, grocery stores limit shelf space to extract bigger payments from the brands they do carry; and airports limit the availability of gates or runways to encourage competition among airlines for gates or landing slots.

Theory tells us that one excluded supplier allows a firm to extract all the bargaining surplus from its suppliers, but recent research by Mike Shor testing this proposition found that firms have to exclude at least 30% of their suppliers to maximize profitability.

Since this result comes from bargaining experiments (using MBA's and the executives of two big companies), I would like to hear from readers if this corresponds with their experience.

Compliance with SOX just got easier

Laws passed in response to crises are almost always over-reaching and Sarbanes-Oxley is no exception (Economist article). Since the law was passed, foreign firms are less likely to list in US markets, small public US firms are much more likely to go private, and there has been a big increase in demand for auditors, e.g., Vanderbilt's new program.

However, with enough subsequent study, a flexible regulatory mechanism, and the short attention span of the US electorate, reform usually occurs. In this case, the SEC just announced changes in the auditing rules for implementing Sarbanes-Oxley, making it much less costly to comply, especially for smaller firms.

I want to hear stories about SOX compliance and opinions about whether it will get better. My accounting colleagues at Vanderbilt tell me that it "depends on the plaintiff's bar."

Is less information better?

How much money do companies spend on public relations, trying to "communicate" with stockholders and analysts? Hank Greenberg has an interesting column on some that don't. He describes Seattle logistical-services provider Expeditors International (EXPD) as being in "a class by themselves":

Rather than hold conference calls, it solicits questions from shareholders in its earnings reports and periodically answers "selected inquiries" in 8-K SEC filings with little tolerance for what it considers stupid or obtuse questions. ...

...A few 8-Ks later someone who claimed to have been a securities analyst for 44 years, complained about the response: "If I had been one of the inquirers and read your wise-ass response to me, I would be quite offended. Contemplate cleaning up the inappropriate stand-up comedy act: it ain't funny."

The company shot back: "Truth is that we have never set out to be like the many thousands of other companies out there ... If you don't like what we have written, and certainly some do not, then don't bother to read it. If you are really worked up, please stop thinking about investing in our stock."

Its current 8-K filing mocks the first questioner with a grammar lesson.

So why is this an apparently successful tactic for Expeditors (which has somewhat of a cult like following); and should other companies emulate it?