Price Discrimination in Action

As a quick reminder, price discrimination is the practice of charging different groups of people different prices based on differences in their willingness to pay. Want to see it in action? Try going to the web site of a major computer manufacturer that offers solutions for different groups like large businesses versus small businesses. Enter the web site twice, once through each link, and price the exact same product.

I tried this recently and got a 20% lower price on a new notebook computer when I entered through the low-value group link (small business) versus the high-value group link (large business). What I don’t quite understand is why the high-value group just doesn’t mimic the behavior of the low-value group. Maybe the manufacturer is offering other services to the high-value group that can only be accessed through the high-value group link.

FYI - I generated the quotes for a Latitude D830 from Dell's online store.

Is deception profitable?

In previous posts, we have talked about the use of testimonial advertising by fraudsters, and this raises the question of how widespread and profitable deception is. Some presidential candidates have blamed deception as a cause of the subprime lending crisis. Eugenio Miravete studies this, and finds some deception by long distance phone companies,

Imagine that you moved to Texas in the middle of the 1990s and wanted to sign up for a long distance telecommunication carrier. After fifteen minutes of answering questions about your personal details, the operator asks you which carrier you choose for long distance calls. You say “I do not care,” .... two months later, when you get your first bill, you realize that you are indeed subscribed to “I Do Not Care, Inc.” which by the way is charging astronomical rates for your long distance calls.

But consumers quickly learn about the deception and react appropriately.

...while consumers often fail to subscribe to the least expensive plan for their usage profile, these mistakes are not systematic, and subsequent plan switching is best explained as an explicit attempt to reduce monthly bills.

This leads Miravete to conclude that

Deceptive behavior is just one of many such quality characteristics – and given sufficient competition, consumers who are unhappy with this particular characteristic can choose to take their business elsewhere. So long as sufficient competition exists, there is no need to impose standards of behavior on firms or to provide step-by-step guidance to consumers in making their decisions: consumers can and will make sensible decisions for themselves.

Professor Miravete testified at the FTC's conference on behavioral economics which provides a nice summary of what we know about behavioral biases of consumers and how they should (or should not) affect policy. It also highlights the behavioral research that FTC staff economists do, leading to innovations like the prototype mortgage disclosure form.

Thanks to Joe Mulholland for the heads up.

Forbes 400 as a lesson in economics

John Tamny (former student) analyzes the Forbes 400. My favorite entries highlight the importance of managerial acumen

A constant complaint among workers at all levels is that management does a poor job. Carl Icahn (#18) agrees, and to fix the latter, he buys troubled companies in order to improve their administration, all the while agitating entrenched managers of companies he owns a percentage of to fix what's wrong or be fired. Google was mentioned earlier, and due to the foresight of venture capitalists John Doerr (#271) and Michael Moritz (#380), it had the funding to morph from a non-entity into the work-enhancing business that it is today.

And only 74 of the 400 inherited their wealth; 270 are self made.

...Min Kao (#64) and Gary Burrell (#114) for designing global-positioning systems.....Craig McCaw's (#135) cellular innovations.....Alfred Mann (#204) developed cochlear implants .....Stryker Corp. CEO John Brown (#380) makes artificial hips and limbs to help the bedridden stand.....Abraxis CEO Patrick Soon-Shiong (#117) presently has the patents for 30 different [cancer] treatments....

Hey, wanna’ make $67,000, tax-free?

Dispatch from Willy Stern, embedded journalist (Runner’s World) in Iraq with the First Cavalry Division out of Fort Hood, Texas.

She was a waitress back home in Texas without a high school diploma. She heard about well-paying jobs in Iraq from a friend. She went to the KBR (Kellogg, Brown & Root) website and filled out an application. Now she has a cushy job helping out at the fitness center at one of the U.S. Army bases outside Baghdad. KBR pays her $67,000, tax-free. She hands out towels to soldiers who stop in to pump some iron and relieve stress. These are the same soldiers who are going over the wire daily, putting themselves in harm’s way. Most of these enlisted men and women make less than $25,000.

At a marginal tax rate of 25%, $67,000 is equivalent to a before tax income of $89,333. This seems like a huge pay disparity between the skilled soldiers who put their lives at risk, and the unskilled contractors, who largely stay safely on the bases. Why does this compensating wage differential seem to have the wrong sign?

Do iPhones bring customers to AT&T?

In previous posts, we asked whether brands bring customers to stores or whether stores bring customers to brands. Now we have evidence that Apple's iPhone is bringing customers to AT&T.

One million customers bought iPhones in the first 79 days; analysts project 4.5m units sold in the first year. And because iPhones are offered exclusively through AT&T, iPhone users have to sign up for AT&T wireless. If you were being careful you would note that the 4.5m could be existing AT&T customers, but then why would AT&T pay so much for the exclusivity. Apple reputedly keeps all handset revenues and $10 a month per subscriber. Judging from the stock price reactions, Apple is getting most of the gains from trade.

Apple's market capitalisation surged $20bn on iPhone profits buzz, AT&T's shares barely budged.

Thomas Hazlett notes that this kind of exclusive contract may be illegal in Europe (exclusives, especially when offered by dominant firms, are often challenged as anticompetitive). Exclusives are also under attack in the US by the "open access" movement (Google, making the rules so its rivals won't). But exclusives are typically pro-competitive.

Apple could have offered its device as an "open" platform [to all wireless customers], but instead chose (as with iTunes, iPods and Apple computers) to control how it builds, and how buyers use, its product. It aims for competitive superiority. Quashing its model bops the innovator on the head.

Now that the SIM lock on the iPhone has been broken by a hacker so that the iPhone can be used on rival networks, will AT&T will try to renegotiate its contract with Apple? Not likely as it takes 2 hours and a soldering gun to modify the iPhone, and you lose some of its features.

Top 100 Blogs every investor should read

Good categorized list of blogs.

No economists among top pundits in America

Forbes magazine recently released its rankings of the top pundits in America. A pundit is one "who makes comments or judgments, especially in an authoritative manner; critic or commentator." So, naturally I expected to see everyone's favorite Managerial Economics professor/author/blogger high on the list - oh, the disappointment.

Who tops the list? Roger Ebert, film critic for the Chicago Sun-Times, who also has a syndicated television show featuring movie reviews (most famously in the past with Gene Siskel).

Check out the list to see whose opinions matter most in America (prepare to be frightened for the future of the country). Amazingly, no economists made the list. Perhaps that's because "likability" was one of the ratings criteria.

World index of economic freedom

The 2007 edition of the index of economic freedom is out. It measures the degree to which government rules support individual choice, voluntary exchange, freedom to compete, and security of privately owned property.

Since 1980,

• Most improved: Hungary, Peru , Uganda, Ghana, and Israel.
• Most degraded: Zimbabwe, Venezuela, and Myanmar.
• Best: Hong Kong (8.9), Singapore (8.8), New Zealand (8.5), Switzerland (8.3), Canada (8.1), United Kingdom (8.1), United States (8.1), Estonia (8.0), Australia (7.9), and Ireland (7.9).
• Worst: Zimbabwe (2.9), Myanmar (3.8), the Democratic Republic of the Congo, (4.0), Angola (4.2), the Republic of the Congo, (4.3), Central Africa Republic, (4.6), Venezuela(4.9), Burundi (5.0), Chad (5.1), and Niger (5.1)
• Others [Country, rank (score)]: Germany, 18 (7.6); Japan, 22 (7.5); Mexico, 44 (7.1); France, 52 (7.0); Italy, 52 (7.0); India, 69 (6.6); China, 86 (6.3); Brazil, 101 (6.0); and Russia, 112 (5.8).

Interestingly, I thought that Ireland would be one of the most improved. In the 1990's they slashed tax rates and their economy is now one of the richest in Europe. Even the violence has stopped because the opportunity cost of fighting is too high.

Sunk-cost fallacy in real estate

In earlier posts, we have documented the sunk-cost fallacy in the reluctance of businesses to pull the plug; and now we have its appearance in the reluctance of homeowners to sell at a loss.

Two homeowners, with identical houses, will list the houses at different prices, depending on what they paid for the house because of what psychologists call "loss aversion." Unfortunately for these loss-averse sellers, buyers don't suffer from similar delusions,

Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

If homeowners know they have this bias, why don't they buy house price insurance against a drop in value? Maybe they dont even know.

Anatomy of a tainted dog food re-call: why did price go up, then fall?

In March 2007, after the Chinese recalled tainted wet dog food, what happened? In the graph above, depicting weekly quantity and price for wet dog food sold in the US, we see that price (red) initially peaked, and then fell. Meanwhile, quantity (blue) initially fell, and then recovered to its pre-recall level. But price never returned to its pre-recall level.

A free copy of my textbook to the best explanation of these price and quantity changes in the comments below.

Making Research More Relevant

AACSB International (the premier accrediting agency for business schools) has recently released a report on the nature and purposes of business school research (full report here and 2-page press release here).

The report recommends closer ties between research and practice: "the task force recommends building stronger interactions between academic researchers and practicing managers on questions of relevance and developing new channels that make quality academic research more accessible to practice."

Of course, a key issue to address is incentive alignment - right now, professors' incentives are not particularly concerned with making research relevant to practice.

In previous posts (Irony: do business schools practice what they preach?, Incentive pay for professors), we have talked about the incentive conflict between alumni, faculty, students, administration, and the governing boards, particularly with reference to Dartmouth where this conflict has become very public (Agents vs. principals: the strange case of Dartmouth, Dartmouth governance, again). This move by AACSB seems like an attempt to control the principal-agent conflict.

Why does a Big Mac cost less in China?

In July of this year, the Economist reported that a a Big Mac cost $7.61 in Iceland, $3.41 in the United States, and only $1.45 in China. The theory of Purchasing Power Parity says that arbitrage should push these prices together. The idea is that if goods are cheaper in China, exporters are more likely to ship them to the US, or tourists are more likely to travel to China to buy them. This will increase demand for Chinese yuan, drive up the exchange rate, and raise the price (in dollars) of the Chinese Big Mac. That this does not seem to happen is one of the biggest puzzles in economics.

Not so fast says colleague David Parsley and Shang-Jin Wei. In a new paper, find that price convergence is masked by the use of different price indexes in different countries (sushi in Japan, burgers in America). Once you look at individual goods, like the Big Mac, globalization really does push international prices closer together. These price diffrences will tend to disappear.

What this means is that the Economists "Big Mac Index" (explanation, video) can tell you which currencies are over-valued (Iceland), or undervalued (China) relative to the dollar. It seems as if economists are just finding out what currency traders knew all along.

Securitisation and its hidden costs

In an earlier post, we asked whether banks were organized to recognize risk. Now we have an article from the Economist about the role that “securitisation”—the process that transforms mortgages, credit-card receivables and other financial assets into marketable securities—played in the functional separation of loan origination from loan servicing.

Until the early 1980s, finance hewed to an “originate and hold” model. Banks generally held loans on their balance sheets to maturity; some debts were sold on loan-by-loan, but this market was small and lumpy. This began to give way to an “originate and distribute” model after America's government-sponsored mortgage giants issued the first bonds with payments tied to the cash flows from large pools of loans.

This functional separation made it harder for investors to "see" risk.

[Securitisation] creates what economists call a principal-agent problem. The loan originator has little incentive to vet borrowers carefully because it knows the risk will soon be off its books. The ultimate holder of the risk, the investor, has more reason to care but owns a complex product and is too far down the chain for monitoring to work. For all its flaws, the old bank model resolved the incentives in a simple way. Because loans were kept in-house, banks had every reason both to underwrite cautiously and also to keep tabs on the borrower after the money left the vault.

In this characterization of the principal-agent problem, investors are the principals, and the loan originators are their agents.

Test your strategic acumen

There is no better way to get a feel for the tradeoffs of repeated strategic interaction than playing this game. You can take advantage of some types, but may blow yourself up in the process.

Unions using CON laws as barrier to entry

In earlier posts, we have pointed out how competitors and unions can use local zoning laws to slow down the forces of competition, and make themselves better off. Now we have an example of unions using Certificate of Need (CON) laws to keep out non-union hospitals.

As in the Wal-mart example, by keeping out new entrants, profits are higher at incumbent hospitals, which puts them in a weaker bargaining position with respect to their labor unions. From Chapter 14 of our textbook,

By increasing your opponent’s gain from reaching agreement, you make him more willing to compromise to reach an agreement, weakening his bargaining position.

CON laws are particularly anti-competitive, and drew the ire of the FTC when I was there (report, press release)

Indeed, there is considerable evidence that CON programs can actually increase prices by fostering anti-competitive barriers to entry.

Most states, though not Washington, have repealed their CON laws.

Clever Way to Combat Moral Hazard

Business Week has a short item about auto insurance companies, like Safeco, offering a GPS-based device that is installed in autos to record information about driving habits. This is one tool that insurance companies can use to combat the moral hazard problem (once you buy insurance, you may engage in more reckless behavior knowing you are covered in the case of an accident).

So, what's so interesting about the solution discussed in the article? First, the product is targeted at teen drivers, and the insurance company doesn't review the information itself. Instead it gets someone else to do its monitoring for them - parents. The system alerts parents by email or cell phone if their teens' speed exceeds a certain limit. Clever approach (similar to this post).

Second, and even more impressive, is that the company charges for the service. The insurance company is charging its customers to engage in an activity that will reduce the insurance company's costs - teens who know they are being monitored will speed less leading to fewer accidents. That's a sweet deal for the company.

Who forecasts better, ecologists or economists?

NY Times has the answer.

Subsidies end, exports surge

Video or article about the rebirth of tobacco farming in the US.

Thanks to Jay for the heads up.

Fraudsters and testimonial ads

In a previous post, we reported evidence that advertising informs, but doesn't persuade. However, some advertising does persuade, and the most persuasive ads often include testimonials.

The Federal Trade Commission prosecutes fraudsters who use credit-repair, work-at-home, and diet and exercise scams to bilk consumers out of millions of dollars.

A common characteristic of these scams is a testimonial advertisement that features a number, like the one pictured here, "I lost 74 pounds wearing slimming insoles." These advertisements are persuasive because:

1. some consumers don't realize that the number is drawn from the upper tail of a statistical distribution [they may not even know what a distribution is]; and

2. some consumers think they can do better than whoever is giving the testimonial [does everyong think they are above average?].

To combat these biases, the FTC requires a disclaimer, e.g., "results not typical."

However, testimonials that mention a number are used for legitimate products as well. For example, the Jenny Craig weight loss plan, which has data to support its effectiveness, has a website that allows users to search for testimonial advertisements by weight, and by pounds lost, so that readers can more closely identify with the stories.

European antitrust: is big bad again?

Every MBA program in every country teaches students to compete using the "four P's" of marketing: price, product, place, and promotion. So when Microsoft began distributing its media player with its operating system, it would seem that it was competing by taking advantage of its low cost distribution channel ("place") and by improving functionality ("product.")

Not so fast. Today, the Court of First Instance ratified the European Commission's case against Microsoft, accusing it of "abusing its dominant position" by bundling its media player with Windows, and by refusing to supply "inter-operability information" to competitors. The Court seemed to be saying that because Microsoft was taking advantage of its advantages, it violated the antitrust laws.

Disappointingly, the Court failed to articulate a principle that would tell firms when they are competing on the merits and when they are going to violate the increasingly murky European antitrust rules about dominant firm behavior. And, in an unfortunate choice of words that invites criticism from those who remember the bad old days of antitrust, the Court seemed to admit that Microsoft is a target because it is successful (decision):

In this case, Microsoft impaired the effective competitive structure ... by acquiring a significant market share...

In other areas of antitrust, e.g., mergers, the European Commission has adopted enforcement principles that condemn behavior based on its likely effect, and not on the share of the firm or on the form that the behavior takes, like tying (article). The Microsoft decision seems out of sync with the increasingly "effects based" analysis that guides Commission decisions in other areas.

This decision will re-open speculation about whether European enforcement has a home country bias (would this case have been brought against a European firm?) and about the limits of Article 82 enforcement (what are they?).

UPDATE: The wording in the Court's opinion saying that big is bad may not just be an unfortunate choice of words. In an interview, Commissioner Nellie Kroes said,

I want Microsoft's market share to diminish to significantly less than 95%.

Milk and Mortgages?

Now, here's a head scratcher.

According to an Associated Press story available at Forbes, national grocery store chain, Kroger, is expanding its financial service offerings - "Stores now market mortgages, home equity lines of credit and a just-expanded set of a half-dozen insurance coverages from identity theft to home and life policies." Huh?

Kroger thinks it will help increase foot traffic to stores and build customer loyalty. I don't know - maybe they're right, but I can't imagine someone thinking about needing a term life policy and heading to the local Kroger to pick one up with the weekly groceries.

Here, Piggy, Piggy

When is it not good for your customers to be consuming larger quantities of your product? When you’re not charging them for it. I was reminded of this as we drove past a Golden Corral restaurant. For those of you not familiar with this establishment, they offer “a famous buffet containing an array of food choices including hot meat options, pasta, pizza, fresh vegetables, salad bar, and a selection of carved meats.”

Buffets face an interesting pricing challenge caused by information asymmetry. Say the population is composed of both big eaters (let’s call them “piggies”) and small eaters (“budgies”). The restaurant can’t tell whether a particular customer is a piggy or a budgie, while that customer knows whether he plans to pack away enough food to sustain a winter hibernation (different knowledge = information asymmetry).

The easiest solution would seem to be to simply set a price that splits the difference between the cost of serving piggies and budgies. But, that’s not going to work due to adverse selection. Who’s more likely to be attracted to a buffet? One might argue that it’s those who appreciate the utility from being able to choose from a variety of “hot meat options” (and pizza, too!), but it’s most likely to attract big eaters. That’s the adverse selection – the restaurant ends up “selecting” more of the “adverse” types. The price needs to reflect this fact.

By the way, Golden Corral is obviously doing a decent job of solving this problem (along with the moral hazard problem – once you’re at the buffet, you are tempted to become a piggie). According to this press release, their second quarter 2007 sales exceeded $350 million.

Unions using zoning laws against Wal-Mart

In a previous post, we have shown how competitors use local zoning laws to keep rivals out, e.g., Starbucks. Now we see labor unions employing the same tactic against Wal-Mart.

Union workers fought the opening of the Supercenter last fall, arguing that the retail giant's foray into discount groceries would undercut better-paying, union jobs at chains like Albertsons and Safeway.

If labor unions can slow down or block rival entry that erodes profitability, then incumbent grocery stores are more profitable, which raises the gain to reaching agreement with the union. From our textbook (Chapter 14 Bargaining),

By increasing your opponent’s gain from reaching agreement, you make him more willing to compromise to reach an agreement, weakening his bargaining position.

Latest "prices" of political futures contracts

Latest prices (in cents) from www.intrade.com for contracts that pay off $1 if the event occurs.

• 35.9 Rudy Giuliani to be the Republican Nominee in 2008
• 24.1 Fred Thompson to be the Republican Nominee in 2008
• 22.3 Mitt Romney to be the Republican Nominee in 2008
• 4.8 John McCain to be the Republican Nominee in 2008

• 67.9 Hillary Clinton to be the Democratic Nominee in 2008
• 16.3 Barack Obama to be Democratic Nominee in 2008
• 7.6 John Edwards to be the Democratic Nominee in 2008
• 7.2 Al Gore to be the Democratic Nominee in 2008

Make the local zoning rules or your rivals will

In earlier posts, we talked about the increasing importance of legal and regulatory rules on competitive strategy. In San Francisco, it seems as if Jesse Fink, who has owned a local cafe for 25 years, has been reading Richard Shell's Make the Rules or Your Rival's Will. Fink has convinced the Planning Commission to deny a zoning permit to Starbucks, a competitor.

At the hearing, mandated by city proposition G for any chain store that tries to enter a "neighborhood" commercial district, Fink said:

I don't want San Francisco to lose its character and become a city of strip malls. ... That's what Starbucks is all about,

Proposition G, passed by 58 percent of San Francisco voters in November, is an example of what Bryan Caplan of George Mason (blog) and REASON magazine calls "the four boneheaded biases of stupid voters,"

1. Anti-market bias [Why not let coffee drinkers decide?]
2. Anti-foreign bias [Seattle is in a different state.]
3. Make-work bias [Will Fink have to lay off employees?]
4. Pessimistic bias [Change is making things worse.]

These biases have to be addressed to secure legal or regulatory approval.

Note that the October issue of REASON (pictured above) is made available online only after print subscribers have had a chance to read their hard copies. I will update the link when it comes online.

Thanks to market power for the story.

Patent ambush

In earlier posts, we talked about the standards war between Blu-ray and HD DVD (Will this standards war become a quaqmire? and DVD war drags on). We have also talked about another way to wage a standards war, by competing within a Standard Setting Organization (Another Standards War--this one with rules).

Standard setting organizations (SSO's) are important for two reasons. First, intellectual property has never been as important to our economy as it is now. In the past 25 years, patent applications have tripled and, by some estimates, intellectual property now accounts for a third of the value of US companies. And second, SSO’s play a vital role in adoption and use of intellectual property by coordinating technology adoption decisions between users (manufacturers) and creators of intellectual property. However, standard-setting organizations (“SSOs”) can also create opportunities for members to engage in opportunistic behavior. There is a history of collusion in SSO's and recently cases have been brought against patent owners for "ambushing" SSO's. (article)

"Patent ambush" is a form of post-investment hold-up when a patent holder who owns a patent that writes on a standard does not assert his or her patent rights until after the manufacturer has made sunk-cost investments. After manufacturers sink costs, they are in a weaker bargaining position which may lead to higher license fees for the patented technology.

Of course, post-investment hold-up is not just a problem for the manufacturer who is held up. Every MBA student is taught to anticipate hold-up with the admonition, “look ahead and reason back," the title of Chapter 5 of our textbook. If manufacturers anticipate the possibility of hold-up, they will be reluctant to make sunk-cost investments and this harms the innovator as well as the manufacturer. To make money, the innovator and manufacturer must find ways to address the manufacturer's concern about hold-up, otherwise no transaction will occur, or it will occur on substantially worse terms for the innovator.

This is too funny

Video: The growing gap between the rich and super-rich

Thanks to Greg Mankiw

Hot Product Pricing

Let’s say you are a technology company getting ready to introduce a heavily hyped new consumer product that has generated a lot of buzz. You know that customers vary in their willingness to pay for your new item, and you would like to charge the high-value customers a high price and the lower-value customers a lower price. What do you do?

One strategy is to release the product with a really high initial price, perhaps accompanied by a restriction in supply to make sure those high-value customers fear that if they wait they might miss out. Once you’ve captured the high-value customers, go ahead and cut the price.

This is a simple case of indirect price discrimination. When sellers can’t tell the difference between high- and low-value customers, they must design some way to get the customers to identify themselves. Sellers often accomplish this by designing different versions of the product (like home vs. business versions of software). In the case we are discussing here, the “versions” of the product differ on the time dimension. Version A comes with the “feature” of being available now. Version B is the exact same except it’s not available until some time in the future. High-value customers identify themselves by shelling out the bucks for Version A, and low-value customers wait for Version B.

Does this sound like anything we’ve seen recently in the technology world? How about Apple’s pricing path for the new iPhone? The company recently cut the price of its 8GB iPhone to $399 ($200 less than its release price).

This example also shows the risks of price discrimination schemes as noted in an earlier post. Remember, no one wants to be the schmuck who paid $200 “too much” for the phone. Apple has tried to control the damage by offering $100 rebates (in the form of store credits) to early adopters.

Can we insure against house price risk?

For many people, their home is their biggest asset

By the end of 2005, the value of residential homes equaled $21.6 trillion, comparable in size to the $17.0 trillion in domestic equities and $25.3 in fixed income assets...

and it is very risky

... house price volatility has been considerable. Quarterly changes of more than 8% (annualized) have been observed in US aggregate house prices in one out of ten quarters in the last 20 years. This masks the severe volatility in regional prices such as the 28% (annualized) increase in Seattle house prices in the late 1990s and the 12% (annualized) decrease in Houston house prices in the mid 1980s ....

One of the easiest ways to insure against price risk is with a futures contract. For example, Suppose a farmer sells a futures contract on the crop that he plants, and the crop price decreases. He loses money on his crop but makes money on his futures contract, and vice-versa. The futures contract transfers price risk from the farmer to the speculator who buys the contract.

So it would seem that home owners would want to insure themselves against price risk by selling futures contracts on the S&P/Case-Schiller(r) local real estate price indices, which began trading on the Chicago Mercantile Exchange in 2006.

Not so fast. Chris Hinkelmann and Steve Swidler (article) find that

Even at a local level, price changes may vary dramatically from one part of the metropolitan area to another. ... In one county zip code, the median home price fell 36.50% for the year, while in another county zip code, the median home price rose 38%. ... With such a wide dispersion of home price appreciation, it is unlikely that any single city index can effectively hedge real estate portfolios from the same metropolitan area.

Robert Reich denounces CSR

Earlier, we reported on an unusual debate between libertarians on Corporate Social Responsibility (CSR). Now, we learn thatRobert Reich, one of its former proponents, denounces CSR as a "dangerous diversion that is undermining democracy." From The Economist book review of Reich's Supercapitalism,

Mr Reich trashes the supposed triumphs of CSR. Socially responsible firms are more profitable? Nonsense. Certainly, companies sometimes find ways to cut costs that coincide with what CSR activists want...But “to credit these corporations with being ‘socially responsible' is to stretch the term to mean anything a company might do to increase profits if, in doing so, it also happens to have some beneficent impact on the rest of society,” ...

He certainly didn't learn this in business school. Curiously, Reich looks back to a post war era when shareholders did not exercise such tight control over managers, and when competition was more gentlemanly.

...Back then, big American firms enjoyed the luxury of oligopoly, he says, which gave them the ability to be socially responsible. Today's “supercapitalism” is based on fierce global competition in which firms can no longer afford such largesse.

I fearfully await the next logical step in this line of argument.

Does advertising inform or persuade?

A working paper from Stanford estimates the effect of advertising on brand awareness (information) and perceived brand quality (persuasion).

For the empirical analysis, we assembled a panel data set that combines annual brand-level advertising expenditures for over three hundred brands with measures of brand awareness and perceived quality from a large-scale consumer survey. ... We find that advertising has consistently a significant positive effect on brand awareness but no significant effect on perceived quality.

Coincidentally, Craig Newmark reminds us that it is the 50th anniversary of the Ford Edsel--advertising may have informed consumers but it couldn't persuade.

How to control the world, the basics

I just finished Tyler Cowen's new book Discover your inner economist, and want to recommend Chapter two, "How to control the world, the basics" as one of the best expositions of how and why incentives work. It is a nuanced, funny, and engaging read on why your kids dont respond to monetary incentives (its not cool to work for your parents) and why parking tickets seem to deter violators from Norway or Sweden, but not from Kuwait, Egypt, or Chad (culture of corruption). On the other hand, people from Norway and Sweden have extraordinarily high rates of job absenteeism.

Tyler, who also runs the most popoular economics blog, comes up with four principles for using incentive pay:

1. Offer monetary rewards when performance at a task is highly responsive to extra effort.
   
2. Offer monetary rewards when intrinsic motivation is weak.
   
3. Pay monetary rewards when receiving money for a task produces social approval.
4. High rewards tend to make individuals "choke."
   

In other words use money as a reward "when effort matters, there is little intrinsic desire to do the job, and money boosts the recipient's social status." But beware stress.

Economics as a Thinking Framework

I believe that one of the most useful aspects of economics is its utility as a framework for thinking about problems. A lot of people get turned off by the abstract, technical, mathematical approach to economics and lose out on the benefits of just using economics as a general way to think. You can get a lot of use from econ without ever considering whether your Slutsky matrix is negative semi-definite (if the last part of that sentence makes no sense to you, I envy you).

I was reminded of the simple power of economics when reading Charles Wheelan's excellent book, Naked Economics. Here's one issue he considers. Why do so many fast food restaurants have signs at their cash registers offering customers a free meal if they don't receive a receipt?

See the comments for the explanation Wheelan offers (hint: think in terms of incentives).

Incentive pay for professors?

When Adam Smith lectured in Scotland, he collected admission from those who wanted to hear him. This kind of market pressure ensured that he would deliver content that students were willing to pay for.

These days, we rely on different mechanisms to align the incentives of faculty with the goals of students. For example, the principal-agent conflict at Dartmouth between the Board of Directors and the faculty can be viewed as an effort to control the "normal" incentive conflict between producers (faculty) and consumers (students). However, this control mechanism may not be working as well as some students would like (Do business Schools practice what they preach?)

James Miller, an economist at Smith College, has a modest proposal to better align the incentives of faculty with the goals of students.

... [give] each graduating senior $1,000 to distribute among their faculty. Colleges should have graduates use a computer program to distribute their allocations anonymously.

My proposal would have multiple benefits. It would reduce the tension between tenure and merit pay. Tenure is supposed to insulate professors from retaliation for expressing unpopular views in their scholarship. Many colleges, however, believe that tenured professors don’t have sufficient incentives to work hard, so colleges implement a merit pay system to reward excellence. ... And because the proposal imposes almost no additional administrative costs on anyone, many deans and department heads might prefer it to a traditional merit pay system.

The benefit of this proposal is similar to the benefit of vouchers. Consumer choice disciplines the producers, as vouchers can be used at any producer.

Thanks to colleague Bruce Barry for the heads up.

The rise of "store brands"

Earlier this week, we reported on a department store buying designer brands, and now we have a similar instance of vertical integration as stores like CostCo, Safeway, Kroger, and Target are beginning to sell their own premium store brands. These store brands have gained share at the expense of branded manufacturers like Kraft. From the Wall St. Journal (article)

For years, retailers' own brands were largely cheap generics with dull packaging. Now, in an increasingly crowded food-retail market, supermarket chains are trying to differentiate themselves and build customer loyalty by offering quality products unavailable anywhere else. Chains have improved the taste of store-branded foods over the years by tapping customers for taste tests. They also hire staff food scientists to help create products.

I am not sure I believe the differentiation/loyalty explanation. A much simpler explanation is that store brands earn higher margins for the grocery store so the grocery store wants to sell more of them. The higher retail margins on store brands are likely due to the fact that they are marked up only once (by the retailer) and not twice (by the manufacturer as well as the retailer). The higher retail margins on store brands may also be due to lower advertising and promotional costs.

The difference between the two cases of vertical integration seems to be that while Lord & Taylor is acquiring a designer label to drive traffic to its store, these grocery stores are acquiring brands to sell to existing traffic. The success of each strategy will depend on whether customers shop at the retailer because of the brands it carries; or whether they buy brands because of the retailers that carry them.

Ask your marketing department to design a test to distinguish between these explanations.

Another standards war--this one with rules

In earlier posts, we reported that the standards war between Blu-Ray and HD DVD is turning into a quagmire, as neither format seems to be able to gain the upper-hand. The two seem to be bidding for the support of major film studios to win the war. But until a victor emerges, consumers are delaying purchases.

Standard Setting Organizations, or SSO's, can coordinate technology adoption decisions between producers and consumers, and avoid a standards quagmire. But when the standard involves patented technology, and when there are competing standards, the battleground shifts from the market to the SSO. MSFT and rival IBM are fighting within the Geneva-based International Organization for Standardization about whether the newest version of MSFT Office should be designated an "international standard." From the WSJ:

The balloting was contentious. Opponents said Microsoft packed national bodies by urging its allies to join standards committees from Italy to Kenya. In Italy, the standards committee swelled from a half-dozen members to 85 in a matter of months. Microsoft responds by saying IBM was stirring up opposition to Open XML.

MSFT has so far failed to convince the SSO. Rivals fear that MSFT's control of the Open XML format would keep them from developing competing office software.

Elvis sitings, alien abduction, and product repositioning

One of the most interesting mergers I worked on at the Department of Justice was between the Star and Enquirer newspaper groups, which produced the two biggest supermarket tabloids. Usually, media are viewed as vehicles for delivering advertising to an audience and the antitrust concern is a loss of competition for advertising dollars.

For supermarket tabloids, however, most of the revenue comes from circulation, not from advertising. In this case, we asked whether the merger would reduce the intense competition between the tabloids for exotic stories of alien abduction and photos taken by the paparazzi. Circulation for these impulse purchases (very few readers subscribe) is largely driven by the cover stories and photos.

Ultimately, this merger didn't pass the laugh test--could you ask a judge to block the acquisition without cracking a smile. In addition, product repositioning and entry appeared to be easy. In one week's time, the National Enquirer changed from a black-and-white tabloid printed on cheap newsprint reporting the latest Elvis sitings to a color, glossy mat with celebrity photos and weight-loss advice.

And as the National Enquirer went upscale, the The Weekly World News stepped into its place. This kind of product repositioning should mitigate the adverse impact of mergers (academic paper).

Time Magazine reports that the Weekly World News has printed its last edition (thanks to Gongol.com). Where were you when you heard the news?

If there is no scope, just say nope.

In a recent Business Week story, Atlanta-based Spectrum Brands is profiled. Over the last twelve years, the company has become a large conglomerate by buying a variety of different consumer products companies, including batteries, plant food, potting soil, rawhide dog bones, and aquariums.

From a prior post, we know the test for whether these acquisitions would add value. Indeed, the article notes that managers claimed value would be created through "synergies" and "diversification."

What do you think? How much synergy do you see between producing batteries and dog bones? How about potting soil and aquariums?

Somewhat predictably, synergies have largely failed to materialize and the article notes that Spectrum is currently "hobbled by a massive $2.5 billion debt load, one that is 10 times larger than Spectrum's value on the stock market." The CEO and senior managers have been replaced, and debt is being refinanced.

When faced with the tempting prospect of acquiring another company, remember: "If there is no scope, just say nope". Maybe I should trademark that phrase - another business bestseller perhaps??

Dartmouth governance, again

Last week we reported on Agents vs. Principals: the strange case of Dartmouth, where the Dartmouth administration is trying to change its governance structure to limit the Board's power. We were rightly criticized by anonymous for assuming away the most interesting part of the problem.

On Saturday, the Wall St. Journal editorialized on the changes, and provided some history that might answer some of the questions raised by anonymous. Quoted in the Volokh Conspiracy,

And so a pattern emerges at Dartmouth, one interminably replicated on other campuses: The academic establishment wants to consolidate its authority and exclude those who might deviate from the party line. .

Department store buying fashion designer

Lord & Taylor is close to an agreement with high-end fashion designer Peter Som (article), giving it "first dibs" on any lower-end lines Mr. Som creates in the future. The Wall St. Journal reports that the merger is a response to new retail competition from lines that department stores once used to carry.

Department stores that once counted on lines such as Liz Claiborne Inc.'s Juicy Couture, VF Corp.'s Nautica, privately held David Yurman and Polo Ralph Lauren Corp. as key suppliers are now competing with the well-known designers' own stores in malls across the U.S.

In earlier posts, e.g., If merger is the answer, what is the question?, we warn against acquisitions that do not have a clear value-creating purpose. In this case, it looks as if Lord & Taylor is buying a brand that will drive foot traffic to its "aging" stores. The fact that these designer brands are opening up their own retail outlets tells us that they can do that.

Just as most grocery stores lose money on soft drinks to attract customers to their stores, so too will Lord & Taylor use the Peter Som brand to bring in younger and wealthier customers. The acquisition will pay for itself if these customers buy other items once they get into the store.

But don't underestimate the incentive problems created by joint ownership of the fashion brand. There is a reason that most fashion brands are owned by the designers themselves. It is probably the best way to motivate designers to design popular clothes.

Celebrate Labor Day

Happy Labor Day! Or, is it Merry Labor Day? - did anyone get the memo on this?

Labor Day celebrates the "contributions workers have made to the strength, prosperity, and well-being of our country" according to this description of the holiday from the Department of Labor. Coincidentally, a U.N. report released today (story) shows that American workers are the most productive in the world.

Sometimes it seems like workers get shorted in economics, especially when it comes to residual claimant status. Why should the firm maximize returns to shareholders (capital) rather than to labor or some other group? Many of us who work in the US and/or who have received training in US schools seem to take shareholder primacy at face value without really thinking about why it should be so. This goes on despite the fact that not everyone in the world agrees with this approach. I don't find arguments opposing shareholder primacy that are based on ethical or moral grounds to be particularly persuasive; however, these aren't the only arguments. Here's a working paper from Joe Mahoney at the University of Illinois based on a property rights view of the firm.

Irony: do business schools practice what they preach?

We teach our MBA student to align the incentives of employees with the goals of the organization. But the Economist has an article on the dirty little secret of business schools--that few faculty know much about business. Our customers demand practical knowledge but we supply abstract theory. The mismatch is caused by incentive compensation schemes that rewards faculty for pushing back the frontiers of knowledge, regardless of the type of knowledge produced.

Market pressure from the Business Week rankings is motivating change, but universities are very conservative (resistant to change). One common strategy response to the problem is to hire "clinical" professors who can deliver practical knowledge.

Who reads this blog?

According to AdCenter by Microsoft, 52% of the readers of this blog are male. These algorithms allow advertisers to more accurately target particular consumer demographic groups which puts competitive pressure on newspapers, broadcast TV, and radio, which offer much less efficient ways of targeting consumers.

These traditional media want to merge to reduce costs, which allows them to provide more competition to these new media. I testified at FCC hearings, asking the Commissioners to bring FCC merger policy more in line with that of the Department of Justice and FTC.

The FTC merger enforcement data indicates that the proposed FCC rules would block all mergers that were investigated, but not challenged, by the FTC from 1996-2003. This rule would result in larger Type I errors (blocking mergers that benefit consumers), which may have significant effects on economic efficiency, especially in an industry such as the television industry with a rapidly changing competitive environment.