Working on the Demand Side of Prostitution

Either a decrease in supply or a decrease in demand (or both) can lead to fewer goods and/or services being traded in a market. For communities trying to reduce prostitution transactions, a lot of the effort has been targeted at the supply side.

The City of Nashville (among others), however, is targeting the demand side with its "John Schools." No, they are not going to teach you how to become a better john. For those not familiar with the term (like me who knows nothing about prostitution so had to look up the term), the "john" is the customer in the transaction.

If a john pleads guilty to the initial offense, pays a $250 fee and completes the course without re-offending, the original charge can be dismissed after a year. The article claims that John Schools are designed to try to reduce re-offending and thereby reduce demand. And, I think the argument is that it's more than just the incentive to avoid re-offending in the first year. Based on the article, the claim seems to be that educating the johns about how bad prostitution is will lead to long-term changes in their behavior. Hmmmm.

REPOST: What causes bubbles?

In the second edition of our textbook, we discuss the feedback mechanism that causes asset bubbles:  when price goes up (or down) in one period, expectations form that price will continue up (or down) next period.  In today's NY Times, Bubbleologist Robert Shiller looks at the mechanics behind these feedback loops

A downward movement in stock prices, for example, generates chatter and media response, and reminds people of longstanding pessimistic stories and theories. These stories, newly prominent in their minds, incline them toward gloomy intuitive assessments. As a result, the downward spiral can continue: declining prices cause the stories to spread, causingstill more price declines and further reinforcement of the stories.

Contracting Versus Love

Economist Betsey Stevenson explains why "family formation," econo-speak for marriage, shares much with contracting between firms.

How important are fidelity, loyalty, generosity, kindness? As an economist I think that a good marriage, like a good employment relationship, has shared vision, common interests, complementary abilities, and gains from specialization.

A long-term contract can facilitate relationship-specific investments. When I go over this in class, some bright student usually asks about the "spot market" in coupling and why it is usually illegal.

What do tonsillectomies have in common with auto repair?

In 1992 charges were brought against Sears whose mechanics were recommending unnecessary auto repairs.  The problem was traced to the incentive system used by Sears (and others in the industry),

[the] use of quotas, commissions, or similar compensation may provide incentives for sales personnel to sell unnecessary auto repair services in order to meet quotas or receive larger commissions.

Sears tried to fix the problem by re-organizing into two divisions, one responsible for recommending repairs; and the other responsible for doing them.  Rather than solving the problem, however, the two divisions got together and began colluding.  In exchange for recommending unnecessary repairs, the service division paid the recommending division for recommending them.  Sears finally adopted flat pay for the mechanics, which led to shirking.

I used this example in Vanderbilt's MMHC class (syllabus) to illustrate the difficulties of aligning the incentives of providers with the goals of payers.  President Obama tried to make the same point when he accused physicians of performing unnecessary tonsillectomies.  However, as the Sears example suggests, there are no "fixes" to the problem, only tradeoffs:

Incentives matter, yet maybe the truth is that medicine is a highly complex science in which the evidence changes rapidly and constantly. That’s one reason tonsillectomies are so much rarer now than they were in the 1970s and 1980s—but still better for some patients over others. As the American Academy of Otolaryngology put it in a press release responding to Mr. Obama’s commentary, clinical guidelines suggest that “In many cases, tonsillectomy may be a more effective treatment, and less costly, than prolonged or repeated treatments for an infected throat.”

Mr. Obama seems to think that such judgments are easy. “If there’s a blue pill and a red pill and the blue pill is half the price of the red pill and works just as well,” he asked, “why not pay half price for the thing that’s going to make you well?” But usually the red and blue treatments are available—as well as the green, yellow, etc.—because of the variability of disease, human biology and patient preference. And the really hard cases, especially when government is paying for health care, are those for which there’s only a red pill and it happens to be very expensive.

Fear antitrust

 

From Princeton Economics Group:

Private antitrust litigation, as measured by the number of cases filed in Federal district courts, has continued to increase sharply in the last several years. The number of private cases filed is now at its highest level in 25 years. One factor that has been posited for this recent increase is the practice of different plaintiffs' attorneys filing multiple "copycat" cases alleging the same or similar violations. The import of this may depend on one's perspective. From the perspective of a practitioner or law firm manager, more cases due to copycat filings may mean there is greater demand for the services of attorneys for both plaintiffs and defendants. From a policymaker's perspective, however, more cases due to copycat filings may not mean there has been an increase of the number of antitrust violations or the amount of substantive antitrust enforcement.

Check Out the Beer Wars

How do you successfully compete in an industry dominated by a few giant companies? You concentrate on one of Michael Porter's generic strategies, either focused low cost or focused differentiation (easier said than done, of course). A new documentary, Beer Wars, takes a look at the challenges small brewers face in an industry with a couple of giant players. I haven't seen the movie yet but it looks pretty fascinating (although I imagine there will be a lot of gnashing of teeth over "unfair" competitive practices of the big players).

CNN has a short video about the documentary included in a story about rising beer prices.

And the trailer via Youtube.


P.S. Many of you might not know, but some of the early influential work in the field of strategic management was performed on the beer industry (by researchers from Purdue University).

What should I read if I want to become a money manager?

Economists are not known for their money management skills, so I asked for advice from Merle Hazard, one of the best money managers around.  He likens money management to Plato's Allegory of the Cave.  The puppets are analogous to "fundamental value" and the shadows cast by the fire on the wall (what we can see) are analogous to prices. 

1.  The Money Masters by John Train.  A terrific book that would inspire someone getting started in the field.   Is a side-by-side study of different money managers (perhaps inspired by Plutarch’s Parallel Lives).  In any case, this is a desert-island book that can be understood and loved by novices and experts alike. At the end Mr. Train reaches some conclusions as to the personality traits that the great investors have in common.  It won’t give you ideas on specific stocks to buy but that’s OK, it is deeper than that.  Train is (or was) a money manager for many years himself in New York, with literary leanings.

2.  Warren Buffett’s letters to Berkshire Hathaway shareholders.  Easiest way to get these is to get a copy of a compendium by Lawrence Cunningham titled, Essays of Warren Buffett.  Basically, Cunnigham, who is a law professor, cut and pasted Buffett’s shareholder letters with the passages arranged by topic.  You can also get each year’s letter to Berkshire Hathaway shareholders for free at www.berkshirehathaway.com, going back a couple of decades.  Actually reading Buffett’s letters directly is best, but most people would not want to do that first.  The real fans definitely will, however.  When asked if he will ever write a book for investors, Buffett has answered that he is already doing so “on the installment plan,” and he is referring to these letters.  Here too, you can look up what he owns or is buying and make your own judgment whether you agree.

3. Value Line. You can subscribe via www.valueline.com.  It costs a few hundred dollars per year BUT a trial subscription is only maybe $75 --- that’s what you should get, then just don’t subscribe when the trial is up.  You can look up individual companies and get a wealth of info on each one.  It’s at Vanderbilt’s business school library, too.  Morningstar has a good website for stock information, too.


OTHER WORTHWHILE IDEAS:

4.Classics II Another Investor’s Anthology (ed:  C. Ellis).  Terrific anthology.  Even better than Classics I, which was OK but not as good.  A rare case of a sequel being better than an original.  The best of this second group.

5.  The Intelligent Investor by Benjamin Graham.  Easier to read than the true classic of the field, Security Analysis by Graham (the 1934 edition).  Graham was a professor at Columbia.  He was the first person to impose order on what was until then a very unprofessional profession.

6.  Buffett:  The Making of An American Capitalist by R. Lowenstein.  A deep book on the Einstein of the field.  Several years old, but very insightful.

Stress separates good firms from the bad

The industrial organization (IO) view of strategy is that the industry structure is the most important determinant of long-run profitability. Michael Porter's "five forces" analysis is a popular manifestation of this view. To be succesful, choose a profitable industry with high barriers to entry, few substitutes, low rivalry, and weak customers and suppliers.

In contrast, the resource-based view (RBV) focuses more on differences between firms. To develope a sustainable competitive advantage, firms should organize to develop "resources" that are valuable, rare, and difficult to imitate.

Of course, there is some merit in each of these views, but during downturns, like the Texas banking crisis in 1985-1987, profit differences across banks within the same market dramatically increased. This is consistent with a "resource-based" view of the strategy, that between-firm differences are more important than between-industry differences (CITE: Amel, Dean, and Luke Froeb, Do Firms Differ Much?, Journal of Industrial Economics, 39 (March, 1991) 23-31.)

There are reports of widening between-firm differences in the current downturn.

J.P. Morgan Chase & Co. is raking in money from depositors -- a bank's lifeblood -- as weaker institutions teeter. Golub Capital, a little-known lender to smaller corporations, has zipped to the front of its field ahead of flailing CIT Group Inc. and General Electric Co.'s GE Capital unit.

Ford Motor Co. is luring car buyers away from General Motors Co. and Chrysler Group LLC. Bed Bath & Beyond Inc. hung Linens 'n Things Inc. out to dry.

They Shoot Horses Don't They?

What is the effect of a "compassionate" stance towards animal cruelty? One state recently banned the slaughter of aged horses. Which state: Birkenstock-wearing, granola-eating, lotus-sitting California or pickup-driving, gun-toting, big buckle-wearing Texas? Brace yourself, but my local paper is reporting on the adverse effect that Texas's ban on horse slaughter is having on horse ownership.

Aside from the recession, the middle and low end of the market have been particularly hurt by a steep drop in the floor price historically created by U.S. slaughter facilities, whose buyers paid $500 to $600 for Texas horses that had outlived their usefulness.

But after the 2007 ban on horse slaughter — one of the country’s three plants was in Fort Worth — the floor dropped to $200 because of the expense of shipping to Mexico, where processing is still legal, said Rusty Addison of Lipan, who operates the monthly horse auction in Stephenville. (More than 27,000 U.S. horses were exported to Mexico for slaughter this year through Aug. 8; that’s nearly three times the total for all of 2006 but down 5,300 from the first eight months of 2007, according to the U.S. Department of Agriculture.)

Raising the cost of "disposal" decreases the supply.

ADDENDUM
An anonymous comment points out that I got the facts wrong. I had thought the ban was due to legislative action but, in Texas, it was due to a judicial decision. This story indicates that in 2007, the Society for Animal Protective Legislation (SAPL) won its case upholding an existing but unenforced law that banned the horse slaughter. The affected facilities existed only in Illinois and Texas. So my digs at my fellow Californians was unwarranted.

Hedge Your Housing Risk

The Economist reports that since June, retail investors have been able to hedge their housing risk through the purchase of MacroShares. MacroShares are tied to the value of the S&P/Case-Shiller home price index across ten urban areas. In the future, MacroShares plans to tie the products more closely to local markets rather than being based broadly across ten areas. MacroShares is courtesy of economists Robert Shiller and Karl Case.

I've Been Doin' it Wrong

Apparently, I should have been 'augmenting' my income. At less than top universitiies, there is little incentive for professors to take on the burden of supervising a doctoral student. Some have found an alternative incentive.

German prosecutors are investigating about 100 professors across the country on suspicion they took bribes to help students get their doctoral degrees, authorities said Saturday.

The most I ever got was my family taken out to dinner (and that was post-defense).

Get out of the sauna and go to work

former Vanderbilt Professor Knut Mork is concerned that oil is making Norwegians soft:

Some are spending too much time in their cabins in the woods and their family boats on the sea, he worries, while others are too eager to abuse Norway's generous social safety net. Eleven percent of the working-age population in Norway is out on disability.

"It's not that the government is handing out money to everybody to live a lavish life," he says. "But it's become, with all the various programs, very easy to escape from working. I call this an oil-for-leisure program."

Anton Mork adds, "Sure, we've been lucky. But I don't think I'm being a crank. I think I'm saying we're living a lie. The lie is that we're taking care of everybody's needs. And we're not."

He says little is being done to deal with problems like Norway's aging population and decaying rail and road network. He says it's time for Norwegians to get out of the sauna and get back to work.

Testimonials and disclaimers

A big chunk of the fraudulent advertising (diet, exercise, work-at-home, credit repair) prosecuted by the FTC involves a testimonial advertisement that mentions a number, e.g., "I lost 74 pounds wearing slimming insoles." Some consumers do not seem to understand that the results for the endorsers may not be typical, despite the disclaimer required by the FTC, "results not typical."

Now the FTC is moving to bar use of such testimonials unless an advertiser has evidence

"... that the endorser's experience is representative of what consumers will generally achieve, the advertisement should clearly and conspicuously disclose the generally expected performance in the depicted circumstances, and the advertiser must possess and rely on adequate substantiation for that representation."

In other words, advertisers can use testimonials only if they develop statistical evidence to support testimonial claims, like the kind of evidence required by the FDA for new drug applications. This could prove so costly that it could discourage the use of testimonials in advertisements in products that actually work, like Jenny Craig, whose website uses customized testimonials.

For a discussion of benefits and costs of these kinds of policies, see "Consumer Protection," an entry in the Encyclopedia of Social Science.

What keeps Warren up at night?

Buyer's remorse?

To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.

Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent.

Theft and Information Asymmetry

Even burglars try to solve information asymmetry problems. You know whether your house has valuable contents, but the burglars don't. And, obviously they would prefer to rob houses with more valuable contents. Some signals they look for: flowers outside your house indicate you have taste and taste means you are more likely to have nice possessions; toys in the yard signal the possibility of valuable gaming systems inside. And, they also obviously look for signals that the house is a soft target.

All the good ones are pre-screened

Adverse selection in marriage/mating/relationships refers to the fact that anyone willing to accept you as a partner probably has limited outside options (otherwise, they would find someone better). So you learn something negative about a person when they accept you as a partner.

Screening is a way to weed out low-quality partners. The trick is finding a variable that effectively separates the wheat from the chaff, like whether someone is already in a relationship.

The most striking result was in the responses of single women. Offered a single man, 59 per cent were interested in pursuing a relationship. But when he was attached, 90 per cent said they were up for the chase.

The authors speculate that single women may be attracted to attached men because they've already been "pre-screened" by other women and found to be satisfactory as a mate.

HT: Instapundit.

Cannibalize, or else your rivals will

If Chapter 12, "more complex and realistic pricing," we give advice on how to price commonly owned products: First, raise both prices above that which would be implied by simple (MR=MC) pricing because common ownership reduces the MR of each product. Second, try to "move" the products apart in product space to reduce cannibalization. If you cannot do this, do NOT make the mistake of suppressing or delaying new product introduction.

Historically, firms ... have tried to hang on to declining market shares for too long before deciding to introduce new products that compete with their own. Kodak, for example, refused for years to introduce the 35mm camera for fear of cannibalising its older products. Likewise, years later, it was late to embrace the market for digital imagery. Bausch & Lomb invented the soft contact lens but failed to launch it because the firm did not want to lose the lucrative business of selling the drops that hard lenses require. As a result, Johnson & Johnson swept into soft lenses, and the market for hard lenses (and their drops) disappeared.

Should you get a personality assessment before you invest?

12 minute "chat" with Greg Davies about how insights from Behavioral Finance are being used to design investment strategies and products to accommodate investor's irrational behavior, like "loss aversion."

Is the stock market over-valued?

Shiller's famous P/E graph says the market was about where it should be, on July 17, when the market was at 940. The recent stock market rally would put the P/E ratio a little above its historical average. Also, the ten-year moving average of earnings is historically high which would also tend to make the P/E appear lower than it really is. Bottom line: the market may still be above its historical P/E.

Cash for Clunkers and Higher Prices

By now, you'd have to be in a coma not to have heard about the "Cash for Clunkers" program. The G is spending our tax dollars to give people an incentive to trade in older, less efficient vehicles and purchase new. So, what do you think happens to prices with this demand stimulus. Not surprisingly, it looks like they are going up. So, if you are in the market for a new car, you get to pay for the program twice - once through your tax dollars and once through a higher price.

When is a 360-fold Price Increase a Bargain?

The abstract of a new paper by Claudio Lucarelli, Sean Nicholson starts:

The average price of treating a colorectal cancer patient with chemotherapy increased from about $100 in 1993 to $36,000 in 2005, due largely to the approval and widespread use of five new drugs between 1996 and 2004.

Talk about health care costs exploding. Yet, they conclude with:

By contrast, a hedonic price index and two quality-adjusted price indices show that prices have actually remained fairly constant over this 13-year period, with slight increases or decreases depending on a model’s assumptions.

In other words, the price per QALY does not appear to have risen. Innovation has provided a new alternative therapy and consumers (or their physicians) have chosen the higher quality treatment. My main concern is whether 'cost containment' under health care reform would maintain the incentives to develop such therapies.

Why is lung cancer better than obesity?

Lung cancer kills quickly and thus holds down costs. Obesity causes increases in chronic diseases that are unusually costly. Are we ready for a fat tax?

The debate over health care reform has so far revolved around how insurers, drug companies, doctors, nurses and government technocrats might be persuaded to change their behavior. ... there has been far less discussion about how the rest of us might also change our behavior. ... A natural response to this cost would be to say that the people imposing it on society should be required to pay it.

Incentive alignment, anyone?

The Return to Studying Economics

I love doing economics and I earn a comfortable living doing it. But, as a professor, my career has been atypical for an undergrad economics major. Now payscale.com tells me that my classmates have done well too.

Best Undergrad College Degrees By Salary

Methodology Annual pay for Bachelors graduates without higher degrees. Typical starting graduates have 2 years of experience; mid-career have 15 years. See full methodology for more.

My wife's field, Social Work, is dead last on their extended table of earnings by major, but she loves what she does too. I would argue that love of subject should trump earnings potential in choice of career.

Elk Hunt Permit Auction Update

Luke previously noted that the state of Tennessee would be auctioning one of the five permits it will issue this year to hunt elk (the other four were awarded in a random draw). Well, the auction has closed, and the winning bid was $17,700. The winner won't be bagging the elk himself, however. He gave the permit to his wife as a gift.

"She supports me and takes care of our boys when I go off hunting all of the time so I wanted to do something for her,'' said Andy, who has been married 5½ years. "That, along with the fact that one of the five people that are shooting this thing ought to be a woman."

Excuse me, while I go wipe the tears from my eyes at that beautiful gesture.

Cash for Buses?

In an Op-Ed in our local paper, Linda Campbell offers suggestions to attract more riders to the Fort Worth bus system (the "T"), including:

Run buses more often, to more places.

Yes, it’s expensive, but how else to convince potential riders that buses can accommodate their transportation needs? Besides my regular route from south of TCU to downtown, I’ve taken buses all over town and gone as far as possible on the system to points south, southwest, northeast and west.

My alternative is to scrap the whole system and use the money to buy all regular riders new cars. Potential riders need no convincing that cars can "accommodate their transportation needs." A tad expensive you say? Well let's see.

According to the National Transit Database, the T has operating expenses of $51 million and collects fares totaling $6 million on 7.6 million "trips." Local and Federal tax revenues subsidize the T's operating costs to the tune of $41 million (and capital costs an additional $22 million). That is, on average riders pay 12% ($0.78 per trip) and subsidies to pay 80% ($6.74 per trip) of operating costs. (The difference is made up by "Other Funds.")

Suppose regular riders take the bus to and from work 250 days a year. This means they are subsidized $3,370 per year (500*$6.74) or nearly $17,000 over five years, a conservative estimate of the life of a car. If we include subsidies to capital costs, this comes to $21,000. Using this money to buy each rider, say, a Smartcar would actually both save money and improve the mobility of these erstwhile bus riders. I know this could never be implemented, but it helps to put into perspective the costs, both to tax payers and to riders, of public transit in a medium sized city.

My fair city, Arlington, has the notoriety (honor?) of being the largest in the US without public transit. City officials keep placing a public transit measure on the ballot. And the good citizens of Arlington keep voting them down. I have new found respect for the intelligence of Arlingtonians.

Outlet Mall Pricing Strategies

Here's a really interesting story about how outlet malls have convinced people that they are getting a great deal by traveling to the middle of nowhere to shop (it's an excerpt from a book called Cheap: The High Cost of Discount Culture). Skeptical about how successful outlet malls are? According to the story, around 55 million Americans shop in at least one of the nation's roughly three hundred outlet centers every year. The total distance that Americans travel to outlet malls each year equals 440,000 trips around the world.

The excerpt notes that one of the key tactics used in outlet malls is refererence pricing. Noted somewhere on or near the product is a really high "suggested" or "retail" price along with the much lower sale price. Individuals get anchored to that higher price, and it affects their willingness to pay. The story mentions a jewelry pendant with a "suggested" price of $3,329 and a sale price of $832 - sounds like a great deal, huh? The author later found what appeared to be similar pendants on eBay for $299. Great example of psychological pricing, a new topic in the second edition of everyone's favorite managerial economics textbook.

Unintended Consequences - Insurance & Obesity

In a new paper, Jay Bhattacharya, Kate Bundorf, Noemi Pace, Neeraj Sood find evidence that health insurance makes you fat. From the abstract:

We find weak evidence that more generous insurance coverage increases body mass index. We find stronger evidence that being insured increases body mass index and obesity.

Bad news for health care reform.

Pricing Concessions at Jerry World

The new Cowboy's Stadium will host its first NFL game in a couple of weeks. We citizens of Arlington voted to tax ourselves to pay for a portion of the costs. Team owner Jerry Jones held an "open house" this past weekend so the we citizens can see what we bought. All snarkiness aside, this was a nice gesture.

Me and the missus headed over there for an hour or so of gawking. It is an impressive structure. One thing that did catch my eye was the concession prices.
Looks like a little indirect price discrimination. I would like to be able to know the margins and back out the implicit price elasticities conditional on being in the stadium.

They commemorated the largest domed stadium in the world with T-shirts printed to say "Ours is bigger." Well, this is Texas.

ADDENDUM
One of the first analyses of sports concessions prices, written by former colleagues Craig Depken and Darren Grant, was recently accepted for publication.

How do banks compete under a salary czar?

The Obama administration’s pay czar, Kenneth Feinberg, must approve compensation for 25 top earners of each bank that receives Federal aid. Banks not subject to the pay czar are trying to lure top talent away from rivals.

In the United States, banks like Citigroup and Bank of America have offered guarantees, arguing that they are necessary to attract new employees and keep existing ones. Indeed, foreign banks like Nomura Securities of Japan, Credit Suisse of Switzerland and Barclays Capital of Britain are making guarantees in hopes of poaching talent.

Stronger banks that have repaid their bailout money and are not subject to Mr. Feinberg’s restrictions — like Goldman Sachs, JPMorgan Chase and Morgan Stanley — have also begun offering guarantees to star prospects.

When Unemployment is a Laughing Matter

The recession appears to be pushing more people to give a life of comedy a try.

Still, a recession always seems to draw people toward careers in comedy, says Stephen Rosenfield, who has operated one of the country's pre-eminent joke-telling schools, the American Comedy Institute, since 1989. His three-week workshops, which start at $425 a pop, sold out this summer, and he's taking reservations for September.

"It's not so strange in a way," Rosenfield says, adding a recession provides "good cover" for someone interested in making the kind of career change that might be considered idiotic at other times.

"If you're bringing home a nice paycheck, and you've got a nice executive position and you announce to your wife or your parents that you're giving it up to become a standup comic, they'll think you're insane," he says. "But if you're in a recession and you're unemployed and jobs are hard to find, they'll say, 'Oh, that's interesting.'"

Innumeracy – Executive Branch Edition

The employment level fell last month at a smaller rate than it has fallen in the recent past, which is good news, but let’s not get carried away. What is wrong with this characterization?

"The worst may be behind us," President Barack Obama said outside the White House today.

And this one?

"Today, we're pointed in the right direction," Obama said.

I may regret blogging on calculus, but he is mistaking an inflection point for a minimum.














Employment is still falling, just not at as fast of a rate. The “worst” is still ahead of us and we are not yet “pointing in the right direction.” Now, Churchill understood multiple meanings of inflection.

Cash for Refrigerator Clunkers?

Not only can you get cash for your clunker car, you can also earn $30 per old refrigerator in a number of states that promote refrigerator recycling programs. According to this New York Times blog entry, the "programs target old refrigerators and freezers because they use substantially more electricity than those built after the introduction of federal efficiency standards."

What's a little confusing is why consumers need this incentive to upgrade their refrigerators. The article claims that "Utilities commonly estimate that homeowners can save up to $150 a year on their electricity bill by dumping their old refrigerator or freezer." One would think that upgrading is a positive net present value investment. Maybe instead of upgrading, they are just getting rid of old, unused or unneeded appliances. (Or perhaps people aren't making NPV calculations in their purchasing decisions.)

Authorized Generic Strategy

The FTC's recent report on the strategic uses of "authorized generics" provides a lesson on the role of long-run versus short-run in policy analysis.

About two decades ago, pharmaceutical firms began releasing "authorized" generic (or AG) versions of their patented product a bit before the patent expired. This can be seen as a price discrimination that would have cannibalized sales of the branded product and so was only profitable when generic entry is imminent. In the early 1990’s the FTC investigated whether such a scheme allows the branded firm to garner so much of the profits from early generic entry that it would deter later generic entry by independent firms. That is, it was recognized that this would have a short-run effect of lowering generic prices but a possible long-run competitive effect leading to higher generic prices. The appropriate tradeoff is an empirical question. My direct involvement led to some empirical answers in publications coauthored with Dave Reiffen that examined the role of these profits on generic entry decisions and the role of this longer-run entry deterring incentive on the release of an authorized generic version of a branded product.

The newer wrinkle is that there appears to be evidence that branded firms have cut deals with generic producers to not release an authorized generic if the generic producer postpones entry. Normally, a branded firm would have to pay off all potential entrants which could be cost prohibitive. A feature of US pharmaceutical regulation, however, provides the first generic producer a period of generic “exclusivity” in some instances. The increase in profits to the branded product more than compensates for the “side payment” to a single generic firm. The report finds that, in the short-run, authorized generic entry does indeed reduce prices to consumers and that “About one-quarter (20 out of 76) of those patent settlements involved (1) an explicit agreement by the brand not to launch an AG to compete against the first filer, combined with (2) an agreement by the first-filer generic to defer its entry past the settlement date by, on average, 34.7 months.”

What are the longer term effects? My earlier work explicitly focused on how changes in expected profits affect the subsequent entry decisions of generic firms. But if the potential profits affect generic entry decisions, perhaps they also affect the entry decisions of the branded firm in the first place. These firms enter by developing new drugs. The return to R&D is the expected future profit from marketing any product that might result. There is evidence that drug companies appropriate only a fraction of the surplus generated by their products, or that drug development generates large positive spillovers. What we need to know is whether changes in their ability to appropriate the surplus alter the level of R&D investments and the pace of new product introductions. Admittedly, this is a tough question.

Washer, Dryer and Pedestal Pricing

So my wife and I went out the other night to buy a new washer and dryer. We did a little research beforehand and identified a couple of models priced in the $600 range ($600 per appliance). After driving over to the Home Depot to check them out, we decided on one of the two potential sets of models. And, then my wife said, "What about pedestals?" To which I replied, "Huh?"

Pedestals are basically metal boxes that the washer and dryer sit on top of. As near as I could tell, they serve two purposes. First, they raise the appliances up a little higher (just over a foot) to make access easier, and second, the metal box includes a built-in drawer for extra storage. So, how much do you think a metal box to accompany a $600 washer costs? I'll give you a hint - think of a ridiculous price.

The pedestals to accompany our washer and dryer were priced at $230 each, over 1/3 the cost of the appliance itself. Wow! I would be interested to see the analysis behind that pricing decision.

Is Free the Future?

Many of you may have heard of Chris Anderson's new book, Free: The Future of a Radical Price. In it, Anderson, the editor of Wired magazine, claims that offering more and more product for free is "the future of business." (here's a Wired article by Anderson from 2008 on the subject).

Some of the reviewers aren't buying the hype - here's Malcolm Gladwell's review at the New Yorker and one from Virginia Postrel at the New York Times.

The other funny thing is that when I saw the book at the bookstore, it wasn't free. It's listed at $26.99 (although it was offered for free on the Kindle for a while, it now looks like the Kindle version is $9.99)

The Identification Problem - Video Game Edition

Video game sales, thought to have been recession-proof, are off. Is the recession the culprit?

When there is a change in the quantity demanded it is important to know why so that you know how to respond appropriately. Empirical economics is increasingly concerned with how to distinguish the identity of one possible cause from another, or we are concerned with the "identification strategy." Many students have been failed and many trees have been felled due to the investigation of poorly identified effects.

Some of our techniques can become quite sophisticated and this limits their applicability in business settings. One writer over at Hellforge (love the name) provides a seat-of-the-pants argument that the recession is not completely to blame. Rather, the newer games "suck."

The recession is not affecting the video game industry proportionally any more than it did from the outset. Recent game releases are above average quality ... but aren't as good as the AAA releases from last year.

Hat tip Craig Depken