The force that Porter forgot

Preston McAfee was the first to realize that Michael Porter's famous industry analysis leaves out one crucial force: cooperation from complements. A new article, How Companies Become Platform Leaders, offers a framework for thinking about strategy in industries like telecommunications where success requires creating an "ecosystem" of complementary products.

A company must first decide whether to pursue a "product" or a "platform" strategy:

Put simply, a product is largely proprietary and under one company’s control, whereas an industry platform ... requires complementary innovations to be useful, and vice versa. An industry platform, therefore, is no longer under the full control of the originator, even though it may contain certain proprietary elements.

One of the biggest mistakes a company can make is to pursue a product strategy and fail to recognize the platform value of their product. The best example of this is perhaps Macintosh computer which, due to its early technological lead, could have become the dominant platform for personal computing. Instead they priced high, failed to encourage complementary innovotion, and let Microsoft become the dominant platform.

If you decide on a platform strategy, then the authors recommend one of two strategies, coring or tipping.

"Coring" is using a set of techniques to create a platform by making a technology "core" to a particular technological system and market. ... Examples of successful coring include Google Inc. in Internet search and Qualcomm Inc. in wireless technology.

"Tipping" is the set of activities that helps a company "tip" a market toward its platform rather than some other potential one. Examples of tipping include Linux's growth in the market for Web server operating systems

Amnesty and Incentives

Amnesty for past bad acts may or may not be a good policy in different situations. But repeated amnesty and anticipated amnesty is probably not. From the archives (well from 2003) we have this gem from "Beware The Amnesty Binge" by Alan Ehrenhalt:

Thirty-seven years ago, Charles de Gaulle decided to spring a treat on the voters of France after they reelected him. He declared an amnesty on outstanding traffic offenses. It was a wildly popular scheme--and every French president since then has repeated the gesture.

These amnesties still serve to enhance the honeymoon effect for newly chosen chief executives. The only problem is that French drivers, knowing that they will be forgiven, drive like maniacs in the months leading up to the election. This isn't just a matter of anecdote: Highway deaths in France consistently increase by significant percentages just prior to an election. In May 2002, the month before France reelected President Jacques Chirac, there were 616 fatalities, compared with 553 during the same period the year before.

Anticipate Moral Hazard

Hat tip Justin Ross

Why are defined benefit pension plans so under-funded?

States still have defined benefit pension and medical benefit plans that promise future payouts to state and local employees. To determine how much they have to save, they calculated the present discounted value of the future liabilities and compare it to current savings. Nashville's pension liabilties, for example are about 90% funded. Pittsburgh's are about 30% funded.  Neither saves for the medical benefits.

So what discount rate should they use? Most use discount rates near 8% because they expect to earn 8% on their investments. A recent paper blamed some of the under-funding on the use of discount rates based on the characteristics of the invested assets:

• the use of higher-than-appropriate discount rates reduces the value of the pension obligations that is reported to the public, and thus likely reduces the contributions that sponsors feel they must make to pre-fund their pension obligations.
  
  
• the link between the discount rate and the expected return on plan assets mayencourage sponsors to invest in riskier portfolios than they would otherwise choose in order to justify a higher discount rate, and thus a lower contribution into the pension trust.
  
  
• these rules may encourage fiscal gaming in the form of “Pension Obligation Bonds.” These devices allow governments to borrow, invest in risky assets through the pension trust, and treat the difference between the expected asset return and the bond interest rate as “found money.”
  

So what rate should they use? The paper recommends a rate equal to 30 year treasuries, adjusted upwards to account for their tax free status. Today's risk-free rate of 4.29% is equivalent to a taxable rate of 6.55%, given a marginal income tax rate of 35.5%.

Where is the housing demand?

According to some real estate analysts, the housing bubble has lost all of its air because we have worked off the excess housing stock built during the bubble, so builders will start building again to serve new demand.

However, three factors are reducing household formation, the primary driver of household demand:

1. Less immigration due to the post-2006 crackdown.

2. Less immigration due to the severe recession and high unemployment

3. 20-somethings who can’t get jobs are living with their parents.

Bottom line, household formation is about 1/3 of what it was forecast to be (0.3% growth instead of 1% growth). This is important because housing is a durable good with a very slow depreciation rate (about 1%/year). So replacement demand is only 1%, plus new household formation. If households are getting bigger, or immigration is slowing, or both, then demand drops precipitously, and prices fall.

Run like hell

Eventually, markets will punish politicians for the policies they enact. As of this post, you can earn a yield of 36% if you buy 2-year Greek debt.

A very high probability of default is built into the yield, in order to compensate investors for the probability that they won't be paid back.

Paper: Teaching Managerial Economics with Problems Instead of Models

Teaching Managerial Economics with Problems Instead of Models

Luke Froeb

Vanderbilt University - Owen Graduate School of Management

James C. Ward

Vanderbilt University - Owen Graduate School of Management

THE INTERNATIONAL HANDBOOK ON TEACHING AND LEARNING IN ECONOMICS, Gail Hoyt, KimMarie McGoldrick, eds., Edward Elgar Publishing, 2012

Abstract:
In this chapter, we address the problems of teaching microeconomic principles to business students. We describe the peculiar features of student demand that make teaching economics using a model-based pedagogy unsuccessful. We conclude that a problem-solving pedagogy is a better way to satisfy student demand for business education.

Keywords: Managerial Economics, Business Education, Problem-Solving Pedagogy, Microeconomic Principles

JEL Classifications: A22, A23

"Bloodbath" in Euro affects US interest rates and trade deficit

The uncertainty about the future of the European Union is causing investors to sell euros to buy dollars in order to purchase safer US Treasury bills. The increase in demand for US debt is reducing interest rates in the US,

The price of the 10-year note is up 9.4 cents for every $100 invested in early afternoon trading. The higher price lowered the yield to 2.91 percent from 2.93 percent late Monday. Long-term interest rates are near their lowest levels this year.

and strengthening the dollar, which reduces demand for our exports increases demand for imports.

The best currency forecasters say the dollar’s 12 percent slide over the past year is coming to an end as Europe’s deepening debt crisis discourages bets against the world’s reserve currency.

What is the Consumer Surplus from the Internet?

Here is a nice Youtube video that clearly demonstrates the value of a specific innovation titled "Would You Give Up The Internet For 1 Million Dollars?"

Even in a lousy economy we all enjoy things, from smart phones to aspirin to air conditioning, that weren't available to the world's wealthiest people just a short while ago. And if we have access to something like the Internet, something that's worth so much to us, we just might be richer than we realize.

I will quote (again) Steve Lansburg, "Henry VIII would have given up half his kingdom for access to the Internet and a handful of antibiotics."

Cartel busted

8 real estate investors have pled guilty to rigging bids at foreclosure auctions.

According to the court documents, the real estate investors conspired with others not to bid against one another at public real estate foreclosure auctions in Northern California, participating in a conspiracy in various lengths of time between May 2008 and January 2011.  After the conspirators’ designated bidder bought a property, the conspirators would hold a secret, private auction at which each participant would bid the amount above the public auction price he was willing to pay.  The department said that the secret, private auctions took place at or near the courthouse steps where the public auctions were held.  The highest bidder at the private auction won the property.  According to the court documents, the difference between the public auction price and that at the second auction was the group’s illicit profit, and it was divided among the conspirators, often in cash. 

The purpose of the second private auction, sometimes known as a knockout auction is to allocate the item to the highest-value bidder, and to compute cartel profits so that the gains from collusion can be distributed.

For example, suppose that of five bidders, three are cartel members. Imagine that they have values of {$500K, $400K, $300K, $200K, $100K} for a foreclosed property. Also imagine that the cartel members are the ones with values {$500K, $400K, $200K}.

In the first auction, the designated bidder will win and pay a price of just over $300K, the value of the highest non-cartel member.

In the second or knockout auction, the cartel members will bid among themselves for the property. The $500K bidder will win the knockout, and pay a price just over $400K, the value of the second highest bidder.

The profit to the cartel is the the winning bid is $100K=$400K-$300K, the difference between the prices in the knockout and the first auction.