Apple's contracts with phone companies

are a closely guarded secret.  But now the carriers are complaining about the contracts to the European Commission antitrust regulators, and some of the details of the contracts are starting to appear:

Apple’s contract differs with every carrier that sells the iPhone. Such sales accounted for 56 percent of Apple’s $55 billion in revenue last quarter. In most cases, Apple sets a quota for how many iPhones the carrier needs to sell over a set period of time, usually three years. If it does not agree to the quotas, it does not receive the iPhone.

If quotas are not met, the carrier is obligated to pay Apple for unsold devices, according to one person who negotiated with Apple while at a European carrier.

Rival phone manufacturers, in particular, seem to be concerned:

...Apple’s competitors complain that the big purchases Apple requires from carriers strongly pressure them to devote most of their marketing budgets to the iPhone, leaving little money to promote competing devices, said an executive at one of Apple’s rivals, who declined to be named to avoid jeopardizing carrier relationships. 

Note that harm to competitors is not harm to competition.  Indeed, the marketing requirements can be viewed as a simple, direct way to better align the incentives of carriers with the profitability goals of the manufacturer.  Often retailers invest less than manufacturers would prefer, and the contract could be one way of addressing this incentive conflict. 

There is also the possibility that the carriers are using the threat of antitrust to re-negotiate their contracts so they can make themselves better off, but often at a cost to competition (see my paper on a related topic).  Remember that parties cannot contract around inefficient antitrust rules. The right to sue to void an anti-competitive contract is an inalienable right.   

Bank Risk Taking during the New Deal

A recent working paper (gated), "Does “Skin in the Game” Reduce Risk Taking? Leverage, Liability and the Long-Run Consequences of New Deal Banking Reforms," by Kris James Mitchener and Gary Richardson examines moral hazard in lending. Essentially, New Deal regulations required bankers to take on some of the risk of the loans they made. From the abstract:

In states with contingent liability, banks used less leverage and converted each dollar of capital into fewer loans, and thus could survive larger loan losses (as a fraction of their portfolio) than banks in limited liability states. In states with limited liability, banks took on more leverage and risk, particularly in states that required banks with limited liability to join the Federal Deposit Insurance Corporation.

Requiring 'skin in the game' appears to reduce risk taking with other people's money.

Joe Fresh at JCP

Joe Fresh is an upscale Canadian retail chain that appeals to a younger demographic. JC Penny is an struggling US retailer not know for being at the forefront of fashion. As widely reported, they have struck a deal in which Joe Fresh would obtain floor space with JPC stores.

The deal's exploitation of economies of scope stem from economies of scale in different complementary assets owned by each firm. Due to its successes, Joe Fresh has a hot brand that could be leveraged into more retail outlets. It is experiencing economies of scale marketing which the deal exploits very quickly. Due to its failures, JCP has plenty of underutilized floor space in its stores throughout the US. It has economies of scale in distribution which the deal could exploit very quickly. If done well, this moves these assets to a higher-valued use. Many of the news analyses focus on whether this is enough to save JCP (generate positive profits). This misses the point that JCP will almost surely be better off (higher profits even if still negative).

Innovation in sailboat racing driven by contest

This is such a cool video that I needed to find a link to managerial economics so I could post it.  Here it is:  a "prize" is a better way of encouraging innovation than subsidies.  See our earlier post, Prizes (McCain, battery) vs. subsidies (Obama, ethanol)

Cypriot depositors respond to incentives

I just moderated a panel where I heard the heads of Cantor Fitzgerald, TIAA-CREF, and Tennessee's public pension fund say (I am paraphrasing) that they thought that Ben Bernanke could re-inflate the very bubbles whose popping had lead to the financial crisis, and then let the air out when the economy improved, all without any problems.

If they are right, Bernanke will go down in history, along with Paul Volker, as the two greatest fed chairmen of all time.  But  yesterday's bank runs in Cyprus tell us that the best laid plans of mice and men often go astray. Here the politics seem to be leading them astray:

The depositor haircuts seem to have been necessary to get political support for the deal in the EU--and political support in the EU was necessary because Cypriot banks had assets somewhere in the neighborhood of 8 times the Gross Domestic Product of Cyprus.  ... And because Cypriot bank accounts seem to be a favorite of tax-dodging Russian oligarchs . . .

From a technical, economic, perspective, however, this looks to be disastrous.  If we are not yet having full-scale runs on Cypriot banks, we've at least worked up to a pretty brisk jog.  No banking system can survive a bank run; if everyone tries to get their money out at once, even the soundest, most prudently managed bank in the world will fail, because they can't liquidate their loan assets fast enough to keep the cash moving out the door.

And if depositors in other troubled EU countries are paying attention, then we may see bank runs spread.

UPDATE:  Economist has a nice article on the perversity of letting the banks shareholders and bondholders walk away while making insured depositors pay for the bailout:

...there is no moral imperative for whacking Cypriot widows and leaving senior bank bondholders untouched, as appears to be the case here; or not imposing any losses on sovereign-debt investors in Cyprus; or protecting depositors in the Greek operations of Cypriot banks, as has also happened. 

Market timers vs. asset allocators

Reblog from Tuesday, March 3, 2009

Modern Portfolio Theory tells us to hold a balanced portfolio of stocks and bonds. If we want higher returns, we have to increase the portion of our portfolios devoted to risky stocks.

Jeremy Siegel takes this argument one step further and notes that if you have a longer time horizon, e.g., 20 years, there is no tradeoff between risk and return: holding bonds serves only to reduce return:

Stocks on the long term have returned 6.8% per year after inflation, whereas gold has returned -0.4% (i.e. failed to keep up with inflation) and bonds have returned 1.7%. The equity risk premium (excess return of stocks over bonds) has ranged between 0 to 11%, it was 3% in 2001^[8]also.

John Mauldin has a good column on the revenge of the market timers. He shows, in the table below, that it matters when you get into the market.

The implied prescription is to look at market fundamentals and enter the market only when stocks are relatively cheap (as Shiller's methodology currently says it is).

Tennessee's pension fund wins recognition

The $36 Billion pension fund run by the State of Tennessee has been recognized as Large Public Plan of the year. 

The fund had a one-year return of 8.61% in fixed income investments as of Dec. 31, beating its longer duration benchmark—the Citigroup Large Pension Fund Index, which returned 6.26%—and its median peer group which returned 7.78%.

“When interest rates fell, the longer duration benchmark did really well,” Brakebill said, adding that the fund’s strategic asset allocation takes on more risk than is typical for funds in its peer group. 

We congratulate Mr. Brakebill for his performance, but more importantly for recognizing that it comes at the cost of assuming more risk. 

 Related links:

• Market timers vs. asset allocators
• Jeremy Siegel, Stocks for the Long Run

FTC regulator calls out Nashville

In the past, we have blogged about how taxis use regulation to thwart competition.  Now we have Dr. Mark Frankena, a former high ranking FTC regulator, calling out Nashville (in a forthcoming article in Regulation) for its minimum price regulation (this would be illegal under the antitrust laws if done by the taxis themselves) and for imposing ridiculous cost-raising requirements on limos:

Those anticompetitive regulations have harmed Nashville’s residents and visitors alike, while enabling taxi and limousine companies to earn greater profits.  ... This article tells the story behind those events, and why Nashville is worse off for them.

Although it pains me to have to teach this to my students, it is yet another example of "make the rules or your rivals will"--in this case to raise profit at the expense of consumers.

Call your Council Members and let them know what you think.  I did. 

Hope for cities: the Sandy Springs model

Quiz: why are divorce filings spiking in China?

Its the incentives, stupid:

Divorce filings shot up here and in other big cities across China this past week after rumors spread that one way to avoid the new 20 percent tax on profits from housing sales was to separate from a spouse, at least on paper.

What does this imply about the value of a marriage contract?

Demographic changes shift housing demand

Baby boomers built large homes on big lots (article):

...80 percent of new homes built in that era were detached single-family homes. A third of them were larger than 2,500 square feet. And most startling – "I checked my numbers over and over again,” a bemused Nelson says – 40 percent were built on lots of half an acre to 10 acres in size. 

But a much bigger chunk of today's new buyers want condos and urban town houses.  So do the aging baby boomers, now empty-nesters, wanting to downsize.  So what will the effect of this shifting demand be?

“Between changing preferences and declining median household income, ...that means we can predict the next housing crash, and that’ll be in about 2020.”

...“My suspicion,” Nelson says, “is that many hundreds of thousands, maybe millions of those households in the 2020s to 2030 and beyond will simply give up the house and walk away.”

Hugo Chavez' legacy

His policies destroyed a big chunk of Venezuela's wealth:

It has one of the world’s highest rates of inflation, largest fiscal deficits, and fastest growing debts. Despite a boom in oil prices, the country’s infrastructure is in disrepair—power outages and rolling blackouts are common—and it is more dependent on crude exports than when Chávez arrived. Venezuela is the only member of OPEC that suffers from shortages of staples such as flour, milk, and sugar. Crime and violence skyrocketed during Chávez’s years. On an average weekend, more people are killed in Caracas than in Baghdad and Kabul combined. (In 2009, there were 19,133 murders in Venezuela, more than four times the number of a decade earlier.) When the grisly statistics failed to improve, the Venezuelan government simply stopped publishing the figures.     

As a result, the most productive people left the country:

Private investors, unhinged over Mr. Chávez’s nationalizations and expropriation threats, halted projects. Hundreds of thousands of scientists, doctors, entrepreneurs and others in the middle class left Venezuela, even as large numbers of immigrants from Haiti, China and Lebanon put down stakes here.

"You are what you measure"

Thus spoke Michael Corbat, new CEO of Citigroup Inc.  (WSJ article)

Mr. Corbat is expected to unveil quantifiable targets that will allow analysts and investors to more-easily gauge the company's performance, said the people familiar with the plan. Those goals are expected to be similar to ones outlined in a new executive compensation plan that grades performance based on return on assets and tangible common equity, the people said.

Mr. Corbat is correct, in theory.  As we note in our textbook, the only problem of management is how to align employee incentives with company goals.  By this we mean how do you design an organization so that employees (i) have enough information to make good decisions, and (ii) the incentive to do so.

And of course, incentives have two pieces:  (1) a performance evaluation metric; and (2) a compensation scheme that rewards good performance, or punishes bad performance.  Mr. Corbat correctly focuses on the most difficult piece of management, measuring performance.  He promised to

...instill the right incentives through the use of score cards that will grade the 50 or so top executives based on a set of weighted goals from five categories: capital, clients, costs, culture and controls. The highest score is 100%; the lowest is minus 40%, said people familiar with the plan.

In practice, it is easy to predict that Mr. Corbat will run into trouble.  There are a myriad of decisions that employees are expected to make, and designing incentives to make sure they make good decisions for each one is a difficult task.  Objective performance evaluation works best for employees like sales people who have a single objective metric that reflects their individual decisions.

With five potentially conflicting categories (how do you measure "culture"), there is a danger that the performance evaluation exercise becomes an exercise in subjectivity--exactly what the quantitative targets are designed to replace.

If he had asked me, I would have suggested company profit or division profit, and grant stock bonuses based on these metrics that could not be exercised for at least five years. 

We will be following Citigroup's performance. 

Beer Consolidation

According to Adam Davidson's NY Times blog entry, the DOJ is using modern tools of managerial economics when seeking to block Anheuser-Busch InBev from buying the rest of Grupo Modelo. AB InBev was formed by a recent merger and Corona's 7% US market share goes to Grupo Modelo.

The case is not built on any leaked documents about some secret plan to abuse market power and raise prices. Instead, it’s based on the work of Justice Department economists who, using game theory and complex forecasting models, are able to predict what an even bigger AB InBev will do.

At the same time, entry has been common,

In 1978, there were 89 breweries in the United States; at the beginning of this year, there were 2,336.

But almost all of these entrants are tiny and their products are quite differentiated from the big guys'.