Competition is good

Warren Buffett’s Berkshire Hathaway and Jorge Paulo Lemann’s 3G Capital just purchased Heinz for $23.3 billion.  This raises an obvious question, "why is Heinz worth more to its new owners?"

The value creation can be seen in the actions of its new owners. 

Since taking over, Hees has eliminated hundreds of jobs, grounded corporate jets, limited spending on office supplies and pulled the plug on mini-fridges at the office. Savings will help pay down $12.6 billion in borrowing supporting the deal.

In other words, the old owners were letting executives shirk, or incur unnecessary costs.

If executives do not maximize shareholder value, it gives someone else the opportunity to come up with a better plan, buy the company, and execute it. 

If someone else can do things better, faster, cheaper, or more attractively, then consumers will abandon the products of the old company (product market competition), or someone will buy the company and make sure they do (competition in the market for corporate control).

Both types of competition help align the incentives of firms (who want higher profit) with the goals of consumers (who want lower prices, and higher quality).  

EXTRA CREDIT:  how do we align the incentives of those providing government services, like mail service or regulation, with the goals of consumers? 

Christmas Bundles

I am torn. Part of me is proud that they understand pricing so well. And part of me thinks they mis-understand Christmas.

How t-shirts get made

Good five part series by NPR that is making me rethink my opposition to government subsidies for public radio. 

Shows how the invisible hand of the market gets farmers in Mississippi to cooperate with factories in India to make a t-shirt. 

Car Dealership Quota: 129 Cars

A nice story on "This American Life" was about a car dealership trying to make its monthly quota.

So they have to make October. And when I say "have to make," this is not some sort of abstract, feel good, compete with the dealership down the block just for fun kind of competition. They're part of Chrysler. And if they sell 129 cars and trucks by the end of October, Chrysler will pay them a bonus that's pretty much the difference between the dealership being in the black or being in the red for the month-- somewhere between $65,000 and $85,000, depending on which models they sell. Different cars earn different amounts. If they sell 128 cars-- fall just one car short-- they get nothing.

Lots in the story about high-powered incentives, bargaining, negotiations, and even the Art of War.

What happens when you post medical prices online?

You attract Canadians,

Smith knew that putting his prices online had been a great idea when Canadians began flying down to the SCO for treatment: “The first thing that happened once we started posting our prices online was the Canadians started showing up. They could pay $3,200 from Vancouver for a hernia operation to step out of line.” The line Smith refers to is Canada’s single-payer, government-run healthcare system, which boasts some of the longest wait times for surgical care in the Organisation for Economic Co-Operation and Development (OECD), the rich-country club. Smith contracts with a Canadian health broker specializing in finding wait-listed Canadians access to care and describes the high number of Canadians he sees as “fascinating because that’s the healthcare system that everybody in this town thinks we need.”

 and Americans with high-deductible plans:

Smith has also had success in appealing to people with high deductibles and to mid-sized companies in Oklahoma and North Texas. He has directly courted companies that feel that they are overpaying for their HMOs, asking CEOs, “Why would you be OK with paying $14,000 for a tonsillectomy across town for one of your employee’s children when we’ll do it for $2,900?” In response, many companies have moved their health plans to the SCO, offering to eliminate employee copayments for treatment on the condition that surgeries are performed at the SCO. As a result, one medium-sized bank in the region was able to drop its premiums by 10 percent. Smith’s corporate accounts have significantly improved his profitability: “In the last year, as a result of our outreach to CEOs of big companies, we are 40 percent busier than we were a year ago, and it’s primarily due to us posting these prices.”

HT:  Blake

Distinguishing FB Friends from FB Trolls

Suppose part of your marketing campaign involves creating a Facebook page to engage in social media marketing but you many of the comments are from disgruntled customers who constantly complain about your product. If you are Burger King Norway, you entice them to go away, e.g. "unfriend" you, by offering them your competitor's product for free.

Those who wanted the giveaway had to agree not to join the new Facebook page, receiving their voucher for a Big Mac plus a signed goodbye letter from Burger King in exchange.

About 1,000 accepted the vouchers but even more left.

Burger King lost 30,000 followers as a result, but says its new fan base of 8,000 are more engaged and interact with the brand in a more positive way.

Losing 29,000 to get rid of 1,000 may seem like a steep price to pay. Perhaps the 8,000 remaining are more likely to post something positive which will show up in all of their friends' news feeds. If the 29,000 who left without the voucher were not "engaged," perhaps there was no ongoing flow of posts in their friends' news feeds to lose.

REPOST: Consult an economist before buying a wedding dress

When Stephanie (her name has been changed to avoid embarrassment) went shopping for a wedding and bridesmaid dresses, she found valuable advice from an unusual source, Chapter 23 of her favorite economics text.  And it was not about sleeve options, figure flattery, or bustles.

She was puzzled that over half of the stores that sell wedding dresses do not permit photos, and do not have tags in the dresses that would identify the manufacturer and style type.  

These retail stores want to prevent customers from "free riding" on their fitting and display services:

I just spoke with someone who had all her bridesmaids sized in the store only to go online and buy them from a discount site. I would assume many of the brides are doing this as well.

Note that this is not just a problem for the store, but also a problem for the dress manufacturer: if stores cannot prevent free-riding, they will invest less in point-of-sales fitting services, and dress sales will suffer.  See our earlier post about golf club manufacturer PING, who faced a similar problem,

The discount retailers were advising consumers to visit a full-service retailer to request a custom-fitting session, and then bring the specifications for custom-made clubs back to the discounter. PING could control this kind of opportunistic behavior only by dropping dealers, a very costly option.

PING wanted to set a minimum retail price (called "retail price maintenance") to address the problem.  The minimum price meant that discount retailers could not undercut full service retailers.  The antitrust laws prevented this until the Supreme Court changed the case law.

For the wedding dresses, the no-photos policy created a problem for Stephanie because she wanted to photograph her bridesmaids in each of the dresses to make sure that they choose the best dresses for the wedding. So she chose to purchase from a large retail chain, like J. Crew, BCBG, Ann Taylor, or Nordstrom’s because they had solved the free riding problem, using exclusives, where only one chain carries the style.

For an economic analysis of resale price maintenance, see the amicii brief of 24 antitrust economists (I am one of the 24.)

UPDATE:  Amazon just made free riding a lot easier.

Flood subsidies are difficult to remove

Subsidies destroy wealth by encouraging the movement of assets to lower valued uses.  Flood subsidies,, for example, encourage home owners to build where they ordinarily wouldn't build because the insurance rates are artificially low.  

But what happens when government tries to make these homeowners bear the costs of their insurance?  

... affluent beachcombers who are accustomed to artificially cheap insurance. Businesses, vacation homes and homes with "repetitive" flood losses will see rates rise 25% a year until those "rates reflect true risk," according to the Federal Emergency Management Agency (FEMA), which administers the federal insurance program. About 20% of the national insurer's 5.5 million policyholders will be affected.

Cue the caterwauling from the 1% and their elected representatives. In June the House voted 281-146 to delay premium increases for a year, a turnaround from the 406-22 vote that passed Biggert-Waters only a year ago. California Democrat Maxine Waters is protesting that she didn't know what was in the law that bears her name—which seems plausible to those who have followed her career. She'd like more Americans to build homes in flood zones and have poor Americans pick up the tab when insurance premiums don't cover losses.

REPOST: Advice for selling on eBay Motors: use lots of photos

A new economics paper has found that prices for cars sold on eBay motors rises the more photos you post on the site (about $80 extra for each photo).

Remember that adverse selection (or the "winner's curse" in auctions) is caused by the fact a seller have more information about the quality of the car than do buyers or bidders (economists call this "information asymmetry"). If buyers offer a high price, then they get a mixture of high and low quality vehicles, and pay more--on average--than the vehicle is worth. So buyers offer only low prices, correctly anticipating that only low quality vehicles will be offered for sale.

So how does a seller with a high value car convince a buyer that it is of high quality. The authors suggest that offering photos is akin to a guarantee of quality, a type of signal:

By disclosing their private information on the auction Web page in text and photos, the seller offers a contract to potential buyers to deliver the item described in the listing. If the disclosures define sufficiently detailed and enforceable contracts, the initial information asymmetry should play no role in determining the performance of the market.

I received this from a former student who verified that this theory, at least, works in practice:

My most recent eBay vehicle sale was a 102,000 mile seven year old truck, tons of bidding and sold for $11,000 sight unseen to a buyer in New York.

Text of the eBay listing is included links to all of the photos you see here:

Photos of EVERY body panel, EVERY interior angle, EVERY tire, EVERY engine bay angle, etc. Buyer was DELIGHTED upon receipt and couldn't believe I'd sent it to him with a full tank of gas.

REPOST: The Winners' curse in Yahoo Display Auctions

Preston McAfee is an unusual economist in that he has passed a market test: Yahoo is willing to pay him for his advice. His latest advice is on the design of auctions for graphical displays on web pages. Yahoo runs billions of these automated auctions every day, through their Right Media Exchange (RMX).  Advertisers can bid for certain kinds of customers, and can pay for impressions, clicks, or sales.

To choose the highest-valued bidder, Yahoo develops predictors of how many clicks and sales result from each impression. For example, if one click occurs for every ten impressions, an advertiser would have to bid more than 10 times as high for a click as for an impression in order to win the auction.

Yahoo was very proud of its predictors, but was puzzled that they systematically over-predicted the actual number of clicks or sales after the auctions closed. A well-trained economist would recognize this as an example of the winners' curse:

In a standard auction context, the winner’s curse states that the bidder who over-estimates the value of an item is more likely to win the bidding, and thus that the winner will typically be a bidder who over-estimated the value of the item, even if every bidder estimates in an unbiased fashion. The winner’s curse arises because the auction selects in a biased manner, favoring high estimates. In the advertising setting, however, it is not the bidders who are over-estimating the value. Instead, the auction will tend to favor the bidder whose click probability is overestimated, even if the click probability was estimated in an unbiased fashion.

As with the winner's curse, there is a simple fix--bid as if your estimate is the highest among all the bidders. This requires shading your predictors downwards, based on the variance of the prediction.

The paper also details two other features that Yahoo uses to make their auctions more efficient: randomized bidding, used when a less-informed bidder bids against a more-informed one; and sometimes the auction is not won by the highest bidder, due to the value of learning. When a bidder has a novel or unusual use for the display, sometimes Yahoo lets the novel user win so that Yahoo can learn more about the value of the use. If Yahoo learns that the novel use of the display is more valuable than they thought, then they can earn enough in the future to more than compensate them for giving up some revenue earlier on.

Posted by Luke Froeb at 5:11 PM 6 comments:

REPOST: Moral Hazard vs. Adverse Selection

Back in 1992, Nobel Laureate Peter Diamond proposed a solution to the adverse selection problem in health care. The NY Times reprinted an old editorial by Professor Diamond based on an article in Econometrica :

The core of the problem is that insurance companies can pick and choose their customers. They tailor policies to attract low-risk individuals, leaving those who are -- or are about to be -- chronically ill to fend for themselves or else pay huge fees.

To solve this adverse selection problem, Professor Diamond would eliminate worker-based coverage and replace it with a government-determined risk pools:

First the government divides the entire population into many large groups. Then, the government creates a Federal Health Insurance System (HealthFed), modeled on the Federal Reserve System, ... There would be redistribution between groups and pricing of alternatives to reflect optimal social insurance principles.

But any solution to the adverse selection problem would also exacerbate the moral hazard problem, so vividly described by my colleague Larry Van Horn

I start each day with my morning “cocktail” of an ACE inhibitor, Beta blocker, and Statin - all grossly subsidized by my health plan. I pay the same monthly premium as every other employee at my workplace with a family health plan. My wages have been reduced to fund the insurance premium behind the scenes, so I never know how much was taken from me. I know the only way to get my money back is to consume the services and drugs.

To solve the moral hazard problem, make consumers face the consequences of their risky behavior, with, e.g., with polices that have big deductibles.

My take away: Democrats are concerned with adverse selection, and want to increase consumption of health care; Republicans are more focussed on moral hazard, which would reduce consumption of health care. Pick your poison.

What they don't tell you about Thanksgiving in school

Peter Klein gives us a more complete story of the first Thanksgiving:

Faced with potential starvation in the spring of 1623, the colony decided to implement a new economic system. Every family was assigned a private parcel of land. They could then keep all they grew for themselves, but now they alone were responsible for feeding themselves. While not a complete private property system, the move away from communal ownership had dramatic results.

Is the Pope committting the nirvana fallacy?

Pope Francis made headlines this week by criticizing free market (Anglo-American) capitalism:

"Just as the commandment 'Thou shalt not kill' sets a clear limit in order to safeguard the value of human life, today we also have to say 'thou shalt not' to an economy of exclusion and inequality. Such an economy kills," Francis wrote in the document issued on Tuesday.

But does this mean that the alternative is better?  The relevant question is not whether capitalism kills but rather whether the Pope's implied alternative would do any better.  In this classic clip from Milton Friedman, he says that the record of history is "absolutely crystal clear" on this point:

The "Replacing Our Bodies Overnight with Technology" Act

Jordan Weissman at the Atlantic thinks we should call the new bill in the Senate that raises the minimum wage and provides tax breaks for technology the ROBOT Act. Because the demand for robots will increase.

In other words, this bill would make it more expensive to hire workers and cheaper to buy the technology to replace them. From a political horse-trading perspective, this makes total sense. From a job-creation perspective, it's a little alarming.  

Never Punt

Risk on trading in Greek debt

Following up on our earlier post about Risk-on, Risk-off trading.

Here is an update of the time series graph, showing that after peaking at 48%, when the European Central Bank said it would buy Greek Debt, the risk premium on Greece debt has dramatically fallen. 

HT:  Matt D.

REPOST: Sales "bunching" and high-powered commission rates

Ian Larkin studies the use of "high powered" quarterly sales commissions, used by virtually every firm that sells software. A typical incentive compensation scheme (as a function of sales) is highly convex: a sales person earns 2% if she sells $100,000 worth of software; 5% if $500,000; 8% if $1,000,000, ..., up to 25% if $8,000,000.

Ian finds that these high-powered (convex) compensation schedules give sales people an incentive to "bunch" sales into the same quarter. Just as concave production costs can be reduced by "smoothing", i.e., holding inventories to buffer sales shocks, so too can convex commissions be increased by "bunching" sales into the same quarter, the opposite of "smoothing."

Using proprietary data from a large vendor he finds that 75% of sales are occur on the last day of the quarter; and 5% of sales occur on the first day of the quarter, as sales people give discounts to customers to accelerate or delay purchases. These discounts cost the firm about 7% of revenue, which is about the same amount that it pays out in sales commissions.

The 7% revenue loss suggests that there is a way to make both firm and its salespeople better off: adopt linear commission schemes to eliminate the incentive to "bunch," and split the 7% savings between the firm and its sales people in the form of higher commission rates.

When asked why they use these costly incentive compensation schemes, managers say only that they need them to retain their "superstar" sales people. But surely there is a better way to retain superstars, isn't there? As always, I would like to hear from readers on whether they think this would work.

Why are turkey prices 9% lower when demand is highest?

The NY Times explains the debate among economists who worry about such things:

The most intuitive and popular explanation for a high-demand price dip is that retailers are selling “loss leaders.” Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups. Likewise, Macy’s offers a big discount on select TVs on Friday, which will ideally entice shoppers to come in and buy clothes, gifts and other Christmas knickknacks on that frenzy-fueled trip.

When you price complementary products (chapter 12) it makes sense to reduce the price.  An alternate explanation is from the demand side:

Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales. Perhaps, during the holidays, the composition of consumers changes; maybe only rich people or people who really love turkey buy it in July, but just about everybody — including lower-income, price sensitive shoppers — buys it in November. Or maybe everyone becomes more price-sensitive in November because they’re cooking for a lot of other people, not just their nuclear families. 

“People are a little less picky about what they’re buying for other people,” explains Judith Chevalier, an economics professor at the Yale School of Management. “Let’s say I prefer Coke over Pepsi. If I’m buying for myself, I’ll probably buy Coke even if it’s more expensive. But if I’m buying soda for a party, I have no reason to think everyone else also prefers Coke, so I’ll go with whichever brand is cheaper.”

If turkey demand becomes more price elastic around Thanksgiving then we know that it makes sense to reduce price (Chapter 6).  A related explanation is that prices dont change, but rather the more price sensitive consumers substitute toward the cheaper brands. 

 One paper looking at canned-tuna prices argued that this kind of brand substitution was the primary case for an overall decline in price during Lent. It turns out that the cheapest tuna brands aren’t significantly discounted during Lent, but because the cheap brands temporarily accounted for a much higher share of overall sales, they dragged down the average price of a can of tuna.

HT:  Sam

If only President Obama had read chapter 19

If you sell insurance at a single price, anticipate that high risk individuals will be more likely to buy, and price accordingly. 

Recent data out of Kentucky, which has one of the best performing exchange websites in the U.S., show that the average age of enrollees is about 51, ten years above expectations.  To insure these higher cost individuals, premiums will have to "skyrocket" and this leads to the so called "death spiral." 

This happened in New York, New Jersey and Massachusetts where young people opted out of the system as a whole because of high prices.

“As premiums rose, healthy people dropped out meaning the risk pool was high,” Herrick says. “Premiums rose again, and more healthy people dropped out. The costs for individual insurance were double and triple the national average.”

If President Obama had read Chapter 19, he would have known to anticipate this kind of adverse selection.

Don't worry though, I am sending him a copy of my book. 

HT:  Roberta

Randomized experiment tells us how to get some welfare recipients back into the job market

Helping needy people can reduce the incentive to get back into the work force.  For example, when I take a job, I lose my welfare check plus other benefits, and this raises the 'opportunity cost' of taking a job. 

Economists call this an "effective high marginal tax rate" because the incentive to off welfare is reduced in much the same way that high marginal tax rates reduce the incentive to work harder. 

So how do welfare recipients respond to these incentives?  A randomized trial from Canada sheds light on the answer:

Basically, a group of welfare recipients were randomly split into a treatment group that received a supplementary payment that reduced the effective marginal tax rate on income from 100 percent to 50 percent for a three -year period, and were compared to a control group that was randomly selected to receive no change to the current program. (The details are available in an excellent program final report from 2002.)

The findings:

People respond to incentives.  During the period of the reduced marginal tax rate, reported work earnings and reported income rose for the test group vs. control during the experimental period.  

Marginal is not average.  At the peak effect of the program (16 months after random assignment), about 30 percent of the treatment group were employed full-time versus 15 percent of the control group. — the vast majority did very little different than they would have done otherwise...

This cost taxpayers more money, not less.  In round numbers, as compared to control the treatment increased total reported take-home earnings by about $200 CD [Canadian $] per month, about $100 CD of which was greater reported wage income, and about $100 CD of which was the supplemental cash transfer from the government  

The effect disappeared after the program ended.  After the program period (... about five years after program entry), the treatment group had about the same level of reported employment and income as the control group. 

 HT:  Instapundit

Dating Game

QUESTION: A man and a woman are trying to decide where to go on a date.  The woman prefers ballet, but the man prefers going to a football game.  There is some gain to going together, but each would rather go to their preferred activity alone, than together to their less preferred activity.  Diagram this game, and show how best to play.

 ANSWER:

                                                 Man
                                              Football             Ballet
                              Football   (1,4)                  (0,0)
Woman        
                                  Ballet   (2,2)                  (4,1)


The man does better by going to the football game, regardless what the woman does, and the woman does better by going to the ballet, regardless what the man does.  These are called "dominant strategies."  The equilibrium of the game is for each to go to their preferred activity.

Notice, however, that the two players could make themselves better off by cooperating.  Self interest is taking them to a place (2,2) with a lower group payoff than the cells on the main diagonal. 

There are two ways to change the game to increase group payouts.

1. Alternate.  If the couples take turns, their group payout goes up.

2. Have the player that receives the higher payoff, compensate the other player for going to their less preferred activity.

In this case, the man could give 1.5 units to the woman if they go to the football game, which would change the payoff in the upper left to (2.5, 2.5).  This would change the equilibrium of the game.

Alternatively, the woman could give 1.5 units to the man if they go to the ballet.  This is the premise of an off-color South Park episode.

Who benefit (or lost) when Central Banks began printing money?

McKinsey keeps score:

When the central banks began printing money, they bought loans, which is equivalent to an increase in the supply of loans. The price of a loan (interest rates) decreased. Low interest rates benefit borrowers, and hurt lenders:

 The winners: 

• From 2007 to 2012, governments in the eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion both through reduced debt-service costs and increased profits remitted from central banks (exhibit). 
• Nonfinancial corporations—large borrowers such as governments—benefited by $710 billion as the interest rates on debt fell. 
• Although ultra-low interest rates boosted corporate profits in the United Kingdom and the United States by 5 percent in 2012, this has not translated into higher investment, possibly as a result of uncertainty about the strength of the economic recovery, as well as tighter lending standards. 

The losers:

• Meanwhile, households in these countries together lost $630 billion in net interest income, although the impact varies across groups. Younger households that are net borrowers have benefited, while older households with significant interest-bearing assets have lost income.

When the banks begin tapering, will the losers  become winners and vice-versa?

Never start a land war in Asia, ...

or a price war.

If you want to compete, choose a dimension (differentiate your product, lower your costs, design an advertising campaign) that is difficult for your competitors to mimic.

Joker's (flawed?) game theory

Should the Joker have predicted this outcome using game theory?  Construct payoffs such that this is an equilibrium.  

HT:  David S.

Make the rules or your rivals will: use anti-growth activists to erect entry barriers

A recent paper by former student Mike Saint's consulting group shows how to erect barriers to entry to protect your market share, without running afoul of the antitrust laws:

The courts have sanctioned the right to organize community opposition that urges government officials and agencies to deny land use permits to applicants, even when the underlying motive of the opposition is protecting market share and eliminating competition. What’s more, the courts are protecting third-party funding sources, in many cases anonymous funding sources, which support the opposition efforts in order to block potential competition.

 The classic example of this is a local grocery story or gas station organizing opposition to zoning changes that would permit Wal-Mart to enter a market.

See related posts: 

Are the Wal-Mart battles over?

Make the rules or your rivals will

Sales Below Cost Laws

Unions using zoning laws against Wal-Mart

Why not just give money to poor people directly?

NPR's Planet Money has another episode that almost justifies the enormous amount of subsidies given to it.  They document an experiment giving $1000 to very poor people in Kenya and in Liberia. 

Those in Kenya did well, and it seemed to result in permanent improvement in their lives.  In Liberia, the results were temporary, probably because the economy is so inefficient in Liberia. 

Long run vs. short run

President Maduro is trying to win re-election so he seized the biggest electronics store and held a "sale."

In the short run, people get cheap stuff and they are happy.  But in the long run, he has reduced the incentive of retail outlets to serve people. 

This summer, I warned him about these kinds of policies, and I even sent him an autographed copy of my textbook.

Someone please get him to read chapter two. 

Using Randomized Experiments to Fight Poverty

Esther Duflo's inspiring TED Talk:

Health is an investment

...so to make people healthier, we have to get them to invest.  TED talk by Emily Oster:

John McMillan's Rational Pigs Puzzle

To illustrate how game theory works, I sometimes pose this puzzle in class, taken from John McMillan's terrific book, Games, Strategies, and Managers.

 QUESTION: Two pigs, one dominant and the other subordinate, are put in a pen. There is a lever at one end of the pen which, when pressed, dispenses 6 units of food at the opposite end. It "costs" a pig 1 unit of food to travel from the food to the lever and back.

If only one pig presses the lever, the pig that presses the lever must run to the food; by the time it gets there, the other pig has eaten 4 of the 6 units. The dominant pig can push the subordinate pig away from the food, and cannot be moved away from the food by the subordinate pig.

If both pigs press the lever, the subordinate pig is faster, and eats 2 of the units before the dominant pig pushes it away.

QUESTION: If each pig plays rationally, optimally, and selfishly, which pig will press the lever?

To answer the question, construct a simultaneous game, where the "payoffs" to the pigs are the net amount of grain consumed.

 ANSWER:  The subordinate pig always does better by not pulling the lever, regardless of what the the other pig does.  This is called a "dominant strategy."  The dominant pig's best response to this strategy is to pull the lever.  The unique equilibrium is for the dominant pig to pull the lever and consume 1 net unit of food while the subordinate pig consumes four.

                                                 Subordinate pig
                                              Pull              Don't Pull
                                   Pull   (3,1)                  (1,4)
Dominate pig        
                           Don't Pull  (6,-1)                 (0,0)


Ironically, with these payoffs, the subordinate pig will soon become dominant.  Then the equilibrium will change.

What should we do during the next financial crisis?

NY Times interview with Nobel Laureate Gene Fama:

In the financial crisis, do you think the government should have bailed out the big banks?

No, I don’t. I would’ve favored nationalizing the banks, not bailing them out.

Really? That’s not very libertarian, is it?

Well, we’re talking about realistic alternatives. It’s not credible that in a financial crisis, the government will do nothing. It never has. There are going to be demands for it to do something. So you’ve got two choices now. Nationalize them or bail them out. Bailing them out gives them terrible disincentives; it encourages them to take risks because they’ll be bailed out. So I’d nationalize them — and clean them up and then reprivatize them.

HT:  Merle Hazard

Reverse deductible creates incentive to shop for healthcare

Here is how it works.  One employer noticed that it was paying between $20,000 and $120,000 for a single surgery.  The employer said it would pay up to $30,000 for the procedure, and identified 41 hospitals that charged less than this.  Patients were free to go to higher priced hospitals, but they had to pay the difference.

Guess what happened next:

Half of the high-price hospitals cut their rates, many by a considerable amount....Across all hospitals, prices charged to Calpers for joint-replacement surgery declined by 26% in the first year and by even more in the second.

HT:  Nick

Risk-on, Risk-off trading

In our chapter 9 video, we illustrate how Vanderbilt Treasurer made money by selling risky assets and buying less risky ones when risk premia (the extra return investors receive for investing in risky assets) moved to historic lows.  He correctly reasoned that investors were ignoring risk in search of higher return, so when risk premia widened, in 2008, the price of risky assets fell relative to their less risky counterparts.  In the jargon of finance, this is known as a "risk off" trade.

We can illustrate risk-off trading, uusing Don Marron's "history of the European Union in one simple chart" below. It shows the premia that the Southern European PIIGS (Greece is in orange) had to pay to borrow money. 

In 1995, for example, Greece (in orange) had to pay 18% to borrow money, representing an 11% premium over Germany's (in red) 7% rate.  The risk premium disappeared in 2002 when Greece joined the EU.  In 2008, the risk premia re-appeared, as the interest rate on Greek debt rose to 16%, a 12% premium over Germany's 4%. 

From investopedia:

...During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.  ... The 2008 financial crisis was considered a "risk off" year, in which investors attempted to reduce risk by selling existing risky positions and moving money to either cash positions or low/no-risk positions, such as U.S. Treasury bonds.

If you can anticipate changes in risk premia, you can make money:

• A prescient "risk-off" trade would have been to short Greek debt and buy German debt in 2007, and sell in 2011.  
• Conversely, a prescient "risk-on" trade would have been to buy Greek debt and short German debt in 1995, and sell in 2001. 

Did "Cash for Clunkers" work?

A new paper confirms what the graph below shows: 

in 957 U.S. cities, the surge in automobile sales was short-lived while the program was in place. About 360,000 automobile purchases were induced in July and August 2009. Most of these purchases simply were brought forward by a few months: a sharp decline in sales after the program ended suggests that it had a muted total effect on auto purchases, the authors conclude. 

One of the criticisms of Keynesian stimulus is that Keynes never told us what happens in his model when taxpayers must pay back the money that the government spent to stimulate the economy.  Famously, he said, "in the long run, we are all dead." (See this post for a discussion of Keynes).  So in essence, Keynesian stimulus borrows consumption from the future. 

This looks like what happened. 

Open enrollment must be limited, or ...

...healthy people will wait until they are sick to enroll.  This is a type of moral hazard.

“If you can enroll at any point in the year, then you can just wait until you get sick,” Brian Wright, an analyst with Monness Crespi Hardt in New York, said in a telephone interview. “This isn’t the industry crying foul and exaggerating the issue, this is actually one of those issues where there is a well-grounded reason for the concerns.”

President Obama's extension of the open enrollment period would make insurance more expensive, as insurers anticipate this reaction from a long open enrollment season. 

Heads the unions win, tails the taxpayers lose

NY Times on the debacle of municipal pensions:

The city’s pension system made extra payments for decades to thousands of people, on the thinking that the base pensions were too small. The pension board thought it found the money for the extra payments by skimming off “the excess” when returns on investments exceeded the plan’s target — 7.9 percent in Detroit.

But the pension fund also had years when its investments fell short of the target. And with millions of dollars being paid out each year in the extras, the fund missed out on all the investment income that money would have brought in. So the extra payments fundamentally undercut the health of the pension plan.

Reform seems to come only from the threat of bankruptcy.

HT: Matthew

Signs of intelligent life in Nashville

... as voters forced Mayor Karl Dean to withdraw a plan to borrow $200M to help cover Nashville's unfunded pension liability.

Future Nashvillians are on the hook for about 2.5B (2B for medical pensions, 0.5B for regular pension) to city workers.  To help cover the short fall, the city proposed to borrow $200M at 4% interest, invest it and earn 7.5%. 

If the investments work out, then we can expect to net 3.5%, money that would ostensibly be used to pay down our unfunded liabilities.  In reality, it would likely fund more current government spending.

If the investments don't work out, our unfunded liabilities get even bigger. 

An Auction Reserve Clause with Consequences

"Glass on the Tracks" is local event in a suburb of Dallas-Fort Worth in which glass artwork is auctioned off. The highlight is the "Glass Guillotine" where, if the bidding does not go high enough, the piece gets destroyed. The hope is that this will motivate bidders.

d

HT: Olga

Why are young people leaving the workforce?

The graph above illustrates the sorry state of the US labor market.  Unemployment is falling only because people are dropping out of the labor force in record numbers.  Some of them are going onto social security disability.  You can see this in the falling labor participation rate (number of people who have jobs or are looking for jobs divided  by the working age population) while the number of working divided by the number who could be working has not recovered from the recessionary lows.

NPR had another story, The Startling Rise of Disability in America, that is making me re-think my opposition to subsidies for public broadcasting.  Here is the essence of the problem:

There's no diagnosis called disability. You don't go to the doctor and the doctor says, "We've run the tests and it looks like you have disability." It's squishy enough that you can end up with one person with high blood pressure who is labeled disabled and another who is not.

As a consequence of the squishy diagnoses, you get moral hazard, i.e., some people on disability don't belong there.  

Interestingly, Great Britain has tried to reduce disability rolls by testing recipients.  Here is what happened:

... in an attempt to make the replacement scheme more rigorous, applicants now undergo the WCA, which can require them to undergo a face-to-face medical assessment and provide a report from their doctor.

But government figures have shown that more than nine out of 10 people who claimed the new sickness benefit have been deemed fit enough to work.

More than a third of the 1.3 million people who applied for Employment and Support Allowance were found to be fully capable of working.

Is it time for a similar test in the US?

UPDATE: 
Donald Marron tells me that the trust fund for the disability part of Social Security is currently expected to run out of money in 2016. So there may be a budgetary "forcing" event requiring Congress to consider what changes to the program might make sense.

UPDATE:
WSJ has a front page article on the growth of Social Security Disability Program.

When you pay people to be unemployed, ...

...you get more unemployment.  Or so says a new paper from NBER.  What is interesting is the mechanism through which this works:

Everything else equal, extending unemployment benefits exerts an upward pressure on the  equilibrium wage. This lowers the profits employers receive from filled jobs, leading to a decline  in vacancy creation. Lower vacancies imply a lower job finding rate for workers, which  leads to an increase in unemployment.

This can understood as a movement up the demand curve (as the price of labor increases, quantity demanded for labor falls).

HT:  Greg Mankiw

When is being a Good Samaritan Bad for Business?

Kristopher Oswald was fired by Walmart for rescuing a young woman from being assaulted (though he was later reinstated). The altercation violated company policies for customer interactions.

The 30-year-old has said he was in his car on his break about 2:30 a.m. Sunday when he saw a man grabbing a woman. He said he asked her if she needed help and the man started punching him in the head and yelling that he was going to kill him. Oswald said he was able to get on top of the man, but then two other men jumped him from behind.

Livingston County sheriff's deputies arrived and halted the fight.

Why does Walmart have a policy against protecting their patrons? Rather than a policy of terminating these employees, don't they have a social responsibility to the local community to help thwart crime when doing so would be easy? Of course, what Walmart worries about is a mistaken employee altercation with perfectly innocent patrons. The possible resulting liability cost could easily outweigh the reputation loss due to more parking lot altercations. Hence the policy. The policy protects Walmart's bottom line but might encourage more crime in the area. Here is a case where there is tension between the pursuit of profits and the pursuit of larger social goals.

HT: Leah Hunter

Simple pricing: the "stay even" quantity

The marginal analysis of simple pricing, i.e., price at the point where MR=MC, is sometimes implemented by using a version of break-even analysis.  Instead of asking which price maximizes profit, you instead ask "will a given price increase, e.g., 5%, be profitable?"  To answer the question, we

1. Compute the stay-even quantity, the quantity you can afford to lose and still break even

2. Predict (or guess) whether the actual quantity lost will be greater or less than the stay-even quantity.

3.  If the actual quantity lost is less than the stay-even quantity, then the price increase will be profitable.  

Here is the derivation of the stay-even quantity:

The benefit of a price increase is the extra revenue you earn at the new (and lower) quantity, Benefit=dP*(Q+dQ)

The cost of a price increase is the margin on the lost sales, Cost=dQ(P-MC)

where dP=P1-P0, dQ=Q1-Q0, P0=initial price, P1=final price, Q0=initial quantity, and Q1=final quantity.

You compute the Quantity at which you are indifferent between raising price or not, and you get the formula:

(dQ/Q)=(dP/P)/[(dP/P)+m]

where m=(P-MC)/P, dQ/Q=% change in Q, and dP/P=% change in P.

EXAMPLE:

The stay even quantity for a 5% price increase for a firm with a 40% contribution margin is 11.1%=(5%)/[(5%)+(40%)].  If you expect to lose less than 11%, then a 5% price increase will be profitable.

REFERENCE:  Page 9 of
A Critical Analysis of Critical Loss Analysis,
Daniel P. O’Brien and Abraham L. Wickelgren, January 2003 (Published in Antitrust Law Journal) [PDF 236K]

How will the the municipal bankruptcies end?

For years, I have been trying to convince Nashville politicians to stop spending more than we are taking in, by fully-funding our pensions. 

Here is an interesting talk about what is likely to happen in places like Detroit, Chicago, Philadelphia, and Nashville.   It is long, so I will summarize:

• Cities bargain with municipal employees, but since employee unions support policitians, the bargaininig is far from "arms length."
• It is unlikely that overly generous, unfunded pensions will be restructured, except through bankruptcy.
• Fortunately, restructuring is likely to be found legal under the bankruptcy laws because funding is like "collateral." 
• This will fix the balance sheets of city governments, but also give the unions a stake in funding the pensions (fix the income problem)

Patent invalidation ==> entry ==> lower (or higher?) prices

The summer, the Supreme Court invalidated patent rights for human DNA.

Until the ruling, Myriad held patents--which gave them a monopoly--on genetic screening tests used to predict the risk of breast and ovarian cancer. These tests generated $519 million in revenue for Myriad, about 85% of the company's total revenue.

Since the ruling, Quest Diagnostics has begun selling its own tests that will have a list price of $2,500, $800 less than the incumbent's price.

If customers are all similar, then it is likely that Myriad will respond with price cuts of its own.  However, as we have noted before (When entry raises price) this is not necessary:

When a branded drug faces entry by a generic copy, it will stop promoting the brand (as that increases demand for the generic), and raise price. The brand loses its low-value (and more price-elastic) customers to the generic so that branded demand becomes less elastic. The brand responds by raising price.

If entry by Quest makes Myriad's demand less elastic--by stealing its more price sensitive customers--Myriad may end up raising price.

What happens when hospitals start serving sicker patients?

Revenue, and profit increase:

...during its better-than-expected second quarter, HCA posted solid same-facility admissions growth and piggybacked on that with sizable increases in revenue per patient. Same-facility revenue per equivalent admission for Q3 is expected to be up 3.4 percent year over year. The company said its treatment of patients with more acute conditions accounted for two percentage points of that rise.

Why is Blackstone buying single family homes?

Bubble-ologist and Nobel Laureate Robert Shiller discussses the housing market:

Dirigiste et absurde: France and its labor unions

France and its labor unions are taking extraordinary measures to stay mired in recession.  They have a raft of regulatory rules that deter wealth creating voluntary transactions, like:

...strict limits on opening and closing hours, the rules only allow sales during certain periods of the year, price promotions are circumscribed, loss leaders are illegal, store sizes are limited and even the types of shops allowed to open up are regulated. 

But now the labor unions have won a case against Sephora to prevent the retailer from staying open late,

...to protect workers from unscrupulous owners who force them to work antisocial hours. ...The cosmetics chain reckons it does about 20 percent of its business after 9 p.m., and the 50 sales staff who work the late shift do so voluntarily — and are paid an hourly rate that is 25 percent higher than the day shift. Many of them are students or part-time workers, and they have publicly expressed their indignation about being put out of work by labor unions.

Why do Chinese SOE's manufacture goods that no one wants?

Because State-Owned-Enterprises (SOE's) are judged on employment, not on profitability.  Eye-popping article in Forbes:

Of the 100,000 machines manufactured in the last twelve months, some 60,000 were manually operated. This is the functional equivalent of making typewriters. When my friend told his contact that that world market for such machines simply didn’t exist, the SOE-operator explained that production could not be cut without laying off workers, so the company continued the rate and was simply storing the machines they knew they could not sell. ...

Of course, this makes it difficult to compete with SOE's:

I repeated the story of the SOE machine tool manufacturer to another American friend working as a the China CEO of an American software-as-a-service company. He nodded somberly: he was trying to recruit an executive from a state-owned competitor, having lost so many deals to the rival firm that he’d resolved to hire their sales leader. But during the interview, his prospective employee explained that sales executives at the SOE were not judged on profitability, but instead on the goal of growing the number of people employed by the company. Profitability was not a meaningful metric, since if an SOE ran into financial trouble, the government would simply give them more money. The American CEO was stunned: how can Western companies compete in China? Any product or service that can be replicated by a Chinese company will be and the foreign company beholden to Western shareholders and ethics standards cannot sustain.

HT:  April

Are single parents causing inequality?

The Atlantic has an interesting story whose causal links go something like this:

Single parent households make less money.

This leads to less investment in kid's education which leads to lower levels of human capital which leads to lower income: 

The decline in marriage rates among poorer men and women robs parents of supplemental income, of work-life balance, and of time to prepare a child for school. Single-parenthood and inter-generational poverty feed each other. The marriage gap and the income gap amplify one another.

Better educated, higher-income men and women tend to marry each other which perpetuates the cycle:

The marriage inequality crisis creates a virtuous cycle at the top and a vicious one at the bottom. It pushes educated and non-educated Americans into entirely different worlds.

What can Nasvhille learn from Detroit's troubles?

In Detroit, where unions controlled the politicians, the politicians appointed union reps to administer the pensions:

Most of the trustees on Detroit’s two pension boards represent organized labor, and for years they could outvote anyone who challenged the payments.

They use this power to "redistribute" wealth from taxpayers to city workers, retired or not: 

Detroit’s municipal pension fund made payments for decades to retirees, active workers and others above and beyond normal benefits, costing the struggling city billions of dollars and helping push it into bankruptcy,

And they made it very difficult for outsiders to get the data necessary to "see" what they were doing. 

An investment banker now advising Detroit, Charles M. Moore, has said in a court declaration that the trustees of the general pension plan were “effectively robbing” the fund when they diverted its assets...

In Nashville, city pensions are underfunded by about half a billion, but our medical pensions are underfunded by about two billion.

Be careful of silos

Interesting talk about inter-divisional conflict: The problem is easily illustrated with a soccer team:

Assume that compensation for defensive players is inversely proportional to goals allowed, and compensation for offensive players is directly proportional to goals scored. Rational defensive players would rather lose 0 to 1 than win 5 to 4—because their payoff is higher when they allow only 1 goal than 4. Similarly, rational offensive players would rather lose 4 to 5 than win 1 to 0—because their payoff is higher when they score four goals than one.

If Walter White Hired a Market Consultant ...

his analysis might look something like the one reported on in the NY Times. Prof. Hart solicits crack and meth addicts into his experiments. After random sized sampling a dose in the morning, they are offered another same sized dose later on or cash or vouchers of varying amounts. When the dose is high and the alternative is low, they take another dose. But at when the dose is low and the payment is high, they opt not to get high again.

When methamphetamine replaced crack as the great drug scourge in the United States, Dr. Hart brought meth addicts into his laboratory for similar experiments — and the results showed similarly rational decisions. He also found that when he raised the alternative reward to $20, every single addict, of meth and crack alike, chose the cash. They knew they wouldn’t receive it until the experiment ended weeks later, but they were still willing to pass up an immediate high.

So there is some non-infinite price elasticity. The characters from Breaking Bad could use the implied elasticity to set profit-maximizing prices.

Fantasy Wealth Creation

NPR's Planet money has a fun story about the economy that is being created around fantasy sports. All these intermediaries are facilitating wealth creating transactions.

There's big money in fantasy sports. Last year, alone, people paid $1.7 billion to play in fantasy leagues. With all that money sloshing around, a fantasy economy has sprung up, giving rise to real businesses. Here are four of them.

They highlight:

• Insurance - against the star player on your fantasy team getting injured.
• Banking - to facilitate participation in multiple fantasy leagues.
• Dispute Resolution - because not all fantasy contingencies are foreseen.
• Extreme gaming - because once a week football games are not enough for your fantasy team.

Surprise Fed announcement causes dollar to weaken

The Fed's surprise announcement that they are going to keep printing money caused US ten year rates to fall from 2.9% to 2.7% in a matter of minutes. And the dollar fell. There are two obvious ways to think about the linkage. First, the carry trade means that the decline in US rates increases demand for borrowing in US dollars. These borrowers then sell dollars and buy foreign currencies to invest abroad. This drives down the dollar, relative to the foreign currency. Second, consider investment demand. As US interest rates decrease, demand from foreign investors falls (who had been selling, e.g., Euros to buy dollars to invest in the US). This drives down the dollar.

Doing "Good" with Other People's Money

Do managers over-indulge in corporate social responsibility (CSR)? Principle/agent suggest that they may over-fund their favorite philanthropic cause if it comes our of shareholder wealth and not their own. In "Do Managers Do Good with Other People's Money?," Cheng, Hong, and Shue examine what happens when insiders have a bigger stake in the company, that is, when more of the "doing good" comes out of their own pocket. When the 2003 Dividend Tax Cut to increased after-tax insider ownership, they observed:

First, increasing managerial ownership decreases measures of firm goodness.

 and

Second, increasing monitoring reduces corporate goodness.

That is, when shareholders could vote on CSR proposals, they tended to slow the growth.

Negotiating at Home

Household members have to decide how to allocate the resources they hold in common. Newlyweds might believe they will always agree on everything, and while few really become jaded, over the years most couples become somewhat disabused of this notion. Spending more on fishing trips, alcohol, and sporting events (traditionally male consumption) necessarily means spending less on romantic getaways, beauty products, and redecorating (traditionally female consumption). While the observance of gender differences verges close to, or into, sexism, these differences can be exploited to study bargaining power. Deciding where to make the split among gender-oriented spending may require some husband-wife bargaining.

This is exactly what Shing-Yi Wang thought when studying the effects of the assignment of housing property rights in China. If these rights go to either the husband or to the wife, then their bargaining position is improved relative to their spouse. Lo and behold, the household consumption of cigarettes and alcohol (male-favored goods) and the allocation household chores (female-favored duties) follow as one would expect from a non-strategic bargaining model.

How Apple Identifies Inelastic Customers

I found this image on the interwebs and so can not verify its accuracy. But if it is correct then Apple 5s customers choosing 32GB over 16GB are paying $120 more for a product that costs ~$8 more to make. Those choosing 64GB over 32GB are paying $130 more for a product that costs ~$22 more to make. (Costs may differ due to access speed, etc., but not much.) Apple can still earn pretty hefty margins.

Criticism of Marx

The undergrad professor (John Gurley) who introduced me to economics was a Marxist. I later took his Marxist econ class, and my copy of Das Kapital was almost pure yellow as I highlighted the hell out of it, struggling to understand what it meant.

The above lecture would have cleared up some of my confusion. It focuses on three of Marx's ideas:

1. The enemy of being is having.
2. From each according to his or her ability; to each according to his or her needs.
3. The point of philosophy is to change the world.

Transfer Pricing Failure in Academia

One of the stories causing "lunchroom chatter" in our profession is the closing of the University of Florida's Doctoral program in Economics. Most of us are shocked because it has been a good program with some top notch scholars. But when you dig a little deeper, this appears to have resulted from perverse divisional incentives. It turns out that the department, which is in the Business School, generates much of its class credit hours and tuition money from students in the Arts and Sciences College. While revenues accrue to one accounting unit, the costs accrue to another. Evidently, the transfer price was set to zero. It might be in the university's best interest to keep it open, but this is not in the different academic units' interests.

BTW, my own institution has the opposite problem. The implicit transfer price is set so high that each academic unit jealously guards against their students taking electives outside of the college. As a consequence, virtually no social science majors in Arts and Science, or students from any other college for that matter, take any economics classes because our department is housed in the Business School.  (We do it by requiring elective courses to be in other departments of our college.)

Misnomer: The Affordable Care Act

Unequal pay for women: rational choice or discrimination?

NY Times gets it half right.   A student summarizes the article:

...women disproportionately choose careers based on factors other than income and they have unique challenges when they do seek more lucrative careers.

HT:  Stephanie

How do you "sell" a lottery with a -50% return?

Here's how:

Our proclivity for fantasy makes us an easy target for advertising. Lottery commercials depict winners in stretch limousines, counting stacks of money, dressed in evening gowns and tuxedos, sipping champagne. The commercials hit home because fantasizing about winning the lottery activates the same parts of our brains that would be activated if we actually won, notes Daniel Levine, a professor of psychology: "The motivational areas of the brain can be heavily influenced by vivid daydreaming."

But even fantasy will drop its hold on us if we always lose. Research has shown that positive reinforcement is key in virtually all of the successful lotteries, notes Williams. Lotteries that allow players to choose combinations of four or five numbers from a total of 60 numbers are popular, he says, because many players experience "the near miss," which creates the illusion that they came close to winning the multimillion-dollar jackpot.

Has the US safety net become a hammock?

The Economist thinks so:

..In 39 states, their hypothetical single mother would make more from benefits than a secretary does from work. In 11, she would make more than a first-year teacher. For many Americans, says Mr Tanner, not working is a “rational alternative” to working.

What happened when Tennessee kicked 170,000 out of medicaid?

They started looking for jobs:

We ... find an immediate increase in job search behavior and a steady rise in both employment and health insurance coverage following the disenrollment. Our results suggest a significant degree of “employment lock” – workers employed primarily in order to secure private health insurance coverage. The results also suggest that the Affordable Care Act – which similarly affects adults not traditionally eligible for public health insurance – may cause large reductions in the labor supply of low-income adults.

HT: Larry

Make the rule or your rivals will: Uber vs. taxis

In the past, we have blogged about how Uber took advantage of inefficiencies caused by taxi regulation to come up with a more efficient way of getting consumers to where they want to go.  Now that the incumbent taxis have fought back, using the regulatory machinery of the state utility commissions, the FTC, a federal agency is pushing back against the state regulators:

• One proposed rule change would create a barrier to the entry ...
• Another proposed change would require ... a specific fixed price.  ..., this change would prevent companies from adopting new forms of variable pricing that might be more responsive to consumer demands for transportation service.
• A third proposed change would...  likely would prevent many consumers from using a smartphone application to get transportation service quickly, especially in downtown and “urban village” areas.

At least one agency of the Federal Government is trying to protect your interests.

DISCLOSURE: I used to work at the FTC.

TW/CBS Negotiations II

Did Time Warner blink? Most accounts of the Time Warner / CBS agreement indicate that CBS got most of what they wanted. Earlier, I had suggested that alternative ways to access CBS content may have increased Time Warner's disagreement value. Maybe I was wrong or maybe this just wasn't enough. CBS's strategy was to hold out until football season. At that point, Time Warner's disagreement value would fall because rabid football fans are more likely to switch to other providers such as Dish or Direct TV.

Microsoft Nokia Merger

Microsoft is buying Nokia's smartphone business. Evidently, vertical relations between smartphone software developers and smartphone hardware makers can get strained. RIM has always held the Blackberry OS close to its chest. Apple enters the consumer market as vertically integrated and, tellingly, has not licensed other makers to use its software. Google took the opposite tack by licencing Android to all comers. Only later does it decide to purchase Motorola's smartphone business to better integrate hardware and software capabilities. Microsoft is the late comer to the smartphone operating system business and has had less success lining up phone producers. The deal insures that a major phone maker will be supporting the Microsoft OS for some time to come.

These deals likely solve incentive conflicts between vertically related firms. Some phone makers may free-ride off of others' being on the cutting edge ("bleeding edge") of new features. Since the software and hardware are complementary, there is likely to be a double-marginalization issue. Finally, there is a fair amount of coordination that must occur for promotional activities.

Wii U, Content and Pricing

Nintendo is lowering the price of its new 8th generation console, Wii U, from $349 to $299 after disappointing sales. They got a one year head start on the 8th generation competitors, Microsoft's Xbox One and the Sony's Playstation 4, to be released for the coming Christmas holiday shopping season. But at the time of its launch there were only 29 games for the Wii U (though there are nearly 200 now). In contrast, there are already 63 games expected for the launch of the Xbox One launch and 110 for Playstation 4. Why buy a Wii U if the game selection is limited?

Video game consoles are examples of two-sided markets (consumers and publishers). Consumer demand increases the more games that publishers write for it and more publishers will write for it the larger the customer base is. New games using the latest generation of hardware are an important complements to consoles. Nintendo writes a number of these games but most are written by a network of third party game developers and publishers. Nintendo works hard to keep a steady flow of games from this network available to console adopters, as does Microsoft and Sony. Perhaps not hard enough. Apparently, the lack of content has led to more elastic demand and, thus, price decreases.

Is China real estate a bubble?

HT: Alex

Is stock price a good performance evaluation metric?

If you announce that you are leaving and your company increases in value by $18B, it was probably time to go.  

HT:  Sam

Prices and health care expenditures

Healthcare expenditures vary widely across different areas.  The economist has an article on the causes.

For Medicare patients [where prices are fixed by the federal government], most variation comes from differences in patients’ health status [consumption] and the overuse of a particular service, post-acute care, [e.g., nursing homes]. 

For privately insured patients, price gaps are to blame. ... In areas with a dominant hospital chain, prices are likely to be higher. The IOM reports that price mark-ups account for 70% of the variation in commercial spending.

How to commit bank fraud

Former student Brian Fox, of Confirmation.com, has created a case study based on some brazen frauds.

I, Pencil: The Movie

The movie version based on the famous essay by Leonard Read.

Reading this essay back in college was one of the more important determinants of me studying economics.

Hat tip: Ed Lopez

The Demand for Low Skilled Workers Just Fell

For over two centuries, mechanization in agriculture led to huge increases in output per farmer so that the demand for farm workers fell. Mechanization in manufacturing has led to so much worker productivity that, even though employment fell nearly 40%, output has more than doubled in the last 40 years. Slowly, mechanization is making inroads on some routinized services jobs - e.g. ATMs and bank tellers, scanners and grocery store clerks or MOOCs and professors? But some very low skilled jobs seemed to be stubbornly impervious to mechanization.

Now mechanization may be reducing demand for hamburger flippers. Momentum Machines has mechanized hamburgers preparation that they claim that is able to produce 360 fresh hamburgers per hour with tomatoes, pickles and such sliced to order.

Perhaps other fast food items will soon succumb to mechanization too.

Do Stock Brokers Work For Their Clients?

They might soon. The WSJ reports that U.S. Department of Labor is expected to propose new rules that would ensure that brokers and other securities professionals would act solely for the benefit of their clients when advising on individual retirement accounts. Currently, they have no fiduciary responsibility to their clients. Since they typically earn fees in proportion to the transactions their clients make, they have perverse incentives for more transactions even if these are not in the clients' best interest. A fiduciary responsibility would help alleviate this but may have other consequences.

The brokerage industry is concerned that they will not be able to earn enough under the proposed rule. As the consistently cogent reporting of Megan McArdle points out, this may be the best evidence for the change in the rules.

On the other hand, when I hear that brokers won’t be able to service small clients any more, my basic reaction is "Good." Essentially, brokers are arguing that they can’t afford to give you honest advice; their livelihood depends on being able to steer you into investment vehicles that pay them kickbacks. Sorry, commissions and referral fees. And where do the fees come from? Why, your pocket, ultimately; there’s a reason your broker has to be paid to tell you that this is a good idea. This sort of free advice you can’t afford.

Why I don't Teach Regression in Managerial Economics

A new textbook adopter asked why there is no chapter on demand analysis in our favorite textbook. I explain why I do not teach this in this longish post.

I was recently made aware of data on the top grossing concert tours in America in the previous decade (hat tip to Mark J Perry).These data are easily read into statistical software where one can then generate an average price as revenue divided by tickets. Plot these and you get what might look like a demand curve.

To get something like an elasticity from this, one would typically take logarithms and regress one against the other. In this case, regressing ln(tickets) against ln(price) yields an elasticity estimate of about -0.5 but regressing ln(price) against ln(tickets) yields an elasticity estimate of about -2.0. If you were going to make pricing decisions based on these elasticity estimates, you might want a bit more precision than this. So what went wrong?

• Are these tours representative of other tours? Many applications of such an analysis would apply the estimate to another setting. For example, one might want this to inform pricing for bands outside of the to 50 or tours in other countries. It is probable that the demand for these mega-stars differs from the demand for up-and-coming bands or in for tours in different locations. But we don't really know how it differs.
• Does the demand curve differ across these tours?  These data points may not be on the same demand curve. There could be differences in locations, production values, etc. that are also affecting the demand. It is likely that, were these factors included in the analysis, they would affect the elasticity estimates. Typically, one needs to collect data on these other factors affecting demand.
• Do important assumptions of regression analysis hold? This is subtle but it is key. Often, demand differs across observations in ways that we might recognize but are not able to measure. It is likely that some artists choose to tour less because there is so much demand that they get a big enough windfall from very few events. (For example, the point in the upper left is for Barbara Streisand who reportedly suffers stage fright.) Regression analysis assumes that the error terms are independent of the explanatory variables. But if artists with greater unobserved drawing power do not have to tour as much, this is violated. More generally, prices and quantities are affected by profit maximization which depends on unobserved variation in demand. In almost all cases, because the demand varies in ways that we do not observe, simple elasticity estimates will be biased. If managers do not know this, they might be lulled into false precision due to the apparent sophistication of regression analysis.

There are other empirical concerns as well and there are methods meant to address each one of them. However, they take more than a few weeks in a Managerial Economics class to learn. I have learned many of them only after a long career. (I joke with MBA students that they can hire me to do this. But because I am both slow and expensive, I am usually only hired for litigation where speed and cost do not seem to matter.) 

Most of these estimation concerns are greatly alleviated by well-run experiments. These can yield quick, cheap and precise estimates of the important underlying parameters. And experiments in business are becoming so much more popular that they will largely replace regression analysis for these applications.