Saturday, November 26, 2016

Bias in forecasting, e.g., US presidential election

The Financial Times has an article on why the forecasters were so wrong about the election, and referenced some research by behavioral economists on bias:
At Oxford university’s Centre for Experimental Social Science, Mayraz ran experiments in which participants were told that they were either “farmers”, who would be paid more if wheat prices were high, or “bakers”, who would be paid more if wheat prices were low. They were then shown a graph, purportedly tracking the wheat price, and invited to forecast the future price, with a cash reward for accurate forecasts. Despite the fact that they were being paid for accuracy, the farmer-participants systematically forecast higher wheat prices than the bakers. Everyone predicted what they hoped would happen. Does that sound familiar?

Saturday, November 19, 2016

REPOST: How did Blockbuster's CEO solve the double marginalization problem?

Monday, January 12, 2015

How did Blockbuster's CEO solve the double marginalization problem?

Hal Varian's (Chief Economist at Google) tells the story of Blockbuster (a video "rentailer") and its distributors who suffered from "double marginalization" or "the double markup problem." In other words, competition between firms selling complementary products results in a price that is too high and output that is too low:
Consider, for example, video tape rental industry. Prior to 1998, distributors sold video tapes to rental outlets, which proceeded to rent them to end consumers. The tapes sold for around $60 apiece, far in excess of marginal cost. The rental stores, naturally enough, economized on their purchase, leading to queues for popular movies.

The old contractual form suffered from double marginalization.  This means that upstream distributors set a single price and the downstream rentailers took this upstream price ($60) as a marginal cost and priced videos at the point where MR=$60.  Since 60 was far in excess of MC (almost all of the costs of video production and video rentailing are fixed), this resulted in video rental prices that were too high and output that was too low.

The Blockbuster CEO recognized this as a problem and proposed a solution:

In 1998 the industry came up with a new contractual form: studios provided video tapes to rental stores for a price between zero and $8, and then split revenue for rentals, with the store receiving between 40 and 60 percent of rental revenues.

Consider how the new pricing scheme changed the incentives of the video rentailer.  Now the marginal revenue from renting one more video was only 50% of the old marginal revenue, but the price was only 7.5% of the old upstream price.  Now the rentailer produced up to the point where (50%)MR=(7.5%)$60.

.. these contracts increased revenue of both studios and rental outlets by about 7 percent and consumers benefitted substantially. Clearly, the revenue sharing arrangement offered a superior contractual form over the system used prior to 1998.

 This arrangement is subject of course to verification of the downstream revenue by the upstream distributor.  New "smart" cash registers at Blockbuster made this possible:

The interesting thing about this revenue-sharing arrangement is that it was made possible only because of computerized record keeping. The cash registers at Blockbuster were intelligent enough to record each rental title and send in an auditable report to the central offices. This allowed all parties in the transaction to verify that revenues were being shared in the agreed-upon way. The fact that the transaction was computer mediated allowed the firms to contract on aspects of the transaction that were previously unobservable, thereby increasing efficiency. 

More of Hal Varian's insights about economics (there are some good stories here) can be found in his popular columns.  He is most famous to MBA's for saying that "marketing is the new finance," urging the Quants, who used to go into finance, go into marketing instead.

HT:  Vlad Mares

Tuesday, November 15, 2016

China plays optimally in a repeated prisoners' dilemma

We have blogged before about how trade policy can resemble a repeated prisoners' dilemma. Now it looks as if China looks as if it is playing optimally:
If Trump acts on his threats to impose a 45% tariff on Chinese imports and officially list China as a currency manipulator, China will take a "tit-for-tat approach," the newspaper, Global Times, said. 
The airline industry was singled out in the list of countermeasures — specifically that China would replace a batch of orders for US-owned Boeing airplanes with French-owned Airbus ones. 
It also said US soybean and maize imports would be halted and China could limit the number of Chinese students studying in the US.

Why is Buffet buying airline stocks?

From the FT:
US airlines have exercised restraint in adding capacity and launching price wars since emerging from the Great Recession and, together with the effects of lower fuel costs, they managed record profits in 2015. This year’s rebound in oil prices has hit profits, however, and made airline shares cheaper.

See our earlier posts on  How to decrease industry rivalry and When do managers care about rival profit?

What happens when you reward monkeys unfairly?

Monday, November 14, 2016

Game theory posts

Pension problems exacerbated by low yields

WSJ has an interesting piece on the difficulties that low yields are creating for defined benefit pension plans.  

Pension officials and government leaders are left with vexing choices. As investors, they have to stash away more than they did before or pile into riskier bets in hedge funds, private equity or commodities. Countries, states and cities must decide whether to reduce benefits for existing workers, cut back public services or raise taxes to pay for the bulging obligations.

Students will recognize this problem from Chapter 5, where managers of defined benefit pension plans are using discount rates equal to 7.5%, when the real rates of return are much lower.

As the following graph demonstrates, this problem is not limited to the US:

Tuesday, November 8, 2016

Minimum Advertised Prices as a form of price discrimination

Saw an interesting explanation for Minimum Advertised Prices at the FTC's annual Microeconomics Conference (my old employer).  Many manufacturers adopt these "MAP" policies which prevent retailers from advertising a price below the manufacturers recommended price.  If a retailer wants to sell at a lower price, it has to "hide" the lower price from online search engines.  The lower prices are revealed only after a shopper "clicks through" several levels.

A numerical illustration illustrates how it works.  Imagine that there are 50 low-value shoppers willing to pay $5 and 50 high-value shoppers willing to pay $10.  A traditional posted-price offers a retailer the choice between selling to only half the consumers at a price of $10 or all of the consumers at a price of $5.  Both strategies would earn the retailer $500=50*($10)=100*($5).

A minimum advertised price allows the manufacturer to price discriminate if the low-value shoppers search for a lower price and the high-value shoppers won't, e.g., because the high-value shoppers have a higher opportunity cost of time.

Imagine that half of the consumers go to the websites of each retailer, one of whom posts (advertises) a price of $10, while the other allows shoppers who click through several layers to buy at a price of $5.  Each retailer receives a even mix of high and low-value shoppers.

For the consumers who go to the high-priced retailer, only the high-value shoppers purchase, which results in revenue of 25*($10)=$250.

For the consumers who go to the low-priced retailer, all of the shoppers purchase. In addition, the low-value consumers who did not purchase from the high-priced retailer will search and find the lower price and purchase.  Revenue at the low-price retailer is 50*($5)+25*($5)=$375

Total revenue from the minimum advertised price strategy is $625=$250+$375 which is bigger than the $500 from a single posted price. 

Sunday, November 6, 2016

Wells Fargo: are the economies of scope big enough?

Wells Fargo's chief re-interated his commitment to "cross-selling" various financial products, taking advantage of economies of scope (it is less costly, or more profitable, to sell multiple financial products to a customer).

However, implementing this strategy with incentive payments resulted in as many as 2m phony fee-generating bank accounts and credit cards, created without customers’ knowledge. This disclosure has wiped $23bn off its Wells Fargo's stock valuation.

 At an investor conference, Wells Fargo chief Tim Sloan re-committed to the practice:
“There’s nothing wrong with cross sell done right.”

To do it right, he has to come up with a way to verify that the accounts are real.

Saturday, November 5, 2016

How are subprime auto loans like subprime housing loans?

From Doug Holtz-Eakin's characterization of the financial crash of 2009:
Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay.

Now we get the FT's characterization of the subprime auto loan industry:

...lenders have relaxed lending standards, offering bigger loans to consumers and giving them more time to pay the loans back, resulting in borrowers taking on debt that they may not be able to repay. The auto loan market has grown from $750bn in 2011 to $1.1tn at the end of June, according to data from the US Federal Reserve. 
The issue is particularly acute for the subprime ABS market, where issuers take loans from less creditworthy borrowers and package them up into bonds that are then sold to investors. 

But maybe this time will be different: far, the risks have not turned to reality in the ABS market. Wells Fargo notes in a recent report that there have been 435 ratings upgrades across the subprime auto sector this year, and no downgrades. Borrowing costs for issuers across the subprime spectrum have also reduced through 2016 as investors continue to clamour for the relatively high returns offered by the products.

Tuesday, November 1, 2016

How the US Presidential race is roiling markets

As odds of a Clinton victory fall,
or the increased likelihood that Clinton will not be able to govern, even if she does win, has caused the VIX, which measures volatility/uncertainty about the US stock returns (invented by colleague Bob Whaley) to rise.  The expected yearly movement (standard deviation) in the S&P is up to 17%.  

Hat tip:  FT