The trouble with average costs as a performance indicator

There are two types of coal from the Southern Powder River Basin in Wyoming: 8800 BTU coal, and 8400 BTU coal. The 8800 and 8400 numbers refer to the amount of energy contained in one pound of coal. The coal is delivered by rail and barge to power plants that crush it, burn it, and use the heat to create steam that drives generators that produce electricity.

8400 coal produces about 5% less electricity per ton than 8800 coal, so when the price of 8400 falls below 95% of the price of 8800, the average cost of producing electricity with 8400 coal falls below the average cost of electricity from 8800 coal.

However, when a plant manager at a coal-burning power plant made the switch from 8800 to 8400, his power plant was "de-rated," which means that its electrical output fell by 5%. The conveyor belts and crushers were already working at capacity, so he could not put a bigger volume of coal through the plant.  This forced his parent company to replace the lost electricity with higher-cost natural gas, which was even more expensive than producing electricity with 8800 coal.

The reason that the plant manager made the mistake was due to his balanced scorecard performance evaluation metric which included the average cost of electricity that he produced.

This story illustrates several ideas in the book:

• the Hidden Cost Fallacy: the manager should have considered the hidden cost of replacing the lost electricity (the opportunity cost of his decision to switch to 8400);
• that average costs are not necessarily the relevant costs of a decision;
• that problems arise when the incentives of a business unit are not aligned with the goals of the parent company.
• that demand is more price elastic in the long run:  in the short run, it would take a bigger drop in the price of 8400 to induce a plant manager--one whose incentives were aligned with the profitability goals of the parent company--to switch to 8400 due to the lost electricity.  In other words, the substitution between the two types of coal (measured by the cross-price elasticity of demand) would be bigger in the long run, when the capacity of the plant can be changed, than in the short run, when it cannot.

The winner's 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.

Coffee Independence

Our "dependence on foreign oil" is only dominated by our dependence on foreign coffee. Allen R. Sanderson writes:

We may constitute only 5 percent of the world's population, but we consume fully a third of the planet's coffee. This nation runs off coffee, most all of it from a sketchy continent. Should we be cut off by one of these sources, for our caffeine fix we'd be forced to drink Coca-Cola for breakfast as well as 10 other times a day.

Somehow congress is not exorcised about this important issue and I have not seen admonitions to "Drink American."

Embarrassing video

Economic Modeling is for More Than Just Counting Cow Chips

Paper on how our book teaches economics to business students

Teaching Managerial Economics with Problems Instead of Models

Luke Froeb 
Vanderbilt University - Owen Graduate School of Management
James C. Ward 
Vanderbilt University - Owen Graduate School of Management
THE INTERNATIONAL HANDBOOK ON TEACHING AND LEARNING IN ECONOMICS, Gail Hoyt, KimMarie McGoldrick, eds., Edward Elgar Publishing, 2012 
Abstract: 
In this chapter, we address the problems of teaching microeconomic principles to business students. We describe the peculiar features of student demand that make teaching economics using a model-based pedagogy unsuccessful. We conclude that a problem-solving pedagogy is a better way to satisfy student demand for business education.


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


JEL Classifications: A22, A23

There is no such thing as a water shortage

In class, I often ask my students if there is a shortage of affordable housing. Then I ask them if there is a shortage of low priced Rolls Royce autos.

Eventually, they begin to get the idea that shortages are caused by an absence of trade, between those who have assets, and those who are willing to pay more for them, but are somehow prevented from doing so. Preventing this trade is what causes shortages.

Here is a good example of this: how development of a water market ended the "shortage" of water.

Entrepreneurs are made, not born

The power of arithmetic

“I am a progressive Democrat who’s broke,” from Andrew Cuomo in a NY Times profile

FINALLY!!!!

Paul Ryan makes "Republican" more than a punch line to some derogatory joke:

He does this without, on net, raising taxes. By closing loopholes, he would pay for a cut in the top personal and corporate rates. So how does he shrink the deficit? Through an eye-watering assault on entitlement spending, in particular health care. Mr Obama’s health care reform would be ditched, Medicaid would be converted to block grants, and traditional Medicare would be replaced with vouchers.

Is $50 enough?

Arizona is considering charging Medicaid enrollees $50 who do not follow physician-ordered weight loss and smoking cessation programs. Apparently smokers and obese people generate a big chunk of the state's medical costs.

In Arizona, 25.5% of residents were obese as of 2009, according to figures from the federal Centers for Disease Control and Prevention, ranking it about in the middle among states. About 46% of Arizona's Medicaid enrollees smoke daily, according to a 2006 survey by the state's Medicaid agency.

My only question, do they think a $50 surcharge is big enough to change behavior?