Black Friday

I was watching the 9 pm news on Fox last night. Sandy Riesgraf was doing a live shoot from a Wal-Mart parking lot in Taylorsville (?) talking about Wal-Mart's Black Friday deals.

Wal-Mart is offering to match any competitor's price on any item Wal-Mart sells. Sandy was telling us how great this is for consumers.

But is it?

Think here about how such price-matching commitments --- which are commonly referred to as "most favored customer clauses" --- might affect the incentives for Wal-Mart's competitors to offer discounts in the first place.

Firms discount because they are trying to steal business from rivals. But if Target, for example, knows that customers will just take Target's advertisement to Wal-Mart and Wal-Mart will match the price, then Target doesn't gain when it offers a discount. It hasn't stolen any customers from Wal-Mart as a result of offering the discount.

So the only effect of Target's discount is to give a lower price to the customers who would have shopped at Target anyway. No business-stealing happens, and so there's no benefit to offering a discount.

So, they don't. This means that consumers don't benefit from most favored customer clauses... But you have to think all the way through firms' strategic choices to see why.

Do Incentives Work?

In a November 20 New York Times Op/Ed, economist Dan Ariely argues that pay-for-performance incentives --- of the type given to commonly given to CEOs through bonuses --- simply don't work. He bases this claim on a number of experiments in which subjects are asked to perform simple tasks. Some subjects are paid more when task performance is better and some are paid the same regardless of performance. In many such experiments, performance is actually worse when pay is tied to performance.

A group of banking executives were, apparently, not convinced that Ariely's "incentive plans cannot work" conclusion would hold in the real world. Ariely offered to perform experiments on the employees of these banking firms to settle this "real world" question. But it seems this kind offer was declined.

Fortunately, however, a large number of executives have allowed economists to examine this question. Researchers in the expanding field of Personnel Economics have performed dozens of real experiments in real firms, on real workers, changing real pay plans, with real money at stake. These are actual controlled experiments where researchers randomly assign workers to "treatment" and "control" groups, just like you would do to test a new drug against a placebo. Accounts of these experiments are published in the leading peer-reviewed economics journals.

Here are some samples: Stanford economist Ed Lazear --- currently on leave from teaching while serving as Chairman of the President's Council of Economic Advisors --- worked with auto-glass installer Safelite Glass to structure a pay-for-performance plan for windshield installers. Randomly selected groups of workers were shifted from hourly pay plans to piece-rate plans in which installers were paid based on how many windshields they installed. The result? Productivity rose. About 44 percent.

Oriana Bandiera, Iwan Barankay and Imran Rasul tested a similar hypothesis on managers at an English fruit farm. At the farm, fruit-picking workers were paid piece rates, but managers received hourly wages that were independent of overall output. When managers' pay was shifted to being performance-based, overall fruit picking productivity rose. How could this be, given that managers themselves picked no fruit? Bandiera and colleagues show when managers were paid a simple hourly wage, they spent their time helping the employees they liked. When managerial pay depended on overall output, managers showed less favoritism, and instead seemed to allocate their "help" activities more productively. As with the Lazear study, the economic magnitudes of the impact of incentives are substantial.

There are many such studies. The broad conclusion is that, in real firms, incentives change behavior. Ariely's argument --- that tying pay to measured performance won't lead to improvements in measured performance --- is therefore not supported by the available real world evidence.

So, incentives work, right? Well, perhaps. If we take the question of "Do incentives work?" to mean "Do incentives improve performance on measured dimensions?", then I think the consensus of personnel economists is that it does. But if we instead interpret this question as "Does the use of incentives lead to higher profits or better organizational performance?", the answer is less clear.

Here's why: Incentives motivate employees to shift effort toward improving performance on _measured_ dimensions. Performance on dimensions of the job that are harder to measure is likely to slip as a result. If, for example, a banking executive is paid based on his firm's earnings for this year, then he may work to raise this year's earnings even if doing so worsens the firm's long-term prospects. If the performance measure fails to capture everything that a firm wants an employee to do, then it's not necessarily the case that using strong incentives will increase profits.

Measuring performance for bankers is hard specifically because these individuals make many short-term decisions that have long-term economic consequences. And it is problems with devising appropriate performance measures that contributed to our recent credit crisis, not Ariely's claim that using incentives does not improve measured performance.

The broader danger of Ariely's point, however, is that it gives academic credibility to those who would want to limit the ability of firms to use pay-for-performance incentives. Providing incentives for bankers is hard, and it may well be appropriate for government to play a role in determining how such incentives are structures. But the case for such regulation rests on problems with performance measurement and externalities from the financial sector on the rest of the economy, not on the unsupported-by-real-world-evidence claim that incentives just don't work.

Health Care Reform

The broad outlines of likely national health care reform are taking shape, and it's looking like there will be an attempt to do something roughly along the lines of the Massachusetts plan that was put in place by then-Gov Mitt Romney.

Two features of the likely plan are closely linked. The first is so-called "play-or-pay" taxes. These are taxes on firms that choose NOT to provide health insurance for employes. The second is a subsidy for working poor (people who don't qualify for Medicaid but still have trouble affording insurance).

So why are these linked? When people think about taxes, they think about "government revenue." But we should also think about "incentives" when we think about taxes. The role of the play-or-pay tax is to make it costly for firms to drop the employee health insurance they currently offer.

To understand why firms would drop, we need to think about why firms choose to offer insurance in the first place. Firms offer insurance because it's a form of compensation that employees value. If a firm drops insurance, some employees would likely quit their jobs, and try to find a job with an employer who did offer insurance. The "cost" to a firm of dropping insurance is the cost of the lost employees.

Now think about how this changes once the government starts offering a subsidy. A firm that drops insurance would find that some of its employees could apply for the subsidy. These employees might not quit. This means the "cost" to a firm of dropping insurance will be lower.

And if the cost of anything goes down, people do more of it.

So, we might worry about more firms dropping insurance after the subsidy goes in. This would increase the amount of people who have to be subsidized, and raise the price tag for taxpayers.

The play-or-pay tax is there to make it less attractive for firms to drop coverage.

One potential problem though: This tax will raise the cost to firms of hiring workers. For firms that don't offer benefits, the cost of hiring a worker is pretty much just the wage. If this tax is implemented, the cost will be the wage plus the play-or-pay tax. And if the cost of hiring a worker goes up, firms will hire fewer workers.

The trick will be to give firms incentives to not to drop insurance, while at the same time NOT giving them incentives to stop hiring.

Sissies

Reading today about ExxonMobil in the Sunday Business Section of the New York Times.

The article (print version) is titled "Green is for Sissies."

It's interesting for students of management (like me) for two reasons. First, it gives a nice account of Exxon's "corporate culture" (and take Fin 6250 if you want to know what I think about that...) and promote-from-within policy.

Second, the article quotes some who are critical of ExxonMobil for not investing more in alternative energy.

While I do think we (as a society) need to find cleaner ways to produce energy, I think it's not obvious we should be expecting ExxonMobil to lead us there.

There's ample evidence that it's difficult for firms to invest in products that destroy their own markets. Go read Clayton Christensen's book "The Innovator's Dilemma" for more on this.

From society's point of view, investments in alternative energy should be made by whoever is going to make the best investments. If that's not ExxonMobil, then let's not bash them for not investing. Instead, let's tell them to be the best hydrocarbon company they can be, and hope that they distribute their profits to shareholders, who can then invest those funds elsewhere. And if the returns for investing in alternative energy are high, that's exactly where ExxonMobil's profits will flow, through reinvestments made by the the firm's shareholders.

(And please don't read this as an endorsement of everything ExxonMobil has done.... I'm saying ONLY that perhaps we should perhaps not expect them to be best able to invest in new technologies).

Anyway it seems like ExxonMobil is doing exactly this --- trying to be efficient in producing hydrocarbons, and then returning profits to shareholders for reinvestments.

The key to getting better energy technology is to make sure the returns to investing in alternative energy are high. And how do we do this? Tax carbon.

Utah's Four-Day Work Week

One of the article discussion assignments I received from this year's MBA class dealt with the four-day work week.

As you may know, over the summer Utah Governor Jon Hunstman announced that state agencies would henceforth be open only four days per week. Rather than five eight-hour days, state employees are now asked to work four ten-hour days. The idea is so save energy and commuting time.

One of the most interesting things about this to a human resources economist has been watching the reactions.

One the one hand, we saw some state employees complain bitterly about this. On the other hand, some people who don't work for the state were completely mystified by the state-employees' complaints.

I'm paraphrasing here, but some state employees said "You're wrecking my life! Now I need ten hours of day-care!"

Some folks who don't work for the state said they'd love it if every weekend was a three-day weekend, and so state employees should stop whining.

The economic point that's illustrated here is self-selection.

What does this mean? First, note that individuals all have different preferences. Some of us like three day weekends. Others like eight hour days and longer work weeks.

Second, note that employers offer different bargains to their employees. Some employers offer lots of flexibility in scheduling. Others don't. Some employers offer a job where there's never any overtime. Other's don't. Some employers offer lots of vacation time. Others don't.

So which employees work where? Well, generally speaking employees are going to try to find the employers who offer a bargain that they like. Many people are willing to accept somewhat lower wages in order to get other workplace features that they like. So employees are trading off wages with other workplace features, and also trading off workplace features against each other. Employees self-select; that is, they choose where to work based in part on the job characteristics that an employer offers.

What does this mean for the four-day work week? Let's think about what sort of job characteristics the state was offering prior to last summer. State work is steady (obviously I'm generalizing here, but go with it). There's not much of a chance at overtime. Employees come at 8 and leave at 5. It's not the sort of job where there are going to be a lot of work-related intrusions into personal life. Some people really like that, and so we'd expect the state's work force would be disproportionately composed of people who value that sort of predictability.

So it's no surprise that such a sharp shift in hours would lead to problems.

The more general lesson for management is that employees are going to self-select to any workplace feature you offer. As a result, your employees are going to like any feature you offer much more than the average person likes that feature.

To give a concrete example, suppose some people really like three-day weekends and some don't. If your firm offers three-day weekends every week, then your firm is going to attract a workforce of folks who really value the long weekends. This effect makes it hard to change workplace features once your workforce has self-selected to them. If your workforce signed on specifically because they want a three-day weekend, they're going to be really mad if you change --- much more so than a randomly selected person would be.

This gives rise to a sort of inertia in workplace features.

This sort of self-selection is actually one of our best recruiting tools for faculty at the David Eccles School of Business. For the most part, our school pays below-market wages. That is, many of our faculty could earn a higher salary at working at another university. So why do faculty stick around? Many professors really value the workplace features. And by workplace features I mean things like proximity to world-class outdoor recreation, or proximity to the LDS community.

Pink Post-It Notes and Education Reform

In an editorial on November 7, the Salt Lake Tribune suggests using students'
evaluations of teachers to determine, in part, teacher pay. The
reasoning goes like this: We're all former students. And most of us
can recall a handful of teachers who really impacted our lives. So
students can identify excellent teachers, and this means student
evaluations will be a good measure of teacher performance.

This reasoning is not quite right, and I'll try to explain why in a
minute. But first I'll explain why a business professor, of all
people, might know something about this. It's because this problem
--- how to reward good job performance by employees --- is faced by
pretty much all organizations. Economists study financial incentives,
and so business economists have put a lot of thought into whether ---
and if so, when --- financial incentives work inside organizations.
I've been trying to help MBA students here and elsewhere think through
these issues for nearly 15 years.

The Tribune assumes that if a measure is correlated with good job
performance, then it's a good performance measure. This is not
necessarily true, for the following reason: Once a performance measure
is used to set pay, employees start to think about ALL of the possible
actions that might make the measure go up. And in some settings,
employees can do lots of things to make measured performance improve,
but that aren't actually associated with good work.

Here's an example from the private sector: 3M Corporation, inventor of
the ubiquitous Post-It Notes, used to require that each of its
operating divisions earn 25% of its sales from "new" products, i.e,
products that had been introduced in the past four years. The firm
felt that innovation was a key driver of success, so this measure was
in place to drive employees to innovate. The result? Employees
innovated. But employees also began to think about all the possible
ways to achieve the 25% target. One division found that changing the
color of an existing product was enough to qualify as a new product:
thus, Pink Post-It Notes were born. When a new CEO took the reins of
3M in 2001, he dumped the 25% rule, citing high costs of employees'
attempts to boost the measure without actually innovating.

Of course, 3M's goal is to generate profits, while our education
system's goal is to generate, well, "education." Does the same
reasoning apply?

Let's ask: Are there actions a teacher can take that might boost
student evaluations, but that we wouldn't call "good teaching"? How
about offering an easy class? High grades? Light homework? Lax
classroom discipline? Movies in place of boring readings? Pizza
every Friday?

The fact is that learning new things can be hard. And while there are
some teachers who can inspire us at the same time they drive us to new
achievements, these are likely the exceptions rather than the rule.
Unless we're very certain that students know what's best for
themselves, we may not want to pay teachers based on how well they
cater to student desires.

More broadly, performance measurement issues are central to education
reform. Measuring the job performance of educators is hard, and as a
result the financial incentives for outstanding job performance have
historically been weak. But tying teacher pay to poor measures of job
performance --- ones that reward "good teaching" but also actions that
we wouldn't call "good teaching" --- might be even worse.

I agree with the Tribune that rewarding good teaching is a worthy
social aim. But any plan to do so must carefully weigh the benefits
and costs of the selected measures of teacher performance.

Stimulus Question

A former student writes "The government issued the economic stimulus package a number of months back. I am wondering your opinion as to whether stimulus packages like this actually work and have a positive effect?"

Checks sent to individuals (like what we saw earlier this year) don't help the economy that much. The reason is that individuals tend to save the money, not spend it.

Spending money on bridges and roads helps more.

Bang for your Stimulus Buck

(See also the "commentary" links at the bottom of this page.)

My view is that we can shorten the recession by spending money on roads and bridges. The problem now is that (1) people are losing jobs, (2) this causes them to spend less, which (3) causes more people to lose jobs. It's a downward spiral that feeds on itself.

If we give money to everyone, then a lot of that money goes to people who haven't lost jobs. They won't spend it, so that money won't help break this cycle. Public works will help more, because that money will go to create construction jobs. The money will go to people who would otherwise be unemployed. These people will keep spending instead of stopping, and this will help break the cycle.

Fiscal Stimulus and Renewable Energy

Here's a question I've heard twice in the last few days.

If the federal govermnent is going to spend money on a fiscal stimulus package, why not spend it on investments in renewable energy?

So let's break this down. A fiscal stimulus package is likely in the works. It will entail (probably) investments in infrastructure: Roads, bridges, schools. Stuff like that. The idea is that we're in a period of falling employment. The falling employment means people have less disposable income. So consumer expenditures fall. Which causes firms to cut back more on production and investment. Which means more falling employment. It's a downward spiral.

The idea behind the stimulus is this: Use road construction to put some people back to work. These people, who would otherwise be unemployed, will take their paychecks and spend them. This spending will help keep businesses afloat, and will mean fewer job losses elsewhere in the economy. That is, building roads will mean, for example, fewer layoffs at Ford.

But why roads? Why not spend the money on sources of renewable energy?

The answer is this: We know we need roads. We know there are bridges and schools that need replacing. So, the payoff to investing in roads and bridges and schools is known. In other words, it's not hard for the government to answer the questions of "What roads should we build?" Or, "What schools should we replace?"

With renewable energy, it's much less clear (I think) which investments will pay off and which will not. As a result, it would be more difficult for the government to determine what to invest in. And before you say that we should invest in all forms of renewable energy, consider this: We have limited resources to invest. So we should be careful to invest in the forms of alternative energy that appear to be most promising.

Governments are pretty bad at "picking winners" when it comes to making investments. This is something markets are better at. Entrepreneurs, who have their own personal wealth at stake when making business decisions, are motivated to figure out which forms of alternative energy investments are likely to pay off. This is a setting where markets are likely to make better investments than governments.

We need a fiscal stimulus package to pull the economy out of its spiral. Government should invest in something in order to achive this aim. But if the government is going to invest, it should invest in the things that it's comparatively good at investing in. Roads.

So how can we stimulate private investments in alternative energy? Simple: Tax carbon.

Doctors and Health Care

Interesting column in the SLTrib today about health care:

Doctors No Longer Control Quality of Health Care in the United States

It's especially timely given that Gov Huntsman easily won re-election last night, and one of his second-term priorities is health care.

Anyway, the central theme of the column is captured pretty well in the title (but you should still read it).

My thought is this: Do we want doctors to control the quality of health care?

And before you answer "of course", consider this: As with all products and services, higher quality health care costs more than lower quality health care. And as with all products, it's important that somebody weigh the benefit of higher quality (in terms of consumer willingness-to-pay) against that cost.

We'd all like to drive fancy cars or live in bigger houses, but most of us choose not to --- because the cost to us is bigger than the benefit we derive.

Things are a bit different in health care, though, because the patient typically does not pay the full cost of the health care he or she consumes. If you're insured, then your insurer pays most of the cost, and this means incentive conflicts. The patient gets the benefit of health care, but doesn't pay the full cost. The insurer doesn't get the benefit, but pays most of the cost. Importantly, there's nobody who's directly weighing costs and benefits to try to come to the right balance.

What's the role of doctors in all this? Well, doctors advise patients on the likely benefits of various courses of treatment. But the doctors aren't motivated to think about the cost side of things any more than the patient is. So, letting doctors (in consultation with patients) make decisions about health care quality means we're likely to get quality that's too high, in the sense that the benefit is smaller than the cost.

Many people have valid complaints with managed care, and it is not my intention to suggest that managed care or the current health care system is the best we can do. But health economists have found that managed care succeeds at reducing costs. (Whether it succeeds at striking the right balance between quality and cost remains unclear.)

But the big point is this: It is essential that as a society we carefully weigh costs and benefits. Giving decision-making rights over quality to people who see only the benefit side --- that's not the way to do it.

(More on weighing costs and benefits within organizations when information is widely distributed in Fin 6250. Everyone should take it.)

What Good Are Economists, Anyway???

Scott Adams, creator of Dilbert, thinks he knows.

(This isn't a link to comic strip, it's a link to a blog post about why economists might be worth listening to, even if it seems like they're often wrong.)

I think Adams got it about right....

Grades

One of the worst parts of academic life is assigning grades to students. And that's what I've spent much of the last week doing.

No fun for me. No fun for the students.

I don't look it, but I am still young enough to know how it feels to be disappointed in a grade. I am still smarting from the B- that Val Hartouni gave me in Western Culture in 1987. (It's funny --- I could not tell you the name of one professor I had freshman year of college... except for Val Hartouni....)

So does grading have an economic purpose? Or is it just some hazing-like ritual of university life?

I can think of two potential purposes:

First, it's an incentive mechanism. Learning new things is actually hard, and it's useful if we have incentives to learn. Grades help serve that function.

Second, grading helps with information asymmetry in labor markets. And it's important to note that in labor markets it's often not so much that employers are trying to separate lemons from plums. Instead, it's often matching rather than sorting that needs to be done.

Let's explain: Pretty much all the MBA students at the DESB are plums. We have standards with regard to GMAT and undergrad GPA, so employers know that certain quality standards are met when they see "DESB MBA" on a resume.

So if everyone's a plum, what's the information asymmetry? Turns out that people have different strengths. Some are great at marketing. Some are better at finance. Others at negotiations.

Consider an employer who thinks "I know all these MBAs are smart, but I need to pluck the smart MBA who happens to be particularly good at marketing." How is that employer going to find that MBA?

One approach is to ask candidates during the interview: "Are you good at marketing?" To which each candidate responds: "Yes". So that's not too informative.

Another approach is to pick the one who took a bunch of marketing classes, and did well in them. So think of grading as a way to show off to employers what your particular strengths are.

Public Universities

A couple weeks ago I wrote about public universities and market failure.

I'll return to this topic, but right now The Economist magazine is hosting an on-line debate on a related question.

Check it out!