iPhone Economics

Some excellent iPhone economics in the NYT business section yesterday. For those interested in a broader view of markets like this (and there are actually a lot of markets like this...), check out Marc Rysman's survey of "two-sided" markets in the recent Journal of Economic Perspectives.

Spencer F. Eccles Convocation

Randal Quarles gave the Spencer Fox Eccles Convocation at the DESB a couple of weeks ago. Quarles is a really accomplished and interesting guy (Undersecretary of the Treasury in the Bush administration), and he was kind enough to meet with a small group of students and faculty prior to the Convocation speech. It was great to get an insider's view of the US Treasury Department.

If you missed the big speech, it's here....

Quarles dropped a book recommendation that I've added to my reading list. It's Robert Rubin's In An Uncertain World. (Link below, and all "affiliate" proceeds to the Utah Food Bank, as usual). Quarles described it as the best book ever written by a Treasury Secretary --- Rubin served under President Clinton --- and this seems like pretty high praise. I'll try to report back after I get through it.



I told Quarles to go read Nature's Metropolis: Chicago and the Great West, which might be the best book ever written by anyone (Treasury Secretary or not).

Textbooks

Sorry for the long blog-pause. The fall term teaching really did me in.

At least some lessons seem to have sunk in, for I am guessing one of my students commented on this article in the Utah Daily Chronicle:

Good education worth high textbook prices

Well said!

Coffee, Part 2

So I was grilling the local Starbucks employees today about their prices.

("Watch out," they must be thinking. "Here comes the crazy business professor!")

Anyway, it turns out that the firm raised some prices, kept some the same, and lowered others. The price of a 12-ounce regular coffee fell from 1.65 to 1.50. The 16-ounce coffee rose from 1.80 to 1.90, and the 20-ounce rose from 1.95 to 2.10.

On a per-ounce basis, things work out like this:

Under the old pricing, the first 12 ounces cost 13.75 cents per ounce. Now those ounces cost 12.5 cents per ounce.

Under the old pricing, the next 4 ounces cost 3.75 cents per ounce. Now those ounces cost a whopping 10 cents per ounce.

Under the old pricing, the next 4 ounces cost 3.75 cents per ounce. Now those ounces cost 5 cents per ounce.

This is a really interesting illustration of second-degree price discrimination. For this pricing to make sense, the firm must have decided that the weak economy and increased competition has made consumer demand for the first few ounces more elastic, but made the residual demand curve (that is, the demand for additional ounces past the first 12) less elastic.

It would be cool to know what data the firm used to come to these conclusions, but I think any MBA ought be to able to at least sort out how you'd design an experiment to measure these elasticities.

I also learned that many customers were quite upset by this pricing change. Apparently there was some yelling at employees (who, of course, had nothing whatsoever to do with the decision to raise prices), and more than a few angry phone calls to the district manager.

So I managed to learn some cool economics, even standing in a coffee shop. The whole conversation was nearly as entertaining as the time that two biz-economist friends of mine and I wandered into a shoe store in Maine (long story) and managed to get a really interesting lesson in mystery shopping and performance evaluation in retail.

Coffee Prices Are Making Me Jumpy

Awesome article in the NYT about Starbucks raising coffee prices.

Will the Hard-Core Starbucks Customer Pay More? The Chain Plans to Find Out

Starbucks, facing competition from McDonald's, seems have decided to raise prices.

Wait a minute... don't firms usually offer lower prices when facing competition? What's going on here?

What's going on here is that Starbucks and McDonald's coffee are vertically differentiated. That is, there's a quality difference between the products --- most customers would prefer Starbucks if the prices were the same. The only way that McDonald's can get customers, therefore, is by offering prices that are so low that customers are willing to accept the lower quality.

So which Starbucks customers quit the brand to instead shop at McDonald's, and which stay loyal? The price-sensitive ones and quality-insensitive ones leave... and the price-insensitive and quality-sensitive ones stay.

This means the following: Prior to McD entry, Starbucks is serving both price-sensitive consumers and price-insensitive consumers. It would like to raise prices for the price-insensitive consumers, but doing so would cause the price-sensitive consumers to stop drinking their coffee.

When McDonald's enters, the price-sensitive consumers immediately stop going to Starbucks --- they now have a lower-priced alternative, and they're happy to give up on quality to save on price.

So who's left shopping at Starbucks? Only the price-insensitive consumers! And this means that Starbucks' customer group has, as a whole, become much less sensitive to prices. And when you have price insensitive consumers it makes sense (and cents) to raise prices.

To stuff this back into economics-y jargon... Competition, in this case, has caused Starbucks demand to become less elastic. And less elastic demand translates to higher prices.

US Manufacturing

So, it's the first week of school and I'm waaaay too busy to actually generate new ideas for this blog (or even to recycle old ideas). But I did chime in on old-friend Kevin's post over at Emergent Fool. We'll see where that thread leads.

Smart Firms Run Experiments

First a note about Google Adsense. I must have misread their TOS when I posted about this before. I thought you got a check when you accrued $10 from blog ads, but it turns out you need $100. So, I will be sending a $100 check to the Utah Food Bank sometime in the far-distant future, assuming I live that long. (Current tally: $18.58.)

---

Continuing on the theme of statistics and data mining...

Every year I teach pricing.

I always conclude that optimal prices depend on two things: Demand elasticity and marginal cost.

Every year students ask how they can learn about demand elasticity.

I say that learning about demand elasticity is really pretty easy. Just do some simple pricing experiments. Change your price a bit here and there, and see how quantity demanded varies with price. Use this to construct some estimates of demand elasticity to plug into your pricing formulas.

And every year one or two students argue that this is really completely unrealistic; that there's no way a real firm would vary prices just to see what happens.

Here's a response, courtesy of Monday's WSJ.

Google, it turns out, is constantly experimenting not with price (since their searches are free to users), but with quality. Users told Google they wanted more search results on a page. So the firm tried it.... and found search traffic actually went down. The extra results slowed down the page, and consumers noticed the difference. Here Google isn't measuring the elasticity of demand with respect to price, they're measuring the elasticity of demand with respect to the number of search results listed. Having measured this elasticity carefully in its experiment, it is now able to make better decisions.

It turns out that the smart firms are doing this all the time, and they're changing not only price but also product characteristics. They're carefully measuring the results of their experiments, and using these estimates to make better managerial decisions. It also turns out that the cost of such experimentation is dropping quickly... Which means the pace of experimentation and change is only going to quicken.

Game Theory Applications

Two game-theory-related items sent in by former students (thanks guys!):

Will the Iranian government develop an A-bomb? They will, if doing so is their best strategy in response to what other actors are doing. Or, in other words, if it's a Nash Equilibrium to develop the bomb.

On a lighter note, game theory seems to be useful for understanding whether the Joker should cooperate with other villains to conquer Batman. I didn't follow all the details, but this seems to be a mathematical proof that the Joker is best off acting alone.

The applications of game theory are indeed endless.

Data Mining for Stocks

Recently, I linked to an NYT article about data mining and statistics. I wrote about how valuable these skills are becoming, but indicated that it's possible to make big mistakes if you don't know what you're doing. This is why it's a good idea to get trained by experts who use statistical analysis in their own work all the time (such as our faculty here at the University of Utah's David Eccles School of Business).

And as if by divine command the WSJ posts an article illustrating just this fact:

Data Mining Isn't a Good Bet For Stock-Market Predictions

Cool nugget in the article: Data mining techniques suggest that Bangaldeshi butter production is highly correlated with US stock returns. So, get the butter data and make a fortune in the stock market, right?

This, of course, is completely ridiculous. As the article reminds us, correlation does not imply causation, and you have be both smart and well-trained (see plug to DESB, above) to know the difference.

But there's more to the stock-market/data-mining interface than just this. To illustrate my point, note that we can probably summarize the WSJ article as follows:

Data mining with stock market data might give you spurious correlations.

But the deeper point (which isn't discussed in the WSJ article but should be) is this:

Any correlations you find doing data mining on stock market data are probably spurious correlations.

Why?

It's the profit motive together with the price mechanism.

Here's how it works: Suppose data mining uncovers a real, causal relationship between some variable and future equity prices. As an example, suppose that any time it snows more than 6 inches at Alta on Martin Luther King Jr. Day, then the S&P 500 goes up by 10% in February. Well, the profit motive means there are lots and lots of people out there looking for such patterns in the data. And once these patterns are discovered, people will start to trade using this information.

We'll end up with a lot of people watching the MLK-day Alta snowfall. When it snows, they'll all buy stock, hoping to cash in on that 10% return in February. And what will their purchases do to market prices? Drive prices up, of course. How far? Prices will be driven up the full 10% on the day right after MLK day. And this means that prices won't go up by 10% in February; because that increase has already been priced into the market.

The profit motive together with the price mechanism will tend to knock out any "real" data-mining/stock-market connections, pretty much immediately.

So the question to ask about data-mining for stocks is this: If the connection is real, then why haven't traders found it (and exploited it) already?

This isn't to say that one could never make money doing data-mining type stuff on stocks. I do know people who do just this, and they seem to make money (sometimes, at least). But these guys have really big computers, and really big data sets, and they're doing really complicated stuff, and on top of that they're always asking themselves why the correlations they've found haven't been found (and exploited) by others. It's an extremely, extremely competitive area. So you gotta be careful.

Cherries

Here's a nice illustration of how market power allows producers to destroy social value (courtesy of Saturday's SLTrib):

Utah growers: No longer a bowl of cherries

Utah's cherry growers plan to let 10 million pounds of cherries rot on the ground this year, rather than putting them on the market and allowing consumers to buy them. Why? To keep prices high.

A few weeks ago, I wrote something about the MBA Oath, and included a made-up example of how market power in the market for fresh daisies destroyed social value. This real-world story about cherries fits that example perfectly.

This cartel behavior --- which would be illegal in most industries --- is coordinated by the Cherry Industry Administrative Board. The US government gives agricultural producers the right to organize to limit production. And we all pay higher prices for food as a result.

Do Physicians Respond to Financial Incentives?

Interesting letter to the editor from Dr. James R. Fowler in the SLTrib on last Saturday. Here's a snippet:

In 40 years of practicing medicine, neither I, nor any physician I have known, has ever based a patient's treatment on financial remuneration. It is an insult to me and the entire medical profession to imply that physicians base their treatments on anything but what is best for their patients.

I'm going to post a response, but first I want to put a big caveat in. I don't know Dr. Fowler, and I probably don't know any of the doctors that he's referring to. It's entirely possible that the first sentence in the excerpt above is the literal truth.

But the general statement that physicians don't respond to financial remuneration is not supported by the data. Health economists have done a lot of work studying this question, and the broad picture is that financial incentives do seem to influence physicians' choices regarding patient care.

Here are a couple of examples:

In the 1989 New England Journal of Medicine, Alan Hillman, Mark Pauly and Joseph Kerstein compared physicians who were paid either salaries or on "capitation" to those paid by fee-for-service. Salaries mean that doctor pay doesn't vary at all with how they provide care to patients. Capitation means that doctors are paid a fixed amount per patient, regardless of the level of care provided to that patient. Fee-for-service means that the doctor gets paid more when the patient "buys" more health-care. The results? Patients of salary or capitation docs had a lower rate of hospitalization than patients of fee-for-service doctors.

In 1999, Jon Gruber, John Kim, and Dina Mayzlin reported (in the Journal of Health Economics) a study of rates of Caesarian Sections for childbirth. Medicaid, it turns out, offers much much lower reimbursement rates for C-Sections (relative to normal childbirth) than does private insurance. That is, a doc faced with a Medicaid patient might get $130 more for doing a C-Section than for a normal childbirth. But that same doc with a patient covered by private insurance might get $550 more from a C-Section. Rates of C-Section are much lower for Medicaid patients than for the regular population, and this remains true even after controlling (statistically) for factors such as breech, fetal distress and maternal distress. Further, the authors show that changes in the Medicaid differential (say, from to $130 to $400) are associated with changes in the relative rates of C-Sections in the Medicaid and private-insurance populations.

These are just two studies out of dozens. I could go on and on.

Two caveats are important here: First, evidence like this doesn't mean that all doctors make all decisions in response to financial incentives. It's likely that there are many physicians, like Dr. Fowler, who don't respond to financial incentives. But the evidence suggests that at least some docs respond to financial incentives at least some of the time. And this means that that policy makers should think about physicians' incentives as part of the broader health-care-reform picture.

Second, it remains unclear what the "right" level of care is. That is, the second study shows that we get more C-Sections under private insurance than under Medicaid, and that this is related to reimbursements. But do we have too many C-Sections under private insurance, or too few under Medicaid? It's simply not clear from studies like this what the right level of care is, so it's hard to determine the right way to structure physician incentives.

All this commentary so far has been directed at the first sentence of Dr. Fowler's snippet, so let me comment a bit on the second. Is it an insult to doctors to suggest that they, too, are at times influenced by financial considerations? Maybe so, but to me this just means that doctors are people too.

Cash for Clunkers, Part 2

Ryan posted a great question about my recent Cash-for-Clunkers post:

I'm curious -- does it make economic sense to pay people money to destroy cars that still have value? I realize their goal is to stimulate the economy and save the environment, but it seems to me that the $3 billion in the cash-for-clunkers program could be better spent. Why ruin working cars?

I think the "stimulate the economy" argument for Cash-for-Clunkers is a bit overblown. (So does the WSJ editorial page.) Even if the government spends $3 billion on this program (and causes consumers to spend tens of billions more of their own money) this is really small potatotes compared to the US GDP of about 13 trillion.

On top of that, it's pretty clear that destroying valuable things isn't a good idea.

Unless, that is, the things are privately valuable but not socially valuable.

Suppose, for example, that a clunker-driver values his clunker at $500, but the rest of society bears $600 of costs because the clunker is being driven. Why might a driver impose costs on others just from the mere act of driving an old car? I can think of three possible reasons: dependence on "foreign oil", local pollution, and global warming. With the numbers in my example, the private value of the clunker is $500, but the social value is -$100. Society overall would be better off if the clunker didn't exist.

An example policy response to foreign oil, local air pollution or global warming would be to raise emissions and fuel economy standards for new vehicles. However, all that new technology costs money, so raising standards for new vehicles will make new cars more expensive. And if new cars are more expensive, consumers will naturally avoid them and hold on to their clunkers a bit longer. And this defeats the whole purpose of raising emissions and fuel economy standards, since these old cars are dirty and low-MPG.

So what can be done about this? One option is to raise the price of old vehicles as well --- if consumers see that the prices of both old and new vehicles rise, then we won't see (as much of) the substitution away from new to old. Instead, we'll see more substitution from new and old cars to things that aren't cars at all --- bikes, buses, scooters.

How can we raise the price of old vehicles? There are two things that change prices --- demand and supply. And that's where Cash-for-Clunkers comes in. Destroying the old cars decreases supply and will raise prices. And this could be good for the world if there are negative externalities associated with dependence on foreign oil, local pollution, and global warming.

Here's an article outlining more of this reasoning.

I've seem some suggestions in the blogosphere that instead of putting sodium silicate in clunker engines, we should give the cars to poor people. It's true that Cash-for-Clunkers will make used cars more expensive, but, as I noted above, that's the whole point. And the best way to help the poor isn't to distort downward the prices they pay or distort upward the wages they receive --- it's to bolster their incomes directly.

Be a Data-Driven Manager

Awesome article in today's New York Times:

For Today’s Graduate, Just One Word: Statistics

The article is about how firms --- faced with mounds and mounds of data --- now find they need people who know how to organize and analyze it. If you have the skills to answer real-world questions using real-world data, you're going to do well.

But getting those skills requires you to do some serious book learnin'. Econometrics and statistics are tricky stuff, and it's easy to make big mistakes.

This is, I think, one reason why the overall rates of graduate school attendance have been rising. The world is an increasingly complicated place, and so there are a lot of valuable, real world skills that are so complicated that you really need a college degree before you can even start to study them carefully. And you need enough experience with the world to see how you'd use the skills, so you can appreciate the relevance.

This is great (for me) because I've been trying to move my MBA classes this direction anyway. So, I'll invite first-year MBA students to ask me how one would use data to answer the questions that come up in class. I'll try to have answers for you.

Cash for Clunkers and Yahoo/Microsoft

There were two big news stories last week that will for sure be discussed in MBA classes this fall.

Story #1 is the Cash-for-Clunkers program; you know, the one where the government throws in $4500 if you trade your gas guzzler for a high-MPG car.

This one has a personal angle for me... My parents, it turns out, are trading the Ford Ranger pickup truck that I bought in 1990 (and sold to them in 1998) for a Toyota Corolla. Had some good times in that truck... sniff.

Anyway it's a great example for teaching microeconomics, for two reasons. One is that it's a great illustration of the economics of a subsidy. Does the program benefit auto companies or consumers more? It depends, in part, on the relative elasticities of demand and supply. Probably I'll write a homework problem about this for the fall, so I shouldn't discuss it in much detail here. Reason two is that it illustrates how hard it can be to assess demand and supply without actually doing some pricing experiments. The reason Cash-for-Clunkers has been in the news so much is the overwhelming consumer response to the program. The government really didn't know how consumers would respond to the offer of $4500 in exchange for clunkers, and it turned out that supply was quite a bit more elastic (that is, responsive to price) than they thought. It's a good reminder to all managers trying to understand demand for their products--- in the absence of data, it's really hard to guestimate demand. So get yourself some data!

Story #2 is the announcement (finally!) of a search deal between Microsoft and Yahoo.

Personal angle here as well: I met Jerry Yang and Dave Filo (Yahoo's founders) a couple times when I was in grad school at the Stanford GSB and they were in engineering grad school. Ask me to tell you my Yang/Filo/engineering-league-softball story sometime. (Probably I drove my Ford Ranger over to the big field behind the Terman Engineering building to play softball --- how's that for a connection?)

This one's nice because it points out that writing a contract really is an alternative to doing a merger. Back when I used to teach strategy, I'd point to, say, the Disney/ABC or Time-Warner/AOL merger and ask students where the value creation was coming from. Students would typically come up with a list of potential synergies, usually involving various cross-selling plans. One justification, for example, for Time-Warner/AOL was the ability to stuff TW's magazines with AOL CDs. But then I'd ask why a merger was necessary to realize the synergy. Firms write cross-selling contracts all the time, and it was just never clear (to me, at least) why TW/AOL couldn't have done exactly the same thing.

And here's a case where MSFT and YHOO clearly thought hard about doing a full-on merger, but in the end decided they could realize synergies with a cross-selling contract. Yahoo is going to shift all search activity to Microsoft, but continue to sell its own advertisements and offer other forms of content. The parties have split the resulting gains using a detailed revenue-sharing contract.

So Yahoo/Microsoft is one example, but could all mergers be replaced by contracts? If not, then when do we need mergers and when do we need contracts? These questions naturally lead into a discussion of the limits of contracting --- limits coming mostly from problems with observability, verifiability, and enforcement of contract terms. And that's where the economics of contracting come in handy for understanding Wall Street financial transactions.

Do Study Groups Matter?

A couple of information items, and then a link.

(1) I'm now an Associate Editor at the Journal of Labor Economics, which is the leading field journal for studies of labor markets and human resource management. Before you get too impressed, the title basically means that I referee a lot of papers for them. (Academic publishing works like this: An author sends a paper to the journal. The journal's editor sends the paper to a referee, who reads the paper and sends some comments along with a publish/don't-publish recommendation back to editor. The editor decides whether to publish the paper or not, and then forwards the comments to the author.)

Anyway, since I'm on the Journal of Labor Economics team, I figured I'd start blogging periodically about interesting papers published in the journal. The July issue just came out, so I'll get to that in a bit.

(2) I'm branching out on you. I'm going to start putting a bit of content on the U's Red Thread blog. As I noted in my recent iPhone post, I've recently developed an interest in the economics of higher ed, so I'll probably put some education-related thoughts there.

My first post there is on the question of whether study groups --- you know, that group of people you meet with to talk over the upcoming marketing exam --- matter for academic achievement.

You can read it here.

Markets and Health Care

A long time reader directs me to Paul Krugman's column from last Sunday, where he argues that markets for health care are unlikely to work as well as, say, markets for bread or soybeans or Hyundais or even --- yes --- the iPhone.

Krugman's column very much reflects the consensus view of economists (including this one) on health care. Economists have learned a lot about when markets work and when they don't. Markets work well when there are many buyers and sellers, when the buyers and sellers all know exactly what's being transacted, and when it's possible to get the incentives right.

Health care is the perfect storm when it comes to free-market economics. There's the potential for market power and monopoly, there are big problems with asymmetric information, and the fact that everyone's insured means that buyers don't have a strong incentive to carefully weigh cost vs. benefit.

I've written about problems in health care markets before (actually a lot: here, here, here, and here). But this point bears repeating, given the current debate. The consensus of economists is that "trust the market to allocate health care" will not work very well. As Krugman points out, this doesn't mean that the only solution is single-payer, but it does mean that this is probably a setting where government will play a role.

And lest you think think that this is only some liberal, lefty, New-York-Times view, here's a link to a 2006 column from the Wall Street Journal's economics columnist David Wessel, which essentially makes exactly the same point. (Scroll down a few pages to see it.)

How to Make Money Writing an Economics Blog

As I wrote a while ago, I signed up for Google Adsense, and they manage the ads you see on the page. (Proceeds to the Utah Food Bank.)

Adsense pays you based on some function of page views and clicks, and this blog makes a few cents a day, on average. Adsense doesn't send you a check until you accrue $10, and I figured it would take years to hit that hurdle.

But then the new iPhones came out.

I was doing some game theory with the EMBAs at the time, and so I wrote a short blog item describing the developer/user coordination game. The post is nothing terribly deep or insightful; just the basic economics of platform competition.

I think the blog traffic on that one post was bigger than the traffic for all my other posts combined. This blog was making about 50 cents a month, on average, from ads. In June, I made more than $6, and that pushed me up over the $10 mark. I'll be sending some funds to the UFB as soon I get a check from Google.

I'm not saying this to try to boast about how insightful I am. As I said, the iPhone blog post is basic network economics that I learned from Garth Saloner (recently appointed as Stanford GSB dean) way back in 1991.

Rather, I'm saying it to point out how interested people are in the iPhone.

I have an iPhone and I like it, but I don't really see where the fascination is coming from.

The strategy and economics of the iPhone are a bit more interesting than, say, the economics of soybeans. But there are lots of goods and services with interesting economics. I think, for example, that the economics of higher ed are richer, more interesting, and more important than the economics of the iPhone.

But I should just be happy that there is something that draws interest to economics blogs. Probably business professors should drop all examples that don't involve iPhones --- we'd do a better job of holding our students' interest!

Just as an experiment, I'm going to put the word "iPhone" in each of my next three posts, just to see what that does to traffic. I promise to report back.

Hyundai

A while back I prattled on about the economics of asymmetric information. I wrote about how asymmetric information might affect the market for used cars. And about how the World Series of Poker is a great illustration of how to infer, based on someone's actions, what their information must be.

And here's a great NPR story combining the two ideas.

Hyundai, the Korean carmaker, had big quality problems in the late 1980s. Throughout the 1990s, the firm invested heavily in figuring out how to make better cars, and by 1998 Hyundai's cars were plums, not lemons. But perceptions are hard to change. A consumer won't pay a plum price for a car that he or she believes to be a lemon, even if the seller knows that it's a plum.

Hyundai had to figure out how to credibly communicate the "We are selling plums" message.

They did it with an aggressive warranty program. How does that work? Suppose you are a firm and you know that you haven't solved all of your quality problems. Offering a 100,000 mile warranty would be suicide --- because your cars will break down and you'll have massive repair bills. Even if offering the warranty allows your firm to fool consumers into paying plum prices, the time bomb of looming warranty obligations will kill you.

But if you know that you have solved your quality problems, then the warranty offer won't be as costly down the road.

Important point: A warranty program is prohibitively costly for a firm selling lemons. It's not prohibitively costly for a firm selling plums.

This means that only a plum-seller will be willing to offer it.

And this means that consumers --- seeing an aggressive warranty --- will infer that quality problems have been solved, because only a plum seller would be willing to make an aggressive warranty offer. The warranty is therefore a credible signal of product quality.

To tie this back to the earlier poker discussion, Hyundai had to figure out what action it could take that would cause consumers to infer that Hyundai cars were plums. It had to find some action that made economic sense for a plum seller, but didn't make economic sense for lemon seller. And the warranty is just the ticket.

The NPR story describes this as a "marketing move," which it is. But to understand why it's so smart, you need to understand information economics. And this illustrates why economic reasoning is useful across all functions of management.

MBA Oath (Continued Again)

So this is pretty cool --- Max from the MBA Oath commented on my earlier post.

I want to thank Max (and his fellow student organizers) for all their efforts. Whether students across the country agree to sign the Oath or not, it's a great conversation starter and a great learning opportunity. Questions about the appropriate role of private enterprise in our society are really important and really hard. As an educator, I love anything that pushes students to think --- the Oath is a smashing success on that dimension.

(As an aside, are you guys trolling the web for "MBA Oath"? Or is my blog is now required reading at HBS? If the latter, it's about freaking time. They owe me after not offering me a job in 1995.)

Max correctly points out that time is one of the key parameters controlled by policy-makers when it comes to intellectual-property protection. Patents don't last forever --- in the US, patent protection lasts for 20 years.

Why the limit?

Making patent protection last longer would provide stronger incentives for innovation, and that would be good. But making patent protection shorter would limit the ability of patent-holders to exploit market power, and that would also be good. So the patent law is a compromise that reflects these tradeoffs.

Governments write laws that trade off various forms of social value all the time. Max points out some of the ethical dilemmas of Big Pharma (coming mostly again from the patent law), but we can see it in our state and local governments as well.

One example comes from my hometown of Portland, Oregon, which has had an interesting urban planning experiment going for years now. Portland is ringed by an "urban growth boundary." If you own property inside the boundary, you can develop it subject to normal zoning laws. If you're outside the boundary, there are very strict limitations on what you can do with your property. If, say, you own a farm that's just outside the urban growth boundary and you decide that farming isn't very profitable, it's very, very hard to work with a real estate developer to turn your farm into a subdivision or an office park.

This means Portland doesn't have a ring of "exurbs" --- far, far out suburbs --- because the land that would have turned into an exurb can't be developed. It has high population density within the boundary, and little in the way of LA-style sprawl. This might be a good thing.

But it has costs. The limits on development and resulting high density mean that housing prices are probably higher than they otherwise would be. And if you're a homeowner who always dreamed of a really big backyard for kids and dogs to play? You can forget about that. Space is at a premium, so lot sizes tend to be small (or very high priced if they are large.)

Let's tie this back to the Oath: Suppose you're a real estate developer in Portland, and you find some undeveloped property that's within the urban growth boundary. You plan to develop it, but worry that you'll contribute to congestion, smog, and all the problems that development brings. Well, in this case it seems reasonable to me to conclude that local government has weighed the competing interests, and made the choice for you. If a property is inside the boundary, then the social benefit of developing is bigger than the cost. If it's outside, then benefit is smaller than cost.

And this is what I was trying to get at with my initial post offering a competing Oath. The role of the political, legal and regulatory system is to weigh these competing interests, and set the rules of the game. If the political, legal and regulatory processes have set rules based on careful consideration of the facts, then it seems like following the rules is a good guide to making socially productive choices.

But notice how I wrote that last sentence, focusing in particular on the first clause: "If the political, legal and regulatory processes have set rules based on careful consideration of the facts..."

That can be a seriously big "if".

And that's where I think the Oath can come in handy.

With patents, the law has been tested, considered, reconsidered, and reconsidered again. This concern over incentives for innovation as been around so long that the Founding Fathers specifically granted Congress the power to write patent law when they wrote the US Constitution way back in 1787.

With Portland's urban planning, the urban growth boundary has been around for dozens of years. It's been tested and considered, and it's more-or-less what the people of the state have decided.

But the world of private enterprise moves much faster than the world of government. And this means firms can sometimes engage in activities that haven't been considered, tested, and analyzed --- or even understood --- by the political, legal and regulatory systems.

Credit default swaps are an example. This is a new kind of financial transaction that just wasn't around when banking law was written. Bank failures lead to major spillovers to the real economy, so our regulatory process has written rules to force banks not to take excessive risk. The law insures deposits, to reduce the likelihood of a bank run, and forces banks to hold reserves and generally act in a conservative manner. But the law --- some of which dates to the 1930s --- didn't have a lot to say about credit default swaps. In this case, the law wasn't very well established, in part because regulators didn't really understand the social costs and benefits of these transactions.

So my conclusion is this: "Follow the rules" is a good guide for socially productive actions when the political, regulatory and legal process has had sufficient time to understand social costs and benefits and to write good law.

But things are murkier when we're out ahead of the legal process. In situations like this, it might be useful for managers to ask themselves the following: "What I'm doing is legal, but is there a chance it would be illegal or heavily regulated if the government and regulators understood it better?"

That's a heck of a tough question to answer. But it's a good one for business leaders to think about, and I think it's what the MBA Oath folks are trying to encourage.

MBA Oath (Continued)

I posted a while back on the MBA Oath, and promised some additional thoughts. So here are some. (And probably there will be more).

My main criticism of the Oath is that I'm not sure that the authors have thought very hard about what "social value" is. To economists, at least, this term has a precise meaning. And there are many things that firms do --- things that I doubt the authors of the Oath would condemn --- that destroy social value.

Here's a great example from the Wall Street Journal: Toyota Builds Thicket of Patents Around Hybrid To Block Competitors.

Is building a thicket of patents an activity that enhances social value? Well, the way economists think about social value, it most certainly is not.

Why?

When economists think about "social value", they think about whether the potential gains from trade are being turned into actual gains from trade. One of the great things about trade is that it's voluntary, and when two people trade they're both made better off. So, if all the potential gains from trade get turned into actual gains from trade, then we're doing great. If there are potential gains from trade that don't get turned into actual gains from trade, then we're not doing great; we're not maximizing overall social value.

Asymmetric information is one factor that can cause gains from trade to go unrealized, as I've written before.

Market power is another. A seller has market power if that seller has the ability to influence the price at which it sells its product.

Here's an example to show how market power reduces social value. Suppose I have two daisy seeds, and I am the only seller of flowers. There are two potential buyers of daisies. Buyer 1 is willing to pay up to $10 to buy a daisy. Buyer 2 is willing to pay up to $5. My cost of turning a daisy seed into a flower is $3.

What will happen if I am forced (say, by a Soviet-style central planner) to produce two daisies, and sell each for $4? I earn profits of $2. Buyer 1 is willing to pay $10, but is able to buy a daisy for $4 --- this yields "consumer surplus" of $6. Buyer 2 ends up with consumer surplus of $1. If we add up my profit plus the buyers' consumer surplus, we get $9.

What will happen if, instead, I am allowed to charge whatever price I like, with the caveat that I must charge the same price to all buyers? If I'm trying to maximize profits, then the best thing for me is to produce just one daisy, and sell it for $10. This leaves me with profit of $7, and yields zero consumer surplus for both buyers. Again, adding up profit and consumer surplus, we get $7.

The $9 turned into a $7... how? Where did the $2 go?

The $2 represented the lost gains from trade coming from the lost sale to Buyer 2. When I sell to Buyer 2, I incur costs of $3. But Buyer 2 gets something he values at $5, so there are $2 of potential gains from trade. When I have market power, that trade doesn't happen. Social value is destroyed because I refuse to trade with Buyer 2 in order to extract a higher price from Buyer 1.

Ok, fine. But what does this have to do with the MBA Oath?

Toyota is putting up a thicket of patents around its hybrid technology to preserve its market power. Toyota wants to be able to keep competitors from offering similar products, because the existence of similar products will reduce Toyota's ability to charge high prices (and earn big profits) on the Prius. The plain fact is that protecting intellectual property preserves market power, and thus destroys social value --- just as surely as my $10 price on daisies.

Would the MBA Oath folks condemn Toyota for their thicket of patents? I'm guessing not. And the reason why is that they realize that Toyota's intellectual-property-based market-power is granted as a sort of "reward" for innovating in the first place. We grant patents in order to reward inventors by allowing them to charge monopoly prices for some period of time after their invention. We do this because innovation creates social value and unless we allow inventors to capture some of this value, there is little incentive to create value.

So mull this over a bit... In order to get inventors to create value (by innovating) we let them destroy value (by exercising market power). Quite an odd circle...

And this is why blanket statements about promising to create social value are kind of troubling to me. In our modern economy, we want firms to create social value, on net. But our legal system seems to recognize that allowing firms some market power in some cases --- thus destroying social value --- can be a good thing, on net.

While this post is a little critical of the Oath, there are some things I like about it. I'll get to those next time.

Is It Economists' Fault?

I set a new blog record a couple of weeks ago. I got three --- count 'em, three --- e-mails suggesting blog ideas in one day! Two were from family, so I'm not sure how those count. But still... one wasn't.

And so I'll write about the one. A friend --- he's both an accountant and now a Texan, but really he's OK --- sends this article asking why economists didn't do a better job predicting the recent financial collapse.

The author --- Robert Samuelson from Newsweek --- thinks it's because economists just don't spend time thinking about finance, and don't realize how important financial markets are to modern economies.

In my view, this claim is so wrong as to be silly.

Finance is "just" a field of economics, but it's a field that has received a lot of research emphasis in recent years. Every top business school has dozens of researchers working on financial economics problems. And it's not just b-schools... There are top finance researchers in econ departments at Harvard, Stanford, Chicago, and on and on. Why, Princeton started a finance department (within their econ department) and they don't even have a business school! Finance scholars have won multiple Nobel Prizes --- for the CAPM, option pricing, capital structure research, and there'll be more --- and so it's just plain nuts to think that economists don't realize how important finance is.

So what was the problem? Why didn't economic and financial models predict impending doom? Should we shoot the economists?

I think there are two answer to this question, and fortunately both are illustrated by articles that were in the WSJ op/ed section on July 8.

Answer #1 is that, despite all the research, there are still a lot of things that economists still don't understand. I don't think this is because economists are stupid or selfish or lazy or wrong-headed --- I think it's because the problems we study are actually pretty hard. And there's a nice illustration in our first article, Let's Treat Borrowers Like Adults, written by law professor Todd Zywicki. He makes the following point: Buying a dangerous toaster is bad for any consumer who buys it. But a financial transaction is only dangerous if the person who buys it doesn't know what he or she is getting into. And it's very hard for economists to look into the mind of a borrower and figure out what the borrower does or doesn't know about the transaction he or she has just entered into. We're working on understanding human decision-making better, but I think we're not there yet.

So shoot the economists for that if you want. But don't shoot us for not thinking about financial markets. (And please don't actually shoot anyone, economist or not.)

Answer #2 is that even the simple and obvious economics --- the stuff that we're pretty sure we have right --- gets ignored by politicians all the time. And there's a nice illustration of this in our second article, written by, of all people, Gordon Brown and Nicholas Sarkozy. In it, they argue that excessive "speculation" is causing problems in worldwide oil markets.

I don't even know where to begin on this one. Point #1 is that if volatility is really a problem for oil-market participants, the solution is for them to use the futures market to hedge. So it's really pretty easy to use a market-based solution to this problem. Point #2 is that speculation is a good thing --- as long as speculators bear the full costs and reap the full benefits of their actions. (Note that the real estate speculators described in Zywicki's article were able to walk away from their bad housing-market bets, and saddle the banks with the losses.) Speculation is good because it connects present and future prices. The only way to make money speculating is to correctly forecast future price changes. If you think prices will be higher tomorrow than today --- which means that oil will be relatively scarce in the future --- then you can make money speculating by buying today and selling tomorrow. This drives the today price up, and this sends exactly the right price signal to the market. It tells the market to begin conserving oil right now, which is exactly what we all should do if oil is going to be scarce in the future. Read this old Hal Varian NYT column for more.

Why do politicians ignore simple economics? Because they can, at times, care more about getting votes than putting good policy in place. Voters don't necessarily understand that speculation is a good thing, so it can be easy to score political points with articles like this.

And why aren't voters more savvy about basic economics? Well, you can shoot economists for that too.

Associate Dean and Canceled Class

As some of you may have noticed, I've recently been appointed the Associate Dean for Academic Affairs at the David Eccles School of Business.

As others of you have certainly noticed, I've had to cancel Finance 6250 for the Fall Term. This is particularly unfortunate, for a couple of reasons. Reason 1 is that I absolutely love teaching about the economics of organization. Reason 2 is that I made a big song and dance on this blog a while back, trying to get students to take the course.

These two events are, not surprisingly, connected.

Our business school has made great strides over the past few years, but I think we still have significant room for improvement. I've argued before that our state is poised to grow, and, as the state's flagship business school, the DESB needs to be ready to provide the business leadership for that growth. This will require continuing improvements in our faculty, our facilities, and our programs. And it's my job to help Dean Randall figure out how to do it. There's a lot that needs to be done --- and fast.

The reason we canceled Fin 6250 is that I've got to get working on all that other stuff. One of my main objectives will be to improve the quality of our masters' programs, so MBA and PMBA students will still find I'm working on their behalf.

I will still be teaching Fin 6025 and Fin 6026 in the MBA and PMBA programs, but that's mostly because we literally don't have another economist around to staff those core classes. The good news is that we're in the process of stealing a truly outstanding economist away from a top-5 business school --- and the kicker is that he's an incredible teacher too. So look for much expanded econ-related course offerings from the David Eccles School of Business in the near future.

So, my message to students who had been expecting to take Fin 6250 is this: I'm sorry to be unable to teach the class this fall. But I will be investing in the future of your school, and sometimes investments require giving up current consumption.

Fall Term Classes

Seems like it's just this week that the weather finally turned to summer... But already I'm starting to think about Fall Term classes.

We're really excited about our MBA groups for this fall. We have a bumper crop of students, so I'm expecting some really interesting classroom discussions.

This fall I'll be teaching Managerial Econ for the incoming MBA and PMBA classes, and I've already started getting inquiries about textbooks and readings and the like.

I figured I'd direct incoming students here for textbook information in the hope that they'll read some blog entries, get engaged, and get a head start on their MBA.

The recommended textbook is Besanko and Breautigam's Microeconomics (third edition). (This blog is an "Amazon Affiliate", so if you click to Amazon and buy it through this link, then Amazon sends me a check --- which I then donate to the Utah Food Bank.)

The text is NOT required. I will not say things like "Turn to page 442 in the text and work problem 3." I do think it is extremely useful as a reference for students taking this class. In class, I will be working hard to illustrate the applicability of economics to management problems. As a result, I'll sometimes go FAST through some of the more technical details, so I can get to the interesting applications. If you have the text, then you have a resource in case you miss some details. And this will come in handy when working homework problems.

But the text is not required, and I won't be asking you any exam questions that are only discussed in the book.

Yes, I do know that textbooks are frightfully expensive. While I can't pay your textbook bill for you, I promise I will teach you why textbooks are so expensive. (And it's not that the professors who assign the books get a kickback.... I'll get to this the second or third week of class.)

And in the meantime, here's an article about a new business model for textbooks... Tell me... What do you think???

We Rent Movies, So Why Not Textbooks?

If you have more questions about the structure of the course, I'll have the course web page posted by mid August, and students can reach it through WebCT. But in the meantime, I invite incoming students to read this blog and think about economics and how it relates to our everyday lives. I'll be commenting on lots of business and economics news here, and I'd love to get an active conversation going even before fall begins.

Auto Industry Wages

Sorry for the utter lack of blogging recently. I'll get back to both the MBA Oath and some immigration issue shortly.

But for today, another great example from the New York Times Sunday Magazine.

(And as an aside, why is there so much great economics in the NYT Magazine? They're not trying to write about economics, after all... It's because they're writing about really interesting real-world issues --- and economics is just the study of how lots of individuals' real-world decisions add up to the world we live in. The Economist --- great magazine, and I read it every week --- tells you about economics. But the NYT Magazine tells you about life, and that's why it's a better source of economics examples.)

Anyway, the cover story from a week ago was how the auto industry helped create a really vibrant African-American middle class in Detroit, and how the auto industry's troubles are threatening that prosperity.

It's a sad tale. African-Americans still make considerably less than whites (on average), even controlling for education and work history and all that. And unlike other "minority" groups, African-Americans haven't been able to close that gap very well.

But here's how I'm going to use the article in class. For years, union wages in auto firms have been way, way above the going wage for comparable work in other industries. As a result, auto jobs were very, very desirable. Supply far exceeded demand for such jobs.

Now, what does a "normal" firm do when supply exceeds demand? That is, what happens when you list a single job opening and get dozens or hundreds of applications? That's a good sign that maybe the wage you're offering is higher than necessary to attract interest. Profit-maximizing firms will either re-list the job with a lower starting salary, or hire someone at the listed wage, but then limit going-forward wage increases.

Auto firms can't do that. Their wages are negotiated with unions far in advance. If supply exceeds demand, there's no way for them to offer lower wages.

It's a lot like what happens when there is a binding minimum wage. If the government says the lowest wage that firms can pay is $6.50 per hour, but the market-clearing wage (that is, the wage where quantity demanded is equal to quantity supplied) is $5, then any listed job will have excess supply.

One interesting question is how firms decide who to hire. If there are 30 qualified applicants for each opening, then which of them do you select?

The answer in the auto industry? Nepotism. If there are 30 qualified applicants for each opening, then the only way to get hired is to know somebody. Which means the kids of auto workers have a leg up when it comes to getting those jobs. And there's an interesting (but short) discussion of this in the NYT piece.

Is this a good thing or a bad thing? Probably bad. One reason is that we (as a society) want the right people in the right jobs. The price mechanism helps with this (as I've noted before), so messing with prices will mess with the allocation of people to jobs. Another problem is that with any sort of favoritism significant resources can be burned in the attempt to curry favor. I'm just guessing here, but I imagine that a GM auto worker who wants to get his/her son/daughter hired by GM would have to do a lot of work to butter up the right people and grease the wheels. Probably it would be better for everyone if auto workers made autos, rather than spending all day and night trying to kiss up to a supervisor so your kid will get hired.

Anyway, it's a nice example of how resources get allocated when we don't let prices do the job.

---

Update: It's a good time to discuss minimum wages --- The Federal Minimum Wage rises to $7.25 on July 24! What will this do to our (already high) unemployment rate?

MBA Oath

Get ready to be provoked.

Sometimes when you're an educator, you get to say provocative things just to try to stir up discussion. And that's what I'm about to do.

So here goes...

And remember, I'm just trying to provoke you.

A group of Harvard MBA students is circulating the MBA Oath. In part, the idea is to remedy the black eye that the recent financial crisis has given to schools of management, by having MBAs promise to work to enhance social value.

I'm not sure what I think of this idea. (Actually, I am sure, but I'll save that for later.)

At the suggestion of a friend who is a professor at another b-school, I wrote up a competing Oath. Here it is:

I, the undersigned graduate of so-and-so business school, recognize the inherent tension between value creation and value capture. Private enterprise has little incentive to create value unless it is allowed to capture at least some of it. Our capitalist system recognizes this tension, and allows firms to pursue profits self-interestedly, subject to many limitations imposed by the legal and regulatory system. As a manager, I realize that it is not my role to determine what is an "appropriate" or "inappropriate" profit-making opportunity; in our society, the political, legal, and regulatory processes make that determination. I therefore pledge to maximize shareholder value (subject to all applicable laws and regulations), and recognize that I serve a great social purpose in so doing.

Now that I've provoked you, tell me what you think. Which Oath is better? Which one would you sign? Should managers work for social value or shareholder value? What the heck is social value, anyway?

iPhone Pricing

An EMBA student points out that Apple announced yesterday some incredibly cheap iPhones --- $99 for the 3G second generation with 8 GB.

What is going on?

Well, a lot. But part of what's going on is that Apple's trying to manipulate a coordination game that's happening between customers and software developers.

I'll explain in a minute, but first let's talk about what a coordination game is.

It's a game where the players' best choices depend on what other players are doing. If you're a former student of mine, you've probably seen me talk through the "Battle of the Sexes" game, where two people want to spend the day together, but they have different preferences about where to spend it. In this game box, Rachel has to choose whether she wants to go to Wrigley Field or the Field Museum. Scott has the same set of choices. If Rachel chooses Wrigley and Scott chooses Museum, the outcome is in the upper-right cell, where Rachel's payoff (represented in lower-left of the cell) is five, and Scott's payoff (upper-right) is also five.

The notable thing about this game is that there are two Nash Equilibria. One is where Rachel and Scott both go the Museum. Another is where both go to Wrigley. At any of the other cells, a player could unilaterally change his or her strategy and achieve a higher payoff --- so those cells aren't equilibria.

Coordination games aren't just classroom trivia --- they're real and they're real important.

Here's another game box. The players here are software developers and end users of smartphones. The choices for the developers are "develop for iPhone" and "develop for Palm Pre". The choices for end-users are "buy an iPhone" and "buy a Palm Pre". With the payoffs I've drawn, the developers don't really care whether they develop for iPhone or Pre --- they just want to be where the customers are. Further, customers don't care about which platform they're on, they just want to be where the apps are.

This is a coordination game, and it has two Nash Equilibria, just like the Battle of the Sexes.

If the developers don't care which platform they're on and the end users don't care which platform they're on, then who does care? Apple (and Palm) care a lot.

My guess is that Apple's super aggressive iPhone pricing is driven (in part) by the recent introduction of the Palm Pre, which has been getting some good reviews. Apple knows that it can't win (indefinitely) by having a better device than other smartphone makers --- device features are just too easy to copy. But it can win (indefinitely) if it can get developers and end-users to coordinate on the iPhone platform. The reason is that no developer will develop for the Pre if developers don't expect end-users to buy it. And no user will buy one if users don't expect developers to develop. By pricing aggressively and pulling as many end-users over to its platform as possible, Apple is trying manipulate the equilibrium of this coordination game, and reduce developer incentives to develop for Pre.

Malcolm Gladwell

A DESB MBA alumnus sends a link to this article from ESPN.com:

Gladwell-Simmons II: Ultimate rematch

In it, Malcolm Gladwell (of Blink fame) criticizes pro sports leagues for rewarding teams that perform badly by giving them high draft picks. Here's a snippet:

I think, for example, that the idea of ranking draft picks in reverse order of finish -- as much as it sounds "fair" -- does untold damage to the game. You simply cannot have a system that rewards anyone, ever, for losing. Economists worry about this all the time, when they talk about "moral hazard." Moral hazard is the idea that if you insure someone against risk, you will make risky behavior more likely. So if you always bail out the banks when they take absurd risks and do stupid things, they are going to keep on taking absurd risks and doing stupid things. Bailouts create moral hazard. Moral hazard is also why your health insurance has a co-pay. If your insurer paid for everything, the theory goes, it would encourage you to go to the doctor when you really don't need to. No economist in his right mind would ever endorse the football and basketball drafts the way they are structured now.

I'm going to argue with Gladwell by re-telling a story. The story belongs to a colleague from my Kellogg days who is an expert on innovation. This story is his, and it didn't happen at Kellogg.

He was teaching one day (at another school) about how to provide incentives for innovation. During the class, he'd argue that innovation is inherently risky. Even if your employees take all the right actions all the time, sometimes they will fail to innovate.

Now, suppose you punish employees who fail to innovate, by withholding raises or promotions or something. What will employees do? They'll pursue the path that seems most likely to lead to some sort of innovation, which may or may not be the path that maximizes the firm's expected profits. To get employees to innovate appropriately, you sometimes have to insulate the employees from the full consequences when things go badly. It's a counter-intuitive and subtle message.

The big finish to my friend's lecture was this message: To encourage innovation, sometimes you have to reward failure.

A student raises his hand. My professor friend calls on him. Student says: "At my company, we tried to reward success."

Now why's that related to anything that Malcolm Gladwell said? Gladwell wrote this: "You simply cannot have a system that rewards anyone, ever, for losing."

A response from this economist: Sure you can. And that's exactly the right thing to do when the costs of "rewarding success only" --- as Gladwell advocates --- exceed the benefits.

Examples:

• Rewarding scientists who take all the right actions but fail to innovate is exactly the right thing to do if you want to encourage scientists to do something other than take the sure-thing path to a simple innovation.
• Rewarding teachers who fail to make students happy is exactly the thing to do if you want to encourage teachers to develop lesson plans that push students.
• Offering a government bailout to banks certainly rewards losing, but it's exactly the thing to do if the consequences of not doing the bailout are worse.
• Offering a good draft pick to a bad team is exactly the thing to do if... fans value competitive balance.

A couple of comments on the financial rescue and the NFL/NBA drafts: It's for sure the case that government bailouts reward failure and can lead to moral hazard, as Gladwell points out. But does this mean we shouldn't have done it? Well, the financial system, it turns out, is really important to the economy at large. And a domino effect of failures through the financial system could have led to a much larger disruption in the flow of credit to the real economy. And that would have been bad. Worse than the moral hazard as future bankers expect big bailouts? Well, maybe, but it's hard to to say. Unfortunately, we (meaning economists) don't get to observe what would have happened if we had let AIG fail.

With regard to the drafts: Would NBA revenues be higher if the "basketball player" labor market worked like every other labor market? Think about what happened when you graduated college --- you were a free agent, free to sign with whatever team, er, firm you wanted. Suppose all rookie basketball players could do the same. Now, players like to win. As a result, they're likely to be willing to accept slightly lower salaries in order to sign with a team that has a chance to win. Now you've got a really pernicious feedback loop going --- teams that have a chance to win would have higher revenues (due to more fans) AND lower costs (due to the players-like-to-win effect). The Clippers would really, really not have a prayer.

As a general rule, I'd say that providing incentives has both costs and benefits, and it's important to think through both. Too often, people make mistakes along the line of saying "X is good. Let's reward X." This is what Gladwell is doing when he says we need to reward winning only. And it's also what my professor friend's student was doing when he said that we should reward success.

Why Work Is Like It Is

Awesome article in the New York Times Magazine last Sunday.

The Case for Working with Your Hands

The article is written by University of Chicago PhD in political philosophy (Matthew Crawford) who gives up on being a so-called "knowledge worker" (that is, somebody who sits in an office and processes information all day), and instead opens a motorcycle repair shop.

The awesome economics in this article just goes on and on... So unfortunately this blog post will go on and on as well.

One great thing about the article is that it re-iterates Princeton economist Alan Blinder's point that young people should think about future labor market competition when choosing careers. If your job can be done over the wire, then you're likely to face competition (if not now, then in the future) from low-wage workers in other countries. Crawford recounts Blinder's great line: "You can't hammer a nail over the internet." This is really useful advice for everyone who's making human capital investments.

Another great thing about this article is how it questions why work is like it is. There's a discussion of how fixing motorcycles is a sort of unconstrained problem-solving that requires both deep knowledge and hard thinking. It's not the sort of job that can be done (well) by people who are simply following steps out of a rule book or owner's manual. Crawford criticizes jobs where people are constrained by rules, steps and processes:

There probably aren’t many jobs that can be reduced to rule-following and still be done well. But in many jobs there is an attempt to do just this, and the perversity of it may go unnoticed by those who design the work process.

While I agree that rule-following has its problems, I don't think it's the case that managers mechanically reduce jobs to rule-following for no reason. So what's the reason? Why is work like this?

Crawford is obviously a brilliant guy. (U of Chicago is no Stanford --- neener neener --- but still they don't let just anybody get a PhD there.) Further, the mechanics that Crawford admires have spent 30+ years acquiring knowledge about how to fix bikes. Brilliance is scarce and career-long investments in knowledge acquisition are costly. As a result, not everyone can succeed in jobs that require skill at the sort of unconstrained, open-ended problem solving that Crawford likes.

So what are the economic implications of this scarcity of problem-solving skill and talent? One is that skill and talent is going to be high priced. And this means people will try to economize on skill and talent. And how do we do this? We try to reserve the skilled and talented people in our economy for solving the really hard problems. We try to give the easier problems to the less skilled and the less talented. And we give them a set of rules to follow, to try to help guide them to the right answer. If they can't get to the answer, then problems tend to get passed up the problem-solving hierarchy, eventually landing on the desks of the most skilled and talented problem solvers. (I'm sketching a model written by Luis Garicano, formerly a professor at, yes, the U of Chicago, and now at London School of Economics.)

In other words, if everyone were as smart as Crawford, then the "rules" that Crawford dislikes so much wouldn't be necessary, because we wouldn't have to economize on skill and talent. But unfortunately that's not the case.

Great thing number 3 is how Crawford points out the "moral maze" of middle management. One interpretation of this is the following: Some jobs make you feel good about yourself. Others not. (This calls to mind the awesome Billy Mays ESPN360 commercial, where a worker reports "Now my job is way less soul crushing!") Would the world be a better place if we didn't have a job called "middle manager"? Maybe... because fewer people would find their jobs to be soul crushing. But that's only the "cost" of having middle managers. What's the benefit?

One benefit is that middle managers allow firms to get big. Think about it... You really can't have a big firm without having middle managers, and you really only get middle managers once firms reach a sufficient scale. And is scale good? It can be, because some of our modern production technologies have increasing returns to scale, which means that average costs fall with size. The benefit side is therefore this: Middle management facilitates scale, which allows society to utilize its resources more efficiently.

So there are costs and benefits.

And is there any reason to think that labor and product markets will get this cost/benefit balance right?

Actually, yes. I'm not a "market outcomes are always efficient" kind of economist, but I do think in this case there's reason to believe that markets will push things in the right direction. If people hate being middle managers, then middle management jobs will have to pay higher wages. (There's ample evidence that people get paid less for jobs that they enjoy, and more for jobs they dislike....) So firms will only hire middle managers if the benefit to the firm (coming from more efficient production technologies allowing the firm to produce goods and services more efficiently and meet customer needs better) exceeds the "cost" to the worker of having a crummy job.

The labor and product markets force the firm to essentially say to the prospective middle manager: "Look, we know this job will be soul-crushing. But your presence is going to make our firm so much more productive that we are willing to pay you enough to make it worth your while."

Great thing number 4 is the discussion of his own soul-crushing job, where Crawford wrote abstracts for scientific journal articles. The article makes clear this exercise was totally absurd; none of the workers had anywhere near the expertise to write abstracts of scientific journal articles. This was completely wasted effort. How can markets be efficient if jobs like this get created?

The answer is that markets aren't ever literally efficient, and Crawford's tale is a great example of that. But markets do have the ability to move things in an efficient direction.

And who's the efficient person to write an abstract for a scientific journal article? The author, of course. And how might markets make this happen? A librarian, unhappy with the cost and low quality of a journal abstracting service, might tell a journal that he has higher willingness-to-pay for a subscription to the journal if the journal requires authors to submit an abstract.

Might this actually happen? Compare this article from the American Economic Review published in 1980 to this one published in 1990.

Economics for Accountants (Part 4)

Finally returning to the much promised Part 4.

The last point I want to make about the Market for Lemons is how it helps us understand the recent financial crisis. You really can't appreciate how the crisis impacted credit markets without understanding the Market for Lemons, and here's why.

One of my favorite articles about the crisis was published in the NYT way back in October:

As Credit Crisis Spiraled, Alarm Led to Action

The great thing about this article is the description of how the entire financial system came to a screeching halt after Lehman Bros. failed. It's the regular old Market for Lemons logic, applied to credit markets. If I'm a bank, I'm happy to lend money to "plum" credit risks. What do I mean by "a plum credit risk?" It's a borrower who is very likely to have the funds to be able to pay me back. And I'm happy to lend money to lemon risks, as long as I get terms that are favorable enough to the lender --- usually, very high interest rates and a lot down. But I'd never want to lend money at a plum rate to a lemon credit risk.

And if I can't tell the difference between plum risks and lemon risks? Then the market for plums ceases to function, and borrowers with plum risks cannot borrow at plum rates.

People with lots of money --- college endowments and hedge funds --- deposit funds with big banks all the time. Making a "deposit" with a financial institution is just like loaning money to the institution, so the hedge-fund/endowment lenders will want to think about whether their commercial-and-investment-bank borrowers are plums or lemons. Because of federal deposit insurance, most of us don't worry about this issue when we put our paychecks in the bank. But if you have millions and millions of dollars, you're way beyond the upper limit of deposit insurance. And this means you could lose out --- big time --- if the bank where you've deposited your money fails.

And normally, the huge financial firms that make up the backbone of our financial system are viewed (themselves) as plum credit risks. Prior to a couple years ago, the possibility of failure for a big bank like Bear Stearns or Lehman Bros was viewed as quite remote. Banks did fail, due most commonly to rogue traders, but it wasn't something that people worried a lot about. And as a result, these firms were able to borrow funds from depositors at plum (that is, low) rates, and were therefore able to lend more cheaply.

But last September, depositors suddenly found they had no idea whether Goldman or Citi or Wells Fargo or Merrill was a lemon risk or a plum risk. If Bear Sterns and Lehman fail, who knows what's next? Lenders refused to lend to anyone (except the US Federal Government) at plum rates --- and banks' sources of capital dried up. The "freezing up" of the credit markets was 100% exactly a case of the failure of a market for plums.

Positively Fifth Street

No time to finish the Immigration or Accounting Part 4 posts today. Soon...

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Positively Fifth Street: Murderers, Cheetahs, and Binion's World Series of Pokeris the self-told story of Chicago-based reporter and amateur poker-player Jim McManus. In 2000, McManus was sent to Vegas to cover the World Series of Poker for Harper's Magazine. One thing leads to another, and the author ends up in the tournament, at the final table. Pretty unlikely, but also pretty good reading.

The cool economics in this book comes because poker is a game of asymmetric information. It's a more complex version of the Spence signaling model, or the Market for Lemons, or hundreds of other games that economists have studied over the past 30 or so years. (My recent Lake Wobegon Effect paper models CEO pay as a game of asymmetric information.)

What I try to emphasize when teaching MBAs to think about games with asymmetric information is this: Think always about what you can infer about your opponent's information by observing his actions. And think about what your opponent is going to infer, in the other direction.

And this is exactly what great poker players do. So it's really interesting reading --- from this non-poker player, but trained game theorist's perspective --- to think along with a poker player as he does this. The best such story starts on page 293, where McManus wins $400,000 from one of his poker idols, TJ Cloutier. Cloutier is a celebrated author within the poker world, having written Championship Pot-Limit and No-Limit Poker. McManus, who has studied Cloutier's books in detail, is constantly thinking through what Cloutier's actions must imply about his cards. McManus gets it right, and also manages to confuse Cloutier's inferences by making some unexpected choices.

I do have one beef with the book --- By my count, there is only one Tiltboy in this story. How can that be?

Education vs. "Real World" Experience

A couple of labor-market related items in yesterday's SLTrib. I'll save the immigration story for next week and write today about a story on a new report on Utah's working families:

Utah working families face economic hardships

Here's a quote:

(W)ithout investment in the state's poor working families,... they will not be an integral component of Utah's future economic growth and prosperity. (The report's author) called on legislators to ensure that educational and training programs are affordable, accessible and tailored to the demands of a knowledge-based economy.

But will that really work? Will additional investments in education help the working poor?

Data say... yes.

Here's why:

Let's think about the factors that increase peoples' wages. One factor is experience. As people get more experience in the workforce, they acquire more skills and become more productive. Supply and demand bids up wages for more productive workers, so more experience means higher wages. On average, it turns out that an additional year of labor market experience boosts wages by 1.5% (depending a bit on how and when you measure it). This is one reason that the poor tend to be young; they haven't had time to acquire enough skills to earn their way out of poverty.

Another factor that increases wages is education. As people get more education, they become more productive. Again, supply and demand bids up wages, so more education means higher wages too. On average, it turns out that an additional year of education boosts wages by an astonishing 8%. Yeah, that's right --- "real world" experience is valuable... but a year of education is more than five times as valuable. Five times! (And of course the exact figure depends on how you measure, but I think the consensus of labor economists is that my numbers are about right.)

These aren't made up numbers. They come from studying the relation between real wages and real experience and real education (using linear regression models and some tricks to help figure out causal linkages) in huge data sets collected by the US Census.

So, if a local high school grad has to skip two years at SLCC and instead go into the workforce... that's a net difference in yearly wages of around 13%. Think of how much of a difference a 13% raise would make for a working family. That's a lot of money, when you add it up over forty years in the workforce.

We always hear that education is a great investment. And labor economists' numbers bear that message out.

Google Runs a Regression

A former Kellogg student forwards this cool article about Google using an "algorithm" to try to figure out which of its employees are likely to quit.

Google Searches for Staffing Answers

While Google is being tight-lipped about what they're doing, I am here to tell you that it's not so complicated. I doubt they're doing very much more than running a simple regression, not that much more advanced than what MBAs learn in b-school. Linear regression is, as MBAs know, is the best linear unbiased estimator of an underlying relationship. So it's exactly the tool for picking out the relationship between "quits" and various factors affecting the work environment.

Here's how you do it:

The simplest way is to estimate what's called a "linear probability model." Let the dependent variable in your regression be a zero if the employee doesn't quit, and one if he does. Let the independent variables be all the data you have pertaining to the employee's personal characteristics and work environment. Run a linear regression, and look for factors that strongly predict quit behavior. In a linear probability model, you can interpret the coefficients on the explanatory variables as how much a one unit change in that explanatory variable increases the probability of a quit.

Now the linear probability model isn't exactly the best thing to do, because of some funny characteristics of probabilities. Specifically, because probabilities have to be between zero or a one but the linear regression model doesn't account for that, you can get situations where the predicted quit probability for a given individual is less than zero or greater than one. So keep that in mind. But the linear probability model is quick and dirty, and it will give you insight into the relationships in your data.

To do something a bit more rigorous, you can do a logit or probit regression. Most of your standard statistics packages can handle this kind of regression pretty easily, and these methods always yield sensible quit probabilities. You have to do some more work to figure out the strength of the relationship using these methods, but it's not too tough.

After you've identified factors that are associated with quits, you can think about doing something about those factors --- and perhaps reducing your turnover.

One danger in this kind of analysis, though, is misinterpreting what causes what. People who know they're likely to quit are probably people who aren't going to undertake long-term projects at work. So the data might well tell you that people who work on a succession of short-term projects are more likely to quit than people who work on long-term projects. But this doesn't mean that shifting everyone to long-term projects will reduce turnover, because it's the employee's turnover intentions that drive project choice, not vice versa. So you need to think hard about what your data means before making wholesale changes in your organization.

Now you're as smart as Google. But unfortunately not as cool.

News Flash: Demand Curves Shift

Back to Accounting shortly....

But I'm teaching Managerial Econ for the 2010 EMBA class this summer, so I'll of course be thinking about some managerial econ ideas over the next ten weeks. And here's one thing that strikes me every time I cover the material about where demand curves come from: Journalists love --- love! --- to write about shifting demand curves.

Remember last summer when gas prices were so high? Every time you opened a newspaper (yes, I'm old-fashioned), there was a story about how people were changing their behavior because of high gas prices. People increased their demand for hybrids, bus passes, and city-center apartments, and reduced their demand for hummers and houses in exurbia.

And here's the latest from the NYT:

Yes, I Look Fabulous, But Inside I'm Saving

Even Hollywood A-listers are reducing demand for certain goods and services now that everyone's 401k is 40% down from last summer. Why, Alice Cooper's bass player parks his own car rather than paying $10 for the valet.

For most goods, we reduce our consumption when our income falls. But falling income leads to hard choices, and these are the sort of choices that attract journalists. This article focuses on how Hollywood-types are reducing spending on status goods only a little, but are cutting back more on goods that don't convey status. One exec canceled her vacation but still splurged in an Audi A5. Apparently nobody can tell whether you went to Fiji or Fresno over spring break, but tongues wag over your sporty new ride.

This article was in the Times The Arts section, which just goes to show that you can find cool economics pretty much anywhere you look.

Economics for Accountants (And Entrepreneurs) (Part 3)

In Part I of this post, I explained why the Market for Lemons results in unrealized gains from trade. This means that there are buyers and sellers out there who could both be made better off by trading... But they can't get the deal done. In the specific case of the Market for Lemons, trade fails because the buyer cannot be certain he is dealing with a plum seller.

Here's an important, related notion: Every business plan ever written starts with the observation that there are unrealized gains from trade. This sounds like an outrageously bombastic proposition, but I argue that it is literally true. When VCs and entrepreneurs ask "What's the value proposition?" (which they do), they are really asking about where the unrealized gains from trade are.

If there were no unrealized gains from trade, then you could never start a new business. Why? Because what businesses do is buy inputs (capital, labor, and intermediate goods) from suppliers, convert them into output (think of goods and services), and sell the output to customers. If the trade between suppliers and customers were already perfectly efficient --- in the sense that there was no way to rearrange things to offer both suppliers AND customers a better deal than they've already got --- then you'd never be able to get the new business off the ground.

Unrealized gains from trade can arise in a lot of ways. As one example, consider search costs. Amazon.com's business is built (partly) around reducing search costs, and hence allowing buyers of books and sellers of books to find each other more easily. That is, before Amazon existed, some buyers and sellers were prevented from realizing gains from trade because of the difficulty of finding each other. A buyer who really wanted quite a specific book might not be able to find it at his or her local B. Dalton Bookseller, and hence the trade wouldn't happen. Amazon makes it easy for buyers to find just what they want. Think of all the trades that didn't happen before Amazon existed, and think of Amazon taking a just a small piece of the value in each trade. Those pennies add up.

As we've been discussing, unrealized gains from trade can also arise from informational problems, as in the Market for Lemons. Because there are unrealized gains from trade, there's money to be made from figuring out how to get the trade to happen.

This explains Carmax. It also explains Executive Search Firms (aka headhunters).

If you think about Carmax's business model, they are an intermediary in the used car market. That is, they buy AND sell used cars. And if they're going to make a profit doing that, then there must be some reason why they're able to do better than buyers and sellers would be able to do on their own. That is, at least some sellers have to prefer dealing with Carmax to dealing with buyers directly. And at least some buyers have to prefer dealing with Carmax to dealing with sellers directly.

Let's start on the buyer side. What buyers are afraid about in the Market for Lemons is buying a Lemon car at a Plum price. This is why buyers shy away from cars with plum prices. But what if Carmax is selling a used car at a plum price? Should buyers believe that the car is actually a plum? There's reason to think that Carmax can do a better job (compared to individuals) of committing to sell ONLY plums at plum prices. Carmax can more easily offer warranties. And it can more easily develop a reputation for honest dealing, at least compared to an individual who sells a car once every five years.

On the seller side, in the Market for Lemons the plum sellers can't sell at all, because buyers fear buying a lemon car at a plum price. But suppose Carmax employs skilled mechanics who can, after inspecting a car for a while, do a good job of distinguishing plums from lemons. Then Carmax can be confident that when it pays a plum price it isn't getting a lemon, and plum sellers will be better off selling to Carmax than selling directly to a buyer who is afraid of buying a lemon.

Now, this isn't everything about the Carmax business model, but it's part of their edge. They facilitate trade in the used car market and, like Amazon, take a small chunk.

Headhunters work on much the same principle. The Market for Lemons affects the labor market because no firm wants to pay a plum price only to find they've hired a lemon executive. Headhunter firms connect buyers (firms looking to hire) with sellers (executives looking for new opportunities) and reduce search costs like Amazon. But they also check references and try to develop a reputation for successful placements. This reduces information asymmetry, and is what allows the headhunters to charge high fees.

So, an important point about the Market for Lemons is this: If markets fail to realize gains from trade, then there's a profit opportunity. So firms (and other economic institutions) will try to arise to get that trade to happen. Accounting is one economic response to the Market for Lemons. Entrepreneurship is another.

So entrepreneurs and bean counters have more in common than they think.

Entrepreneurship Reality TV Needs Utahns

Two notes before I get to my actual post.

(1) Turns out it's hard to get motivated to blog about economics when the springtime sun is shining in the Wasatch Mountains.

(2) I'll return to your regularly scheduled discussion of accounting shortly.

For today, I got an e-mail from my college friend Rafe --- He's connected to all kinds of Hollywood types, and he sent me a casting call for ABC's new show "Shark Tank." Apparently the idea is to put budding entrepreneurs in front of money people, and then watch the money folks rip the poor little entrepreneurs to shreds. Sounds like great TV, right? Somehow at the end, the winning entrepreneur gets funded.

Anyway, we all know that reality TV loves Utahns, so everyone out there should sign up.

Here's the call:

DO YOU HAVE THE NEXT GREAT MONEYMAKING IDEA? We are currently on the search for entrepreneurs, inventors, businesspersons, dreamers, promoters, creators, innovators, etc. If you feel you have a lucrative business idea but just can't seem to secure the financial backing to get it off the ground then Shark Tank is just the show for you. Each episode features aspiring entrepreneurs pitching their business ideas to moguls in hopes of landing investment funds. Apply now for your chance to enter the "Shark Tank" and see if your idea survives.

All interested parties should email David Polanzak at dpo.casting@gmail.com with the following information:

Name:
Age:
Hometown:
Phone:
Photo:

*Please put in the Subject Line of your email if you are an: Inventor, Entrepreneur or both

As if you needed any more inducement, Rafe is willing to sweeten the deal in various ways. If you sign up, let me know and I'll connect you to Rafe.