Economics for Accountants (Part 2)

Why does Financial Accounting exist?

No doubt many a-MAcc student has pondered this question during preparations for final exams.

Well --- lucky you --- I am here to answer all your existential queries. Financial Accounting exists because of the Market for Lemons.

From used cars to GAAP --- isn't that too much of a stretch? Actually not... And here's why.

Instead of thinking about the market for used cars, let's think about the market for firms' shares. Let's consider the case of ABC Corp, which is a growing but privately held firm. ABC's owner is concerned about finding sources of capital that it needs in order to grow. ABC is considering doing an IPO to sell shares to the public.

To tie this back to the Market for Lemons, ABC is the seller (of shares) and the share-buying public is, well, the buyer. As in the Market for Lemons, ABC's management probably knows more about the firm's future prospects than the share-buying public does.

Just to keep things simple and concrete, let's assume that ABC's future profits depend on whether its market position is "Good" or "Really Good." If the market position is "Good", then the NPV of the firm's profits is $100. If the market position is "Really Good" then the NPV of future profits is $200.

Let's further assume that the ABC's management wants to sell a 25% equity stake to outside investors.

Now, if the buyers know the firm's market position, then this sale can work out very easily. ABC sells its 25% stake for $50 if the market position is Really Good. ABC sells it for $25 if the market position is Good.

But what if the buyers don't know what ABC's market position is? And, to complicate things further, what if the seller knows, and the buyer knows the seller knows, and so on? Suppose also that the buyer thinks there's a 50% chance that the firm's market position is Good, and 50% that it's Really Good.

Just like with the Market for Lemons, we can sort out what's likely to happen by asking about what offer the buyer should make.

If the buyer offers $50 for the 25% stake, then half of the time the buyer will be buying a quarter of a Really Good firm, but half of the time the buyer will be buying a quarter of a Good firm. The buyer has paid $50 for shares that are worth

(1/2) * 50 + (1/2) * 25 = 37.50.

Not a good deal for the buyer.

What if, instead, the buyer offers $37.50? Will ABC sell?

If ABC's market position is "Good", then yes, this is a good deal for the seller. But if ABC's market position is "Really Good", then they won't sell. After all, this would mean selling something worth $50 but receiving only $37.50 back. And if ABC only sells when its market position is "Good", then this means the buyer has paid $37.50 for something that's worth only $25.

So again, not a good deal for the buyer.

What if, finally, the buyer offers $25? Will ABC sell?

If ABC's market position is "Good", then ABC is willing to sell. But if ABC's market position is "Really Good", then they won't.

What does all of this mean? As with used cars, we have a market for lemons but not a market for plums. That is, ABC can sell shares when its market position is Good. But it cannot sell shares when its market position is Really Good. Again, the reason is that buyers are afraid of paying a "Really Good" price ($50, in our example above), because it's hard for buyers to determine whether they're buying a "Really Good" company or just a "Good" company.

Now, why do we care about this? We care because the specific market that's failing here is the capital market for plum firms. And it's potentially very bad for society if we starve our very best firms of capital. But that's exactly what's happening.

So I still haven't said how accounting matters in all this. Let's get to that.

What's GAAP? It's a set of rules that firms have to follow when disclosing information about the economic status of the firm. With some exceptions, GAAP doesn't allow firms to selectively disclose things. Firms have to tell current and future shareholders a lot about what's going on with the firm. Armed with this information, buyers might be able to distinguish plums from lemons. And if buyers can tell the difference, then the markets for plums will function --- and our best firms won't go starving for capital.

The key social role of accounting is this: Financial accounting exists to make it harder to sell a Lemon firm for a Plum price. This facilitates trade in capital markets, and allows our best firms to thrive.

Our course, accounting isn't perfect --- just think of Enron for one example of a lemon firm that managed to convince investors it was a plum by manipulating the accounting system. But it's better than nothing.

Economics for Accountants (Part 1)

I gave a short talk a couple of weeks ago to some of the MAcc courses here at the U of U. The Masters of Accounting is a professional degree that prepares folks for a career in auditing and public accounting. It's one step on the path to a CPA. (And by the way, demand for CPAs remains strong. The MAcc is a great degree, and our School of Accounting does a super job with it.)

I was talking about the economy generally and the complex chain of events that led us into the deep recession we're now in. But I only had an hour and twenty minutes. So I didn't get to do everything I wanted to do.

One of the key ideas for understanding various aspects of the crisis is called "The Market for Lemons." This is one of the very most important ideas in economics. George Akerlof won the 2001 Nobel Prize for it. Put it in the same "really important ideas" bin as Hayek's notion that prices convey information.

The Market for Lemons doesn't just help us understand the crisis --- it actually explains why financial accounting exists in the first place. So it's an important idea for accountants (and everyone else, for that matter) to get a grasp on.

I was hoping to explain it to the MAcc students, but didn't have time. I'll explain it here instead, and hope that they'll come read. It's a big idea with lots of moving parts, so it will probably take me a few posts to get everything out.

So here's the one sentence version: "Asymmetric information can lead to market failure."

And here an example showing what that means.

Let's consider the market for used cars. We have two buyers and two sellers. One of the sellers has a really nice car to sell --- great shape and plus it runs good. One of the sellers has a junker: dents all over and maybe it needs a transmission.

The seller of the "plum" car is willing to sell as long as she gets at least $6000 in exchange for the car. The lemon seller is willing to sell as long as she gets at least $2000.

There are buyers out there as well. Buyers like plums, of course, but they're willing to buy a lemon if the price is right. Buyers are willing to pay up to $7000 for a plum, and up to $3000 for a lemon.

Because the most the buyer is willing to pay is bigger than the least the seller is willing to accept, there are gains from trade. That is, one buyer can offer the lemon seller, say, $2500 for the lemon. The buyer thinks "I'd be willing to pay $3000, so if I get it for $2500, that's giving me $500 worth of surplus." The seller things "I'd be willing to sell for $2000, so if I sell it for $2500, I get $500 of surplus." Both buyer and seller are made better off through this trade. Same for the plum; a price of $6500 makes both better off.

Note what happened here: In each case, the car ended up with the person who valued it the most. The lemon buyer values the car at $3000, while the seller values it at $2000. The buyer ends up buying it. The plum buyer values the car at $7000, while the seller values it at $6000. The buyer ends up buying it. This market worked, in the sense that the cars are put to their highest-value use.

Now I'm going to make one small change to this market interaction, and it's going to mess things up pretty badly.

I'm going to assume that the buyers cannot determine whether a car is a plum or a lemon and that sellers know whether their cars are plums or lemons. To make this more concrete, have a look at this article about post-Hurricane-Katrina flood cars. Turns out that it's pretty easy to take a flood-damaged car and make it run. The problem with flood damage is that it shows up over time. This is exactly the sort of problem that a seller might know about, but where it'd be hard for a buyer to detect prior to purchase. You could imagine the same sort of issue surrounding a faulty transmission, or balky radiator.

Just to throw some jargon at you, these assumptions mean there's asymmetric information. The seller knows something, and the buyer doesn't. I'm also going to assume that the buyer knows he doesn't know, and the seller knows the buyer doesn't know, and the buyer knows the seller knows the buyer doesn't know, and so on. That is, the asymmetry of information is common knowledge.

How does this change things?

To see the problems, we're going to talk through a buyer's thought process about what offer to make to a seller. Recall that this problem was pretty easy in the "symmetric information" case above. The buyer above makes a high offer if the car is a plum, and a low offer if the car is a lemon.

In the "asymmetric information" case, things are more complex. Suppose the buyer sees a car. He doesn't know whether it's a plum or a lemon, but figures there's half a chance of either. What should he offer?

One possible offer is $6500.

If the buyer offers $6500 and the car is a plum, the seller will probably accept the offer. In this case, the buyer ends up happy, because he's just bought a car that he values at $7000. As above, he ends up with $500 in surplus.

If the buyer offers $6500 and the car is a lemon, an unscrupulous seller will.... accept the offer (and secretly scream in joy) In this case the buyer has just purchased a car that he values at $3000 but has paid $6500 for it. This is $3500 in "negative" surplus for the buyer.

Let's summarize: If the buyer offers $6500, he gets a car for sure. Half the time the car is a plum (in which case the buyer gets $500 in surplus) and half the time the car is a lemon (in which case the buyer gets -$3500 in surplus). On average, the buyer gets

(1/2) * 500 + (1/2) * (-3500) = -1500

in surplus. The buyer is better off making no offer than offering $6500!

What about other offers? Maybe the buyer should offer $2500?

If the buyer offers $2500 and the car is a plum, the seller will not accept the offer. No trade happens, and the buyer gets $0 in surplus.

If the buyer offers $2500 and the car is a lemon, the seller will accept. This yield $500 in surplus for the buyer.

Again to summarize: If the buyer offers $2500, he gets a car only if it happens to be a lemon. Half the time the car is a plum (in which case the buyer gets $0 in surplus) and half the time the car is a lemon (in which case the buyer gets $500 in surplus). On average, the buyer gets

(1/2) * 0 + (1/2) * (1500) = 250

in surplus. The buyer is better off when offering $2500 compared to making no offer.

Notice what's going on here. The buyer is afraid to make a high offer, because high offers attract both lemon sellers and plum sellers. Because the buyer won't make a high offer, the plum car doesn't get sold, even though the buyers value the car more than the plum seller. This means there are unrealized gains from trade --- the market has failed to achieve all possible gains from trade.

We call this example "The Market for Lemons" because that market works. It's specifically the market for plums that fails.

Asymmetric information is a big problem in lots of markets. It can cause trouble in labor markets, financial markets, insurance markets, health care markets,... you name it. And while the example I've written down is quite specific, the conclusion of market failure isn't driven by any of the specific assumptions. We could, for example, allow the seller to make offers, let the buyer make multiple offers, assume the seller doesn't know with certainty what kind of car he has (but still has a better idea than the buyer). None of this changes the basic conclusion that asymmetric information can lead to market failure.

In Part 2 of this post, I'll explain why the Market for Lemons explains why financial accounting exists. In Part 3, I'll write about how this idea can explain other "institutions" we observe in the world. Then in Part 4, I'll get back to showing how this idea is useful for explaining various parts of the financial crisis.

Getting Incentives Right (and Learning About it in B-School)

This post is directed at first-year MBA students at the David Eccles School of Business. For the rest of you... Maybe you should consider becoming a first-year MBA student at the David Eccles School of Business.

Read this article from yesterday's Wall Street Journal. I don't agree with everything that's written here. I do agree that bad incentives are the central problem that led us into the financial mess. But I don't agree that business schools don't teach students how to think in a structured, careful way about the provision of incentives in modern firms.

Because this is what I do.

I know you didn't see me do any of it in the fall. Unfortunately, that core micro course you took is way too short. Plus there are some basic micro principles (supply/demand/elasticity/etc) that have to be covered. So I don't get to do any incentives stuff there.

But let me tell you what I'm doing in the Fin 6250 elective this fall. I'm teaching essentially the same course I developed and taught for ten years at the Kellogg School of Management at Northwestern. At Kellogg, the course was called "Strategy and Organization," and the emphasis was on how you design an organization to achieve strategic objectives. I'm downplaying the strategy angle a bit (but not completely) because I'm in finance department not strategy here. But we're still going to start from the notion that in order to achieve different strategic objectives, you need to change the actions of individual people inside your firm. And individuals' actions in a firm are determined (at least in part) by the organization surrounding those individuals, and the resulting incentives.

That is, we're going to undertake a serious study of the economics of incentives. We're going to use that to develop economic theories of optimal organization. And we're going to link that to ideas from strategy, finance, and accounting.

Economics isn't, of course, the only useful way to think about these issues. But I think it provides a practical and useful perspective, and I'll hope to convince you of it in the fall.

I'm not really that comfortable blowing my own horn. But I've come to the unfortunate realization that marketing oneself is actually sort of important. So here's the hard sell: Kellogg is one of the top management schools in the world, and this elective was one of the most popular elective courses offered there. I picked up a slew of teaching awards there for this course. Students would save their points (electives were allocated using a points-based bidding system) and blow all of them to get into this course. The course is at the leading edge of what economists know about incentives and organization.

Teaching micro to MBAs? I could take it or leave it. Teaching how to analyze incentives and organization using economics? That's what gets me going.

If you think you might run an organization (for-profit or not) in your career --- and if you don't think you might do this, then why are you getting an MBA? --- you should take this course.

It's suitable for Masters of Accounting, and Masters of Finance, and Masters of Public Policy, and ... well, you can see I get excited about this stuff... So look into it.

Earth Day

It's Earth Day, so I thought I'd liven things up with some concerns about the environmental movement. I know I'm a wet blanket, but economics isn't called the dismal science for nothing.

Before I do this, I'll issue a disclaimer. I'm not a global-warming denier, or an anti-environmentalist. My concerns are more along the lines of questioning whether we're taking the right approaches in trying to change behavior to make it more environmentally friendly. So here goes:

I opened the SL Tribune today to this article. A Dutch scientist has coined the term "water footprint" to capture the notion that water is an input to the production of many of the goods and services that we consume every day. And if we're trying to conserve water, then we can't just be satisfied by turning off the tap. We should also think about reducing our consumption of other goods and services that use a lot of water.

From the article:

A middle-class American woman who eats an average amount of meat consumes 3,245 cubic meters of water each year in her diet, according to the Dutch quick calculator. If the same woman is an ovo-lacto vegetarian (who avoids meat, but does eat eggs and dairy products), her footprint drops to 2,514 cubic meters.

It takes a lot of water to raise livestock, which makes sense although I hadn't really thought about it.

And so what should we do about this? What the "H20 Conserve" folks have done is put together a web site that allows you to compute your water footprint.

This is a fine thing to do, and I'm not criticizing the H20 Conserve people for putting this information out there. More information is better, and it's obviously a huge effort to put this site together.

Is it the best way to conserve this resource?

My answer is no. Why?

One of the problems with this approach is that environmentally committed consumers need to keep enormous mental lists of what products use what resources. We know, for example, that we're supposed to conserve water. And so if you're really serious about conserving water, you need to know what products use a lot of water (so you can reduce use thereof) and what products don't use a lot of water. We also know that we're supposed to reduce carbon. So we need to keep lists of what products use less carbon, and what products don't. The list of environmentally harmful by-products of modern life is long, and the resulting computational burden on the environmentally conscious consumer is large.

There must be a better way, right? And there is.

The better way is to use prices.

For example, let's imagine that we implement a carbon tax. If you emit carbon, you pay. What will this do to the prices of the goods and services we consume? Products that generate substantial carbon emissions will become more expensive to produce. Basic microeconomics says that the prices of these products (to the end user) will rise. Consumer demand will shift --- exactly to the products that don't use a lot of carbon, because prices for these products will stay low! (Which is exactly the consumer behavior we're trying to generate with the "mental lists" approach outlined above!)

Under the "price appropriately" approach, we don't tell consumers "avoid products that use a lot of water, and by the way here's the list". Instead, we tell them "Water is scarce and high-priced as a result. If you want to consume a product that uses a lot of water, you can. But you'll find it's in your own financial best interest to shift consumption to less-water-intensive products."

The "price appropriately" approach has three big benefits over the "mental lists" approach.

Benefit #1: Doesn't rely on public-spiritedness The efficacy of the "mental lists" approach depends on the willingness of people to ignore their own economic interests and instead do what's best for the planet because it's the right thing to do. A lot of people are willing to do this, but not everyone is. If instead we tax environmentally harmful activities, then we won't be relying on public spirit; we'll be aligning self-interest with what's best for the planet.

Benefit #2: Doesn't require mental lists It's hard to be gentle on the planet. You have to do a lot of research into what products use a lot of resources and what products don't. Even for the committed, this can be a big burden.

Benefit #3: Might actually work Did the American people know before the summer of 2008 that consumption of gasoline was environmentally harmful? If so, then why didn't we reduce usage? The fact is that people respond to changes in prices in way that they don't respond to hearing the message "it's really best if you drive less." Yes, gasoline prices rose to frightful levels last summer. But gasoline consumption fell for the first time in years. And it didn't just fall because of people driving less --- it fell because the price increases trickled through the rest of the economy, landing heavily on goods and services that use a lot of gasoline as part of the production process.

So, if you want to fix our planet, fix our markets. And this is why environmentalists should undertake serious study of economics.

Economists and Rush

Turns out Rush fans are disproportionately economists. Even more reason for readers of this blog to dig them.

Time Banks

I'm way behind on answering blog-related e-mail, but keep sending them. I'm hoping to catch up.

A Fin 6250 student sends in some interesting notes on "time-banking." Check it out here.

Here we have an example of people trading, but not using money to do it.

I think this sort of trade is a step up (in terms of efficiency) from barter, and a step down from using money.

I'll try to explain why, but first we need to think about where trade comes from in the first place.

Gains from trade --- that is, an opportunity for parties to trade and both be made better off --- exist any time two individuals have different marginal rates of substitution among two goods.

What’s a “marginal rate of substitution”? My marginal rate of substitution for, say, oranges with apples is how many apples I’d need to be given in order to give up an orange. Suppose I’m indifferent between one orange and two apples. Then I'd be willing to give up an orange as long as I get two or more apples back. Then my MRS for oranges with apples is 2.

Any time your marginal rate of substitution is different from mine, then gains from trade exist. If your MRS for oranges with apples is 1, then you can give me one orange and I’ll give you 1.5 apples, and we’re both better off. If your MRS for oranges with apples is 4, then I can give you an orange and you give me three apples, and again we’re both better off.

So the simplest form of trade is barter. You and I get together to talk. We figure out where our MRS's are different, and we trade. As examples, think about the early fur traders coming to North America and trading European goods for beaver pelts. Native Americans are thinking "We are up to our ears in beaver pelts --- I'd give up to five of them for an iron kettle." The Europeans think "Wow, I can easily get my hands on another iron kettle. I'll give up my kettle for three or more pelts." The parties are both made better off by exchanging four pelts for a kettle.

Barter has some problems, however. One of the big problems with barter is what happens if I don't have anything you want.

Consider, specifically, the following: I am good at plumbing. You are good at cutting hair. You have a plugged sink. I am bald.

Can we trade? I'm not going to give you an hour of plumbing time for nothing back. And you don't have anything I want. So we can't barter.

But what if there's another person out there who needs a haircut and is a chef? And suppose further I'm hungry. Then there's a three-way barter that makes us all better off. The issue, however, is that you're only going to get your plumbing done if we happen to find this chef at exactly the time your sink clogs. And coordinating so that all three of us are present at the same time is going to be tough.

We can overcome this coordination problem by devising a reliable "store of value," and that's what the time bank is. Suppose I do your plumbing. You now owe the time bank an hour of hair cutting. I am owed an hour of something by the time bank. I can then go "spend" my hour on the chef --- and notice that the chef doesn't even have to know where my hour in the bank came from, nor does she have to be present when I do your plumbing. The chef can then take the hour she earns from me, and buy a haircut from you.

Having a store of value facilitates trade, because it alleviates the problem of having to have everybody involved in a three-way barter present at the same time.

So why do we use "money" rather than a "time dollars" as the store of value in our economy?

One problem with time dollars is that the store of value works best when everyone --- and I mean everyone --- agrees on what the store of value is and will be. Specifically, I'm only willing to trade my plumbing time for time dollars if I'm pretty sure that somebody will, in the future, be willing to accept my time dollars in exchange for something I want. The more people who accept time dollars, the more likely that there's someone who will accept time dollars for something I want. Further, if I'm worried that at some point the time dollars system will break down and future people won't accept the time dollars, then I'll be reluctant to accept time dollars today.

Given these issues, we facilitate the most trade by having a single store of value. And that's one socially valuable role of "money."

Fix Director Pay

I recently referenced my ongoing conversation with old friends Rafe and Kevin regarding CEO Pay. The conversation, in the end, degenerated into sophomoric name calling. Just like it did when we were all, uh, sophomores.

But before the verbal melee (which I clearly won, btw), some interesting stuff got said that I thought I'd comment on.

Kevin, responding to a Rafe point, wrote:

Any compensation scheme will eventually start to be gamed. So you have to constantly improve them.

By "gaming," we usually mean two things. Either (1) the employee takes an action that improves measured performance (and hence increases pay) but doesn't actually create value, or (2) the employee fails to take an action that would create value, because taking that action doesn't increase measured performance.

Except in a very few cases, it's generally true that explicit pay-for-performance schemes can be gamed. This stems from problems in measuring performance. Unless your way of measuring performance reflects all the things you want done and none of the stuff you don't want done, you're due for some gaming behavior.

So, what can you do about gaming?

Option (1) Live with it. This option works best when the gaming isn't that costly to the firm. For many salespeople, for example, pay comes from sales commissions. This is an explicit pay-for-performance contract that rewards salespeople who sell more, so that's pretty good alignment between the measure and what the firm wants done. However, there are some documented examples of gaming, even here. Many commission contracts feature quotas or other kink points. Suppose for example that I'm a salesperson whose contract calls for a $10,000 bonus if I hit annual sales of $2 million. Suppose it's December 15, and I've already hit my target --- I'm best off pushing all sales for the rest of this year into next year. This probably isn't what the firm wants me to do, since competition could find these customers and try to steal them away as I dawdle to push the sales into next year. Paul Oyer (at Stanford) and Ian Larkin (HBS) have written nice papers documenting this.

Option (2) Don't use pay-for-performance incentives at all. This option works best when the gaming is really bad. If you think about some of the objections to pay-for-performance for public schoolteachers, they usually go along these lines. Some teachers unions argue that paying teachers for raising student test score causes reductions in education quality, because teachers misdirect their effort toward test scores and away from other valuable educational activities. The argument is that teacher gaming would be so bad that we're better off with no incentive pay than with incentive pay that's directed at test scores.

Option (3) Use subjective assessments of employee performance in addition to the explicit pay-for-performance plan. The idea here is that a "boss" subjectively assesses whether employee performance was achieved in the "right" way. Both the subjective assessment and the numerical measure play a role in determining pay. Examples: A salesperson's supervisor might pay attention to whether the saleperson's performance slackens after a target is met, and reduce pay if so. A school principal might tell a teacher to raise test scores as much as possible, but then monitor the teacher to make sure that the teacher doesn't drop art and science to simply do arithmetic drills all day.

A final example: A board of directors might monitor the CEO to make sure that earnings growth is achieved in a sustainable manner. There is evidence that boards do at least some of this: See my paper with Rachel Hayes from the RAND Journal of Economics in 2000.

So, getting back to the Rafe and Kevin conversation, if it's impossible to design a bulletproof pay-for-performance plan, then maybe instead we think about making sure that we're combining the (inherently flawed) explicit pay-for-performance plan with strong board oversight and subjective evaluation.

One of the big problems with subjective evaluation of performance, however, is that we now face the problem of providing incentives for the evaluator to give good evaluations.

And so one response to Rafe's initial idea is this: Let's not think that making a one-size-fits-all change to explicit pay-for-performance plans can solve all our corporate governance problems. Probably this could never work due to the inherent problems of measuring performance. So let's instead continue to give directors the freedom to compensate CEOs in the way that fits the specific needs of the firm. But let's also figure out how to give stronger incentives to directors to do a good job monitoring CEOs.

Easier said than done, but I'll post some thoughts sometime.

Local Entrepreneurs

I've been involved the last few years with vSpring Capital's v100.

This is a list of movers-and-shakers among the local entrepreneurship community, as nominated and voted by peers. I'm on the v100 Audit Committee, which means I help oversee the selection and voting process to insure objectivity.

The 2009 list is just out, and I've been meaning to post something about it. Luckily for me, the Salt Lake Tribune beat me to it, so I'll just link to their article instead.

Congratulations to all of this year's v100 members!

Blame the Dutch

My college/grad-school roommates Rafe and Kevin (both successful entrepreneurs) are blogging like manimals about CEO Pay. You can see their ideas and some of my responses here.

I also left a tease about some suggestions I'll put here (soon) on fixing corporate governance. Not that I think it can be "fixed", per se. It's a thorny mess, and has been since the Dutch East Indies Company first came up with the idea of the joint stock company in the 17th century.

Reading

Why do I post tidbits about the books I read? Two reasons. First, I'm trying to illustrate that Economics is Everywhere. I can usually find some interesting bit of economic decision-making in any nonfiction. The way I see it, economics in the world is like white on rice. This is why econ is such a great thing to study; its applicability is really really really broad.

Second, one thing I like to use this blog for is keeping a record of interesting examples I find. Sometimes I'll be teaching, and I'll preparing to talk about some economics-y idea. I'll remember that I found some great example of that idea, but then I'll be unable to remember anything specific about the example or where I found it. So I try to write the examples down here when I find them.

So here's a too-long post about some books.

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A while back I read The Wild Blue : The Men and Boys Who Flew the B-24s Over Germany 1944-45 by Stephen Ambrose. I hadn't realized that George McGovern ('72 Dem Presidential candidate) was a bomber pilot in WWII; this book is something of an oral history of his training and service. Here's the cool economics: During the war, the US military was trying to send bombers over Germany and Romania. To send a bomber on a mission, you need at least two inputs: (1) bombers and (2) bomber pilots. Both inputs require big investments: bombers are expensive to build, and pilots require lots and lots of training. (Apparently the B24 was quite a hard plane to fly.)

Now one cool feature of bombers and pilots is that it's an example of a fixed proportions production technology. You need to combine bombers and pilots in exactly a one-to-one ratio in order to generate bomber missions. One thing that happened during the war was that the military's ability to produce bombers got out ahead of its ability to train pilots. Which leads to some interesting tradeoffs (page 115). The army could let the extra bombers sit idle while the pilots are trained. Or it could shorten pilot training. If the army's goal is to maximize the probability of winning the war but at the same time minimize US casualties, it's not clear which option is better. Idle planes mean a smaller impact on Nazi oil refineries, and more gasoline for Nazi tanks. But less training means more pilot error, fewer bombs correctly dropped, and more crash landings. So this is quite a complex problem.

Ambrose, of course, doesn't focus on how exactly the army made difficult resource allocation decisions like this. But he should have. (The generals shortened pilot training in the end.)

(And yes I signed up for Amazon's "Affiliate" program. If you click on a link and buy books they'll send me a check. Same deal as with the Google Ads --- All proceeds to charity. I figure I'm going to link to the books anyway, and if Amazon is going to give away money I might as well take them up on it and direct proceeds to the Utah Food Bank.)

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John McPhee is one of my favorite writers. If you haven't read his Annals of the Former Worldrun don't walk!

Recently I read McPhee's Table of Contents; It is a collection of stories and essays, all reprinted from the New Yorker.

Two in particular struck me.

One essay, Heirs of General Practice, is about the then-new medical specialty of Family Practice (this essay dates from the early 70s?). Specialization questions in economics go back to Adam Smith, and recently Luis Garicano (now at LSE) has written some interesting papers on how to optimally organize knowledge-based workers. Some of the main ideas are that it's costly for everyone to learn everything, so specialization is efficient. Thinking about doctors, the field of, say, orthopedics is so big that's it's not very easy for someone to master both that and, say, neurology. So we split up the work. But once you do that, you run into coordination problems. If one person knew everything, then we could just have that one person solve all problems. But if different people know different things, we have to have coordination mechanisms in place to get the right problem to the right expert. Family practitioners play an important role here. They know a little about a lot (as opposed to a lot about a little), and one of their main goals is to get the patient to the right specialist. Setting up incentives and organizational structures to get these referral decisions right is actually a hard (and economically interesting) problem, and it's present not just in medicine but also in law and consulting. Anyway, the essay focuses on the stories of several rural family practitioners in Maine.

Side note: Great recent article in the NYT Magazine about the issues in getting experts working together to solve hard problems in medicine.

Another aspect of McPhee's essay that was noteworthy: There's just a little discussion of competition among hospitals in Maine for patients. It's a great example of the Hotelling model of competition. In the Hotelling model, firms are geographically differentiated, and potential customers find it costly to travel. This means each firm is a local monopolist with respect to the customers that are close by. Firms compete for customers who are "in between" two firms. The story in the essay is along these lines: Hospitals are in the cities in Maine (do they have cities? towns, maybe...), and so if you live in a town you would almost never travel to go to a hospital in another town. So all the competition for patients happens in the in-between, rural areas --- right where the family practitioners in the essay are located. The Hotelling model is one the big workhorse models of the economics of strategy and marketing. While as originally written the model is about geographic differentiation, the main insights apply just as well to differentiation that comes from heterogeneity in consumer preferences, not just locations.

I told you this post was too long.

A second essay, Minihydro, is about how entrepreneurs responded to the 1970s oil price shock. The price of energy rose, and so suddenly it was profitable to figure out ways to produce energy more cheaply. One approach taken by many was to revisit small, abandoned dams in New York State, and get the electricity generators working again. Turns out that if coal is sufficiently cheap, mini hydro power can't compete. But once coal prices rise (and I think in this case there were also subsidies from the state for hydro), then getting these generators working again is profitable. The stories are about entrepreneurs scouring maps of New York looking for lakes that might have old dams. The entrepreneurs would then try to figure out who owned the dam (not an easy feat), and try to buy it.

Of course we've seen the same thing in the recent oil price increase --- long abandoned uranium mines in southern Utah have opened as entrepreneurs bet on increases in demand for nuclear.

Note the linkage here: Entrepreneurs observe high energy prices and immediately begin investing in ways to develop cheaper energy. This is one of the big arguments in favor of carbon taxes --- if we guarantee that oil and coal prices will be high, then we guarantee that entrepreneurs can make money from figuring out ways to produce carbon-free energy. And we really could use a burst of entrepreneurial zeal in this area.

Utah: Long Term Prospects

I have a theory about Utah. My theory is that this state is going to grow much faster than the rest of the US over the next 30 years. I think this is a very good place to invest your money and human capital. I'm not saying this because I live here. Rather, I live here (in part) because I'm thinking it.

Why do I think this? Two reasons.

Reason #1 is related to a recent David Brooks column in the NYT. The column summarizes a recent Pew Research Center study on where Americans want to live. The survey asked only about large cities, so Salt Lake wasn't in there. But Brooks writes

Americans still want to go west. The researchers at Pew asked Americans what metro areas they would like to live in. Seven of the top 10 were in the West: Denver, San Diego, Seattle, San Francisco, Phoenix, Portland and Sacramento. The other three were in the South: Orlando, Tampa and San Antonio. Eastern cities were down the list and Midwestern cities were at the bottom.
These are places (except for Orlando) where spectacular natural scenery is visible from medium-density residential neighborhoods, where the boundary between suburb and city is hard to detect. These are places with loose social structures and relative social equality, without the Ivy League status system of the Northeast or the star structure of L.A. These places are car-dependent and spread out, but they also have strong cultural identities and pedestrian meeting places. They offer at least the promise of friendlier neighborhoods, slower lifestyles and service-sector employment. They are neither traditional urban centers nor atomized suburban sprawl.

This is Salt Lake City to a T. SLC's combination of amenities perfectly lines up with where Americans' preferences are going.

But of course this isn't sufficient to get growth; prices matter too. An example will help make my point. I can say from experience that the SF Bay Area is a spectacularly great place to live. But it's such a great place that prices of scarce local resources --- think housing, in particular --- are incredibly high. So, even though Palo Alto has great amenities, it's doesn't offer great value.

Which brings us to Reason #2.

Outsiders' perceptions of Utah are simply mistaken. Outsiders think you can't get a drink here (false). They think the LDS Church runs every aspect of life (false). It is true that state liquor laws remain unusual. And it's also true that the Church is influential. But the impact of these factors on day-to-day life is small, at least to me.

However, these misperceptions keep people out, and means that prices are lower here. If you want to live in a nice place and live an active outdoor lifestyle... I think you can do so less expensively here than anywhere else.

But as more outsiders respond to these price differences by moving here, Utah will change. It'll continue to become more like the rest of the US, and as it does, its strangeness will fade --- which will make it that much more attractive. Once this growth-ball gets rolling, it's going to be hard to stop.

So this is one reason why the University of Utah is a great place to be. We're quite a good university now, but there's going to be a chance for greatness as the resource base of the state expands.

I hope I'm right.