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.