Crowdfunding and Financial Intermediation

City Weekly called a couple days ago with a few questions about the recently passed JOBS Act, and specifically about the new provisions for "crowdfunding" of small startups.  The article is here.

"Financial intermediaries" are institutions --- banks, venture capitalists, private equity, angel investors --- that make money by connecting investors with good investments.  If you have a deposit account at a bank, the bank is essentially borrowing money from you (paying you a low interest rate) and then lending it to someone else (and charging them a higher rate).  The bank makes a buck on the spread.

One question to ask with any sort of intermediary is why the parties on either side of the transaction can't simply go around the intermediary.  That is, if the bank is paying you one percent but charging a borrower three percent, then why can't you just call up the borrower and offer to lend at 2%?  You earn a higher interest rate on your money, and the borrower pays a lower rate.  This would cut out the middleman, and the banks would quickly go out of business.

This observation suggests that intermediaries can survive only if they're doing something better than you could do it yourself.  In the case of financial intermediation, one of the big possibilities is that banks/VCs/angels are better at distinguishing good investments from bad.  If borrowers know better than potential lenders whether their investment opportunities are likely to pay off, then you can easily get a market for lemons, which is a subject I blogged about in long-winded, four-part fashion back in 2009.

So I think the whole crowdfunding thing is a bit more complicated than just saying "Hey, let's use the internet to allow investors to connect directly with promising startups."  Banks and VCs do things that us regular people just aren't good at --- like reading financial statements and assessing future market growth --- and the internet isn't by itself going to make us a lot better at these tricky tasks.

Financial intermediaries are really interesting to economists, probably because the very fact that intermediaries exist tells us something about when markets work well and when they don't.  I'm attending the Financial Intermediation Research Society annual meeting next week, and you probably don't need me to tell you what a good time that is....

Hollywood Economics

I'm a big fan of the television show The Wire, which aired on HBO between 2002 and 2008.  It's a gritty police drama, by which I mean that every fourth word is profane.  If you watch it, wait til after your kids are asleep.

Stringer Bell (played by Idris Elba) is a terrific character who's the #2 man in a big Baltimore drug gang.  He's unusual for a druglord in that he wants nothing more than to be a legit businessman, and he's hoping to use his drug profits to invest in legal businesses that he can run after he retires from selling dope.  There's a great scene in Season 1 where the cops are tailing Bell as he drives to the local community college.  He heads into class where the professor delivers a lecture on demand elasticity.   Later, Bell walks into a copy shop that's he's purchased as part of his plan to go legit, and notices that his employees --- who appear to have been hired from the neighborhood based on criteria other than experience or skill at managing a copy shop --- seem not to be pushing very hard in the direction of superior customer service.

Bell expresses his displeasure, as follows:

Yo, you know what we got here?  We got an elastic product.  You know what that means?  That means when people can go elsewhere to get their printing and copying done, they goin' do it.  You acting like we got an inelastic product and we don't.  Now, I want this to run like a true (gosh-darn) business.  Not no front.  Not no (other stuff).  

Gritty, as I indicated.

As with all Hollywood Economics, however, they don't get it quite exactly right.  (It's not nearly as bad as the economics disaster that is A Beautiful Mind....)  On the outside of the classroom door that Bell enters at the CC, a sign reads "Introduction to Macroeconomics."  Demand elasticity is a *micro* topic, but close enough I guess.

Google & Motorola Mobility

Google completed its purchase of Motorola Mobility, which is what's left of Motorola's wireless phone business and was spun off by Motorola in January of 2011.  Motorola Mobility makes the Droid RAZR --- a pretty successful Android smartphone --- so the merger raises the question of whether Google is trying to get into the handset business with this purchase.

I think this would be a terrible idea.

Here's why:  A big part of the Android platform's appeal is price.  You can get a reasonable Android setup for a lot less than any iPhone, and there are at least five or six major players --- Samsung, HTC, LG, Motorola Mobility, etc --- producing Android handsets.  And these firms are competing fiercely on price, which drives the overall cost of an Android system down.

This hardware-side competition benefits the Android platform, and therefore Google, quite a bit.  It's the same logic that helped Microsoft dominate the desktop twenty years ago; DOS and Windows ran on commodity machines, so the total cost of a Windows setup was much lower than that of a comparable Mac.

So the last thing Google wants to do is give Samsung and HTC any reasons to stop pushing handset prices down.  And if Google were in the handset business itself, it'd be hard to resist the temptation to help its in-house handset business at the expense of Samsung and HTC.

There is talk of some other reasons for this deal, so I wouldn't be surprised if Google shuttered the Motorola Mobility handset operation.

RIM = DOA?

I've written about iPhone economics before, and it remains a really interesting market.   One of the great stories is that of RIM, the maker of the Blackberry.  Here's a firm that had a commanding market share not too many years ago, but has been completely hammered by the rise of the iPhone and Android smartphone platforms.

RIM is trying to catch up, so have a look at this recent article in The New York Times about release of the Blackberry 10 prototype.

The good news is that RIM understands the importance of getting a large group of software developers to work on applications that run on their OS.  The bad news is that developers will make their decisions based largely on whether they believe the product will be a hit with consumers.  RIM wants developers to make significant investments, but these investments will pay off only if the product sells well.  It's a tough sell for RIM, and I thought it was interesting to listen to the voice of skeptical developers such as Phill Ryu at Impending.

Even the pro-Blackberry-10 people quoted in the article didn't say much that would convince me the firm has settled on a good strategy.  The CEO of Refresh Mobile says the platform integrates well with social media...  but is "connect with Facebook" really much of a differentiator at this point?  And a Gartner analyst cites the phone's ability to capture extra frames when shooting photos.  I agree that this sounds like a nice idea, and is very much something I'd like to have on my phone.   But good ideas are different from good strategy, and it's hard to imagine that "extra frames when you snap" is something that iOS or Android couldn't replicate in a day or two of development-team time.

Gold Storage

I talked to City Weekly earlier this week about an interesting company that offers gold storage right here in Salt Lake.  Here's the story.

Gold prices are up sharply since 2002, but the metal really hasn't been a great investment over the past 40 years.  Here's a link for a chart comparing gold to the Dow since 1980, and you can see that while gold has about doubled over the period, the Dow is up by something like a factor of 14.

Gold might well be a sensible hedge against economic catastrophe, but buyers should be keep in mind they're probably giving up returns in order to buy safety.

Delta: Computer Glitch or Price Discrimination?

A current Executive MBA student sends a link to this article:  Delta Says Frequent Fliers Saw Different Fares

Nice find!

So maybe this is an unfortunate computer glitch on Delta's part, and maybe it's true that Delta Frequent Fliers were sometimes offered higher prices and sometimes lower.  Maybe.

But this is also perfectly consistent with a third-degree price discrimination strategy.  The rationale would go like this:  Delta knows that anonymous searchers are probably searching lots of airlines and comparing prices.  These travelers respond to low prices, which means their demand is elastic.  And as I discussed earlier today, it pays to offer lower prices when demand is more elastic.  Frequent flier club members are probably less likely to search widely and compare prices, and this means their demand is less elastic.  So Delta can increase profits by charging higher prices to this segment.

This is called "price discrimination" because the firm is charging different prices to different customers for the same product.  It's entirely legal --- although you can tell from Delta's response that it's often not a popular thing with customers --- and firms do it all the time.

(I do fly Delta a lot, and I hope they won't put me in the middle seat because of this blog post.)

The Economics of Driving Around

It's time for a new feature here on Utah Economist Blog: The Economics of Driving Around.

I like driving around, and one of the best things about it is the real-world economics you can see as you go from place to place. Even if you don't like driving around, you probably have to do it --- and it's a great opportunity to look for economics.

I had some errands last Tuesday, and managed to catch a few snapshots.  I was also messing around with Instagram (a billion?  with a b?), and uploaded shots there.  The Economics of Driving Around really benefits from the geo-tagging feature of your typical smartphone, and I've linked so as to show you both a photo and a map.

So, here's a picture of some Powerbars.  This was taken at the Common Cents convenience store at Bangerter and about 200W.   And here's some more Powerbars --- the same kind, in fact --- taken as the Fresh Market grocery store on 900 East and about 17th South.

What's the difference?  Well, same product.  Similar display.  Difference price.  At the C-store, the bars go for $1.69 while at the grocery they are $1.59.  So here's where you can put your brain to work as you're out running errands.  Same product, so why not the same price?

Typically, people jump to thinking about cost differences, and very often to differences in the fixed costs associated with running each business.  But fixed costs don't (directly) affect optimal pricing decisions.  As we learn in a basic managerial econ class, the profit-maximizing price depends on two things:  marginal cost and demand elasticity.

So one possibility is that the convenience store pays a higher wholesale price for Powerbars, and selects a retail price accordingly.

But another possibility is that demand is more elastic at the grocery store than at the c-store.  Demand elasticity is a measure of how sensitive quantities are to prices.  If demand is elastic then small price changes lead to big quantity changes, while if demand is inelastic small price changes lead to small quantity changes.

It works out that if your demand is elastic (rather than inelastic), then it makes sense to charge lower prices and accept lower margins?  Why?  Well, the benefit from reducing prices is that you're going to sell higher volumes.  And if your demand is elastic, then a price reduction gives you a big increase in volume, and this big increase in volume can make it worthwhile to accept lower margins.  If, on the other hand, your demand is inelastic, then a price reduction gives you a small increase in volume, in which case it probably isn't worth it to accept lower margins to sell more.

All this can be made horribly precise --- the inverse elasticity pricing rule is the governing equation --- but the key point is to think about potential differences in elasticity in addition to potential differences in cost when thinking about price variation.

So the question then becomes:  Is there any reason to think that Powerbar demand would be more elastic at a grocery store compared to a convenience store?  Is there any reason to think that a c-store price reduction would have a smaller impact on quantities sold than a grocery store price reduction?  And that's a good question to ponder, as you're thinking about the why behind the price variation we observe every day.

Here's some more food-for-driving-around thought:

• 3.59 for regular unleaded
• 3.64 for regular unleaded

Moneyball and Management

Did I mention that you should go see Moneyball?  Oh, that's right, I did.

In an earlier post, I discussed why this movie is useful as an example of a failed strategy --- despite the fact that the team had a few great seasons.  The important idea is simply that a great strategy is one that insulates a firm from margin-destroying competition, and this means strategy must deliver ways of creating value that rivals cannot emulate.  Rivals had a pretty easy time of emulating the A's, and this is why their advantage dissipated over time.

I'd guess, in fact, that the rivals had an easier time emulating the A's than the A's had in implementing the strategy in the first place.  And the movie --- with its made-up dialogue, fictionalized situations, and, yes, the dreamy Brad Pitt --- illustrates the issues far better than any Harvard case study could.

There's a wonderful, wonderful scene where the A's General Manager lays out his reasoning:  We can't compete with the high-payroll teams if we keep doing things the way we've always done them.  We need to find ways to identify the opportunities that others are missing.  And we're going to do it by out-analyzing them.

This is, as I wrote last week, an amazingly good idea.  And it was completely dismissed by the team's old guard.

The "old guard" had made large investments in skills that were specific to the "way we've always done it."  The scouts had spent their entire careers honing their abilities to determine, by watching, whether a young ballplayer had the potential to grow into a productive major leaguer.  The scouts hadn't spent a minute figuring out how to organize data, how to run regressions, or how to devise good quantitative measures of future ballplayer productivity.  Given this, it's no surprise that the old guard tried to paint these new ideas as crazy, nonsensical, and radical.  Success of these new ideas would reduce the old guard's value to the organization, and threaten both their earnings potential and job security.

In the film, the A's GM explains his reasoning...  over, and over, and over.  And he completely fails to rally the troops; he utterly bombs at building consensus in support of the new ideas.

It's a tough situation. What do you do, as a leader, when you come across untested ideas that you think will be good for the organization, but will require employees with markedly different skills than what your team currently possesses?  Do you keep trying to build consensus before making changes?  Do you push ahead with radical change without internal agreement?  Or do you simply make do with the status quo?

If you're a manager, you'll probably have to make really difficult decisions like this sometime.  So when you watch Moneyball, don't think about the baseball.  Think about the human resource management, and how you'd try to implement change in an organization that you are or will be running.

Local Business --- Radio Interview

It seems to be Radio Week here at the Utah Economist Blog.

I was on KCPW's City Views yesterday, talking a bit about local business.  Of course, you always learn more from listening than talking, and I learned about the upcoming (tomorrow!) Salt Lake City Neighborhood Business Conference.  Embarrassingly, the conference is being held in the Spencer Fox Eccles Business Building here at the U of Utah, but I must not be paying attention because I had no idea!  Registration seems to be free, and maybe I'll see you there.  

You can listen to my conversation with hosts Jennifer Napier-Pearce and guest Nan Seymour from Local First Utah here.  

Hiring: Radio Interview

I was on KPCW's Monday business show Mountain Money yesterday, talking mostly about hiring and why it's so hard.  I think hiring well is a big key to success in many businesses, but unfortunately it's an area that economists and other management professors don't have enough to say about.  We're working on understanding it better.

You can listen to my conversation with hosts Pam Wylie and Doug Wells here, and I'll try to write more about this important topic in the future.

Delta Buys A... Refinery???

According to Tuesday's New York Times, Delta Airlines will purchase a refinery outside of Philadelphia.  The idea, at least according to the article, is that Delta will somehow use this refinery to "get control of fuel costs."

This is a clear example of a make-or-buy decision.  Delta can easily buy jet fuel on the open market.  This has been an expensive option, for sure, in recent years, but this market seems to be working just fine (in the sense that anyone who's willing to pay the market price can get any amount of jet fuel that they like).

Obviously I wasn't in the room for the deliberations by Delta management, and so maybe something else is going on...  But it sure seems to me like Delta is falling for one (or more) of the big "Make-or-Buy" fallacies.  While there are many good reasons why a firm might want to buy one of its suppliers, this is one of the areas of management where you hear a lot of really dubious arguments.

In our Economics of Strategy textbook, my co-authors and I describe five make-or-buy fallacies (page 123 of the fifth edition), and I'd guess that Delta is falling for number 4.  We describe this one as follows:

Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply.  (This fallacy is often expressed this way: "By vertically integrating, we obtain the input 'at cost,' thereby insuring ourselves against the risk of high input prices.)

Why is this a fallacy?  Well, there's a long numerical example in the text illustrating why this won't increase expected profits, but here are some quick thoughts:  First, Delta still has to buy crude to feed its refinery, and it's fluctuations in the price of crude --- not the margin earned by refiners --- that has been causing the ups-and-downs in the price of jet fuel.  Second, if Delta wants to hedge jet fuel prices, it can do so in the futures market pretty easily.  Finally --- and this I think is the big one --- what is Delta management going to do if/when its refiner falls behind other refineries in terms of cost-reducing process innovation?  Note that if Delta has an independent supplier (that is, one that's not owned by Delta) and this supplier falls behind rivals on costs, then Delta can easily switch to a lower-cost supplier.  Will Delta management idle its own refining capacity if the managers it hires cannot stay competitive?  I bet not, and this will sharply reduce competitive pressures on the in-house supplier relative to the market.

My view:  I think this plan will lead to higher medium- and long-run jet fuel costs for Delta.  Not a good move...

Moneyball

Best.

Movie.

Ever!

And no, it's not because Brad Pitt is so dreamy.

I like baseball, and people would maybe say this is a movie about baseball.  I like statistics too, and people would maybe say this is a movie about that.

But it ain't about that; this is a movie about management and strategy, and that's why it's so great.  I'll get to the management part in a later post; let's talk about strategy.

(And I'm going to assume you've seen it; if not, stop reading and go watch!)

I was giving a talk about strategy at the Governor's Utah Economic Summit a few weeks ago, and started by asking whether people had seen the movie, and if so, whether they thought the Oakland A's strategy --- essentially using innovative analysis to identify players whose contributions to on-field success were undervalued by the labor market --- was a success.  The movie shows that the A's did, indeed, have a couple of very good seasons in the early 2000s, and so the audience mostly concluded that this was a successful strategy.

But the great thing about this movie is that this is a strategy that failed.  And I think understanding why can help businesspeople understand what strategy is, and what a good one looks like.

In my view, the Big Question of Strategy is this:  How can a firm deliver long-run superior performance?  How can we do what General Electric did in the 1980s and 1990s?  Or what Apple has done over the past 10 years?  

This is a hard problem because markets work against you.  Turning short-run success into long-run advantage is difficult because rivals can so often just copy you.  Or worse, take your ideas and improve upon them.

This is exactly what happened to the Oakland A's.  The team's ideas were amazingly good.  The A's achieved their goals and topped their rivals.  For about two years.  But then...  The rivals took note.  They saw that the source of the A's success was in their front office and the people who analyzed the players.  Rivals started to copy their methods, poach their talent, and generally compete for the same players that the A's had been after.  And there was really nothing the A's could do about this.  Their advantage quickly dissipated, and the team has been mostly medium-ish over the last few years.

The business world has dozens and dozens of examples of innovators, like the A's, who were unable to convert short-term success into long-run advantage.  (Do you remember Myspace?  Yahoo?)  The moral of the story is this:  A plan for long-run competitive advantage has to be built around things that rivals can't easily copy.  The A's were likely doomed from the start, and that's why the Moneyball story fails as a strategy.

To be clear, I'm not saying the A's made a mistake by pursuing this innovation; the team was clearly better off having a couple of great seasons than not having that success.  But when you're presented with options about what direction to take your firm and your career, it's important to keep in mind the impact of future competition on your ability to sustain performance.  And if you can get to places where competitors will have trouble following... those are the great strategies.  (It's a bit easier said than done.)

More on the "management" side of things, upcoming...