Utah Economist

Insurance and Redistribution of Wealth

2010-03-31T21:10:00.000-06:00

I don't usually read the comments of the SLTrib when I write something for them or when I'm quoted there. I did see one comment on my article from a few months ago that I wanted to touch upon. The comment had something to do with how the current health reform plan was all about redistribution of wealth, and questioned whether that was a good idea.

Before I get into this, let me say first that economists don't have a lot to say about income redistribution generally. Economics doesn't offer much guidance on whether taxing the rich to help the poor is a good idea or a bad idea. Different societies make different decisions on how much redistribution to do, and that's usually accomplished through the ballot box.

But there is one important sense in which any sort of insurance is a wealth-redistribution plan. And it's a form of weath redistribution that, for the most part, people engage in willingly.

Insurance redistributes wealth from the lucky to the unlucky.

How does this work? Think about your homeowner's insurance. If your house burns down, that's unlucky. But if you have homeowners' insurance, the insurance company is going to pay a big part of the replacement cost. Wealth has been redistributed (from somewhere) to you. And where does that wealth come from? People usually figure it's coming from an insurance company. And this is right, sort of, except for the fact that corporations are just legal shells that allow people to transact. The corporation's wealth has to come from somewhere. So where does the wealth come from?

Now think what happens if your house doesn't burn down. That's lucky, right?. But you still had to pay your insurance premium. And it's the premiums from the lucky that are transferred to the unlucky.

It's wealth redistribution, pure and simple.

So why do the lucky put up with it? Wouldn't they be better off refusing to subsidize the unlucky? Well, yes, and that's why we don't allow people to decide whether to buy insurance after they know whether they're lucky or unlucky. You can't go to Allstate and say "Hey, my house burned down last night. So how about a buy a policy that covered me starting yesterday?"

Lawyers: Who Got Laid Off?

2010-03-24T11:58:00.002-06:00

I don't usually publicize my working papers. Prefer to wait until they're published so I'm (reasonably) certain that all the kinks are worked out.

But if others are going to publicize for me, I guess I should at least link to it. Paul Oyer and I have a new working paper on which lawyers lost their jobs at the top 300 law firms during the recent recession. Here are three blog links to it:

Blog of the Legal Times

Above the Law

Business Insider

I'm happy people found the study interesting, but the authors of these posts didn't summarize entirely right. A couple of quibbles/clarifications: First, it's not at all the case that people at fancy law schools are worse off than those who went to lower-ranked schools. You're much more likely to end up working for a big, fancy law firm making a lot of money if you go to a top school. (And Paul and I have another working paper that showing that.) It's just that conditional on making it to a big, fancy firm, it seems you were a bit more likely to get laid off (at least early in your career).

Second, it's not the case that hiring networks are associated with the likelihood of being laid off, just the likelihood of turnover. That is, an associate is less likely to leave a job voluntarily if there are partners from the same school at the firm. But an associate is no less likely to be laid off when there are partners from the same school.

We don't exactly know why the patterns in lawyer firings look like they do, but we're working on some models that might explain it.

Another Reason to be Bullish on Utah

2010-03-07T18:21:00.000-07:00

Check the map about halfway down the page....

Utah's projected employment growth through 2018 is 27.8%, second in the nation to Nevada. The Great Basin is the place to be for sure.

As an aside, I have no idea how The Daily Beast is coming up with these "rankings." Utah is 12th, but if you compare to #11 New Mexico, you'll see we had stronger 2006-09 job growth, lower current unemployment, stronger projected employment growth and higher median salaries. Since we top NM on all four of the reported dimensions of the ranking, it's hard to see how we're ranked lower overall.

Are they giving extra points based on a state's overall level of "Enchantment"?

(And if so, I would put two feet of Alta powder up against a chile ristra on the enchant-o-meter any day.)

Does Capital Punishment Work?

2010-03-06T20:05:00.001-07:00

Does capital punishment deter potential murderers? Or are people simply not thinking about the consequences when they commit homicide?

New evidence came to my mailbox last week in the form of the lead article (by Franklin Zimring (Berkeley), Jeffrey Fagan (Columbia) and David Johnson (Hawaii)) in this month's Journal of Empirical Legal Studies.

(You can download a working-paper version of the article here. )

The paper looks at differences in the homicide rates in Hong Kong and Singapore between 1973 and 2008. Notably, Hong Kong had very few executions over this period (and made capital punishment illegal in 1993). Singapore, on the other hand, went from 2-3 executions per year in the 1980s to 21 in 1992 and 76 in 1994, before dropping back down to 17 in 2003 and just 2 in 2007.

This setting is a good one (but of course not perfect) for testing the deterrence effect of capital punishment. Hong Kong and Singapore are similar (though not identical) in terms of demographics and ethnicity. Both are small, urban enclaves with a British colonial history. Both had rapidly growing capitalist economies over this period.

If capital punishment deters homicide, then we might expect rates of homicide in Singapore to fall (relative to those in Hong Kong) around the time that Singapore became so execution-happy. So what do the data say? Homicide rates were slowly falling in both Hong Kong and Singapore throughout the entire sample period. But there's no noticeable reduction in Singapore homicide rates (relative to Hong Kong) at the time that Singapore starting executing a lot of people in the early 90s. Nor is there an increase in the Singapore homicide rate (again relative to Hong Kong) around when Singapore stopped executing folks so much around 2005.

So what does it all mean? It's pretty hard (though not impossible) to reconcile this evidence with the view that capital punishment deters homicide. Proponents of the deterrent effect will need a story for why the Singapore murder rate didn't follow a very different pattern from the Hong Kong rate, given the very different patterns in capital punishment rates.

Individual Mandates in Health Insurance

2010-01-08T21:38:00.002-07:00

See this weekend's SLTrib for some thoughts on individual mandates in Health Insurance.

Airport Security

2010-01-02T22:12:00.002-07:00

So there's a lot of new concern about airport security after the recent incident on the Amsterdam/Detroit flight Christmas Eve.

Here's what I don't get about airport security --- Why aren't we using the good ol' fashioned profit motive to try to improve things?

I'm not a "privatize all government services" kind of guy (as many readers know), but airport security seems to me to be something that's extremely privatizable (if that's a word).

Here's my quick and easy plan for fixing our nation's airports without forcing travelers to arrive four hours early for their flights.

1. Auction the right to perform airport security checks to private firms.

2. Make the payments to these private firms a function of how effectively they prevent prohibited materials from getting inside our airports.

3. And how do we measure whether they're doing a good job? Have the government employ a staff of auditors. And what do the auditors do? They try to smuggle stuff into airports. That's right... government agents with liquids zipped into their underwear trying to get through security checkpoints. Every time the private firm stops a government agent... Boom $10,000, straight to bottom line.

I see a few problems with this system --- specifically, some ratchet effect issues once the security firms get really good at detecting liquids in somebody's shorts, and also some potential issues with getting the security agents to actually be nice to people. But in the meantime , don't you think that having money-motivated security agents would make our air travel safer?

Thoughts?

iPhone Economics

2009-12-07T10:24:00.002-07:00

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

2009-10-29T21:27:00.008-06:00

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

2009-10-28T21:25:00.005-06:00

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

2009-09-12T22:09:00.002-06:00

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

2009-09-11T15:48:00.003-06:00

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

2009-08-25T10:40:00.003-06:00

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

2009-08-21T07:07:00.000-06:00

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

2009-08-19T07:47:00.004-06:00

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

2009-08-17T10:22:00.000-06:00

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

2009-08-16T10:38:00.002-06:00

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?

2009-08-11T07:36:00.004-06:00

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

2009-08-08T18:59:00.005-06:00

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

2009-08-06T21:00:00.004-06:00

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

2009-08-05T22:06:00.003-06:00

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?

2009-08-03T14:43:00.001-06:00

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

2009-07-29T08:01:00.000-06:00

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

2009-07-28T08:33:00.005-06:00

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

2009-07-26T12:38:00.000-06:00

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)

2009-07-23T20:16:00.005-06:00

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)

2009-07-22T00:58:00.002-06:00

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?

2009-07-20T21:41:00.000-06:00

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

2009-07-08T20:38:00.003-06:00

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

2009-07-07T09:24:00.004-06:00

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

2009-07-06T11:09:00.005-06:00

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

2009-06-23T16:36:00.002-06:00

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

2009-06-09T12:30:00.001-06:00

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

2009-06-02T14:00:00.000-06:00

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

2009-05-29T12:15:00.001-06:00

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)

2009-05-27T07:14:00.004-06:00

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

2009-05-26T09:50:00.004-06:00

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

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

2009-05-21T12:41:00.006-06:00

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

2009-05-20T07:56:00.002-06:00

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

2009-05-19T20:51:00.003-06:00

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)

2009-05-15T09:45:00.005-06:00

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

2009-05-12T14:26:00.003-06:00

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.

Economics for Accountants (Part 2)

2009-04-27T16:46:00.007-06:00

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)

2009-04-25T09:02:00.002-06:00

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)

2009-04-24T19:22:00.010-06:00

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

2009-04-22T12:16:00.003-06:00

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

2009-04-15T11:55:00.002-06:00

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

Time Banks

2009-04-15T09:24:00.003-06:00

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

2009-04-09T20:05:00.009-06:00

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

2009-04-07T10:17:00.004-06:00

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

2009-04-04T13:11:00.003-06:00

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

2009-04-04T11:21:00.010-06:00

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.

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.)

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

2009-04-03T01:10:00.000-06:00

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.

Liquor

2009-03-31T13:05:00.003-06:00

To any out of state readers:

Utah is undertaking a major reform of its liquor laws. It will now be easier to get a drink here.

I think this is a small step in a big trend. Utah is slowly becoming more like the rest of the US. More on the resulting big picture economic ramifications --- including why YOU should move here --- soon.

Google AdSense

2009-03-29T15:11:00.005-06:00

You might notice that I've had ads on this blog for a while now. Lest you think I'm hoping to use the earnings from this blog to retire early, be advised that so far I've made $0.53. That's from almost 2,000 "page impressions" and exactly one "click." You have to get $10 in earnings to get a check, so I anticipate getting a check from Google in about, oh, seven years. I promise I'll send any earnings to charity; this blog is a public service project not a business plan. I mostly signed up for the ads because there's a lot of interest among economists in how the auctions for these ads are done, and I wanted to see how they work. My OIS colleague Vandana Ramachandran is doing some interesting work along these lines.

(I think the Google AdSense terms-of-service requires that I NOT encourage readers to click ads. So don't!)

Anyway, imagine my surprise when I noticed that ads for Westminster College's business programs popped up. I guess I write about business and education and Utah, so their algorithm is just giving people what it thinks they want.

Now, I'm not going to tell you not to go to Westminster to get an MBA; everyone should pick the program that's right for him or her.

But don't go there thinking you're getting something similar to what you'd get at the U of Utah.

What's the difference? Faculty.

At Utah, our faculty are leading researchers in our fields. Just a snippet (and apologies for not mentioning everyone): Hank Bessembinder is one the world leaders in understanding how specific details of the trading process affects prices in financial markets. Mike Lemmon is a top guy (again, worldwide) in studying the financial structure of firms. Mike Cooper just spent a leave-of-absence helping a large bank run a hedge fund --- he's one of the top guys in that area. Rachel Hayes is a leader in studying how accounting information is used in CEO compensation contracts. David and Marlene Plumlee spent a year recently at the SEC, helping regulators there understand how investors use financial statement information. Christine Botoson is a leader in advising accounting standard-setters, and has worked extensively with the FASB. And that's just in our finance and accounting departments; I could go on and on.

For proof, scroll down the list of Utah faculty... and enter our names into Google Scholar. Look for papers we've written, and check the "Cited by" numbers. A "cite" is when a professor at another university builds on our ideas --- and includes a reference to our work in their bibliography. High cites mean high impact.

The Eccles School has literally dozens of professors who are who are actively shaping how faculty across the world think about their subjects. This just isn't an imperative for Westminster faculty, like it is for ours.

And so what, you ask? If the Westminster faculty isn't spending all their time doing that publishing in academic journals, won't they be better teachers?

Actually, no.

The reason is that "management" isn't a completely solved problem. Business schools don't know the answers to all the questions. There are textbooks, of course, but there are lots of really important questions that the textbooks are just silent on. At Utah, faculty are actively working on filling in those gaps. When those questions come up in the classroom, we'll have better answers. We'll have ways to help you think through those issues. We'll be able to help you avoid the common pitfalls. When the answers are developed, you'll have connections to our faculty and alumni network, to help you make use of the answers in your career.

Teaching and research are complements, because being at the forefront of research in your field forces you to be better informed as a teacher.

And that's the difference you get at Utah.

Who Needs a Million Bucks?

2009-03-25T19:26:00.006-06:00

Why is it a good thing to allow CEOs to get paid a lot of money?

One idea you hear floating around these days is that nobody really "needs" to earn $1 million a year or more. So there's really no argument for continuing to allow the very large pay packages that CEOs typically earn. It's a bit of a variation on the old quote by Marx --- something about "to each according to his needs."

I have a couple of responses to this point, and I'll focus on one of them today.

This argument --- that no social purpose is served by allowing CEOs to earn large sums --- ignores the role of matching in the managerial labor market.

What do I mean by this?

One problem we face in the economy is getting the right employees working for the right firm. Think about all the resources that are expended in job interviews and applicant screening. It's important, in most firms, to get the right employees; that is, to get the employees that are going to help the firm create the most value. And the same is true for CEOs.

Think about the following example: Jimmy the CEO is a pretty good CEO for the ABC company. Let's suppose that if ABC employs Jimmy, then the firm's profit (gross of Jimmy's salary) will be higher by $1 million than the profit would be if the firm employed its next best CEO. Let's also assume that jobs and profits are positively related (which they often are but sometimes aren't). If ABC employs Jimmy then the firm will create 100 additional jobs, compared to what would happen if ABC employed its next best CEO.

But Jimmy the CEO is no one-trick pony.

Let's suppose that XYZ company also wants him. And let's suppose XYZ's profit will be higher by $2 million (again gross of Jimmy's salary) and its jobs higher by 200, again compared to the case where XYZ employs its next best CEO.

Now... Where should Jimmy work?

Both profits (for Wall Street) and jobs (for Main Street) are highest if Jimmy works at XYZ, not ABC.

But suppose there's a government-mandated cap on CEO pay; the most Jimmy can be paid is $500,000. And let's also suppose ABC makes Jimmy a job offer with a half million dollar salary. What should he do?

He can't do any better by waiting around for another offer. So he might as well take it. Jimmy ends up working for ABC. And 100 jobs and $1 million in profits are lost as a result.

Now let's suppose that Jimmy's pay isn't capped.

ABC offers half a mil. Jimmy thinks "Oh, that's plenty. I'll take it." But then XYZ counters with $750,000. Jimmy thinks "Cool, now I can get a bigger boat!" And ABC counters with $900,000. XYZ finally wins the bidding with an offer of $1,000,001. ABC is not willing to match this offer, because it earns higher profits when employing its next best manager, rather than paying Jimmy that amount.

So Jimmy gets richer under this arrangement. But that's not the only thing that happens. More overall profit is created (some going to shareholders and some to Jimmy), and that money can be reinvested in other socially valuable activities. And more jobs are created too. All because the bidding didn't just change what Jimmy was paid, it changed where he worked.

This is related to Hayek's ideas (which I have discussed before) about how prices convey information. People tend very much to focus on the role of wages --- which are just a "price" in a labor market --- in determining who gets rich and who doesn't. But wages also communicate information about socially valuable career choices. And that's what's going on here.

My example is just, well, an example. There's no reason to think that this describes everything about the managerial labor market. But this effect is potentially important, and we'll at least want to think hard about this effect before legislating pay caps.

Enough with the Basketball Already

2009-03-25T02:38:00.003-06:00

I know, I know, I write about basketball too much. Lucky for you the season's almost over.

A friend forwards this article from ESPN Magazine. It's another about measuring performance of basketball players, which, as I've noted, is harder than measuring the performance of baseball players.

But the interesting thing is how the author complains that the "experts" aren't saying anything. That is, they won't say what they're measuring or how. (This came up the Battier article previously, as well.) The reason is that these basketball experts work for basketball teams, and they don't want to give away their competitive edge.

And this makes me think about... finance. I don't know much about finance, but what little I do know comes from having sat through three plus years of finance seminars at the U of Utah. A lot of the seminars have to do with asset pricing; that is, trying to explain and predict how prices of stocks and bonds move.

Asset pricing is tough. The prices don't move in the way our theoretical models predict (there's apparently way too much day-to-day price variation), so we have a hard time explaining the data with economic theory. Further, while there's a lot of variation, there's very little in the way of predictable variation. This fact makes it exceedingly difficult to devise trading strategies that consistently win.

But my overarching thought about the asset pricing literature is this: I wonder how much of what's known is publicly known. I mean suppose you're a finance genius and you figure out a theory that explains and predicts asset prices. You could publish your model in the Journal of Political Economy, and probably win a Nobel Prize in Economics.

Or...

You could start a hedge fund and trade on your idea. And if you did that, then the last thing you'd want to do is tell anyone what your idea is, lest they replicate your trading strategy and reduce your profits.

The "publish" option makes you extremely famous among an extremely small group of people (basically economists and no one else). The "hedge fund" option makes you fabulously wealthy. Hmmm....

So this is why I wonder how much of the asset pricing knowledge is really making it to the academic community at large. I suspect the banks might know a thing or two that us finance profs don't. And the same thing seems to be happening with regard to measuring the performance of basketball players.

I promise --- no more basketball posts for the whole rest of this week.

AIG

2009-03-20T14:09:00.003-06:00

I received a question from a friend about AIG, but not about the on-going bonus scandal.

Are we giving all of this money (or a huge chunk) to AIG as a result of the CDS (credit derivative swap) positions they had vis-a-vis Lehman? Would we have been better off bailing out Lehman?

How about this for a hedge of an answer: Mostly No and Maybe Yes.

To get a sense what happened that brought down the financial system in mid-Sept, read this first.

Lehman's failure didn't affect just Lehman's counterparties. Lehman's failure caused everyone to worry about all their counterparties. That is, Lehman's failure made everyone worry about the failure of everyone, and this made it impossible for AIG to get out of all their CDS positions, not just their Lehman positions.

It's possible that things would have been better had Paulson simply bailed out Lehman, although we'd still be facing the problem of lots of bad assets on bank balance sheets. Suppose Paulson had bailed out Lehman. Morgan Stanley would have been next, and then others. At some point, political patience would have run out and they'd have let someone fail. And that would have brought AIG down.

I think Paulson didn't expect the bank-run type of phenomenon (described in the nyt article) that was kicked off by the Lehman failure. I think he did expect Lehman's failure to cause AIG to have to write off a lot of losses due to its Lehman CDS's. But he figured AIG would be able to get access to enough liquidity to cover those losses, and that's where he was wrong.

And what about the bonus scandal?

The depth of the public outcry has me concerned about bad regulations being written regarding managerial labor markets. Getting managerial incentives right is both hard and important. And frankly, quizzing the man on the street about how to do it is probably not too productive, but that seems to be roughly what Congress has in mind.

While it's clear that too much risk was taken on Wall Street over the past decade or so (with disastrous consequences), it's also clear that encouraging the right amount of risk taking is really important. Innovation is the goose that laid the golden egg for the US economy, and we don't want to stifle innovation (which, by nature, is risky) in a misguided attempt to punish Wall Street. We want entrepreneurs with good ideas to get funded, and the financial system plays a key role in this process. A populist backlash would, I think, not be a good thing for standards of living in our country.

Unpopular Thoughts About Business Education

2009-03-16T15:03:00.005-06:00

Great article in the NYT about business education.

At the risk of being flayed for being a non-visionary, status-quoist, doofus, I'll respond with some thoughts about why business schools have somewhat of a harder time instilling "professional standards" and "codes of ethical conduct," at least compared to law schools and medical schools.

One big difference between law/medical schools and business schools is that business schools compete against non-consumption.

What does this mean?

If you want to be a lawyer, you need to go to to law school. There's no other way to do it. If you want to be a doctor, you have to go to medical school. There's no other way to do it. But if you want a career in business, you don't have to get an MBA. You don't even need to have a bachelor's degree in business. There are a thousand ways to have a business career that don't involve spending time at a business school.

This fact might make it harder for b-schools (relative to law schools and med schools) to require students to acquire skills that have social value but not private value.

Here's why:

When students decide whether to go to any kind of school, they compare the private value of going to school to the private cost. "Private value" here is the amount by which school will make the person's lifetime earnings higher. "Private cost" is the amount it costs the person.

Where does private value come from? Private value comes from the market value of the skills that the person will acquire. If we teach you how to apply the net present value rule and employers like that skill, then they'll be willing to pay you a higher wage as a result of your having gone to school. If we teach you how to make better ethical decisions and employers value that skill, then they'll be willing to pay you higher wages as a result. Both skills allow the student to capture some private value.

But suppose employers aren't willing to pay for skills involving ethical decision-making. Suppose these skills make the world a better place, but they don't make the employer a higher-profit firm. (You might, in fact, think that one reason to emphasize ethics is to help students make better decisions in cases where the profit motive and "what's right" don't line up.) In this case, we'd say that the skills have social value but not private value.

Developing these skills is still costly --- the school still has to pay the instructor --- but the skills don't allow the student to capture any direct benefit, because the employer isn't willing to pay higher wages as a result.

Now, schools could still require the student to get the skills because it's the right thing to do. But this raises the private cost of getting the education without raising the private benefit. And this makes getting the degree less attractive.

Here's where the difference between law/medical schools and b-schools really bites. Law schools don't face competition from non-consumption. Neither to med schools. So, pushing lawyers and doctors to get socially-but-not-privately-valuable skills doesn't have a significant effect on student demand for the degree.

I'd guess the same isn't true for b-schools --- pushing students to acquire socially-but-not-privately-skills might well have a larger effect on student demand here. Imagine a potential student saying "Why should I go to b-school where they'll teach me all that stuff I don't need? I'm just going to keep working and try to move up the ladder without the degree. I'll learn more practical skills here at work anyway."

So, competition against non-consumption is one possible reason why business schools differ from law/medical schools when it comes to professional standards.

To put this another way, if the schools have a monopoly on certifying people for a profession, then it's easier for the schools to impose good-for-the-world standards. If access to the profession is open, then it's harder for schools to insist on such standards; people might just opt out of school.

Now, my argument here relies on a number of assumptions that might not be true.

First, I've assumed that students look at private benefits and costs only, and aren't thinking too hard about whether their training will help them make the world a better place. If "student altruism" rises, then this assumption won't be true, and schools should respond with more ethics in the curriculum.

Second, I've assumed that employers might not have a sufficiently high willingness-to-pay for ethical decision-making skills. If, going forward, employers have a much higher willingness to pay for these skills, then b-schools can push curriculum that direction without reducing student demand. If employer willingness-to-pay for ethics rises, then more ethics-in-curriculum will actually increase student demand for the degree.

Education Policy

2009-03-12T08:38:00.001-06:00

Really interesting: President Obama has come out pretty strongly in favor of pay-for-performance for teachers, and against tenure for teachers who are underperforming.

As I've noted here before, measuring the performance of teachers is not a trivial thing. It will be interesting to see how the administration approaches this issue. The details of the policy matter, but the details are a little fuzzy just now.

Old Friends (Continued)

2009-03-11T09:16:00.001-06:00

I had two roommates throughout most of my college and grad school years. One of them was Scott Smith, and he's found this blog through Facebook.

Smith (we had to dispense with first names due to the commonality) ended up getting a PhD in MechEng at Stanford. Somehow he missed his chance to become an economist --- I recall he took Don Brown's intermediate micro class sometime during college, but I guess the ME geeks already had their hooks in him by then.

Anyway, his interest in economics seems to have returned. He's started reading the blog, and a couple weeks ago he emailed a message to my readers.

Of course, Smith has many stories about me that I don't want shared, so I have no choice but to do as he instructs and post the message. His comments are quite complimentary to this blog, but I hope posting it doesn't make it seem like I'm fishing for such compliments. Really I'm not.

(And no I don't know why he wrote this. Let's just say I long ago gave up wondering why Smith does the things he does.)

To Utah Residents and Others Who are NOT Economists,
I first met Scott when we were eighteen years old, before either of us had taught a class, had children, or the word blog was in use. If you must pin us down, lets just say he brought an Apple 2e to college (and roomed with future World Series of Poker bracelet winner Rafe Furst.) And as Scott is the first to recognize, he has spent most of his educational and professional life since then in the pursuit of understanding, explaining and furthering economics. If I can offer one thing beyond the pat-on-the-back compliment, it is this: Economics is not what I thought it was, which is great news because it is actually much more interesting than I thought. And since I have not spent a lifetime pursuing economics, I consider myself qualified to talk about how to approach a blog on economics if you are not an economist.
If I saw a blog by an economist, I might expect to see a few paragraphs on where the stimulus package is being spent, a blog entry on where people are likely to spend their money in a contracting economy, and perhaps some references to money supply. I seem to remember M1 and M2 having specific definitions regarding money supply. In short, I might expect to see a more formal perspective on the same articles you can find in the business section of the Salt Lake Tribune or the Wall Street Journal.
But like I said before, since I knew Scott as he discovered his own interest in economics, I can offer some insight into what you see here and what you do not. When I was younger, I assumed economists studied money, but it is more interesting than that. They study incentive and motivation, value and the exchange of value, optimization and efficiency. Money just becomes a measuring tool (and a finicky one at that). So between the daily articles on the business page and grandiose pronouncements of an efficient market, there are great insights that an economist can provide.
A journalist will ask which firms will have price caps on executive pay, when the caps are going to be in place, what the upper payment is, and who will oversee their enforcement. Scott and other economists can present more useful information. They are keepers of answers to questions like: How will executive price caps affect the value of the decisions made by the restricted firms? And, Is there proof that firms with highly-valued (and highly paid) executives outperform firms with lower paid executives?
And Scott is always willing to use a more captive environment to further discussion. Right now, the NBA is distributing upwards of $175 million dollars to some of its member teams that are losing money. (Sound familiar). Are they considering setting lower price caps on the players for teams that receive the stimulus money (in other words, lowering the salary cap)? Should they? Ask Scott. And if you live in Utah, imagine if the salary cap for the Jazz was cut in half. Would your reaction be, good, the players are overpaid. Or would it be, hey that’s not fair, how can we compete with the Lakers now? Again, ask Scott. And trust me, after growing up in Portland, he too does not want to give the Lakers any advantage.
The list of possible topics is long and varied. Why do colleges offer tenure to professors, where few other jobs have that kind of guaranteed employment? Twenty years ago, the answer was because the only judges of the quality of advanced intellectual work are other professors, and the incentive given to gain their unbiased answer to the work of an assistant professor, is to remove the competitive approach of competing for a job. Do the business school students at the University of Utah learn more than the students at Harvard business school? Again, twenty years ago, the answer was there is very little difference, and the variation in the graduating students is due to the quality of the applicants. Personally, I am curious if a lifetime of study has shifted any of these views.
And if you are wondering, yes Scott does speak math, advanced math. But the beauty of economics is both the questions and the answers are best explained using good old fashion English. Keep in mind, you can always ask if his model accounts for or has any comments on a certain issue. If the language of economic modeling seems to misplace the seriousness of some issues, please forgive him. When he says, “One outcome of this game is for no [firms] to have a layoff. Another outcome is for everyone to have a layoff,” he knows it is no game; game theory is a mathematical term. And you can ask him, what insight do economists have in the effects that cause the shift from the layoff outcome to the no-layoff outcome? And I can presume a third outcome is firms hire. In other words, what insight do economists have in the seemingly cyclical nature of recessions, which seem to happen every four to eight years. Is it really a cycle, or are the changes random occurrences?
So I encourage everyone to keep reading. Remember behind each small article is another insight into incentive, value and efficiency. And in my opinion, once you get the basic facts from the general news, the information Scott provides is of the highest quality and use.

Friedman and Walsh

2009-03-10T09:36:00.007-06:00

So unfortunately I won't be able to go listen to Thomas Friedman tonight. A work-related dinner came up and I have to go to that. I'm sending my brother-in-law and his friend instead; perhaps he'll report back.

Meanwhile, Rebecca Walsh of the SL Trib criticized the Utah Museum of Natural History and the Hinckley Institute of Politics over the whole thing in her column last Sunday.

While I often like Walsh's work, I disagree with her on this. (And I should say that I'm in no way affiliated with either the UMNH or the Hinckley Institute, although both are affiliated with the U of Utah.)

It's certainly the case that Friedman is earning a lot of money for this visit. And it's also the case that the message he'll deliver isn't that different from what a lot of people are saying. The UMNH could, for example, hire yours truly to deliver an insightful lecture on carbon taxes vs. cap-and-trade systems --- and I'd probably do it for a just bit less than the $75,000 Friedman is going to make.

But the local media wouldn't cover a talk from me like they'll cover a talk from Friedman.

And let's keep in mind that the UMNH's mission is to "illuminate the natural world and the place of humans within it." Paying me (or other U faculty) will get you a lecture, but no "illumination" because my talk wouldn't be in the news. Paying Friedman gets you a lecture plus a lot of illumination.

Given that the Museum has a budget, it seems like we should let them spend in the way that they think will have the biggest impact with respect to their mission. Friedman's a high-impact guy. It seems completely reasonable to me to have one expensive-but-high-impact guy, rather than ten cheap-but-low-impact guys. I don't know that Walsh would criticize if the Museum was spending $7,500 each on ten low-profile speakers. (Or $750 each on a hundred really-low-profile speakers, like me.)

Perhaps the Museum shouldn't have a budget at all in these lean times, but that strikes me as a somewhat different conversation.

Comments / Performance Measurement

2009-03-09T20:59:00.003-06:00

More on the "Good Comments from Readers" thread. Regarding pay-for-performance in basketball, reader Jay writes:

(Players) should be getting paid for the overall team performance. Incentives are (probably) not aligned.

This comment perfectly illustrates one of the main performance-evaluation tradeoffs. Here's how:

Imagine you're the Memphis Grizzlies. Your record this season is 16-46. Not too good. But you've got rookie OJ Mayo, who's averaging more than 18 points per game.

Is it Mayo's fault that the Grizzlies are so bad? Should his pay be lower because the other players on his team stink? Mayo cannot, after all, help Quinton Ross (a 39% FG shooter) make shots.

Or...

Should we pay OJ Mayo based on how HE plays?

If we pay Mayo based on how he does, then we face the problem of measuring his performance. And this is hard. We usually think points-scored is a good measure, but as the Shane Battier article points out, there are times when the best thing for a player to do is pass the ball. If we use "points" as a performance measure, then Mayo might be motivated to shoot when that's not the best thing for the team.

If we pay Mayo based on how the team does, then he'll never shoot when he should pass. That is, Mayo's incentives will be aligned. But his pay will depend on whether Quinton Ross can shoot or not. And this means Mayo's pay will depend on random factors beyond his control. And just like we don't like it when the stock market goes up and down (affecting our investments in a way that's beyond our control), employees usually don't like this.

So, there's your tradeoff. Firmwide performance measures get good alignment, but subject employees to risk. Individual performance measurement can reduce risk, but won't necessarily get good alignment.

Utah WBEC Roundup

2009-03-05T11:52:00.001-07:00

Last week, I hosted the fourth annual Utah Winter Business Economics Conference.

We had a good turnout of economists from around the world, with the following universities represented: Carnegie-Mellon University, Columbia University, Duke University, Massachusetts Institute of Technology, Michigan State University, Northwestern University, Queen's University (Canada), Stanford University, University of California San Diego, University of California Santa Cruz, University of Chicago, University of Michigan, University of Munich, University of North Carolina, University of Rochester, University of Texas, University of Toronto, Washington University (St. Louis), and Yale University.

Why does the University of Utah do this?

Actually there are multiple reasons.

First, it's a great way for us to keep up with developments in our field. The academic format has six professors from other schools present papers. Then six other professors comment on the papers, and we take questions from the audience. It's one way I keep up with the flow of new ideas.

Second, it's cheap for us. The U of U --- and by extension, the Utah taxpayer --- doesn't spend a penny on this conference. When I joined the U faculty in 2005, I negotiated a small budget to help defray conference expenses in the first year. Since then, I've tried to maintain that starting budget as a cushion. I aim each year to have the conference break even, and I do this by charging participants a small registration fee.

Third, it's part of our faculty recruiting strategy. We are a small state and U of U salaries are typically below market. When the DESB goes head to head with, say, Duke in trying to attract a professor, the Utah salary offer is typically lower. So how do we attract faculty? One way is to target offers to people who want to live here because of the abundant outdoor recreation opportunities. And one way we identify those folks is to invite them to come skiing for a weekend in February. A professor who visits year after year might just be somebody we want to talk more to.

Layoffs vs. Salary Cuts

2009-03-04T09:38:00.002-07:00

I skied 5 straight days (Th through M). My legs hurt.

As I noted recently, the U was considering some salary cuts for next fiscal year. (It's now looking like salary cuts might not happen next year, because the legislature is going to use some federal stimulus dollars to support higher ed.) Utah State already cut everyone's pay by 2% for this year.

In other news, IBM announced higher profits, and shortly thereafter, a round of layoffs.

Both IBM and Utah State are trying to reduce labor costs. Why is one doing it through layoffs and one through salary cuts?

This is actually one of the big questions in economics. Wages, it turns out, tend to be sticky in the downward direction. And this is weird.

In a normal market, prices fall when demand goes down. Think about what's happened with oil recently. Demand has fallen, and so has the price. The price falls so that quantity demanded and quantity supplied are the same --- the market is in equilibrium.

IBM's demand for labor has fallen. Are they cutting wages? No --- IBM is keeping wages the same for the workers who keep their jobs. The fact that wages stay the same means that the quantity of labor demanded and the quantity of labor supplied are not the same. We've got an excess supply of labor. We call this "unemployment".

In some sense, it would be better if firms cut wages rather than cutting people. Why? Let's apply some marginal analysis to the question of how many workers a firm should employ. A firm should keep hiring until the worker's marginal revenue product --- that is, the extra revenue the firm makes as a result of hiring the next worker --- is no longer larger than the wage.

So let's suppose times are "good", and my marginal revenue product at my employer is $105. If my wage is $100, then the firm is happy to employ me, because it earns $5 in profit. If times turn "bad", my marginal revenue product might fall (due to decreased demand for my employer's products) to $95. If I'm bringing in $95 to the firm but costing the firm $100, then I'm a prime target for a layoff.

But what if I'd rather work for $90 than be unemployed? Then the firm and I can both be made better off if I stay employed but take a wage cut. If the firm lays me off, then it earns $0 and I am unemployed. If the firm keeps me around but cuts my pay to $90, then the firm earns $5 and I stay out of the unemployment line.

In that sense, salary cuts make both parties better off.

But in the real world, things are more complex. And this is due in large part to asymmetric information problems.

In real recessions, employees don't really know their marginal revenue products. And as a result, employees might worry that firms are using the recession as a pretext for cutting pay. An employee might wonder "Are times really so bad? Or is my employer simply using the recession as an excuse to cut pay so it can make more profits?"

This is the sort of thing that could make employees mad. And employees can do a lot of subtle things to retaliate against an employer who they think has treated them badly.

As a result, a firm might be better off cutting employees rather than cutting salaries. The employees who are let go will be unhappy, but they won't be around to cause trouble.

The argument I'm sketching here is laid out in a book by Yale economist Truman Bewley. This is truly one of the most unusual books in economics: Bewley is quite famous as a serious math-econ theorist, but in this book he eschews math entirely and simply goes out to interview managers and ask them why they do what they do.

It seems to me that this recession is seeing more across-the-board salary cuts than we've seen in the past. A former student sends in this article about Microsoft. I have not seen any data on this point, but I'm sure some enterprising labor economist will be exploring this question soon.

One reason might be scale of this downturn. Because everyone knows that this recession is pretty bad, employees might not be as prone to think that employers are simply using the recession as an excuse to cut pay. But at least some MSFT employees seem pretty grumpy about the whole deal.

Skiing

2009-02-26T16:53:00.000-07:00

No blogging this week: I'm going skiing.

Comments/HMOs

2009-02-23T14:09:00.004-07:00

A bunch of good comments on my posts lately, and rather than responding in the "comments" area, I thought I'd bring some of them up here. Regarding my post on adverse selection in health insurance, an anonymous reader writes:

So it is apparent that our current costs are known and this points out the flaws in our system. However, a fully socialized health care system can worry people, who think they will not get as good of care. But, wouldn't we paying in what we are now, or roughly the same to a socialized system? And if so and we eliminated the insurance shuffling and paperwork issues (because of this change) wouldn't more of the money we spend go to treating people? What am I missing?

Before I wade into this, let me state that I am not a health-care economist, and I don't know the answer to the question of "what should we do?" But I do know enough to at least see the costs and benefits of various courses of action. This reader is asking about the costs of a single-payer system, so I'll comment on that.

One issue with a socialized, single-payer system is that we're not using the power of competition to keep costs under control.

What happens to automakers who don't contain costs? Consumers stop buying their cars, and they'll be competed out of business (or, perhaps, competed into a massive government bailout... But you get my drift). The key notion is that market competition rewards those firms that figure out ways to keep costs down and still provide goods and services that consumers want.

We'd like the same thing to happen in health care. That is, we'd like someone to be shifting health-care business around to the providers who can offer care that consumers want in a cost minimizing way.

This sounds simple and obvious, but it doesn't work very well in this market. Why not?

One reason is that most of us don't pay the full cost of the health care we receive. Just a quick story about this: I was in Alta's Watson shelter last Friday and walked past the ski shop. The shop is selling helmets and their sign read "How large is your health insurance deductible? Buy a helmet!" They're saying to potential helmet-buyers: "You are on the hook for part of the cost if you hit a tree and have a head injury." Notably, however, you're not on the hook for the whole cost --- once your deductible is paid, any incremental costs are paid by the insurer.

Because consumers don't pay the full cost, they don't shop around aggressively for low-cost care. We don't haggle for medical care the way we do for a car. (And insurance isn't the only reason for this lack of haggling --- Health care is credence good, which means it's hard for consumers to even assess quality.)

So is there any haggling in this market? Any attempt to find low-cost providers? There is, and it happens between your employer (assuming you have employer-provided care) and some HMOs. Think of an employer negotiating with a bunch of insurers. The employer wants to get a good deal, and the HMOs compete by trying to buy low cost care from providers, packaging that care with insurance, and selling it to employers. One way the HMO can get a competitive edge is to negotiate lower rates from doctors --- this is a force that helps control health care costs.

Essentially, the current system uses the profit motive to contain costs in the following way: HMOs are allowed to keep any profits they earn by negotiating for lower-cost care with health-care providers. What keeps those profits from getting too big? Competition from other HMOs. What keeps HMOs from completely ignoring the quality of care? Again, competition from other HMOs. If employers look for the best quality care for employees at the lowest possible cost, then the current system at least has some competition-based mechanisms that pushes things in that direction.

Single-payer relies on the government, not markets, to find the balance between quality and cost.

Now, before you completely flame me for writing something nice about HMOs, note that I'm not saying that the current system is the best we can do, and I'm not saying socialized medicine would be worse than the current system. But I am saying that the big question mark for socialized health care is finding a means for appropriately matching up quality and cost. The current system isn't ideal by any means, but there is at least a profit-motive-based mechanism (an imperfect one, to be sure) to get health-care costs under control.

Read the last couple paragraphs of the Gruber article, for some hints on what the big drivers of health-care inflation have been.

All this is a bit moot anyway, since most Americans are happy with the insurance they have. Read Gruber's discussions of the overinsured and the underinsured in our country on this. As a result, it seems reform will be incremental, along the lines of the Massachusetts plan.

Old Friends and Taxing CEOs

2009-02-20T21:48:00.003-07:00

One of the cool things about the internet is that people can find you. I have friends who don't want to be found --- something about a crazy ex-girlfriend? --- but I don't mind it.

Anyway, this week I got two e-mails about this blog from old friends. One was from a Kellogg MBA who took a couple of classes from me a few years back. She's now working for a large global consulting firm. I was thrilled to get her mail --- and also thrilled to know that somebody is actually reading some of what I write here. If there are other Kellogg MBAs out there in cyberspace, come on out of the woodwork. Let me know what you're up to.

She was wondering if I had any thoughts about this article from the NYT.

After the small fortune she paid to Kellogg, I figured I should probably answer one more question from her. (Utah students: You get zero extra questions... jk.)

So here are a few thoughts:

(1) I'm not a fan of caps on pay. Super smart people have lots of opportunities. They're going to make scads of money one way or another. Do we want them to make their money working as "consultants" to the banking industry, where they can charge whatever fee they like? Or do we want them to be employees, where their fortunes can depend a bit more on how the firm does? I think the latter is better, but the pay caps will push people to the former. (I do think we should be limiting payments to owners --- that is, limiting dividend payments --- for bailout banks.)

(2) Is the Obama administration thinking about this? I am 100% certain they are. How am I so sure? Austan Goolsbee, an economist from the U of Chicago GSB who's on the President's Council of Economic Advisors, is one of the leading experts on taxing CEO pay. Here's a link to a paper of his on this.

(3) What Goolsbee found in his research was that CEO labor supply seems to be pretty inelastic. If you think back to how taxes affect economic activity, a lot depends on how elastic --- that is, how price sensitive --- demand and supply are. If demand and supply are elastic, then taxes can cause buyers and sellers to choose not to transact. The tax increases the price buyers pay and reduces the price sellers get... So if buyers and sellers are sensitive to price, this government interference will lead to reduced buying and selling. If demand and supply are inelastic, then the price doesn't matter much to the buyers and sellers. They're so eager to trade that even the tax doesn't deter them.

When the Republicans talk about how taxes will hurt economic activity, they're essentially arguing that demand and supply are elastic. This is for sure true in many markets, but not all.

Putting this in the CEO labor market context, if sellers (that is, CEOs) are price sensitive and their wages are taxed more heavily, then you might imagine them working less. A CEO might think "Well, I used to keep 70 cents of every dollar I earned, and now I keep 60. So I'll work less." If this were true, you might think that the pre-tax level of pay would go down after a tax increase.

But this isn't what seems to have happened in Goolsbee's data. CEO pay went up in the year before the tax increase and down in the year after. CEOs seem to have found ways to shift a little pay from the future to the present. But then pay went up on pretty much exactly the same trend as before.

So --- I think the advice the President is getting on taxing the rich is this: "Probably it won't cause the rich to work much less."

Let's see in the upcoming State of the Union address if Obama has anything to say about this.

Adverse Selection in Health Insurance

2009-02-18T14:17:00.002-07:00

Front-page article today in the NYT on young adults who choose not to buy health insurance.

What's wrong with this?

When I teach about adverse selection in Fin 6025, students usually suggest that the big problem is uncompensated care. Uncompensated care happens when an uninsured person gets sick or is injured, and then seeks treatment (usually at an ER), and then can't pay.

But uncompensated care is actually quite a small part of overall health care costs. According to a recent survey by leading health care economist Jon Gruber, uncompensated care is only $30 bn out of the $2 trillion US health care spending. That's 1.5%.

A bigger problem is that when healthy people jump out of the pool of the insured, then insurers figure that you must be pretty sick to want to buy health insurance. This is called adverse selection, because the "selection" of people who choose to buy insurance is "adverse" to the interests of the insurer. And this raises the price of insurance, and causes more of the relatively healthy to jump out of the insured pool.

So we end up with risk-averse people choosing not to buy insurance, because the price of insurance reflects the _average_ cost of insuring those who choose to buy, not the specific cost of insuring that person.

This sort of adverse selection problem can lead to market failure --- that is, it can lead to a situation where everyone's well being could be improved by changing the market outcome.

And this part of why markets don't do as well at allocating health care resources as they do at allocating, say, tin.

And this is why governments (around the world) are so heavily involved in the provision of health care. Health care is no more a "basic human right" than, say, food, but governments play a comparatively small role in the provision of food.

Basketball

2009-02-16T09:38:00.004-07:00

Cool article in Sunday's NYT magazine about measuring the performance of basketball players.

It's a harder problem than measuring the performance of baseball players. With the exception of playing defense, baseball isn't really a team sport. It's more a series of one-on-one matchups that can be easily analyzed.

But the Rockets are clearly thinking pretty hard about applying analysis to this performance measurement problem. They've broken down, for example, what actions a player might take that help the player's resume but don't help the team win. And that's a good lesson for any manager --- sports fan or not --- trying to measure employee performance in settings where performance is hard to measure.

Here's the best line of the article:

It turns out there is no statistic that a basketball player accumulates that cannot be amassed selfishly. “We think about this deeply whenever we’re talking about contractual incentives,” he says. “We don’t want to incent a guy to do things that hurt the team” — and the amazing thing about basketball is how easy this is to do. “They all maximize what they think they’re being paid for,” he says. He laughs. “It’s a tough environment for a player now because you have a lot of teams starting to think differently. They’ve got to rethink how they’re getting paid.”

"They all maximize what they think they're being paid for" --- that's a starting place for a course on organizational economics, just like the one I teach.

Friedman and Hayek

2009-02-14T10:13:00.004-07:00

A former student wrote this week to ask some questions about an old lecture. I directed him to what I think is one of the very most important ideas in economics: The notion that a fundamental role of prices is to convey information that guides individuals' choices in a socially productive direction.

I can't improve on what Nobel-laureate Friedrich Hayek wrote about this in 1945, so I'll just link to it.

Focus on H.21 through H.24, in particular. (H.24 might be my favorite paragraph of economics ever. It totally rocks!)

Thomas Friedman, the NYT columnist, will be speaking in SLC next month, and a frequent theme of his columns is that we need to get the price signals right so that people will make socially efficient investments in energy technology. He supports higher taxes on carbon-based fuels.

This notion of getting the price signals right is straight out of Hayek. Now, there's nothing in Hayek about taxes and further Hayek's work is often held up as an intellectual justification for free markets not government taxation. How do we get from Hayek to "tax carbon"?

In Hayek's conception, prices come from perfectly competitive markets with no externalities. His discussion of tin, for example, fits this. Perfectly competitive markets without externalities "work", in the sense that they achieve a socially efficient allocation.

My interpretation of Hayek is that when markets "work" --- which they very frequently do --- we should be really, really careful about messing with them. Because government interference can mess up the price signals, which will mess up individuals' choices. Government subsidies for housing loans, for example, can mess up the prices (that is, interest rates) for home loans, and cause people to make poor choices. (Sound familiar?)

But, economists have learned a lot about when markets "work" and when they don't. Markets can fail to achieve the best outcome when externalities are present. In cases like this, prices will send the wrong signals, and we'll get a not-the-best outcome. Friedman's point is that we need to use the power of markets (with a boost from tax policy) to send the right signals.

So, go listen to Friedman (and look for me there), and read Hayek.

Whaling

2009-02-13T10:08:00.000-07:00

More winter reading: I recently finished Nathaniel Philbrick's "In the Heart of the Sea." It's about the 1820 wreck of the Nantucket -based whaling ship Essex. This true event is believed to have been the catalyst for Melville's fictional Moby Dick.

I learned a lot about the industrial organization of whaling --- Very interesting industry! Seems to have been a lot of labor-market-related knowledge spillovers that allowed the little island of Nantucket to dominate this industry. But those advantages were eventually outweighed by the fact that Nantucket's harbor isn't really that good. Any really big ship had to be unloaded far from shore, and whale oil brought in to the town by small boat. This is expensive, and eventually the industry moved.

Oh, and plus there was a horrible disaster on the Essex when an angry sperm whale attacked. For some reason Philbrick spends most of his pages on that rather than the economics of whaling...

The most relevant passage in the book to today's economy was this:

Making (Nantucket's) level of profitability all the more remarkable was the state of the world's economy in 1819. As Nantucket continued to add ship after ship to her fleet, mainland businesses were collapsing by the hundreds. Claiming that the "days of our fictitious affluence is (sic) past," a Baltimore newspaper reported that spring on "dishonored credits, deserted dwellings, inactive streets, declining commerce, and exhausted coffers."

Sounds familiar. And serves as reminder that economic times have been bad before. They'll get good again.

Chaffetz: Wrong on Stimulus

2009-02-12T10:52:00.001-07:00

Our 3rd District Congressman Jason Chaffetz voted against the stimulus package and recounts his reasoning on cnn.com.

Most economists, myself included, think he's wrong on this issue.

The big immediate problem we face in the economy --- the problem that's leading to the half-million jobs lost each month --- is a kind of coordination problem.

To understand it, think about a firm making decisions about how much output to produce over the next six months and, by extension, how many people to employ. If our firm expects demand for its product to be strong, then it will plan to produce a lot. It will plan to employ a lot of people. If it expects demand to be weak, our firm will cut back on output, and we'll have to lay some of our workers off.

Now, what determines demand for our firm's product? One factor that determines demand is whether our firm's customers are likely to have jobs. So, if our firm expects other firms to have layoffs, then our firm will expect demand for its product to be weak. Expectations of other firms layoffs can trigger layoffs at our firm.

The reason I refer to this as a "coordination problem" is that our firm's best strategy --- layoff or no layoff --- depends on what other firms are doing. One outcome of this game is for no one to have a layoff. Another outcome is for everyone to have a layoff. We're on the "everyone" track as of now.

So how can we stop this cycle?

Well, this isn't the sort of thing that any single firm can undo. One firm deciding not to lay off its employees won't have a big enough impact. A group of firms --- a very large group --- could undo this by all simultaneously deciding to maintain or increase employment. But think of the problems of getting all those CEOs on board.

A final possibility is to take the single biggest player in the US economy --- the federal government --- and have them spend money. And this is what the stimulus package is for. The idea is that the government puts people directly to work --- and this will support demand and induce the firm we considered a few paragraphs above to not do layoffs. This will then support demand at other firms, and we can limit the spiraling job loss we are currently seeing.

This is what the president means when he says that only the federal government is large enough to have an impact on this crisis.

Don't take my support for the stimulus bill to be support for each and every provision in it. My view is that it would be better if we saw more immediate spending and less in the way of tax cuts for anyone with high earnings (unless those cuts are in rates that could somehow be made permanent, which I don't think is feasible.)

But when Congressman Chaffetz votes no because he "spoke with a guy who employs 12 people in his small trucking company, (who) sees a trillion dollars in new deficit spending and yet nothing that will help him," I just have to respond.

Ask the trucking company owner whether his business has been affected by the general economic slowdown. Ask him whether he'd prefer Utah's unemployment rate to rise to 6-7 percent (which it is likely to do even with the stimulus package), or whether he'd prefer Utah's unemployment rate to hit 8-9-10 percent. Most economists think the stimulus bill will mean lower unemployment. And this is likely to be good for the demand faced by local trucking companies.

And since I'm criticizing a Republican here, let me praise some as well. How should governments manage their fiscal policy, if they want to limit the impact of the business cycle on residents? They should do pretty much exactly what I'm guessing the State of Utah will do. Run surpluses and eliminate debt in good times. Bond --- that is, borrow --- and use the Rainy Day fund to support spending in bad times. This allows the state to work against the business-cycle coordination problem outlined above, without running massive long-term deficits.

The Middle Class

2009-02-09T10:53:00.002-07:00

Article in the D-News yesterday on "The Middle Class".

Reporter Lois Collins did a nice job summarizing the facts, so I won't repeat them here. But I will add a little about some theories on why this might be happening.

The leading theory among economists is something called "skill-biased technical change." The idea is that production technologies --- that is, the way we make good and services --- have changed. And they've changed in such a way as to make the skills of very educated people (think of college graduates and those with graduate degrees) more valuable relative to the skills of somewhat educated people (think high school grads).

If your skills become more valuable, then employers will be willing to pay higher wages to try to hire you. If your skills become less valuable, then employers won't be as eager to hire you, so your wages won't grow.

Why might this have happened? Computerization is one possible answer. A computer isn't a good substitute for a truck driver. But a good piece of accounting software is a good substitute for a bookkeeper. So, maybe in 1980, a CFO needed a staff of ten bookkeepers to track accounting numbers in a large firm. By 2005, though, a similar CFO could do the same work with only five bookkeepers. Computers substitute for bookkeepers, and therefore make bookkeeping skills less valuable.

At the same time, the computers are allowing the CFO to do more with less. This might make it more important to have a really good CFO. If computers complement CFO skills, then good CFOs will be even more highly sought after, and their wages will rise.

David Autor is an MIT economist and a friend who works on these issues. He's written recently on the polarization of the labor market.

I want to emphasize that skill-biased technical change isn't the only potential explanation for what's been happening in our labor market. This is not a settled question in our field --- others think globalization or tax policy might be driving changes in the labor market.

Present Value Math, Mitt Romney, and Tax Cuts

2009-02-06T12:52:00.004-07:00

Mitt Romney says he wants permanent tax cuts rather than direct government spending.

One problem with tax cuts in the current environment is that it's hard to commit to making them permanent. Even John McCain's economists think that overall tax rates have to go up --- due to the large entitlement spending that our government has to do over the next 30-40 years. And if businesses expect tax rates to go back up after the current crisis is over, then they won't respond (as much) to a current tax cut.

Here's some present value math on that:

Businesses decide whether to invest by following the net present value rule. Consider a project that costs $7.5 this year, but will pay $1 in revenue annually starting next year. If the tax rate on those revenues is zero and the interest rate is 10%, then this project has a positive net present value.

The present value of a $1 perpetuity is $10, and so the present value of $10 exceeds the present cost of $7.5.

If the tax rate is 30%, then this is a negative NPV investment --- the after-tax NPV is $7, which is less than the cost.

If we permanently cut the tax rate 20%, then the the after-tax NPV rises to $8, and the project is positive NPV. The firm will invest today, which will create jobs and stimulate the economy.

But what if the owner of the firm doesn't think the tax cut will be permanent? In particular, what if the business owner thinks the tax rate will be 20% next year and the year after, but will return to 30% after that?

Then the after-tax NPV of the investment is $7.17. So no investment!

What this means is that expectations of future tax rates matter a lot for the stimulative effect of tax cuts.

Oil Prices

2009-01-28T10:24:00.003-07:00

A former student writes in:

Oil prices were high in the 1970s, and we had a recession. Oil prices are now a third of what they were this summer... and the economy seems to be suffering. I remember learning in my undergrad that energy prices play a significant part in the economy overall. But, I thought the cheaper the energy...the better off the economy. So, what's going on now? Would we somewhat better off if gas prices increased?

Changes in oil prices can either cause, or be caused by, broader changes in the economy. That is, the causality can go both ways.

In the 1970s, oil prices rose in the US because of the Arab Oil Embargo. This caused a recession in the United States. The reason for this is that oil was an input into many firms' production processes. When input prices rise, firms produce less. This makes GDP (gross domestic product --- the sum value of all goods and services produced) go down. It also makes employment go down. Think of a trucking firm that hauls fewer loads because diesel is more expensive; this means fewer truck drivers will be employed.

In today's US economy, oil prices are much less important. We have fewer manufacturing jobs and more service jobs. Manufacturing jobs tend to be ones where "energy" is combined with "labor" to make "output". These are the jobs that go away when oil prices rise. In service industries (like mine), the price of oil has only a very minor impact on costs. So these jobs don't go away when oil prices go up.

This is why the changes in oil prices we saw from Jan 2007 to Aug 2008 didn't cause a severe recession.

Our current troubles are driven largely by the problems in the financial sector. We were already in a recession by Sept 2008, but the collapse of Lehman Brothers and subsequent problems in the credit markets have led to a serious economic slowdown.

Consumers in the US are spending a lot less money as a result. And this means less demand for "stuff." Because there's less demand for stuff, firms that manufacture things are cutting back. They're cutting back on output, which means using less labor and less energy. Unemployment in China has risen, due to reduced demand for workers by Chinese firms. Because these firms don't want as much energy, the demand for oil has fallen, and this is what has caused the recent drop in the price of oil. Think about all the TVs that aren't getting bought because US consumers feel poor. Those TVs would have been shipped from China on boats, and boats run on oil. This is a drop in the demand for oil, and this is why prices have fallen.

So, in the 1970s high oil prices caused the economy to struggle. Now, a struggling economy has caused oil prices to fall.

Here's a link to a recent NPR story that hits on the interconnectedness of the global economy that draws out some of these themes.

Winter Break Reading

2009-01-22T16:01:00.001-07:00

I'll get back to the personnel economics of U budget cuts tomorrow maybe, but some winter reading for today.

Two of the books I read over the winter break were related, and they were:
Wallace Stegner's Beyond the Hundredth Meridian: John Wesley Powell and the Second Opening of the West
Mark Stein's How the States Got Their Shapes

I certainly wasn't expecting to see a connection, but one of Powell's proposals (in the late 1800s) involved the economics of political boundaries, which is the topic of the second book.

Powell recognized, long before most anyone else, that water was the crucial resource in the American West. This is unlike the Eastern US, where there's plenty of water falling from the sky ("rain", I guess they call it) onto any piece of land. Here, we don't get too much of this "rain" stuff. For most agricultural purposes, land is useless without water. Powell argued that the homestead laws used to settle places like Iowa just weren't going to work in the West. It just wasn't going to work to give individuals 160 acres --- the standard grant under the Homestead Act --- with no thought about where water was going to come from.

One of Powell's water-centric proposals was made to the Montana territorial legislature. He advised them to organize counties according to drainage basins. If all residents on a particular creek or river are members of the same county, then water usage decisions can be delegated to that county and resolved locally. Essentially, Powell was arguing that political boundaries ought to be drawn to allow for localized decision-making regarding scarce resources. He was ignored, of course, and this means that upstream counties and downstream counties fight over water rights. One problem with this political organization is that both upstream and downstream counties act in a completely self-interested manner, and issues are either resolved by the state (which has comparatively limited access to information on local conditions) or through protracted negotiations. Witness the problems of the Colorado River Compact --- which is an agreement of seven Colorado-River-basin states --- for examples of the exact problems Powell was hoping Montana could avoid.

This year is the 100th anniversary of Stegner's birth, so it's a good year to read him. I'm not a big fan of fiction --- why read something made up when the real world is so interesting? --- but he wrote lots of great non-fiction stuff about the West (and about Mormonism in particular).

Mark Stein's book is about how Powell's advice --- design political units to minimize across-jurisdiction conflict --- was sometimes heeded and sometimes ignored as the Congress drew up state boundaries. Under "heeded", have a look at Washington and Idaho. Gold was discovered in what-was-then the Washington Territory north of Boise in 1860. Miners flocked to the area. Farmers in the Puget Sound area did not want miners in Boise making laws for them (and vice versa), so Congress split the territory in two.

Under "ignored", look at Wyoming. It's four degrees of latitude high, and seven degrees of longitude wide. Same with Colorado. Congress was pretty much ignoring conditions on the ground, and just making similar-sized states out of blank spaces on the map.

From Stein's book, I also learned that Utah is smaller than originally planned. Much of eastern Nevada was part of Utah --- until the mining really got going there. Congress didn't trust the LDS settlers of Utah, so they lopped off big chunks of land and put them in Nevada (which Congress figured wouldn't be LDS-controlled) instead.

West Wendover was nearly ours!

U Budget Cuts

2009-01-21T09:20:00.002-07:00

As you probably know, the U's budget has been cut, and probably will be cut again. I'm on the U's "Salaries and Annuities" committee, and I attended a meeting yesterday with the committee and some high-up administrators.

Faculty salary cuts are being considered, depending on the size of the cut coming from the legislative session.

But what a great meeting!

The reason this was a great meeting is that I study labor markets, employment relationships, and how to structure decisions in organizations. And this meeting had all these issues.

(As an aside: Pretty much everything that has happened since September 17 has been bad for my portfolio and salary --- just like everyone else's. But for me it's been interesting professionally. In expressing my interest, I risk coming off like I'm enjoying this. I'm not --- and on top of that I know that a lot of people are hurting from job loss. I'd for sure undo it if I could.)

The U is facing a bunch of interesting decisions right now, and I'll probably blog about them over the next week or so. One decision is this: If the U needs to cut faculty salaries by X%, how should it do so? Here are a couple of options:
(1) Reduce every professor's salary by X%.
(2) Tell each college that its total salary amount has to fall by X%, but let the deans and department chairs determine how to achieve that goal.

Fundamentally, this question is one about delegation of decisions. It's about where we should put decision-making responsibility in this organization. Option (1) is central administration making the decision. Option (2) is central administration delegating the decision to the deans and department chairs, subject to some parameters. It's exactly the kind of issue we consider in Fin 6250.

So what are the economics of delegation?

As with everything in life, delegation involves tradeoffs. There are benefits and costs associated with delegation, and it's important to weigh them carefully.

On the benefit side, delegation often means you're better able to make use of local information. What does that mean in this context? As one example, deans and department chairs know best about the labor market conditions in their particular fields. Central administration doesn't know (at least, not as well as the deans and department chairs) which of the finance professors are highly sought after by other universities, and which are not. In cutting salaries, you're providing opportunities for rival employers to pick off your best faculty. Choosing option (2) allows deans and department chairs to be a bit strategic about any salary cuts. It allows them to make smaller cuts in cases where labor market competition is intense, and larger cuts where the competition isn't so intense. This is potentially beneficial, in that it might allow the U to do a better job of retaining faculty.

There are a couple of potential costs of delegation. The first is agency costs. Deans and department chairs might have different preferences from central administration. It's possible --- at least in principle --- that deans might not allocate scarce salary dollars in the way that central administration thinks is best for the university as a whole. The best example of this comes from thinking about across-department and across-school externalities. Suppose there's a math professor who spends a lot of time working with faculty and students from the school of engineering. The math department might not value this person so much, and might decide to focus salary resources elsewhere. If this person left, it might hurt the school of engineering, but the math department might not take that into account.

A second potential cost comes from coordination problems, but I'm hard pressed to come up with an example of this one in the context of university salary cuts. In Chapter 3 of the forthcoming fifth edition of my book Economics of Strategy, I write about coordination in military organizations. Delegating decisions to lower-level commanders in military operations is often not a good idea, because actions of different units need to be coordinated. Attacks might work best if all units attack at the same moment, and as a result delegating decisions might achieve the best outcome. One good example of coordination in for-profit firms comes from marketing campaigns --- it's sometimes best if a firm's various products are marketed using a consistent message. Delegating decisions to product-level marketing groups might fail to deliver that consistent message, and so it can be good to have centralized oversight of such choices.

External Perceptions of Utah

2009-01-18T23:42:00.006-07:00

I was in Portland over the weekend taking my kids to see the grandparents. And this was the top story in the (Portland) Sunday Oregonian.

It doesn't show in the online version, but the subheading of the article caught my eye: "The (Portland) metro area is less diverse than most -- even Salt Lake City."

Whiter than --- gasp! --- Salt Lake City!?!

I point this out here just to illustrate one example of external perceptions of Utah; and how those perceptions are not always on the mark. The Oregonian's headline writer is clearly shocked --- shocked! --- that Portland could possibly be whiter than Salt Lake. But as the article recounts, census data shows that SLC is not the least diverse city in America.

As I've noted here maybe once or twice, we've seen substantial Hispanic inmigration over the past decade. I imagine the data will show this trend slowing due to the recession. But Utah is looking more and more like the rest of the Western US. Perceptions will catch up. Someday.

Private Clubs

2009-01-15T09:34:00.001-07:00

The Utah Legislature is considering lifting the "private club" requirement for entering a bar. Or, at least, the governor may ask the Legislature to consider doing this.

(For those who aren't Utahns, the way bars work here is this: Bars in Utah are "private clubs" that are not open to non-members. You can enter a bar if and only if you are a member or you're there with a member. You can easily become a member for a small fee --- you just sign a card at the door.)

Some of the talk you hear in support of private club requirement is bad economics, and I thought I'd point that out.

Alcohol consumption certainly has negative externalities associated with it. Go read Paying the Tab by economist Philip J. Cook for more on this. One solution to the problem of externalities is to tax the activity that leads to the externality. Higher alcohol taxes would probably mean lower consumption, less drunk driving, and lower incidence of alcohol-related illness.

Without doing a lot of statistical analysis, it's hard to say exactly what the "right" alcohol tax should be, but I think it's safe to say that economists would agree that alcohol should be subject to taxes that are higher than other goods.

The private-club requirement isn't a tax on alcohol, it's a tax on entering a bar. So maybe that's the same as a tax on alcohol?

Some in the legislature seem to think so --- Senate President-elect Michael Waddoups said in the SLTrib "Unless we find something better that protects our children and protects us from drunken drivers, we want no change in private club memberships. Someday we may find a better solution, but it hasn't even been suggested at this point."

What the Legislature is doing here is taxing a complement to alcohol consumption, rather than taxing consumption itself. "Entering a bar" and "drinking" usually go together, so economists call them complements.

The problem with this approach is that it's the "drinking" part, not the "entering a bar" part, that causes harm. So a more effective way to reduce drunk driving would be to tax alcohol consumption directly.

This approach of "tax a complement to the harmful activity" is a pretty common thing for governments to do when the tax itself is unpopular. This is what the Congress did when it implemented the CAFE (Corporate Average Fuel Economy) standards on the auto industry in the 1970s. Taxing gasoline would be unpopular, so instead the Congress imposed a hidden tax on a complement. By forcing auto firms to raise average fuel economy of the vehicles they sell, Congress made it more expensive to own a gas guzzler --- this is a tax on a complement to fuel consumption.

There are (at least) two problems with the CAFE standards: (1) Driving a Hummer 1 mile to work uses less gasoline than driving a Honda Civic 50 miles to work. That is, the harmful activity is "burning gasoline" not "owning a Hummer". The CAFE standards didn't do anything to deter driving your Civic a lot, but that's an activity that causes a lot of harm. (2) The CAFE rules had an exception for light trucks, and so this meant SUVs were subject to different rules.

My suggestion for the Legislature on reforming alcohol laws? Raise the tax on alcohol itself, and get rid of the other rules.

Information on Utah's comparative alcohol taxes is available from The Tax Foundation. Turns out that Washington, Oregon, Alabama, Virginia, Alaska, Michigan, Iowa, North Carolina all have higher "Spirit Taxes" than Utah. Utah's "Beer Tax" trails Alaska, Alabama, Hawaii, South Carolina, North Carolina, Florida, Georgia, and Mississippi.

Education Reform

2009-01-14T14:15:00.000-07:00

A Fin 6250 Student sends this link about Washington DC education reform:

D.C. Schools Chief's Plan Faces Opposition

DC School Reform will be a really interesting laboratory over the next few years, in part because the federal government is so heavily involved in administering the District.

One interesting feature of the DC plan is to get rid of tenure for public school teachers. This raises the question: Why does tenure exist in the first place?

The main reason for tenure cited by teachers' unions is to protect teachers from arbitrary firings. This raises an important issue, namely that it can be hard to provide incentives for supervisors to do subjective evaluations of performance. Getting rid of tenure would require principals to make hard decisions about who stays and who goes, and DC will have to grapple with this issue.

One reason for tenure in at the university level comes from the work of Lorne Carmichael, an economist who was thinking about hiring decisions. University professors have very specialized expertise --- my dean just isn't trained as an economist, and so it's very hard for him to figure out who we should hire if we're going to hire more business economists. In fact, I'm really the only person at the whole university with the expertise and connections to know which business economists are really good and which are just OK.

This means the "hiring" problem is really an "information extraction" problem. The university has to provide incentives for me to tell them the truth about who we should hire.

What role does tenure play?

Well, suppose I didn't have tenure. Then I might have an incentive to hire an economist who's good, but not quite as good as me.

Why would I do this?

Sometimes universities face budget cuts (like this year). And without tenure, the university might think about laying off some business economists. And if I hire someone better than me, I might be the one laid off. But if I hire someone worse than me, then maybe I'd be the one to keep my job.

To summarize, my incentives to build an excellent department would be weaker if I feared that doing so might cause me to be the first to go in a downturn.

We're trying to hire another business economist right now, and frankly the guy we're talking to is a lot better than me! Good thing I have tenure....

Tax Cuts

2009-01-13T20:48:00.002-07:00

Some details of the Obama stimulus package have been announced, and I was surprised to see $300 bn in tax cuts. It's looking like the plan is to send stimulus checks to individuals, sort of like what happened last year.

The problem with tax cuts like this is that people don't tend to spend that money, and as a result there is little impact on overall demand for goods and services. And this means that these tax cuts probably won't do much to stop the bad employment news that we've been seeing.

This point was illustrated for me today --- I was giving another talk on the economy downtown (similar to my last one, so no new slides to post here), and I made the point about people not spending their stimulus checks.

One audience member works for a local firm that is a collection agency; the kind that calls you when you get behind on your mortgage or your credit card payments. She said that when last year's stimulus checks went out, her firm saw a big increase in payments, and asked how this fit in with my claim that people didn't spend their stimulus checks.

This fits my point exactly. Rather than using the stimulus checks to buy NEW goods and services (which would then increase demand and help keep people employed), lots of individuals used their checks to pay off the debt they owed on goods and services they had already bought. So.... not the sort of thing that's going to lift us out of our 500,000 per month job loss cycle.

Why (Some) Behavioral Economics Bothers Me

2009-01-07T11:30:00.004-07:00

Before I launch into my tirade, I want to emphasize that Behavioral Economics is useful and economics has learned a lot from it. Understanding how people actually make decisions and what drives their preferences is important. Economics should be studying preference and choice, and we are.

But....

Some of it is just bluster. I've already criticized behavioral economist Dan Ariely's NYT piece on incentives in this space. He's just choosing to ignore reams of research on how financial incentives work in real firms. I don't know why he is doing this.

Other times, regular old economics gets labeled as behavioral, because it's easier to attract attention that way.

I've seen this a number of times in seminars and journals and the like, but here's an example from the New York Times recently. (And I should note that this article was submitted by a Fin 6250 group for their article discussion assignment --- way to go, group!)

Budgets Behaving Badly

This article is about how behavioral economics can help make better policy. I don't disagree with this claim; everyone should read Nudge for more on this.

But here's the thing: Read the section on how "Medicare separates hospital insurance and drug insurance into different programs." Any time an organization separates responsibility like this, you run the risk of across-department externalities. Here the drug insurance side of things is limiting access to drugs, thinking they're saving money. This, of course, makes people sicker, which means that the costs for the hospital insurance side of things goes up. It would probably be better if the people making the drugs decisions were motivated to care about the hospital side of things, but as of now they're not. Intra-organizational externalities like this are common (see Fin 6250). And they're understandable with regular old, garden-variety, neoclassical economics --- nothing obviously "behavioral" about it.

(Sorry for all the caveats in this post --- but here's another. I doubt it's Dana Goldman at RAND who's marketing this idea as behavioral. I'm guessing here, but probably this is the reporter's doing. I haven't been able to find Goldman's work on this, though.)

I'm of course showing my biases, but I think one reason that behavioral economics is popular is the notion that it's showing that regular old economics stuff is all wrong. "Oh, that economics you took and hated in college? The reason you hated it was because that stuff was wrong anyway because of strict rationality assumptions."

The big problem with college economics isn't that it's wrong; the big problem is that it's taught badly. Teaching regular old economics well is teaching exactly "the study of everyday life as it actually happens," just at Leonhardt wishes for.

On top of that, the big problem with our application of economics to policy isn't that economics is wrong (even though it surely is, at least on occasion); the big problem is that economists (and other social scientists) get ignored too often.

CEO Pay

2009-01-06T12:56:00.003-07:00

Hope everyone had a great holiday! I just got back from the American Economics Association meetings. You have not lived until you've gone to some econ conferences, that's for sure.

Two notes about CEO Pay for today:

(1) A former student mails this link from Sunday's NYT:

Should Congress Put a Cap on Executive Pay?

I'd be surprised if Congress did any sort of hard cap on pay --- it's just too obviously a bad idea, for the reasons Frank identifies.

(2) My paper (co-authored with Rachel Hayes) on CEO Pay and the Lake Wobegon Effect is now forthcoming the Journal of Financial Economics. Here's a non-technical press-release type summary that the marketing folks here at the DESB put together:

In humorist Garrison Keillor's fictional hometown of Lake Wobegon, all children are above average. Now, University of Utah finance professor Scott Schaefer says that corporations might want investors to believe the same thing about highly paid CEOs. "CEO Pay and the Lake Wobegon Effect," a study by Schaefer and Utah accounting professor Rachel Hayes, argues that this effect may help explain high CEO pay. The paper is forthcoming in The Journal of Financial Economics.

The Lake Wobegon Effect in CEO Pay is the idea that a firm might want to convince investors that the firm's CEO is above average. An above-average CEO might, after all, be able to deliver above-average performance, which is what investors are after.

But how can a firm convince investors of a CEO's quality? "Everyone knows that in well functioning labor markets, better performers earn higher salaries," Schaefer points out. "The reason the Yankees are paying star pitcher C.C. Sabathia $161 million is that some other team was willing to pay him $160 million."

Schaefer applies this reasoning to CEOs like this: Think about a firm that hires a bargain-basement CEO. The CEO's labor-market options probably aren't that good, so suppose the firm can pay the CEO a low salary; say, $1 million a year. Investors, seeing that salary, might conclude the CEO isn't so great, and will downgrade the firm's stock.

The firm might wish it could hire a better CEO, but good help is hard to find. What if, instead, it simply decided to pay its bargain-basement CEO as if he were a superstar? If the firm bumps the salary to $3 million, investors might conclude the CEO is a superstar ---- and the firm's share price might jump. If the increase in the stock price is bigger than the increase in the CEO's salary, then this could be a good move for the firm.

Schaefer notes that this idea --- which has been around in the business press since at least the late 1990s --- has not received much careful scrutiny by economists. "The big problem with the Lake Wobegon idea as applied to CEOs," he says, "is that it seems to presume investors aren't very smart. You can imagine investors getting fooled by this trick once or twice, but over time they'd probably catch on as highly touted and well paid CEOs consistently fail to deliver." And if investors understand a firm's incentives to goose CEO pay just to pump up stock prices, then wouldn't firms give up trying?

The answer, Schaefer argues, is no. "What we show in our research is that the Lake Wobegon Effect can drive up pay even if investors are super smart about it. The key," he notes," is the role of investors' expectations."

His reasoning goes like this: Suppose investors expect the firm to play this game. Then, when investors observe a CEO being paid $3 million, they think "Oh, that's a bargain-basement CEO who should really only be paid $1 million. So we're not impressed." But should the firm then pay its CEO only $1 million? Perhaps not; if investors are expecting CEO pay to be inflated, then they'll figure any CEO who is paid "only" $1 million must be truly unqualified for the job. And the firm's share price will drop like a rock. The firm might therefore be better off overpaying its manager, even if investors are not fooled.

Although Schaefer believes he's demonstrated that the effect can occur, and identified conditions under which it can occur, one question remains: Is it actually occurring? Finding the answer, Schaefer says, might prove to be difficult with the data that's currently available.

"It's hard to calculate the exact financial impact a CEO has on a company," he says. "We would like to know what the firm's profits would've been if the CEO had not been there. It's hard to tell whether firms are profitable because of their CEO or in spite of their CEO."

With CEOs' pay packages in the headlines following the recent wave of bankruptcies, Schaefer says the practice of rewarding managers regardless of companies' success deserves to be re-examined.

"Pay packages for CEOs have gotten so high that the repercussions of getting fired are minimal because these guys are so wealthy," he says. "It can useful if CEOs are afraid of getting fired because this makes them cautious. Exorbitant pay packages can make it so they're not afraid of taking risk."

Despite this, he's not a proponent of limitations on pay levels. "If we limit CEO pay amounts, then it will be harder for firms to hire top talent. If private equity guys or investment bankers are earning tens of millions per year but CEOs are capped at a million, well, talent tends to follow the money." Instead, he thinks corporate America need to find better ways of rewarding managers for the long-term success of the firm.

Proposed SLC Infrastructure Projects

2008-12-18T20:54:00.003-07:00

The nation's mayors have made their request for federal stimulus dollars. You can view their report here.

There are 8 Utah cities that list projects here: Brigham City, Herriman, Holladay, Murray, Orem, Provo, Salem, and Salt Lake City.

I didn't realize we had a Salem; seems to be down in Utah County. (They want a sewage treatment plant.)

The reasoning behind the stimulus package is to get jobs created. Construction is a good candidate for this sort of package, because the technology is fairly simple, and we can put people to work quickly.

Salt Lake City makes the biggest request among Utah cities, with almost $800 million in projects. The big dollars are for trains --- Sugarhouse trolley, Trax, other stuff.

The strangest SLC request? $350,000 for an Iron Sponge at the Water Reclamation Plant. What the heck is that? I thought sponges were made of, well, ... I have no idea what sponges are made of.

Utah Demographics

2008-12-16T23:25:00.002-07:00

I hinted in the last post about Utah's interesting demographics. Everything I've learned about that subject comes from Pam Perlich --- Here's a link to her latest report on how Utah's population is changing.

Utah Salaries

2008-12-11T15:46:00.003-07:00

A reporter asks about salaries for professional occupations in Utah.

First, some facts:

Here is data on average salaries for some professional occupations in a few western metro areas. This is from the Bureau of Labor Statistics' Occupational Employment Statistics Survey. You can get to this data here.

Accountants and Auditors
Phoenix $55,050
SF Bay $72,340
Denver $67,450
SLC $60,570

Computer Software Engineers, Systems Software
Phoenix $79,220
SF Bay $101,490
Denver $90,550
SLC $78,720

General and Operations Managers
Phoenix $99,060
SF Bay $123,850
Denver $107,880
SLC $95,140

Financial Managers
Phoenix $89,020
SF Bay $130,370
Denver $112,330
SLC $94,590

Compensation and Benefits Managers
Phoenix $68,550
SF Bay $106,820
Denver $92,480
SLC $93,660

You can see that for the most part, salaries are lower than SF and Denver. But higher, mostly, than Phoenix.

I think there are a few reasons for this:

(1) Composition of employers. I think there may be fewer corporate headquarters here than in Denver and SF, so on average managers here may not be as high on the corporate ladder.

(2) Our area is quite differentiated. What I mean by this is that people tend to have strong opinions one way or the other about Utah. For many of us, there is no place else we'd want to live. For individuals who value the strong LDS community or the very easy access to skiing, there is almost nowhere else on earth that offers comparable amenities.

For others, the cultural conservatism of our area can be off-putting. Think here of a non-religious, wine connoiseur who doesn't ski. For such individuals, our area might not be a good match.

What does this mean in terms of the labor market?

It means there is a set of workers that is going to live here even if wages are low. It is also means there's a substantial set of workers who wouldn't move here even if wages were much higher.

This means that local demographics matter a lot, or at least relatively more than in other parts of the country. If we have excess demand for managers, then wages will rise... but this increase in managerial wages won't draw workers from around the country to the same extent as it would in a less differentiated region. Similarly, if we have excess supply, wages will fall, but this might not push workers out of Utah to the same extent as it would in other locales.

Interesting, the demographic trends in Utah are quite different from those in other states, due to high fertility rates and the like. Pam Perlich is the U's expert on this stuff.... Maybe she'll guest blog for me someday on this. (Are you out there Pam?)

Talk on "The Economy"

2008-12-09T23:02:00.002-07:00

I'm giving a talk downtown tomorrow on "The Economy". Kind of a big topic for 50 minutes, but I'll do my best. Here's a link to my slides.

Sugar Bowl

2008-12-08T09:14:00.003-07:00

There is some economics at the end of this post... Just wait.

Utah is going to the Sugar Bowl, where they will have no shot at winning the NCAA football championship, despite the fact that they may finish the season as the only team without a loss.

The NCAA says it supports sportsmanship. But is it sporting or fair to tell a team that it cannot win the championship, no matter how well it performs on the field? Of course not.

The real reason we don't have a college football playoff can be found in the work of one of the 2007 Nobel Prize winners in economics. Roger Myerson and Mark Satterthwaite's paper on bargaining shows that two parties can fail to reach an agreement even if it is common knowledge that gains from trade exist. The necessary ingredient is asymmetric information.

That's exactly what's going on here. Everyone --- everyone --- in college athletics knows that a college football playoff would be a huge moneymaker. Huger (is that a word? if not, it should be) even than the current bowl system. It's common knowledge that a playoff could make everyone better off.

We don't have it, for the following reason. Suppose the current system nets $9 Zillion for the BCS conferences, and $1 Zillion for the non-BCS conferences. Suppose everyone knows that a playoff would result in at least $10 Zillion, but that nobody knows exactly how much.

The extra money needs to be split among the schools. But how? Should the non-BCS schools get half? Should they get a 10%? Should they get a payment that's proportional to their current revenues?

It's simply not clear how this extra should be split. The BCS conferences want a large share of it. So do the non-BCS schools. So no one is willing to make a deal.

Auto Bailout

2008-12-03T10:10:00.003-07:00

JB points out that much of the discussion about the auto bailout centers on promises by the car companies that they'll innovate to produce more fuel efficient cars. It's related to my earlier point that ExxonMobil might not be best able to make investments in renewable energy.

One interesting wrinkle in the auto business is that innovation in fuel efficiency complements existing auto technology. What does this jargon mean? The innovation we need is new, more fuel efficient engines. But those new engines then need to be paired with wheels and tires and doors and steering wheels and all the other stuff that's in cars.

This makes the innovation game tricky. Detroit is really good at internal combustion engines. This suggests that Detroit might not be that good at developing technologies that replace internal combustion engines.

But Detroit is also really good at doors and wheels. And this means that anyone who does develop an economically viable electric drive train will want to combine that innovation with Detroit's skill at wheels and doors and other car stuff. An electric-car entrepreneur would be (a bit) at the mercy of Detroit in terms of capturing the value of this innovation.

To put it back into jargon, an electric engine would substitute for Detroit's knowledge of internal combustion. This suggests that Detroit might not be good at developing electric engines. But an electric engine would complement Detroit's knowledge of wheels and doors. This suggest that Detroit might be good at developing electric engines.

So it's not clear to me whether our car innovations are going to come from Detroit, or from non-Detroit entrepreneurs like Tesla. There was an interesting 60 minutes piece on this a couple months ago.

My colleague Lyda Bigelow studies this sort of stuff, using historical data from the auto industry in the 1920s.

Black Friday

2008-11-26T17:28:00.004-07:00

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

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

But is it?

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

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

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

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

Do Incentives Work?

2008-11-24T11:56:00.003-07:00

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

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

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

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

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

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

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

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

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

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

Health Care Reform

2008-11-22T20:51:00.004-07:00

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

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

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

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

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

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

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

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

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

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

Sissies

2008-11-16T09:55:00.005-07:00

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

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

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

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

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

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

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

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

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

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

Utah's Four-Day Work Week

2008-11-14T12:54:00.003-07:00

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Pink Post-It Notes and Education Reform

2008-11-10T14:08:00.002-07:00

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

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

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

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

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

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

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

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

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

Stimulus Question

2008-11-10T09:50:00.001-07:00

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

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

Spending money on bridges and roads helps more.

Bang for your Stimulus Buck

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

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

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

Fiscal Stimulus and Renewable Energy

2008-11-07T12:18:00.002-07:00

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

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

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

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

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

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

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

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

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

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

Doctors and Health Care

2008-11-05T12:19:00.008-07:00

Interesting column in the SLTrib today about health care:

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

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

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

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

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

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

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

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

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

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

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

What Good Are Economists, Anyway???

2008-11-03T04:51:00.001-07:00

Scott Adams, creator of Dilbert, thinks he knows.

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

I think Adams got it about right....

Grades

2008-11-02T01:00:00.001-06:00

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

No fun for me. No fun for the students.

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

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

I can think of two potential purposes:

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

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

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

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

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

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

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