Global Economics and Management

Worker Incentive Schemes Based on Economic Profits

Here is a fascinating blog post from the WSJ, which neatly illustrates the difference between accounting profits and economic profits, a subject to which we shall return starting this week.

The Case for Market-Based Pricing

The title of this blog post would be a slightly more accurate (if less catchy) title for this excellent Slate article by Matt Yglesias, suggested to me by your classmate Jud Winton. The article's economic analysis of the pricing reaction of retailers in disaster zones is spot on. Not only is demand for some emergency products likely to rise steeply around the time of disasters, justifying upward pressure on prices, but supply is also likely to contract due to disruptions in the supply chain. The latter force also creates the basis for increased prices. Thus, not changing prices on the occasion of a major disaster could result in severe shortages.

You might ask (as Jud did) whether higher prices during disasters might have adverse distributional consequences: after all, at the higher prices only relatively rich people may be able to afford emergency supplies. But you also need to ask: adverse distributional consequences compared to what? During disasters, an unlimited supply of emergency goods at reasonable prices is not available (otherwise, the market reaction would not be for prices to rise!). The plausible alternative, here, is a shortage of goods due to prices that are too low. Next, ask yourselves: what is more fair or just: to have markets clear on the basis of willingness to pay, or to allocate goods on the basis of whoever shows up first, leaving latecomers without the opportunity to purchase anything?

This case illustrates the hard economic reality that we do not live in a world of unlimited resources, where all can enjoy the unlimited bounty of unlimited supply. We need to make difficult allocation choices for scarce resources. Whether these allocation choices should be made on a first-come, first served basis, or on the basis of a well-functioning price system, is not an obvious issue. There is a good case to be made that first-come, first-served allocation is grossly unfair compared to the market-based alternative. What is certain is that with a flexible price system, supply will equilibrate with demand and nobody will be left wanting more goods at market prices.

Politicians can sound convincing when they call for price regulations to avoid so-called "price gouging". A little bit of economics demonstrates that things are not so simple.

Incidentally, the next module in our course will be devoted to examining precisely this type of problem.

Are Finance Jobs Becoming Less Attractive to MBAs?

The Wall Street Journal seems to believe so. The journal may be confusing supply and demand, however. For instance, the article states: "Students' trepidation about jumping into what had historically been a coveted career path adds to the challenges already facing financial companies at a time of spotty economic growth, fearful investors, complex new regulations and even questions about the future existence of large banks." It could be, of course, that fewer MBAs launch into finance careers because fewer job open in that field, due to said spotty growth, fearful investors, new regulations, etc. It is very hard to know.

My view is that finance jobs will continue to be attractive to MBAs in the medium to long run. These jobs will continue to offer expected financial rewards beyond those offered by most other sectors. And, as one of my former Stanford colleague used to observe: "Money attracts smart people".

Weekend Readings

1) A fascinating new paper by Alwyn Young, suggesting that Africa over the last two decades has grown at a rate about twice what GDP statistics suggest. In Africa, measures of health, consumption and well-being reveal greater rates of economic progress than GDP per capita figures. Across countries, the two sets of measures are correlated, but at specific times or in specific regions they can diverge significantly. This article illustrats the general issue that getting the numbers right is one of the biggest challenges in economics.

2) Swing states since Eisenhower. Endless fun in these times of intense political competition. Even more endless fun here. 

3) More companies allow their employees to use unlimited paid vacation time. Yes, you read that right. Is this a sign of an inexorable slide of the US economy toward the continental European model? Is it a marketing ploy aimed at giving employees the illusion of a great benefit that does not in fact cost employers much? I would bet on the latter. This scheme is likely more prevalent in high human capital industries where performance is judged by the effectiveness at delivering specified tasks, rather than by the number of hours or days of work put in (you are judged by the output, not by the input, much as in academia). Employees who shirk on performing tasks by taking vacations all the time would likely see their career cut short, unlimited paid vacations or not.

Two Articles on Pricing

1) Courtesy of your classmate Trevor Armstrong, here is a great WSJ article on price matching. Threatened by stiff competition from online retailers, some brick-and-mortar retailers such as Best Buy and Target have decided to extend a policy of matching the lowest online price. You will immediately recognize this as an attempt to reduce the elasticity of demand that market players face: by matching their competitors' lowest prices, Best Buy retains some customers that they would otherwise have lost to online retailers. If everyone matches everyone's price, then every market player faces the industry elasticity of demand, which is (in absolute value) much lower that the elasticity that each firm faces independently.

You might think that such price convergence raises antitrust concerns, but keep in mind that 1) there is no explicit price fixing here and 2) the prices are matched downwards, which benefits consumers.

The big drawback of this scheme is that it leads consumers to shop online for lower prices in the hopes of requesting these prices at Best Buy or Target. This could inadvertently lead them to conclude the transaction online instead of at the store. My guess is that an increasing proportion of transactions will continue to migrate online, and that brick-and-mortar stores will become little more than showrooms, ultimately integrated into some online retailers at some point, if not completely destined to extinction. Online retailers are about to lose their tax advantage in many states, but they will retain their cost advantage stemming from technological efficiencies and labor savings. Does this spell doom for the Best Buys of this world?

2) Courtesy of your classmate Aylon Ben-Shlomo, here is another great WSJ article on the optimal timing of airline ticket purchases. When it comes to complex pricing to extract maximal consumer surplus, airlines are the world champions. They will charge different prices to business versus leisure travelers; different prices for travel in different seasons, dates, days of the week, and hours of departure; different prices on different routes, depending on the degree of competition on each route; different prices for non-stop versus layover flights. The list goes on. Yet, as we saw in class, the drawback of charging different prices to different market segments is that it needs to be an incentive compatible price discrimination scheme: consumers should not be able to behave strategically to undermine the scheme. Sophisticated consumers can notice regularities in pricing, and take advantage of the best possible deal. The article discusses one such possibility, which arises from the fact that airlines charge different prices depending on the day of the week at which tickets are purchased. Airlines must have determined that it was more profitable to extend discounts during the early days of the week than during weekend. The optimal response of a rational consumer is to avoid purchasing tickets during the weekend, when prices are high. Might airlines decide that time-varying discounts don't make sense after all?

Two Statements on India

Last Friday during my inaugural class on India (458I) I made two statements on that country, as follows:

1) I said that the Indian Railway system is the largest employer in the world. That was incorrect - it is the 8th largest employer. The largest employer is the US Department of Defense, followed by China's People's Liberation Army and Walmart. See here for the rest of the ranking. I stand corrected.

2) I said that population growth meant that India was adding the equivalent of the population of the Netherlands to its population every year. India's current population is 1.21 billion (2011 census). The rate of growth of the Indian population is 1.41% per year. Thus, India adds about 17 million people annually. The population of the Netherlands is 16.696 million (2010). At least I got that one about right!

Luxottica and Monopoly Power in the Eyeglass Market

Via your classmate Neel Bhattacharyya, here is a CBS 60 minutes segment on how the Italian company Luxottica became a dominant player on the eyewear market. The segment is a beautiful example of many themes discussed in class:

Product differentiation: Luxottica owns several brands and designs and produces frames for countless others, meaning they use product differentiation to capture large swaths of the market, with different customers sorting into different price-quality combinations depending on their willingness to pay.

Monopoly pricing: Luxottica has such a large market share that it is a price maker in the eyewear business, allowing it to earn monopoly profits and to purchase smaller competitors.

Vertical integration: Luxottica has purchased distributors and even an insurance company offering vision plans.

Willingness to pay: Finally, the story (particularly at the end) illustrates our discussions of consumer willingness to pay. The money quote from the CEO of Luxottica is "everything is worth what people are ready to pay".

There is a slight tone of antagonism in the reporter's questions, stemming no doubt from her concerns about monopoly power. There are of course serious concerns associated with monopolization, for reasons we will examine in class later this quarter. That is why we have antitrust law, but Luxottica seems quite far from a situation where it might be accused of antitrust violations. Stories like these are how antitrust concerns can start, however, so be careful about the curse of success!

The full segment is here: 

 

Price Fixing in the eBook Market

If you are a Kindle owner, you may have recently received the following message from Amazon (click on the image for a bigger version):

It turns out the that three companies mentioned in the message were accused of price fixing - specifically of fixing the prices of eBooks. Price fixing is what happens when competitors get together to try to behave as a single monopolist. As we will see, such behavior can result in bigger profits for each member of the conspiracy, because monopoly profits on the aggregate are larger than the sum of each firm's oligopoly profits.

Unfortunately, price fixing is illegal under US law and the laws of most other countries. In the US, the practice is per se illegal. That means that all the prosecution has to prove is that the practice actually occurred. The prosecution does not need to argue that the practice of price fixing harmed anyone in the specific instance brough before the court. Moreover, conspirators are criminally liable, and can go to jail. That probably explains why these companies settled out of court: they did not want to take the risk of seeing some of their executives sent to jail, not to mention that damages can be sizeable.

More information can be found at https://ebooksagsettlements.com/. In a few weeks, we will study cartels and oligopoly in class, so hold on for much more.

I Finally Found Out How Facebook is Going to Make Money!

This:

Just kidding. They're never going to make money. Discuss.

Price Discrimination in NY Restaurants

Your classmate Evan Ellsworth sends me a facinating article (with video) from CBS News New York on a new idea to maximize profits in the restaurant business. Some restaurants in New York City, like Le Cirque, plan to start charging customers more for dining at peak times. It makes sense for restaurants to charge more for meals at those times, because demand is strong at peak dining times, and the elasticity is therefore lower: when there is excess demand, a price sensitive customer wishing to have dinner at those times can easily be replaced with a customer who is willing to pay more. The restaurant therefore experiences a lower elasticity of demand, and can/should charge higher prices. This is an example of price discrimination.

The scheme will also reduce "black market" ways to get a table, such as slipping a bribe to the Maitre D, so that all those willing to pay will be on an equal footing. It will also serve to reduce congestion at peak times, since some customers will opt to frequent the restaurant at other times, when meals are cheaper. 

This example neatly illustrates the concepts of demand elasticity and price discrimination that we are discussing in class these days.