Global Economics and Management

The Cost of Pennies

Please read this in its entirety.

Warning: I am not financially liable for any resulting losses.

Weekend Readings

1) John Cochrane on the madness of the US tax system. Meanwhile, some famous economists advocate a top marginal rate in the US of 73% (welcome to the new France), a famous rich guy advocates a minimum tax for the wealthy (but he may be a hypocrite) and others disagree with all this tax raising. Seems to me we need to rethink the entire system, both on the spending and the tax sides. Fat chance of that happening politically...

2) Insurance companies get creative to overcome problems of asymmetric information in insurance markets. This is a problem we will explore next week in class.

3) The Mexican President's view of the war on drugs. Summary: it's a losing proposition. The solution, to which the article hints but does not mention clearly, is legalization. That will almost certainly guarantee falling prices, since these will no longer incorporate the expected cost of detection and punishment for illicit activities, and supply will be free to expand. Moreover, legalization would afford the opportunity to regulate and tax these goods, as opposed to having them be consumed in the black economy. Legalization would also afford the opportunity for greater domestic production, reducing world prices and gang activity in Mexico. Let's start by treating marijuana like we do tobacco and alcohol, and let's see how that works out. Then consider extending the legalization to other drugs (hat tip: Aylon Ben-Shlomo).

The Economics of Black Friday

Thanksgiving weekend is every year in the United States the opportunity for a day of binge shopping, known as Black Friday due to the crowds that flood malls and retail outlets. On this occasion the Wall Street Journal featured a series of interesting articles:

1) This piece describes the variety of pricing strategies adopted by retailers - some keeping prices high to take advantage of the demand curve having shifted out, others cutting prices aggressively precisely to attract more customers. What considerations determine whether a retailer will adopt lower or unchanged prices on Black Thursday? (hat tip: Trevor Armstrong)

2) Do you think that you are getting the best deals of the year on Black Friday? Think again. (Hat tip: Suthee Lertsakornsiri)

3) Sometimes, however, retailers cannot avoid erupting into a price war. Price wars, as we will see next week, are inherently hard to predict. When they do occur, they can be terribly deterimental to profits. This is the domain of game theory, a topic to which we will turn next in Management 405.

With this, let me hope that all of you are having a great Thanksgiving weekend!

UPDATE: Your classmate Li-Chung Wang adds this great article from the NYT on real-time price adjustment during Black Friday.

Making Economics Useful for Management

Here is a great article from the print edition of The Economist surveying the work of 4 academic economists who made the transition to helping real companies achieve better results using the tools of modern economics (full disclosure: two of them are friends of mine: one (Tadelis) was a former grad school classmate and another (Athey) a former colleague at Stanford). Put that together with the recent Nobel Prize awarded to Al Roth, and there is an emerging pattern here: that of the economist as an engineer, using concepts specific to economic science to design new markets, to modify existing markets to make them more efficient, and to bring the quantitative and formal tools of economics to bear on detailed microeconomic problems. The idea that firms like Yahoo, Google and Microsoft have Chief Economists should be telling.

My advice to MBAs (repeated over many years and never modified) is that you can do no better in business school than to pick classes that: 1) further your understanding of economic mechanisms (advanced finance, advanced strategy, macroeconomics) and, 2) rely on strong analytical (math) and quantitative (stats) skills. You can take all the practitioner-oriented classes you want, there will be very little left after a few months that will stick with you for your whole life. Learn regression in depth, on the other hand, and this skill will be with you forever. This advice is more and more relevant as the economy has moved to the digitized space and companies can use very advanced quantitative methods to improve their bottom lines (see my first paragraph above).

Notable News from the Weekend of November 17-18

1). This could mean a recession, as business investment is often a sign of bad things to come. Business people may see clouds on the horizon more clearly than consumers, which might explain the disconnect between business confidence and consumer confidence. The article does a great job linking micro factors (managerial economics) to macro developments (the business cycle). Note the emphasis on both supply-side factors (policy undertainty) and demand-side factors (the shortfall in demand due to the weakness of the world economy).

2). Bal Thackeray is dead. Much to learn from this event, and the article describing it, on the state of modern India, with its persistent blend of modernity and traditionalism.

3). Prominent Indian development economists opine on the Indian government's recent initiatives regarding food security. Hat tip: Marginal Revolution.

4) Still in India, Walmart is investigating possible violations of the US Foreign Corrupt Practices Act (hat tip: Sumukh Shevde).

The Debate over Virgin America

In this blog post I pointed out that "the value proposition offered by Virgin America (the combination of high price and high quality) clearly does not match the value proposition of its competitors (lower price, low quality), else Virgin would attract more demand." In a very thoughtful email to me, your classmate Will Teslik objects. Will writes: 

"Virgin America is a low cost carrier - their cost per seat mile is lower than the industry average (see quote from CFO here). In fact, their unit cost is lower than JetBlue "The airline’s unit costs excluding fuel of $6.56 cents were lower than the $6.71 cents recorded by JetBlue and the $7.60 cents posted by Alaska Airlines". This article from the USA Today discusses what Virgin describes as its business model - it is using the low cost model, but trying to attract "self-managed" business travelers. In the article, Virgin's CEO explicitly discusses attracting such customers with LOWER fares, "Cush also believes corporations are becoming more interested in "transactional" rather than "contractual" buying, wanting the lowest price on each transaction rather than the overall discounts offered by global airlines. The article from the center for aviation, referenced earlier, point out that "The combination of lower fares relative to its legacy rivals and its superior product to those carriers has allowed Virgin America to gain a significant following among tech-savvy business travellers." 

Let me make two points about this:

1) Per se having lower costs does not imply you will charge lower prices. More fundamentally, whether Virgin charges lower prices than its competitors on similar routes is, as Will rightly points out, not so obvious. In my original blog post I was going on the information contained in the referenced Time article: "And because Virgin America offers a premium product (...), its flights often aren’t as cheap as those of competitors like Southwest and Alaska Airlines - and low price is overwhelmingly important to leisure travelers." This quote suggested a clear trade-off between price and quality, on which I based my analysis.

2) If a rigorous price comparison analysis were to conclude that Virgin America does indeed charge lower prices than the relevant competitors, the analysis of competitive advantage could still apply, in slightly modified form, to a trade-off between two dimensions of quality. On one axis you might plot one dimension, say cabin comfort, and on the other you would plot another dimension, say whether the airline flies to a wide range of desirable destinations. Then Virgin's value proposition seems to be to have chosen the former over the latter. That value proposition, according to the Time article, does not seem too successful given Virgin America's profit numbers.

Conflicting information on price in this specific case may make the price-quality trade-off to which I originally alluded more or less pertinent. But the basic tenets of the analysis of competitive advantage, which this case gave us an excuse to study in class, remain unchanged: to be successful a business must offer a value proposition that matches or surpasses its competitors' value propositions. Whether that value proposition is made up of a specific price-quality combination or of a combination of different dimensions of quality (holding price constant) does not change the basic picture.

UCLA Anderson's Greatness

We interrupt our regular programming for a bit of shameless self-promotion - of UCLA Anderson, that is!

Licensing Requirements in the Hair Braiding Market

Via your classmate Arash Nasibi comes this great story of licensing gone crazy in the Utah hair braiding market (see here for a more detailed story, replete with details of the politics behind the practice of licensing). Incumbents opposed the activities of Jestina Clayton, who did not possess a Utah cosmetology license, because of supposed public health issues. What they were really doing was protecting the barriers to entry they had erected to protect their rents. Fortunately, a judge saw right through the scheme. This story and the follow-up are great illustrations of our class discussions on the growing trend toward licensing requirements. It should also be clear why it is so hard politically to get rid of this system: it protects the concentrated interests of the incumbents to the detriment of the dispersed interests of consumers and the amorphous interests of potential entrants.

The Economics of the Sirius XM Merger

Your classmate Michael Schlossberg sends me this very interesting Bloomberg article on the legal wrangling that followed the regulatory approval of the Sirius-XM merger, discussed in class a couple of weeks ago. 

My view on the matter is that there was no way a market with such high fixed costs was going to support two firms, and that the merger was the only plausible outcome for that market. Further, raising prices post-merger was the only way the resulting single firm was going to be profitable, so any moderately literate economist should have seen such price increases coming. The subscription rates are still very low and affordable, and the availability of a growing list of substitutes means that the threat of monopolistic behavior will be contained, so I am not too worried about abusive monopolistic behavior on this market.

Weekend readings

1) An interview of Eugene Fama, father of modern finance. Worth a close read for anyone with interests in finance. (h/t: Greg Mankiw).

2) Using non-financial leverage as a leading indicator of looming financial crises. (h/t: Calculated Risk)

3) More on price gouging during natural disasters.

3) Two articles on business ethics, one pursusing an experimental approach to evaluating whether consumers are willing to pay more for "ethical" products, the other arguing that corporate social responsibility, correctly defined as companies taking actions that do not directly maximize profits, can be counterproductive. These articles raise subtle issues concerning the movement toward CSR, and are highly recommended to all those of you who, like myself, have a keen interest in these issues.