Thursday, August 24, 2006

Natural selection at the universe level; Expectations of Stability

This idea has no doubt been tossed around for hundreds of years, so if anyone knows a good reference on it, let me know please.

The idea is that we should expect our natural environment to have stable equilibrium properties for the simple fact that we exist. If our natural environment were inherently unstable, we would have blown up long ago and would not be here debating the topic. So there is a form of natural selection at work in our physical universe: the fact that our world exists as we know it means that it has to exhibit stable properties.

So what brought this up?

What bothers me, and many others, about the global warming climate models is that the primary forcing of increased CO2 accounts for only a small portion of the predicted warming -- maybe 1 degree centigrade for a doubling of CO2. The rest of the warming comes from positive feedbacks such as changes in clouds, water vapor, and oceans. It turns out that these things are also the least understood in terms of climate theory.

Positive feedbacks tend to cause either the nonexistence of equilibrium or unstable equilibria. In economics, if an increase in demand were to cause price to increase, and the increase in price would in turn INCREASE demand instead of decreasing it (the normal effect) then we would have a positive feedback effect and most likely nonexistence of equilibrium or at least an unstable equilibrium.

The original "Limits to Growth" book put out by the Club of Rome in 1972 argued that we would soon run out of many resources. The modeling in that book had very little in the way of the negative feedbacks that economists believe in: as prices go up, substitution occurs and quantity demanded declines; or as prices go up, quantity supplied increases, thereby also causing the price increase to be limited.

Some of the climate "sceptics" seem to assume that the climate is characterized more by negative feedback effects and stability than the models imply. Lindzen's "iris" theory is one good example of a strong negative feedback effect. I actually do not know if the large climate models are equilibrium models or not. Is the change in CO2 modeled as pushing the climate from one equilibrium to another, or are the models more naive in that they only look at what would be at best characterized as partial-equilibrium effects? To take an economics example, if we assumed that supply is fixed, and then increase demand, we will get a larger predicted price increase than if we allow a new supply-demand equilibrium to develop.

As I think more about the primary chart in Gore's movie, the one showing the thousands of years of fluctuations in CO2 and temperature, what I see is evidence of inherent stability. I don't know what is causing temperature to increase (as it is well known that temperature does increase first) but I don't see the system spiralling out of control. It is cyclical, not exponential. Even if something as potentially important as fluctuations in solar output causes the temperature flux, we still see the Earth's climate move as an equilibrium, negative feedback system.

Now I grant you that the range of equilibrium might imply very large changes in climate, but I think the general philosophic view here is important. Our physical universe might also be very unstable over very long periods of time; we just haven't reached the end of time yet (if the universe is contracting, I guess it is unstable in that we will have another big bang at some point). But look, if our physical universe were so unstable that relatively small changes in exogenous factors (e.g., a 2 percentage point in greenhouse effect forcing) were to cause massive changes in climate, I doubt that we would be here now.

Wednesday, August 23, 2006

Record Low Temps in NH again

The forecast low temperature in Berlin, NH for tonight is 37 degrees...and the record low for that date is 39, set in 2003.

Even colder, the forecast for Friday night is 35 degrees!!

I don't expect any mention of this in the local or national press (nor should there be; it is just ironic with all the press that the non-record heat wave a few weeks ago received). And meanwhile, the Al Gore movie is BACK at the Nugget Theatre in Hanover...supposedly on the basis of popular demand (which I do not doubt given the populace around here).

Thursday, August 17, 2006

Pricing of iTunes and iPods: Vive la France!

I’ve wanted to write a post on iTunes/iPod pricing for some time now. That the French actually passed a law aimed at forcing Apple to allow songs purchased from iTunes to play on other portable music devices makes the issue all the more interesting. The more general issue however is simply the economics of pricing in this kind of “hardware/software” paradigm. Warning: this gets a bit intense on the economic theory front.

The basic point that bothers the French, and could in fact bring up antitrust issues in the US as well, is that songs purchased from iTunes are not playable on devices other than iPods. While not exactly fitting the typical story, this practice is a form of tying or bundling, where the purchase of one product is conditioned on the purchase of another, or two products are only sold together. In this case, we really have the ability to use one product (songs)conditional on the purchase of another (the players). The competitive concern with tying/bundling, and with the iTunes situation, is that of extension of monopoly power in one market to another market. Apple has market power in the online music industry, the claim would go, and by not allowing its songs to be played on anything other than iPods, it is restricting competition in the portable music device industry.

Before I get to some more interesting economics of this practice, I have to note that Apple would seem to have a very strong “efficiency” defense – at least on the basis of what I understand about the technology. The efficiency defense is that Apple must restrict its music only to its own devices, for in order to let the music be playable on other devices, Apple would have to release the code for its digital rights management (DRM) scheme. This is the technology that, for instance, keeps us from transferring a song to an iPod and then downloading it to a computer, from whence we could make even more copies.

Truly one of the genius aspects of iTunes is that it has made legal downloading of music competitive with piracy. If forcing Apple to make iTunes music playable on other devices made piracy even easier, then one would hope that regulatory authorities would use a “rule of reason” approach and conclude that the restriction, while possibly causing competitive harm in the device market, creates outweighing benefits in the online music industry overall.

(There should also, of course, be an assessment of whether Apple does have market power, in the antitrust sense, in any significant market. It is not clear at all that they do, if you consider the broad market for music.)

I also should point out right away that there is a sort of “straw man” argument against Apple restricting iTunes only to iPod. Why not make iTunes songs playable on any device – this can only increase the demand for songs from iTunes and increase Apple’s profit?

To answer this without resorting to the DRM point, let me get into the more interesting economics of the practice. To do this, I want to begin with the essential pricing analysis of songs from iTunes and the devices, i.e., the iPods. As we will see, this pricing theory relies upon the fact that consumers will be different in their demands/values of music, especially in terms of price sensitivity, and it will also rely on the inability of Apple to price discriminate on the devices.

To start, let’s suppose that, contrary to the last statement, Apple could identify different types of consumers and charge them exactly what an iPod is worth to the individual consumer. Of course, an iPod is not valuable by itself; its value derives from its ability to play music. And while the value of an iPod to an individual consumer will depend upon many things, it will most certainly depend on how much music will be played on the iPod, and that in turn depends on the price of music from ITunes. Thus enters the key dependency between iTunes and iPods pricing.

With the ability to differentiate consumers in this kind of situation, Apple would want to price its songs from iTunes at the marginal cost of the songs (essentially, the royalty that Apple must pay, which I believe to be about 67 cents per song). This induces consumers who have bought iPods to consume the “right/efficient” amount of music – so long as the value to a consumer of a song exceeds the marginal cost, it should be purchased and consumed.

Then comes the grand whammy, which is that all the net value for consumers created from their ability to buy songs at marginal cost is taken away in the device pricing. If Consumer A values the combination of an iPod and the right to buy unlimited songs at marginal cost at $300, then Apple would charge that consumer $300 for the iPod. Another consumer who values the package at $400 would pay $400, and so on.

This pricing model works wonderfully – under the rather unrealistic assumption that we can differentiate perfectly across consumers. What happens if we can only set one price for the device itself? (Note that I am not dealing with the “versioning” aspect of iPods, which is that you can in fact differentiate across consumers a bit by offering different versions of the same basic device, at vastly different prices. How much more does a 4 GB Nano cost, by the way?)

So, let’s take the easy case and suppose there are two kinds of consumers (obviously I am being restrictive here, but if you want more realism, you are going to force me to use math rather than words). Type I consumers don’t really want a lot of songs; they just want the device and want to listen to their favorite music. These consumers will be insensitive to the song price, for again, they really want, and just want, their favorite music. Type II consumers like a lot of songs, and they are price sensitive: if you lower the song price, they buy a lot of music, and if you raise the song price, they cut back a lot.

So suppose we still have the songs priced at marginal cost. What do we price the iPod at, if we can set only one price to the entire market? The key point is that the value of the iPod will be different for the two types of consumers, and I am going to suppose that it is lower for Type I consumers.

So Apple would have two choices: price iPods at the lower value, driven by Type I consumers, or at the higher value of the Type II consumers. So long as there are enough Type I’s out there, the optimal choice will be to set the iPod price at the lower Type I value.

And note how Type II’s feel about this: they are getting a bargain, for they buy the iPod at the value of Type I consumers.

That is what makes Apple want to revisit the song pricing. Remember that as of now we have the songs priced at marginal cost, which means that Apple makes no profit at all from the songs. Now this might be what people believe to be true about iTunes, but I don’t think it is right. Apple might not make a huge amount from the songs itself, but it clearly does not have them priced at marginal cost (67 cents).

In order to capture some of the “consumer surplus” from the Type II consumers, Apple will in fact want to raise the price of songs above marginal cost, thereby making a profit contribution from each song sold. Yes, this reduces the value that every consumer places on the iPods, but because Type I’s are not price sensitive, it does not reduce their value by very much. This means that Apple does not have to reduce the price of iPods by very much, and it ends up getting a lot more revenue and profit contribution from the Type II consumers who buy a lot of music.

OK, that is all fine. Basically we end up pricing songs somewhat above marginal cost (99 cent price versus 67 cent marginal cost) and we still take in a lot of profit from the devices as well. It is not the classic razor/razor blade paradigm, where we give away the razor and instead take in all our revenue from razor blade sales, but that is because the economics of the music industry is different (I think the main difference is in price sensitivity. I will use one blade every couple shaves almost no matter what the price is, but I will vary my music purchases a lot on the basis of song prices.)

Now we get to the punch line on the tying aspects of iTunes/iPods. There are two angles to be discussed. First, note that since we are saying that Apple prices its songs so as to actually make some money off of them, it would not want its device owners to be able to buy songs elsewhere. That would defeat the bundled/tied pricing scheme. And if you don’t think the profit from songs is large enough to make this argument interesting, let’s wait until we start getting videos in a big way. Also, if Apple sells 1 billion songs per year, a contribution of 33 cents per song is $330 million dollars profit contribution – not exactly chopped liver.

But the more interesting tying aspect to the case, and what really ticks off the French, is that iTunes songs cannot be played on other portable devices. What about our pricing scheme makes Apple want to put that restriction in place – especially when allowing other devices would only increase demand for songs?

It is a subtle argument that I want to make, but let me try. The price per song, in the pricing scheme as I have described it, will be above marginal cost of a song, but it would be below the price per song that Apple (or anyone else) would set if it were only selling songs. Apple holds the price of songs below what I might call a “market power only in songs” level because by pricing songs lower, it increases the value of an iPod, and by pricing iPods higher, it extracts value through that channel.

So with the tying of iTunes and iPods together, the price of songs is lower than otherwise would be. But think of the advantage that this gives other manufacturers of portable music devices! The essential complementary product to, say, Sony’s portable music device, the songs, is being priced lower than otherwise would be because Apple is trying to capture revenue through its iPods sales. Well, just as this increases the demand for iPods, it also increases the demand for other portable music devices. So essentially, Apple is subsidizing the demand for competing manufacturer’s products. This does not make sense in even a static sense. And in a dynamic sense, it is only going to contribute to the entry and growth of other portable device manufacturers, and all of that competition is going to destroy the basic pricing model for the package of iTunes and iPods.

To keep this from happening, and capture at least some of the value of its innovation, Apple will want to restrict its iTunes product to use only on iPods.

Is that anticompetitive? Does it restrict entry of other device competitors? Well, I think it depends on your vantage point. Yes, it restricts entry relative to what we would get with the same song pricing and no restriction. But my argument is that if you do away with the bundled iTunes/iPod scheme, you would see even higher prices of songs and probably even less entry.

Interesting economics, if you ask me. The French might not agree – but that is their problem.

Middle East Time Out

There is so much being said on the Israel/Hezbollah/Lebanon front, and much of it quite simple minded and wrong headed, that I am going to give it up for a while. The dice have been rolled, so we can all wait to see how things play out. There will be future events to talk about, that is for sure.

Sunday, August 13, 2006

Misguided Youth Alcohol Policies

Sometimes I cannot believe the irony in New Hampshire's motto, Live Free or Die.

There have been three articles in our local newspaper recently on the local police treatment of teen drinking (at least one of the articles can be found here).

These are not instances where youths under 21 have been drinking and driving. The most recent incident was one where a neighbor kid was walking home and the Hanover police stopped him. When asked if he had been drinking, he innocently but probably foolishly replied yes. Wham -- out came the handcuffs, and he ended up at the station. Now he gets to go through an education program that I suspect will create more ill will and cynicism on his part than anything else.

Another story relates how police broke up a late night high school party out on the Dartmouth golf course and subsequently chased kids all over town. Kids who were caught were allegedly asked to give out names of others who had been present, and those kids were then tracked down.

I think I am going to organize a concerned parents' meeting with the police to find out just what the laws are and how those laws are being interpreted. I know that New Hampshire can arrest teens for "possession by consumption" but can a teen really be forced to take a breathalyzer test, even if not driving? More important, does this community really believe that drug and alcohol problems will be solved by handcuffing and arresting first offenders? Is this how we want our local police to behave?

If my children were found on the streets of Hanover with beer on their breath, I would hope the Hanover police would simply drive them to my house and let me deal with the situation. That would be the first offense, and if they were caught subsequently, I could live with slightly harsher treatment by the police. But the policy now is that if an 18 year-old admits to drinking two cans of beer, she will get handcuffed and arrested. Does this start sounding like a police state or what?

There was a time when I had Libertarian dreams that smoking marijuana in the privacy of one's own home would be legal. Now it appears that I can't even offer my 18 year old daughter a glass of red wine at dinner without risking her ( and I suppose my own) arrest.

Saturday, August 12, 2006

Powerline's Critique of the US/Israeli War Policy

I must say I don’t quite understand the Powerline guys’ rather harsh criticism of the Bush/Rice policy on the Israeli/Hezbollah conflict (see here). They go so far as to say that “It's almost as if Kerry, not Bush, won the 2004 election.” Powerline's concern is over what they think was US pressure in stopping Israel from the ground forces invasion of southern Lebanon.

I think the Bush/Rice policy has actually been quite good – maybe even strategically genius.

A few points to support my position.

1. I usually hate to recognize the middle ground, but in this case it is necessary. There is certainly a continuum with a lot of real estate between two extremes: appeasement, or “protect(ing) Hezbollah from the Israelis” on the one end, and outright war in southern Lebanon on the other. I would certainly not characterize the Bush/Rice policy as anything close to the appeasement policy of Chamberlain in 1938. Indeed, if the British had done to the German Army when it marched across the Rhein, or when Hitler demanded Czechoslovakia in 1938, what the Israelis have done to Hezbollah, the 20th century would certainly have turned out quite different. I would put the Bush/Rice/Israeli policy closer to the outright war end of the spectrum than to the appeasement end.
2. The main question pertains to what Israel’s objectives were and should have been. Powerline seems to think that the only objective was to destroy Hezbollah’s capability. I think this is one valid goal, but only one, and a short term one at that. Hezbollah can easily rebuild military capability once Israel leaves Lebanon, maybe even while it is still there. As I pointed out in my earlier posts, another critical objective of Israel was to create a belief in its opponents’ minds that Israeli reactions to provocations would be unpredictable generally but that there would be a reasonable likelihood that the reaction would be rather irrational and quite aggressive. As one of my Israeli students puts it, the goal is to create the impression of a “mad dog.” I don’t think there is much doubt that Hezbollah, Iran, Syria, and the rest of the world were surprised by Israel’s reaction, and a pause in the attack does not change that calculus. The third goal was to get a true multinational force into southern Lebanon to monitor Hezbollah for the longer term and give the Lebanese government a chance at governing. Now I know there is reason to doubt any UN force, but this will be a large force, supplemented with the regular Lebanese army, and it will have more leeway in action than the previous UN force. If this force does not manage to control Hezbollah in the south, it may end up serving a useful role as hostage. Perhaps the Israelis are thinking like the French General Foch, who was asked before World War I by the British General Wilson what the smallest British force would be that would be of any purpose. Foch replied: One single British soldier – and we will see that he is promptly killed.
3. One has to recognize that at the time of the Israeli delay, world opinion had turned extremely negative, fueled of course by lopsided media coverage. How much further could Israel and the US go militarily, with unavoidable collateral damage to Lebanon, and still achieve the goal of having Lebanon be in a position to control its own destiny? The sympathy for Hezbollah and Lebanon was building to the point where the world's goal would be to simply get Israel out of Lebanon, never mind what was left in place, Hezbollah or other. But look at the masterful ploy that the US and Israel came up with: The invasion is delayed, due to pressure from the US on Israel. Israel ends up still looking strong (a mad dog restrained), and its continued build-up on the border lends credence to that view. The US takes the hit as being "soft", and even gets criticized by people like Powerline. But we gain some goodwill (being "reasonable") at the UN. The combination of the goodwill and the continued and real threat of massive Israeli action gets a UN resolution that is decent for Israel and rather hard on Hezbollah. Plus, Israel still gets three days to move to the Litani River. Who thinks that this outcome is what Hezbollah expected when they captured those Israeli soldiers?

I am extremely impressed by the courageous and strategic policy developed by Bush and Rice. What other US leader would have held as much ground as Bush did in the last month, with the rest of the world simply ganging up against the US and Israel? Does Powerline really think that a Kerry administration would have done the same? Come on, they would have capitulated long ago.

I am not saying that this UN resolution guarantees “peace in our time.” Far from it. But it is a reasonable amount of progress. The test will come in the future months and year as we see if the Lebanese government can exercise authority throughout Lebanon, so that Hezbollah gets marginalized in that it loses its military capability. That will be the real key.

Record Low Temps in NH But Not Worth a Mention's cold up here. 47 degrees outside my house at 6am. Tonight we are forecast to go below the record low for this date, and there are frost warnings further north.

I am so looking forward to all the news reports about the record lows, and to see the weather people pointing out frost on the ground on August 13. I mean, the brief heat wave we had a couple weeks ago that did not even break records occupied the news folks for days on end. Certainly some real record-breaking weather will merit at least a mention, no?

Better keep the cat inside tonight; she just might freeze to death.

Wednesday, August 02, 2006

More Game Theoretic Analysis for the Middle East

One of my favorite classes when teaching my game theory course is on so-called judo economics. The classic example has a small firm entering an incumbent firm's market. Think of a discount airline entering an existing airline's market. The judo arises from the following economics: If the entrant is small, threatening to take only a small part of the incumbent's market, then the incumbent firm will be tempted to not retaliate (cut price) against the new competition, playing instead a strategy of accommodation. The basic tradeoff occurs if retaliation requires some price cut on all of the incumbent firm’s sales; if that is the case, it might be better to just lose a small portion of sales to the entrant rather than cutting price on the entire market.

The mathematical form of the model is great, in that it allows you to calculate just how much of the incumbent firm’s sales the entrant can take and still not induce retaliation. I like to think of the model as showing us “how far you can push someone.” It applies really well to business, but I always try to extend it to general life as well. If someone just bugs me a bit, I might let them get away with it – but when they contest my principles, I will fight back.

So a couple thoughts on applying this to the current Israel/Hezbollah conflict.

First, judo economics requires the entrant (Hezbollah) to not bite off too much, or it will incite retaliation. That some reports have Hezbollah being surprised at Israel’s reaction suggest that Hezbollah went a bit too far.

But it gets even more interesting when you start putting the judo economics ideas into a multiperiod context, where the incumbent (think Israel) is worried about what might happen in future situations if it accommodates in the current situation. There are several game theoretic ways to think about the value of retaliating even when it might not be in your “short run” interest. One approach I really like is the reputation model originally constructed by the “gang of four ” (Kreps, Milgrom, Roberts and Wilson). In this model of reputation, the incumbent will sometimes want to mimic an “irrational” player and retaliate against even a small entrant. The idea is that other potential entrants believe that there are some truly irrational players out there, and if you don’t play irrationally, you remove all doubt in the minds of future entrants and they will act accordingly. (By the way, I think the best reference for the model is Kreps, D., Milgrom, P., Roberts, J., and Wilson, R., "Rational Cooperation in the Finitely Repeated Prisoneers' Dilemma," Journal of Economic Theory 1982.)

I find this a pretty attractive way of thinking of much of what we do in life. I tell my students that as a manager I am often trying to make people think I am crazy, so they won’t think I am going to be a pushover. If you give in once, people know you are not crazy, that you look at the world like the rest of us, and then people can play judo economics against you till the cows come home.

So for the Israeli situation, application of the model is quite straightforward. Certainly when we are dealing with the Middle East, we have to be willing to accept the possibility of truly irrational players (I use irrational pretty broadly here – acting consistent with strongly held religious beliefs would certainly qualify, and I say that without any moral judgment implied). So Israel acted in a way that surprised Hezbollah, who were not expecting a large scale war after what they might have viewed as a relatively minor violation of Israel’s border and the death and kidnapping of small numbers of Israeli soldiers. But now what do future players think about future reactions by Israel to possible future incursions and violations? A bit more fog of war, no? And sometimes, that is just what is required in order to reduce the likelihood of future incidents.

Look Ma, No Links!

OK, I have had several comments about the lack of links in my postings. I have two reactions. First, yes, I should give some references so that readers can check my facts and perhaps dig deeper in someone else's writings. So as soon as my tech consultant shows me the easy way to do links, I will begin.

But second, I must say that I occasionally feel that the blogosphere looks a bit like a big Ponzi scheme...with everyone just linking to one another, and not adding much to the conversation. Not to say that pure linking is not valuable. It is, and I like some sites that just give me access to my usual suspects for news. But at some point, someone has to do some real analysis.

I will have more to say about the lack of real investigative reporting by the classic media soon.