Private Equity and Venture Capital Firms Acting Anti-Competitively?

An interesting story last week suggested that the Justice Department was investigating private equity firms for possible anti-competitive behavior.

Just this last spring, a student of mine at Tuck did an independent study on the incentives and potential for cooperative behavior in the private equity and venture capital arenas. How's that for prescience?

Justice's focus appears to be on private equity firms and their behavior in auctions for companies (by the way, I have a paper with exactly that title: "Auctions of Companies", Economic Inquiry Vol 39 Issue 1 January 2001). Judging from the news reports, the investigation focuses on behavior by the firms that could reduce competition in the auctions and result in lower prices. This reminds me a bit of claims that the major audit firms were not aggressively competing against one another in bidding for audit jobs, since they realized that they were in a repeated game with the same players. Certainly there are good arguments from game theory to suggest that in a repeated context there are numerous strategies that evoke ongoing cooperative behavior and overcome any tendency to the classic "prisoners' dilemma." One strategy that has gotten a lot of play in theory is "tit for tat." In the private equity world, this would mean that if one firm were to bid aggressively for a company in one auction, then in the next auction a competitive private equity firm would bid aggressively just to punish the first firm. Of course, in the Middle East tit-for-tat seems to cause unrelenting cycles of escalating retaliation...

This is also nothing more than an interesting theoretical possibility without any convincing empirical evidence. And the story can be applied to almost every industrial setting where a relatively small number of firms compete with one another in a repeated context. So at this point it sounds like a Justice Dept. fishing trip.

My student and I were more interested in other areas where cooperation would pay. This story goes back to work by John Lott and myself: "Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers," Journal of Financial and Quantitative Analysis, March 1996.

Suppose one venture capital firm has investments in two portfolio companies, which we will call A and B. What if A and B have some competitive fronts, or even more interesting, areas where there are complementarities? Then the venture capitalist should internalize those externalities and make sure that the two firms act so as to maximize their JOINT value rather than maximizing values independent of one another. If the two firms are interacting competitively, then joint value maximization could be contrary to consumer welfare, but if the two firms interact with complementarities, then joint value maximization would enhance consumer welfare.

Or to take it another step, suppose there are two venture capital firms, VC1 and VC2. And suppose that, through the syndication process, each venture capital firm has investments in both of the client firms A and B. Typically in these situations, one VC firm takes the lead investment role in each syndication. So VC1 might be the lead in Firm A and VC2 would be the lead in Firm B. On the surface, since the two VCs would have unequal stakes in the two clients, they would not each have incentives to maximize joint value of A and B. However, if VC1 runs Firm A as to maximize value of A at the loss of value to Firm B, VC2 will suffer. Similarly if VC2 runs B so as to destroy value at client Firm A, then VC1 will suffer. The two VCs might see that they would both be better off if they managed their clients with an eye to joint maximization. As with the private equity firms, any such coordination like this is much more likely to arise if VC1 and VC2 are in repeated syndications.

In 1953, the US government brought suit against 17 investment banking firms (US v. Morgan et al), alleging that they had used the syndication system as a means to perpetuate their coordination in investment banking. The case was lost, with the judge concluding that the defendants had acted independently and that the syndication system had an efficiency role to play.

My prediction is that history will repeat itself. Maybe this time we will be spared the cost of an extensive fishing trip. On the other hand, maybe the guys in Justice agree with me on something: A bad day fishing is better than a good day at work.

The Media Cascading into Falsehoods Once Again?

There are numerous reports in both newspapers and on the radio (I haven't had the TV on, but no doubt it is there too) of an American diplomat who supposedly said on Al Jazeera that the US has been "arrogant and stupid" in Iraq.

The only problem is that the diplomat was speaking in Arabic (good to hear that they can do that!) and Arabic can be tough to translate into English.

So do we think that every media outlet that passes this story on has had their own translator check the accuracy of the translation? Or is everyone just assuming that since someone ran the first story, and then someone else respectable ran the story, that it must be right?

In information cascades, you will frequently have everyone coming to the same wrong conclusion, even when their own private information suggests a different conclusion. The situation above could be a perfect example: a reporter who knows a little Arabic might check the actual words, but if they are not expert, then they will put more weight on the cascade of everyone else saying the original translation was right than on their own opinion. The result? A cascade of the same story, with the same translation.

Record Breaking, and Deadly, Early Snow

An update: A state of emergency in the Buffalo area from the record early snowfall, and tragically, three deaths attributed to the snow. Health care workers had to bring dialysis patients in to the hospital and bring other medical supplies to people who could not get out.

Two Feet of Snow in October!

Ah, how I wish I were in Buffalo today, getting socked by lake effect snow. Brings me right back to home in the good old UP of Michigan. Soon we will be getting some snow in NH as well, but we don't get blizzards out here like we did in the UP. I still remember one snowstorm that stranded hundreds of cars along US 41 for at least a whole day.

By the way, if climate change reduces the severity and frequency of snowstorms like this in the large metropolitan areas of the Northeastern US, do the financial savings and reduced lives lost (how many people die from heart attacks every year shoveling snow?) count as a benefit?

An Admirable Peace Prize

The 2006 Nobel Peace Prize has been awarded to economist Muhammad Yunus and the pioneering microfinance organization, Grameen Bank. This is wonderful. Microfinance is a great institutional innovation that helps get capital, in small amounts, to entrepreneurs who can help eliminate poverty and provide goods and services in developing areas of the world. A good number of Tuck's MBA students are interested in microfinance. While it will be hard to get mainstream capital markets involved in any large way in microfinance, the point of developments like these is that they do not need to be huge to have a significant effect.

Two Papers for the Price of One

I was meeting with a very famous economist last week, lamenting the deterioration in coverage of business news by the Wall Street Journal. My guest said, yes, one of his friends laughs about getting two papers for the price of one with the WSJ: the traditionally conservative opinions on the editorial page, and now increasingly, a liberal slant towards the news in the rest of the paper.

This blog of mine started with my observations of poor reporting in the WSJ's front page story on the British Petroleum "corner" of the US propane market. I will now add another observation to the database, this time from the October 6 edition, an article on the front page entitled,"How Quiet Moves by a Publisher Sway Billions in Drug Spending." Ominously, this is noted as the fourth in a series titled "Health Care Goldmines. Middlemen Strike it Rich." Not off to a very good start with those leading words, are we now?

Since the WSJ online is a subscription service, and I don't have an account, I don't know of any way to link to the article. I apologize for that, but using the title and the author and date you could easily find it.

My apologies to the writer, Barbara Martinez, if I appear a little harsh here.

But this article is one of the more breathless juvenile attempts at creating (not exposing) a business scandal that I have ever seen. I really expect more from what was once the world's leading economics and business newspaper.

The thrust of the story and situation, as best I can fathom, is as follows: One company, First DataBank, has historically collected data on average wholesale prices for pharmaceuticals. These data were used in setting a benchmark that determined what retail pharmacies would be paid by insurers when the pharmacies dispensed drugs to individuals. From the sounds of it, the average wholesale price (AWP) would be used as a base, from which an insurer would tack on a margin to compensate the pharmacy. The higher the AWP, the higher the compensation for the pharmacy,

That is all well and good. The main claim, from a court case in Boston, is that First DataBank was collecting shoddy data -- that in the past several years, only one firm was being surveyed, the drug wholesaler McKesson. A second claim seems to be that First DataBank raised its reported average wholesale price around 2002 -- and since there was not really a valid survey being conducted at the time, any such raise of the reported AWP would be unjustified. The article, by innuendo, attempts to rope McKesson into this business. McKesson would not appear to benefit directly from any increase in the AWP. Its customers, the pharmacies, conceivably could benefit from an increase in AWP that was not actually caused by a real increase in wholesale prices, for the pharmacies would get more compensation but would not be paying more at the wholesale level. I suppose you could say that McKesson would benefit indirectly, if its customers were to benefit. There are no claims anywhere in the article that First DataBank and McKesson were colluding actively to raise AWP. There are some emails reported in the article, including one from some unnamed McKesson manager, saying "that is awesome" about how pharmacies would get higher compensation.

So there are several things that really bug me about this story. The naivete is striking. Here is one example: "Between the manufacturer and the end user stand a variety of middlemen who take their cuts." Standing alone, that may not be too bad. In the context of the article, it shows a view of middlemen as parasites that should be driven out of any college freshman's mind by their introductory economics course. Another example of naivete is a paragraph that attempts to show how pharmacies have been profiting in the last few years. The paragraph mixes stock returns with Walgreen's doubling of net income and ends with "Share prices of the three major PBMs (pharmacy benefit managers) are also sharply up over the past few years." I love to get reports written by students like that; they are so much fun to tear apart. "Sharply up?" Is that some scientific term, "sharply up?" Are they up relative to a relevant index? Up relative to zero?

Another major point of mine is that I think the reporter simply has the whole story wrong. I find it very difficult to believe that contracts of any significance were as reliant on the AWP as the article asserts. It is just very hard to believe that billions of dollars of reimbursement are based on such poor data. The article mentions that AWPs are not taken seriously in the industry, with some referring to AWP as "ain't what's paid." So the data are a joke, but billions of dollars ride on it. If this is true, then THAT is the story! Why would insurers be using such a terrible metric for their reimbursement schemes, a metric that is not only inaccurate but subject to manipulation because only one company is being sampled. Rather than a story on middlemen making profits, we should have a story on stupidity in the insurance and reimbursement industry.

A third point is the needless and slanted language throughout the whole story. I have already pointed out the headline and the title of the series. Here are just a few more juicy quotes:

"For years, a little known unit...played a powerful role...

"The new prices had the effect of fattening the profits...

" Now a tentative legal settlement, reached quietly in a Boston court...

"Even as patients face higher co-payments...many pharmacies and PBMs are prospering...

"Documents ... suggest that McKesson had a key part...

Wow. I am just breathless from the excitement of reading this. A little known unit, playing a powerful role, fattening profits, a quiet settlement, companies prospering while patients pay more, a wholesaler playing a key part...

When is the movie coming out? Will it star Meryl Streep?

Come on, Wall street Journal. I expect bias and slanting on the editorial page, and I love it. But nobody can complain because it is known to be opinion. But to have this kind of reporting on the front page? I expect better.

Raising High before Smiting Down

Last night at Tuck, yours truly was on a panel discussing climate change. It was fun, and we had Professors Richard Howarth and Walter Sinott-Armstrong from "up the street" here as well.

I detect a certain cockiness in some of the climate change scientist crowd, and it infects even the more casual observers of the science. A telltale remark is along the lines of, "Well, 1000 scientists believe it to be right, so how can we argue?" (Now what exactly "it" is that is right is of course very interesting. I said numerous times that I believe some climate change has occurred and that humans are likely responsible for some of it, but people still asked me after what it would take to make me believe...)

So if a 1000 scientists believe a paradigm or theory to be absolutely true, that is the end of the story right?

Just in my short academic career, I can think of three paradigms in economics that have been overturned quite dramatically. At least two of them were characterized before the fall of extreme confidence in the paradigm -- yes, cockiness.

Two examples come from finance. The Capital Asset Pricing Model in the 70s and early 80s was held to be the key to understanding asset pricing, in particular the cross section of stock market returns. It is now dead.

A second related one comes from finance as well -- versions of market efficiency, especially that rational investors determine prices and that any inefficiencies in prices would be quickly eliminated. Now I and others can still argue this one pretty well, but there is no doubt that two decades of empirical studies on stock market pricing anomalies, along with experimental work on behavioral economics and finance, has removed the aura of invincibility around strong forms of market efficiency.

A third one is outside of my area a bit, but a colleague suggested it this morning: the death of structural equation macroeconomic modeling upon the development of the rational expectations critique by Robert Lucas. The Lucas critique effectively brought a whole industry of macro modeling to a stop.

So let's be a little respectful of the scientific process. The beauty of these examples is that knowledge does evolve: that even in a discipline as self-sure as the finance profession, a steady stream of contrary theory and evidence, even when produced by a small set of contrarians (think Richard Thaler of behavior finance), can lead to upheavals in the fundamental structure of theory.

The Opening Salvo in a New Health Care Battle?

I am most intrigued by WalMart's new drug-pricing strategy: $4 per prescription for up to a 30-day supply for a generic version of the drug. The program is being rolled out in Florida, but the company appears to have plans to go nationwide. Right now there are almost 300 drugs available at the $4 rate, covering some of the more common ailments (diabetes, cholesterol, high blood pressure, depression).

Many people are focusing on the "corporate social responsibility” aspects of WalMart's move. Under pressure from commentators for its "poor" treatment of employees (not providing health care for part-time employees, for example), this move certainly will give the company some community goodwill. That is fine. But I suspect there is more to the story than that. And I suspect there is more to this than simply WalMart's ability to cut costs out of the chain of distribution.

What intrigues me the most about this pricing program is precisely that it has the hallmarks of a PROGRAM: it is almost like consumers are enrolled in a WalMart prescription drug insurance plan or program. Many health insurance plans offer similar sorts of prescription drug policies --– for instance, each prescription will cost $5, or $15. But those deals have traditionally only been offered with health insurance, which of course requires a large up front cost. Here is WalMart essentially offering Blue Cross- level prescription drug pricing, but offering it to anyone, including the uninsured, without any subscription price!

The other programmatic aspect of the pricing policy is that all drugs are being offered at the same low price of $4. From WalMart's point of view, that cannot be optimal pricing when you look at it on a drug-by-drug basis. Some drugs have higher marginal costs to WalMart and should be priced higher, again if you were looking at the drugs individually. Clearly, WalMart is viewing this as a package deal, and they must have some research supporting the idea that consumers will value greatly the certainty of the $4 price for any drug.

With more consumers going to WalMart pharmacies, the company will have even more bargaining power with the pharmaceutical manufacturers: the ability to move WalMart-level volume from one manufacturer to another does wonders for the ability to extract price concessions. But the real question is to what extent this represents WalMart taking a shot at the United States' very high-cost health care business model? Maybe as they move beyond just 300 drugs, they will start charging a monthly premium in order to get the $4 per prescription pricing? That starts sounding like an insurance plan, but of course it is really not different from Net Flix' DVD plans or even Amazon's new pricing for shipping (pay an annual amount and get free two day shipping). And what if WalMart decides that it could also start hiring doctors and nurses and providing basic health services? Wouldn'’t that be something? Anyone want to bet that WalMart could provide many health care services at much lower prices than our nearby hospital or doctor’s clinic -- with probably very similar quality?

A Simple Math Question

Here is, I believe, a great math question for any kids in grades 8 or above...in case you have to ever prove the relevance of math to your kids.

So I had a great time today out at my beloved camp on a remote lake in New Hampshire. Unfortunately, the pump in my septic system burned out so I had to get the guys out to replace it. I was there, of course, to oversee the process.

It turned out that because of the tendency towards freezing temperatures in this area, the piping that goes from the septic pump to my leach field would empty back into my pump tank once the pump shut off (which it does automatically, through a float mechanism). Since the leach field is 100 yard from the tank, this is potentially a lot of liquid coming back into the tank after the pump shuts off. One could envision a situation where the pump would be on more or less continuously: the tank would fill, the pump would turn on from a float mechanism, it would pump until the level in the tank went down to a certain point and then shut off, all the liquid in the 100 yards of 2 inch piping would run back into the tank, at which point the pump would turn back on....You can imagine the electricity bill from this endless do-loop, as well as imagine how long the new pump would last under such circumstances.

So two math questions emerged. How much liquid will 100 yards of 2 inch piping hold? (Let's assume that the 2 inches is the internal diameter, not external.) Two, what is the capacity of a pump tank that is 4 feet in diameter and 5 feet tall? And last, if the pump turns off and on in a range of 2 feet vertically, how much liquid will be pumped out in one pumping?

All this should help us figure out if the back draining of the water in the pipe will simply fill the tank enough to turn the pump back on, or if that is an issue we can ignore and go to sleep.

Good math stuff. What I haven't gotten into is the really interesting thing, which is how we used a little logic and a little knowledge of electrical circuits to figure out that there has to be a short somewhere between the house and the pump. Now I get to dig up the cable and find if our theory is true! Ah, the pursuit of truth! I love it.

Business Schools and "Business and Society"

Yes, it has been too long since my last post. Too busy, plus I suppose there has not been that much in the news of late to stimulate me. We did definitely have some record cold the other night in northern New England, and oil and gas prices appear to be starting their predicted decline. But not enough excitement to warrant anyone's time.

Here is an issue, though. It is somewhat close to home, and I generally don't like to write about things that are Tuck School related, but this one does have some generality that makes it OK.

I am Faculty Director of the Allwin Initiative for Corporate Citizenship at the Tuck School. I am currently trying to define just what this Initiative should be and do. It is sort of like a Center, if you know what centers at universities tend to do. But it has lacked clarity in its area of focus and its mission, and I think it has suffered somewhat from taking on a bit too much of an "advocacy" role. If there is one thing I feel strongly about, it is that academic institutions should advocate only for the truth, not for any particular value system. If you look across business schools and even universities, you will see many centers or programs in environmental areas or in corporate social responsibility generally where it is real clear that the institution has taken a stand on what the proper policy of either corporations, individuals, or governments is. That kind of advocacy bothers me. I think we should stand for the pursuit of knowledge and of truth and not much else.

That said, any modern business school has to have some kind of organizational structure that facilitates students and faculty in exploration of issues that, in the language that I find most illuminating, lie at the intersection, or interface, of business and society. The trick is in defining this area, and the activities that the organization will engage in, in ways that are true to the "pursuit of truth" ideal but that also stimulate student, faculty, and broad audience excitement. There can be no doubt that in today's cultural environment, there are many MBA students who want to discuss those issues that fall in the arena known as "corporate social responsibility." The discussion just has to be consistent with our pursuit of knowledge and truth rather than advocacy (if you don't understand the difference, go watch Al Gore's movie...).

So here is some language that I wrote this evening that attempts to define the area of focus for the Allwin Initiative for Corporate Citizenship at Tuck (and yes, the name may not be perfect either). Reaction is welcome.

The Allwin Initiative focuses its attention on the intersection between business and broader society -- where issues of the overall impact of business activity on social welfare, of corporate objectives and responsibility, and of ethics, citizenship, and leadership become paramount . Rather than defining the precise areas where the Initiative will work, we prefer to set the defining characteristics of the areas that are most interesting and relevant for us. These defining characteristics are three-fold: first, the topic should be one that involves a large potential impact on society; two, the topic should be one that is mainstream, in that a typical Tuck MBA student would be likely to encounter such an issue in their career; and third, the issue should involve a situation where laws, regulations, and/or cultural norms are non-existent, poorly defined, or changing. The first two conditions are self-explanatory, but the third needs clarification. We wish to work in areas where the quality of management, leadership and knowledge will make a large difference. At the intersection of business and society, it is those situations where it is unclear what should be done -- what the right course of action is -- that are important to highlight for both Tuck students as a learning experience and for faculty as scholars, for research purposes. When regulations, laws and cultural norms and expectations are lacking in clarity, that is when the value-added from leadership and from knowledge will be greatest.
It will be useful to note just a few specific topics that meet these criteria at this point in time. Part of our desire to state only the defining characteristics rather than particular areas is our belief that the world is always changing, and the topics that are relevant today will not be tomorrow. We should also note that situations of classic market failure – in the formal economics sense – will almost always be of potential interest to us, but that there may be topics that are not clearly classic market failures, but will still be of interest to us. To put it differently, conditions of market failure are sufficient but not necessary to create interest by the Allwin Initiative. Here are four examples of topics that would currently meet our tests for interest and relevance:

1.
The case developed by a certain Tuck professor of a cement factory being constructed in Vietnam. There are issues of environmental damage and cultural damage. Both of these issues could be construed as classical market failures, with the cement factory not being made to bear the cost of damage to the environment and to cultural artifacts and sacred areas. There are also issues related to the exposure of banks and other lenders due to possible liability from future laws and regulations. There are important embedded questions for the plant managers, for the banks and lenders, for non-governmental organizations, and for governments. The issues are common in large scale economic development projects in the developing and developed world and are therefore mainstream.

2.
There has recently been much criticism of WalMart, in regard to its effect on communities; its employment practices; and even its effect on international trade and our relations with China. Questions concerning the impact on broader society of new business practices and organizational forms, like those related to WalMart, are prime fodder for the Allwin Initiative. Note, however, that it is not at all obvious that these issues are ones of classic market failure. They are instead questions on the overall impact of business on broader society that get to the heart of the role of free enterprise and market economies. Note also that the laws, regulations, and customs surrounding the role of "“big box"” retailers are definitely in a state of flux, not just in the US but globally.

3.
• Another traditional topic for an entity like the Allwin Initiative would be the impact of plant closings, perhaps especially when brought on by a merger or acquisition. This is a topic that falls clearly in the realm covered by “corporate social responsibility” as typically defined, and would be of interest to the Allwin Initiative. These issues are definitely mainstream for Tuck students, and there can be no doubt that the laws, regulations and customs around issues of plant closings and employment reductions are in flux.

4.
One last one, and one that we used at Tuck as the theme for the Halpern Lecture on Business Ethics in 2006: the topic of executive compensation. There is a lot of interest of late in this topic, and it is clearly important (with recent academic papers calculating the relatively large fractionof corporate earnings that actually go to compensation for top executives). Laws and regulations concerning executive compensation are also in flux.

We believe that by studying situations like these, from both a student perspective and from a scholarly/faculty perspective -- and in both a traditional academic learning environment as well as a more active, experiential learning environment -- we can add to knowledge and we will be better able to prepare our students to be effective managers and leaders of tomorrow'’s organizations.

The Decline of the Mainstream Media and the Theory of Informational Cascades

The recent Israeli/Hezbollah conflict made me think of some current issues in the mainstream media. While I do think that my game theoretic analysis of this recent conflict was good -- and may end up being right on yet -- it certainly did not answer all my questions. As that conflict went on, additional questions and issues emerged. One that has been written about in the blogosphere a fair amount concerns the way that Hezbollah seemed to control the battlefield of the media. While Israel may have gained some strategic advantage from the conflict (granted that the final outcome is still unclear) I don't think anyone would argue with the view that Hezbollah won the communications war.

So let's put this into a broader context.

And I do want to give the Economist credit for its cover story this past week, "Who Killed the Newspapers?" There was not too much to follow inside the cover, but a few points were made.

Since the onset of the TV (geez, I remember our first black and white!) the newspapers have fought for market share of readers and of advertisers. The recent Internet-based economic changes have further affected the market position of not only newspapers, but the whole "mainstream media," TV and news magazines as well. Richard Posner had a great review article in the Sunday New York Times a while back, laying out very well how the new technology destroys the old economies-of-scale model of the old media business (see here).

The point is that the old business model of the TV news service, newspaper, or news magazine is seriously suffering. They are now seriously losing readers and advertisers to the Internet.

Whether this is the correct response or not, I don't think there can be argument over the proposition that the mainstream media are cutting their investigative journalism budgets. In the face of declining revenues and profits, a natural reaction is to cut the number of reporters.

So we have a situation where the amount of true investigative reporting in the industry, worldwide, has declined. This now sets us up for situations where information cascades and "rational herding" will occur more frequently. Once I explain these, you ask yourself if you do not agree that we are seeing more herding and cascades in the media.

A good link to the theory of informational cascades and herding is by Ivo Welch at Brown, here.

Let me briefly describe the theory. I think informational cascades are the easiest and most illuminating. Suppose you are uncertain about something, say whether a news story is true or not. You have some private information on whether the story is true or not, and so does everybody else. You don't observe other people's information directly, but you do observe how other people behave -- say, whether they choose to pass the story on to other people. If other people only pass on stories that they believe are true, then when you see someone passing on a story, you should rationally infer that their information supported the truth of the story. With fairly reasonable underlying assumptions on the structure of the information, once you observe even two people pass the story on, you will have to rationally assume from that point on that the story is true. You will therefore pass the story on, and now the next person has seen three people act as if the story is true. They will have even more reason to disregard their own information and act just like everyone before them...hence the term informational cascade.

A key point, of course, is that those two people who made the initial decisions to pass the story on could have had bad information (this is all in a world of uncertainty). No matter, once they decide to pass the story on, everyone thereafter will behave in the same way. So we will get a lot of false stories passed on as truthful, and everyone will believe them to be true!

And not to get ahead of ourselves too much, but suppose you know that this is how the world is operating, and you (Hezbollah) decide to be those two people who make the first decisions that everyone else is going to use to infer what is actually going on...

This is the theory of informational cascades. The theory of rational herding is very similar; the term herding refers to the tendency of people to make similar decisions under conditions of uncertainty. Herding can be reinforced by other incentive issues. For example, in the investments world, managers of mutual funds might "herd" not only because they are watching one another, but because their compensation is based on relative performance. If I know what other fund managers are doing in terms of stock picks, then if I mimic that, I cannot go too far astray in my performance.

I think the applications to the media industry are now apparent. With the decline in resources devoted to true investigative reporting, the tendency towards informational cascades and herding are stronger. Nobody really knows what is going on, so when we see someone with some information, we will rationally believe it. I cannot yet present data to support my claim, but my casual observation is that "herding" is more rampant in the media than before. It seems that one story or one fact has much longer and stronger "legs" than ever before. Deaths in Iraq are one example; someone puts out the data on how many were killed, and everyone reports that story. The craziness over Mr. Karr who confessed to killing Jon Benet Ramsey is another good example. Does anyone want to write a paper with me that would create some measure of "herding" for the media and show that it is negatively correlated with the resources devoted to investigative reporting by the mainstream media?

Two further observations. The first is really important, I think. In a world with less investigative reporting by the Fourth Estate, the ability for governments or other organizations and individuals (read Hezbollah, OBL, etc.) to influence people's beliefs is enhanced. I hinted above how someone like Hezbollah could start an informational cascade. Does that story describe pretty well what happened in the recent Lebanese conflict? I think so. Any country that enters into a conflict without a grand strategy of controlling the media is in for a real battle. Israel certainly lost the battle for world opinion, and increasingly, it appears to have done so on the basis of just a couple stories that were exaggerated.

Amazingly, in this new world of technology, we are getting less information being produced, yet more (false) consensus in the world on what is truth, and therefore worse decisions being made.

The second observation related to an earlier post of mine on the tendency for bloggers to simply link to other sites (see here). Bloggers are not yet fully replacing the investigative reporting role of the mainstream media. They (and I) are serving at best an analytic role, trying to opine on the facts that we assume are being collected by others. This is a classic free-riding situation! Who is going to start collecting the information that the old-style reporters used to collect? Discovering the economic model that will support bloggers actually doing more primary data collection will be a challenge, but the potential economic rewards could be huge.

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.

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).

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.

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.

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

Brrrrrr....it'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.

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.