October 29, 2009

Predatory pricing


Greg Mankiw's blog directs us to one interesting article by the New York Times about how the American Booksellers Association is accusing Amazon, Wal-Mart. and Target of predatory pricing:

"In [a] letter [to the Justice Department] dated Thursday, the association argues that steep discounting on 10 hardcover titles by authors including John Grisham, Stephen King and Barbara Kingsolver “is damaging to the book industry and harmful to consumers."

Initially you would think that price competition is good for consumers--it brings down the price and so increases the welfare of the society as a whole. Not good for the losing companies though. If a firm can't take the heat, then that means they're not as efficient as the winning firms, and so society is better off that they're out of the market. In the end, everyone's happy--the remaining firms are efficient in producing goods, the consumers are satisfied with the low prices.

But then again, the problem comes in when winning firms are charging prices that would make them lose profits. Doing so, anyone can think that these firms are just charging this low just to push smaller competitors out of the market. When the dust is settled, and the firm with the lowest price is the one remaining, he can practice monopoly power and then charge higher prices. How can the consumers complain--only one firm is remaining and the firm can charge whatever it wants. And this is what you call predatory pricing.

This is what they meant when you start to question: "Hey prices are going lower and lower, and low prices are what consumers want. So how can they say this behavior is harmful to consumers?" The answer is, it may be good in the short term, but it's not in the longer term. And when that time comes when there's only a monopoly remaining, it may be hard for new entrants to come in because the monopoly might again revert back to its practice of predatory pricing to drive out the new player. So, better avoid that situation and let the government make a stand that such behavior will not be tolerated.

So in sum, it may be good for consumers to have a price war, but it is only up to the point where one firm or three will start doing some predatory pricing. And it can be easy to determine if indeed some firms are practicing predatory pricing--the burden is with the other firms to prove that the prices charged by winning firms are below profit levels. And I think the American Booksellers have established that already. It's exciting to look forward now to what will happen to Amazon, Wal-Mart, and Target in this case.

October 27, 2009

Honoring John R. Meyer


John Robert Meyer of Harvard University, who is considered to be the father of transportation economics, died on October 20, 2009. His life's research included transportation issues, studies of market evaluations of corporate equities and their relationship to debt structures, capital write-offs, takeover defenses, cash flow, and information asymmetries.

Here is an excellent tribute by Economix's Edward L. Glaeser.

October 22, 2009

Holiday cheers... or not


Well, since that part of the year when most holidays are occuring are near, I thought I'd share this enlightening article from the Economist:

"Employees in European countries tend to have a better deal than most, enjoying more days off work than their counterparts in Asia or America. Workers in Finland, France and Brazil have the most generous statutory allowance, getting 30 days of holiday every year. Americans work longer hours: theirs is the only rich country that does not give any statutory paid holiday. (In practice, most workers get around 15 days off.) This work ethic may in turn help to explain Americans' material wealth. Even adjusting for purchasing-power parity, America generates more wealth per person than all but a handful of mainly oil-rich economies such as Norway."

Basically, what the article is saying is that it seems the less holidays a country has, the richer the country is (the Economist webpage has an excellent graph). I mean, when I noticed that there's not much holidays here in the U.S. and there's a ton in the Philippines (the Philippine president can declare a holiday--even only a week in advance), I suspect that's there's a correlation somewhere.

It could be more intuitive than you would initially thought. I mean, there is really a trade-off--a day of holiday is a day without production. Thus decreasing the overall GDP for the year. Go figure.

October 20, 2009

Altruism in Game Theory


Most if not all microeconomic models assume that individuals only care about what increases their utility. In fact, this notion goes back to Adam Smith, who believes that it is individuals' self-interests that keep the economy going. Even the most recent evidence on altruism, an exception to the notion of the self-interested homo economicus, show that altruistic people are not really motivated by generosity per se. According to a paper by Matthew Rabin of University of California-Berkeley, people who seemed to be altruistic are so only to altruistic people; they are similarly motivated to hurt people who hurt them. This concept of "fairness equilibrium" is the revolutionary concept that is introduced by Rabin into game theory:

"People like to help those who are helping them, and to hurt those who are hurting them. Outcomes reflecting such motivations are called fairness equilibria. Outcomes are mutual-max when each person maximizes the other's material payoffs, and mutual-min when each person minimizes the other's payoffs. It is shown that every mutual-max or mutual-min Nash equilibrium is a fariness equilibrium."

In other words, for Rabin:

"If somebody is being nice to you, fairness dictates that you be nice to him. If somebody is being mean to you, fairness allows--and vindictiveness dictates--that you be mean to him."

Rabin's revolutionary idea comes into play when he contends that people are willing to sacrifice their own material well-being to either help those who are kind or hurt those who are unkind, and that these two stylized facts have greater effect on individual's behavior because as it will turn out, the material cost of such sacrifices becomes smaller.

The implications of Rabin's study are similarly interesting. His ideas create issues that do not arise in the simple two-person, normal-form, complete-information games. The implications are more complex if an individual is given the choice of helping everybody or hurting everybody. A classic example that Rabin discussed is how much an individual will contribute to a public good--should she contribute to reward those who have contributed, or should she not contribute to punish those who have not contributed? Another interesting implication is if we extend the idea to sequential games. In particular, fairness equilibrium may change the motivations of players at a certain stage of the game: a first-mover may choose some action that will compel another player to regard him positively (or negatively).

Rabin's idea could help explain why if you and your wife are facing a prisoners' dillema and you're willing to sacrifice yourself by not squealing. It's the same reason why your wife will not squeal also. Therefore, we find another Nash equilibrium different from the standard Nash equilibrium solution to the prisoners' dilemma game: both prisoners are better off squealing.

Reference:
Matthew Rabin. 1993. "Incorporating fairness into game theory and economics." American Economic Review 63(5):1281-302.

October 19, 2009

Truman and the Economists


I just want to share a little anecdote here. Late President Harry S. Truman (1884-1972) is not only considered one of the greatest U.S. presidents, but he is also one of the most well-celebrated natives of Missouri. The Univeristy of Missouri mascot is even named after him--Truman the Tiger. Us economists, on the other hand, are famous for making different assumptions before arriving at a conclusion. Economists are famous for popularizing the terms "ceteris paribus," and it's no surprise that the different schools of thought that plague economics since Adam Smith arise because each school is based on differing assumptions.

So what does President Truman and economists have in common? Well, none actually. In fact, President Truman's not too excited about economists, as the following quotation that he immortalized shows:

"Give me a one-handed economist! All my economists say, 'on the one hand...on the other'."


Well, what can economists say? For economists, economic outcomes is predictable only if you make certain assumptions. But of course, you can't help but emphatize with him. Can't wait for that day when there's only one school of economics and that we don't need to give different outcomes based on different assumptions in answering every economic questions.

October 13, 2009

Managing Transactions


Just to give you a background on economic governance, which is the body of work for which Professors Ostrom and Williamson are awarded the Nobel prize of economics, the following are taken from the fast readdocument that can be accessed from the Nobelprize.org website, written by its Editor-in-Chief, Adam Smith (cool name):

"The 2009 Sveriges Riksbank Prize for Economic Sciences is concerned with the basic question of where best to conduct transactions; in the open market, within firms, or among self-regulating groups of individuals."

For Professor Ostrom, it is self-regulating groups of individuals on the subject of the infamous common good:

"Elinor Ostrom has made extensive studies of the management of common property by groups of common owners, contrasting that with management by state or private institutions. Perhaps surprisingly, she has found that those with a vested interest in the resources they manage are frequently better at regulating those resources than publicly-appointed management bodies would be. Her research reveals that in many, but not all, cases, allowing users to develop their own rules to regulate the use of common property results in the most efficient solution for managing those resources... In short, self-governance can be successful."

User participation in governing public projects is not a new thing. Lately, it has been one of the blueprints of developing agencies when they lend money to governments to fund public projects (I should know--I came from the Asian Development Bank). And this is because they want end-users to get a great sense of ownership on these projects. But what sets Professor Ostrom's work apart is that for her, there is more participation for the end-users:

"[Ostrom's] principles are in stark contrast to the common view that monitoring and sanctioning are the responsibility of the state and should be conducted by public employees."

It is quite unusual that Prof. Ostrom won the Nobel Prize in Economics, and it is not just because she's the first woman to be awarded the prize. It is also because she's really not an economist; she's a political scientist. And that could probably be the reason why her huge contribution is really not theoretic, but empirical:

"Her work incorporates both case studies of numerous real-life examples and laboratory experiments testing the ways people interact. The experiments reveal that people seem more willing to regulate others' behaviour than predicted, and also that the development of efficient rules for regulation depends critically on good communication between the people involved."

If you want the theory, we now turn to the other winner, Professor Williamson. For him, some transactions are better conducted within firms:

"Oliver Williamson's work deals with understanding the limits of the firm. He has extended the theories of why certain transactions can be accomplished more efficiently within firms than they would by competition between firms or individuals."

The first way to understand Williamson's contribution is to think that transactions may not be efficient in the market:

"[N]egotiations have to continue until both parties agree, haggling costs can be substantial, and there is no guarantee that the final agreement will be either immediate or efficient."

Williamson argued that firms can be s oltion as they provide a cheaper way to resolve conflicts:

"[H]is theories predict that hierarchical organizations are better places to conduct transactions, such as the sale of coal for power plants, wherever there is either significant complexity or mutual interdependence underlying the transaction. The results of his analysis have significant implications for public policy, including the regulation of competition, since what at first sight might seem an apparently imperfect market may in fact be the most efficient way of regulating a particular set of transactions."

But this does not also suggest that all transactions should be done within a firm; they're also not perfect: executive authority of firms can also be abused. Also, some recent trends point out that transactions are better handled outside the firm: outsourcing is one perfect example:

"Williamson's theories extend previous work on the limits of the firm's efficiency, by Ronald Coase among others, to a level at which empirical testing of predictions becomes possible."

Nevertheless, Williamson categorized when are firms appropriate--it is when transactions are complex or non-standard, parties are mutually dependent, and assets are relationship-specific. But Williamson warns that if government tries to come in and regulate in this case, policies should be careful not to limit the size of corporations.

In conclusion, Williamson's message is simple and clear:

"Large private corporations exist primarily because they are efficient. They are established because they make owners, workers, suppliers, and customers better off than they would be under alternatie institutional arrangements. When corporations fail to deliver efficiency gains, their existence will be called in question."

October 12, 2009

2009 Nobel Prize for Economics




Copyright Indiana University and UC-Berkeley


Wow, history is made today when the Nobel Prize for Economics for this year was awarded to a woman, the first one in the Prize's 40-year history. Professor Elinor Ostrom, a professor of political science at Indiana University was awarded the prize "for her analysis of economic governance, expecially the commons." She shares the prize with another American economist, Professor Oliver Williamson. Williamson is awarded the prize "for his analysis of economic governance, expecially the boundaries of the firm." And about time too. Williamson is a great influence of mine, particularly on his work on institutional economics. He has contributed much on the economics of transactions cost, and so this prize is well-deserved.

According the Nobel website:

"Elinor Ostrom has demonstrated how common property can be successfully managed by user associations. Oliver Williamson has developed a theory where business firms serve as structures for conflict resolution. Over the last three decades these seminal contributions have advanced economic governance research from the fringe to the forefront of scientific attention."

For more information on their work, check out the Nobel website.

Congratulations, Professor Ostrom and Professor Williamson!

Their Nobel lectures will be held on December 18 at Stockholm University.