Convergences

Business Talks: Eric Schmidt Gets It Wrong

Google President Eric Schmidt was interviewed for The McKinsey Quarterly. One statement that I found fascinating, because of its utter wrong-headedness, was his embrace of the concept that prices for goods and services should equal their marginal cost:

A rule of economics is that for manufacturing and mature businesses, eventually the price of the good goes to the marginal cost of its production and distribution. Well, in the digital world, for digital goods, the marginal cost of distribution and manufacture is effectively zero or near zero. So, certainly, for that category of goods, it's reasonable to expect that the free model with ancillary branding and revenue opportunities is probably a very good thing.

The concept of marginal cost pricing is useful in abstract analysis and virtually worthless in the real business world. In any enterprise which depends on up-front investment, a category that includes everything except peasants scratching the ground with sticks, marginal cost pricing leads to destruction. Every business, including most emphatically Google itself, schemes night and day to avoid consignment to marginal cost pricing hell.

When pressed, economists always say, "well, we did not really mean it -- everyone knows that the concept of static efficiency with marginal cost pricing is an abstraction with little relevance to business decisions in the real real world." Unfortunately, everyone does not know this -- Eric Schmidt, for one, apparently. But this has real consequences, because it seems to underlie Google's drive to turn all its complements into commodities.

To add to the puzzle, Google has a Chief Economist named Hal Varian, from the University of California at Berkeley, who is a very good and sophisticated thinker. I would be quite surprised if he regards marginal cost pricing as a good thing. If it is, then someone should remind Google that the marginal cost of a click search is almost non-existent, so it should be giving away its services.

For more, and references, see:

William Baumol, Regulation Misled by Misread Theory: Perfect Competition and Competition-Imposed Price Discrimination, AEI (2006)

Solveig Singleton, Is Cheaper Always Better? Misusing the Concept of Marginal Cost in Policy Discussions (July 24, 2008)

James V. DeLong, "Avoiding a Tech Train Wreck," The American (May/June 2008) & "Marginalized," TCS Daily (July 29, 2003)

Business Talks: Rupert Murdoch Gets It Right

Rupert Murdoch is one of the towering figures of business history, and, in keeping with his chosen field of media, an unusually articulate one.

Now 77, Murdoch seems to be feeling a bit valedictory (even as he is probably scheming to add the New York Times to his domain). The Australian Broadcasting Corp. recently broadcast a series of six lectures by Murdoch called A Golden Age of Freedom that are well worth the listening, or reading, since transcripts are available.

The theme:

Rupert Murdoch beholds a period of great transformation that will bring prosperity to billions around the world. This golden age of freedom will unleash a new global middle class. Markets, media and technology will all play their part.

But to reap the rewards we must make some drastic changes. A ballooning welfare state, failing state schools and full reconciliation among all Australians head his list.

Thanks to Coop's Corner.

Property Rights & Markets

The polity seems to be in a mood to delegate economic decisions to government bureaucracies rather than markets. This will not end well, and as authority for this I will plagiarize myself, defending the superiority of a property-based approach in a context not usually thought of as involving property:

The time for this scenario is sometime before 1978. Suppose I am an airline agent for a flight due to leave. It has ninety-nine seats, but we have sold one hundred tickets, so someone must be bumped. I must decide who, and I am charged with making a decision that is just and fair. Clearly this will not be easy. I must interview all one hundred passengers to determine their individual reasons for traveling and decide whose need is least worthy. Some of the passengers may lie to me, so I need to investigate suspicious stories. Perhaps each deserves a chance to investigate all the stories of all the others and to introduce evidence of lying, or to bring in witnesses as to the urgency of his or her journey. We will have hearings! They can hire lawyers! This could take a while, but who can object to delays in the name of Justice? And I am not going anywhere.

Real-life airlines are interested in quick departures more than perfect Justice, so their approach to bumping was more direct. As the agent, I would pick someone and say 'Sorry.' Randomness might seem fair, but there were other considerations. The prosperous-looking woman with the expensive briefcase might complain to the airline president and cost me my job. She was not in the draw for the black ball. The tough-looking gent picking his teeth with a bowie knife might impose other kinds of costs on me personally, so let's not bump him. Airline agents were instructed in the art of choosing victims. Elderly people were regarded as less likely to make trouble, so they were a preferred category. The one certainty was that the chosen sacrifice would be angry. In an effort to avoid inflicting this pain on passengers and on themselves, the airlines tried to underbook, allowing an ample safety margin for no-shows. Often the planes took off with empty seats that could have been filled. This cost the airlines money and raised ticket prices.

The system changed in 1978 through an act of creative government. The Civil Aeronautics Board, acting at the prodding of economist Julian Simon, required airlines to institute a 'voluntary bumping' system. This meant that they were required to offer to pay bumpees. If the airline sells too many seats it offers money to anyone who will give up her seat on the next flight out. If not enough takers appear, the offer is raised until a sufficient number of passengers volunteer. The underlying structure of the deal is that the airline gives each ticketed passenger a property right in his seat, and if it overbooks, it buys this right back at a price satisfactory to the passenger.

The results please everyone. Almost 700,000 passengers profited from a buy-back payment in 1993. By definition, they are happy because they wanted the money more than they wanted the seat on that flight. They were also spared the ignominy of having their fate decided by the whim of airline passenger agents without knowledge of individual needs. All the people not bumped are happy, or would be if they knew of their escape. The airlines are able to increase overbooking, which raises their load factors. This makes their stockholders happy indeed. Fares have gone down, to the joy of the traveling public. Ticket agents do not get grief from bumpees, which improves their lives. Particularly vulnerable people have ceased to be special targets for bumping. No one has claimed damage from the system. The net result is that the new system of making an airline seat into property is an improvement on the old system of random bumping in every possible dimension -- Justice, Economic Efficiency, Political Freedom, and Personal Autonomy -- and it all results from creating a property right. Who, given the choice, would substitute a system where a passenger agent, however capable and earnest, is charged with finding 'Justice'?

James V. DeLong, Property Matters: How Property Rights Are Under Assault -- And Why You Should Care (Free Press, 1997), pp. 49-50.

Dead Business Model Walking (but now it is down to a crawl)

Today's Financial Times has an excellent article by John Gapper, "Who will mourn local newspapers?" He makes the point, indisputable but often ignored, that the institution of the newspaper depended ona  congruence of technologies and economic advantages, that the Internet has superseded the technologies and slain the advantages, and that the local newspaper is a dead institution.

His conclusion:

My working assumption . . . is that consolidation – or, more accurately, eradication – of local newspapers will strengthen the editorial position of the remaining elite: The New York Times, The Wall Street Journal, Bloomberg, the Financial Times etc.

I also assume that this elite will find some way to cover its costs. Here’s hoping, anyway.

The last point is the rub. Newspapers were based on a two-sided business model of selling content to readers and at the same time selling those reader eyeballs to advertisers. At the moment, it is impossible to enforce property rights in content, so it is extremely difficult to think of a model that will cover costs. Without property rights, the creator cannot even monetize its effort via advertising.

Of course, the press has mostly supported things like P2P and attacked all efforts by content creators to defend themselves, so one can watch its destruction without a sense of fairness outraged. Live by the sword, etc.

Live.com

Live.com is replacing Google in my affections as my first-line search choice. Substantively, the searches seem a bit more precise, with fewer extraneous hits near the top of the list. In the long-term, as the volume of noise on the Internet grows super-exponentially (if there is such a concept), excluding becomes as or more important than including.

Also - LIve has great pictures as background, every day a new one. Run your cursor over the picture and various mini-window pop up, with links to information about the site. Today is Wyoming's Devil's Tower.  As I said to a colleague recently, the great thing about the Internet is that it makes procrastination so efficient.

Bail Outs

"Bail out" is a term of many meanings -- bail out of jail; bail out a boat; bail out of an airplane. 

Congress is now adding a new definition -- jumping into a doomed automobile [company]. A $15 billion bail out of Detroit has been agreed to "in principle." But the principles do not include any haircut for the  dealers, the bondholders, the UAW, state and local governments, or any of the other dug-in vested interests that have put the companies into stasis for 30 years, nor any restructuring or serious planning. The best the government will get is an agreement from the companies to consider possibly doing something. Sometime.

At least not all the money will be wasted. GM can continue to be the world's largest private buyer of VIagra. Maybe this is the secret -- drop enough of it into the soup in the Senate cafeteria and the Congressional urge to waste money, a drive stronger than sex, becomes irresistible.

One can make a case for a bail out that takes the form of a bankruptcy with the government then providing Debtor in Possession financing. But this deal gives political corruption a bad name.

My Seconds Will Call on You, Sir!

BitTorrent is back in the news:

The alleged problem: The new transmission method uses a channel currently only employed by a handful of applications, like gaming and VoiP. With P2P traffic flooding that transmission line, users' Skype calls or World of Warcraft sessions could get interrupted amidst the P2P noise . . .

Silicon Valley Insider thinks the ISPs can deal with it by download caps. The Register thinks its war:

The internet evolved as a gentleman’s system in the comfortable confines of the ivory towers of academe, but now that it’s an essential part of daily life for more than a billion people, the time has come to get realistic about its management. Some of the people who use this system are spoiled children with no more concern for the greater good than junkies looking for their next fix. They can’t be allowed to spoil it for the rest of us, and the only practical means to prevent their doing so is to unleash effective management upon them.

Finance: Regulation as a Cause of the Crisis?

Julian Morris (International Policy Network) and Bill Stacey (Lion Rock Institute) have published How Not To Solve a Crisis (Nov. 2008). Given the current level of screaming that the crisis was caused by insufficient regulation, their thesis is worth attention. They think that four types of mis-regulation were crucial:

First, sharply divergent capital rules for banks, security companies and special purpose vehicles (SPV) led to ‘regulatory arbitrage.’ Specifically, by purchasing asset-backed securities through an SPV, banks were able to minimize capital requirements on their balance sheets and thereby increase their return on equity, performing better within capital adequacy rules. . . .

Second, US government sponsored entities, Freddie Mac and Fannie Mae, were required to buy up, securitise, and resell hundreds of billions of dollars of mortgages, with an increasing proportion coming from people on low incomes. . . .

Third, the existence of Federal Deposit insurance and other explicit and implicit government guarantees led to the mispricing of counterparty risk. Under the presumption that certain companies (such as major insurers) would not be allowed to fail, banks and other financial companies bought credit default swaps (CDSs), thereby insuring themselves against the failure of less privileged companies. Moreover, these CDSs, created opportunities to create synthetic credit structures, again purchased through SPVs, that added substantially to leverage in the financial system.

Fourth, governments granted privileged roles to certain ratings agencies, leading to over-reliance on those agencies in determining the risk of ABS, CDOs and other SIVs. [W]e now know that . . . serious errors were made in some ratings models and that liquidity and counterparty risks embedded within these structures were under estimated.

The piece is a useful counter to the assumption that a hysterical competition to create yet more regulatory structures to be gamed by the politically privileged is the road to salvation.