Sunday, April 29, 2012

Pricing an Asteroid

... unless the price of platinum, cobalt, iron and nickel goes down to account for all of the additional minerals on the market.  Via Xan, I came across this description of untold riches buried in the asteroid clouds of space.  The author of the article makes the concession that offloading the platinum on the market at once would crash the world price for platinum, but then offers this gem of a quote:
Of course, there’s a catch. You couldn’t offload all those metals on the world market at once, for fear of crashing their prices. But the company would still own that much in equity, which would allow them to borrow against it. They would be that wealthy, to all intents and purposes. That’s just how capitalism works.
No.  As Xan pointed out, there is no reasonable sense in which the asteroid is actually worth $20 trillion (current market price times current asteroid quantity).  Set aside the issue of whether anyone has $20 trillion to capitalize into an asteroid.  Here are some questions to consider before slapping a $20 trillion price tag on your newly found asteroid:
  1. Who would agree to finance $20 trillion for something that cannot be sold for $20 trillion for fear of crashing the market price?  On the revenue side, the asteroid's value should be the net present value of what the minerals can fetch on the market.  In other words, you need to account for the cost of waiting to sell the minerals (which is a cost), as well as the cost of depressing the price by selling so much platinum.
  2. How much will it cost to extract these minerals and transport them back to Earth?  Surely, this space mineral exploration venture is not zero cost, and these costs should be netted out (again in net present value) in determining the overall value of the enterprise.
These questions are the writer of the article (and anyone else who thinks of this as a $20 trillion company), not Planetary Resources itself unless they've said the silly things mentioned in the article, elsewhere.

The promotional video makes the enterprise seem more sensible.


After all, as far as space mining goes, asteroids make sense because they cost less to mine than planets or moons -- it is easier to dock on an asteroid  than to land on a planet.  The fact that it won't take a lot of fuel partially addresses my Question #2, and there's a lot of talk among the Planetary Resources team about doing this "at lower cost," and "operating more efficiently," which is what it makes this possible.  In sum, I'm looking forward to seeing the "robotic arms" of Planetary Resources hug this asteroid, but it will take the discovery of a lot of platinum-infused asteroids before Planetary Resources is more valuable than Apple is today.

Sunday, April 22, 2012

Speculation: A hypothetical example

Suppose a horrifying hurricane, Hurricane Adam, is barreling toward the metropolitan area of Las Smith, which has one million people, comprised exactly of 250,000 families of four.  In exactly one week, Hurricane Adam will make landfall and wreak unthinkable devastation -- devastation so bad that all one million people have been ordered to evacuate to the nearest safe haven, 200 miles away.  Between now and 7 days from now, they must evacuate or face doom.

To carry out this evacuation, each of the 250,000 families needs to buy enough gasoline to make a 400 mile trip (200 away, 200 back) for a total of 100 million car miles.  Suppose that each car in Las Smith gets 20 miles per gallon.  Hence, the evacuation will require 100 million / 20 = 5 million gallons of gasoline.  For the sake of this post, suppose this is 5 million extra gallons of gasoline beyond what the residents would consume otherwise.

Where does this gasoline come from?  The market provides an answer.

Because of Hurricane Adam, the residents of Las Smith have extra demand for gasoline.  In an overly stylized market for gasoline, an increase in demand raises the price for the product.  At a higher price, everyone has an incentive to conserve (if they can afford to conserve), and some cut back.  In equilibrium, the rest of the market cuts back on gasoline consumption by 5 million gallons, and the residents of Las Smith have gasoline available for their trip.  

Notice another thing: the people who cut back are those who value the gasoline the least.  Turn this on its head: the price goes up and people who value the gas least don't consume it.  It's a simple insight, but one that describes the power of the market to promote efficiency.  Hayek describes this decentralized process in The Use of Knowledge in Society in much greater detail.

For a more interesting application, think about our ability to store and ship gasoline.  In Chicago, I can cut back on my driving today, and my cutting back can make available some gasoline one week from today in Las Smith.  If only there were a mechanism to get me to cut back... This is where speculators come in.  

If the price of gasoline in Chicago does not adjust today, a speculator who buys gas from Chicago today and ships it to Las Smith before next week will be rewarded (technically, you have to cover the shipping costs, but you get the point).  After all, today gas is cheap in Chicago while the residents of Las Smith will pay more.  A profit-seeking speculator will buy gasoline from Chicago today and ship it to Las Smith next week as long as it continues to be profitable.  The very act of buying gas today in Chicago will drive the price up now in Chicago.  On its face, this seems odd, but there is good reason for the price to go up immediately.  The gas is needed less now in Chicago than it is a week from now in Las Smith.  In this story, the speculator moves gas from where it is needed least to where it is needed most.

This description of the gasoline market is stylized -- in reality, there are more than two locations, and more than two time periods -- but hopefully, the simplicity of the example shows what role speculators play in more general settings.  Speculators can make profit when they move the objects of speculation from low demand states to high demand states (that's how they can buy low and sell high).

For much more, including the inspiration for this simple example, check out James Hamilton's excellent post on the matter.  In closing, here's an excerpt:
Here I have a modest suggestion. If Representative Kennedy knows a way to go out and produce another barrel of oil somewhere in the world for $11 a barrel, he would do a world of good if he would actually go out and do it himself, as opposed to simply asserting confidently in the pages of the New York Times that it can be done. People with far more modest fortunes than Kennedy inherited are out there using their resources to try to bring more of the physical product out of the ground. 
And many, many more would be attempting the feat if it were remotely possible to produce a new barrel of oil for anywhere close to $11. 
If you want to prove me wrong, Mr. Kennedy, then don't talk about how easy it is to produce more oil-- just go do it.
In other words, maybe before criticizing speculation, we should all walk a mile in the speculator's shoes.  Not only would we see the difficulty of making money speculating, but we would have a new pair of shoes (and a mile head start).

Friday, April 20, 2012

Holy Bologna: A back of the envelope calculation

I saw this on the Colbert Report last night, so I had to look up the motivation.  Here's an excerpt from a news article on the bust.
This is a prohibited product because it is made from pork and has the potential for introducing foreign animal diseases to the U.S. pork industry, “said Gomez.  
Authorities say Mexican bologna is sometimes resold in other parts of the country at deli counters in small grocery stores that cater to immigrants or on the black market. This batch of baloney was not refrigerated and also could have posed a health risk for consumers.
The man who tried to sneak the baloney across the border in his truck is a 33-year-old resident of Ciudad Juarez, Mexico. He was fined $1,000 and released. The contraband bologna was seized by CBP and destroyed.
When would this meat smuggling be worth it? According to Mary Mervis Deli, the cheapest bologna on the menu is $3.99/pound.  Suppose that's what Mexican bologna could fetch, and guess that the wholesale cost is about $2/pound (so that $2/pound of bologna is revenue - cost).  This time, the guy was busted with approximately 400 pounds of bologna.  

Suppose that he's going to be caught smuggling meat one out of two times.  For each of the successful trip, he makes $800 in excess of costs.  For the unsuccessful trip, he loses $800 in "product" and is fined an additional $1000.  For these three trips, he makes a loss of $1000 (profit =  $800 - $1000 - $800 = -$1000).  So, it wouldn't be worth it if these are the prices and the probabilities.

Moreover, repeat offenses likely come with increasing fines.  Also, it is awfully inconvenient to be arrested, yet I ignored these opportunity costs.  Despite all of these costs, people "regularly" try to smuggle meat across the border.  In practice, this means that meat smuggling must still be worth it.  What does this imply about smuggling meat?  Either the likelihood of getting caught must be lower than 1/2, or this is some high value bologna.

Even in the high value bologna case, fix the one in two chance of getting caught and suppose that the bologna could go for $10/pound, keeping a markup of half of the retail price.  Then, each shipment of 400 pounds could sell for $2000, and the profit would be $2000 - $1000 - $2000 = -$1000.  As you can see, for higher quality goods, a key ingredient to the enforcement policy is destroying the product, but the effectiveness depends on catching the smugglers in the first place.  Given that this is a persistent problem, a 50 percent success rate at catching bologna smugglers is likely too optimistic.

Wednesday, April 18, 2012

Discouragement, Racquetball and Supreme Victory

Cheap Talk links to an interesting theory with empirical content about the discouragement effect:
A new paper by Fu, Lu, and Pan called “Team Contests With Multiple Pairwise Battles” analyzes this kind of competition and shows that they exhibit no discouragement effect.  The intuition is straightforward:  if I win the second match, the additional effort that would have to be spent to win the third match will be spent not by me, but by my teammate.  I internalize the benefits of winning because it increases the chance that my team wins the overall series but I do not internalize the costs of my teammate’s effort in the third match.  This negative externality is actually good for team incentives.

The implied empirical prediction is the following.  Comparing individual matches versus team matches, the probability of a comeback victory conditional on losing the first match will be larger in the team competition.  A second prediction is about the very first match.  Without the discouragement effect, the benefit from winning the first match is smaller.  So there will be less effort in the first match in the team versus individual competition.
The leading example of a squash game resonated with me because I play racquetball twice per week in a group size that ranges from 2 to 5.  If the number of players is odd, we usually start by playing cutthroat.  If the number of players is even, we usually play one-on-one games.  There are other strategic incentives in a cutthroat game, but it can be viewed as a series of three overlapping team games where one team size is 1 (the person serving at the time) and the other is 2 (the other two players).  Should one expect less discouragement in a cutthroat game versus a one-on-one game?  If we can swing the logic of team-shared effort into a match with unbalanced team sizes, the answer would be yes, but there are certainly some details to work out. 

In another vein, our racquetball matches have a weird property in that the discouragement effect seems to be masked by what I'll call the supreme victory effect.  An implicit assumption in the discouragement argument is that winning is all that matters, but if you break this assumption by allowing supreme victories to matter more (say in racquetball games among friends), I'll bet one can get some interesting competitive dynamics.

Sunday, April 15, 2012

Textbooks and Drugs

Greg Mankiw gives his favorite example of competition in his latest column:

Granted, competition is not always good for producers. I produce economics textbooks. I curse the fact that my competitors are constantly putting out new, improved editions that threaten my market share. But knowing that I have to keep up with the Paul Krugmans and the Glenn Hubbards of the world keeps me on my toes. It makes me work harder, benefiting the customers — in this case, students. The upshot is that competition among economics textbooks makes learning the dismal science a bit less dismal.

From my perspective, this is the wrong example for how competition benefits consumers.  To be sure, there are competitive forces in the textbook market, but the textbook market is far from a model of perfect competition.  The textbook market is more like the market for pharmaceuticals, and the analogies run deep.  In case you are unfamiliar, here are the salient features of the textbook market (along with how big pharma marketing is similar): 

  1. Professors -- not students -- make decisions about which textbook to adopt for a class.  From the standpoint of quality of content, this is likely optimal.  After all, the professor knows more about the subject, and should be better positioned to know what constitutes a comprehensive and useful treatment of the material.
    • Professors are like doctors, while students are like patients in the parallel universe that is the market for pharmaceuticals.
  2. Because professors decide on textbook adoption, textbooks are marketed directly to professors.  All else equal, professors care more about the quality of the book than the price (profs don't pay for the book).  The result is that the marketing and competition emphasizes quality, and price just isn't salient -- even though students justifiably care about the price. Students may complain about the expense of the textbook, but students will always complain about something, so profs imperfectly account for student price sensitivity.
    • The market for pharmaceuticals is slightly different, but ends up with the same tension / emphasis on quality rather than price.  Doctors don't care directly about price, but nor do patients (really) because a third party usually heavily subsidizes the cost of the drugs.
  3. There is extensive (maybe excessive) detail advertising of professors.  It does not look like advertising, but rather appears to be "peer review."  If you teach a class that could use a textbook at some university, textbook companies solicit you to review some small part of the textbook (one or two chapters, the table of contents, the book "mission statement").  They even pay profs some small amount to provide feedback, but to solicit feedback, they need to send a trial copy of the book.  There is likely some value to the peer review aspect of this, but a significant component of this is direct-to-professor advertising.
    • This is not unlike how the pharma industry treats doctors -- although doctors probably get better treatment.  To my knowledge, professors are not solicited by gifts like watches or golf clubs (see Table 2 of link).
All of this is to say that there are frictions in the textbook market -- the market is imperfectly competitive.  It is true that imperfect competition is still competition of sorts, but when you're trying to argue for the force of competition to generate outcomes that are greatly beneficial to consumers, it is harder to get on board when your example is a book with a list price of $268 (on sale today for $255 at Amazon!).  For my money, the three-pound can of Kirkland Signature coffee for $14 is a much better illustration of the forces of competition.

Thursday, April 12, 2012

Self-Funded Classes and Protests

Via Daniel Hamermesh at Freakonomics, here's a quote from an interesting article about self-funded classes:
Some faculty members and administrators countered that the students did not understand the plan. They said it would have offered some classes at higher prices, in addition to sections of the same courses at regular prices, simply giving students more options and freeing up space in the less expensive sections of popular classes. One teacher at the college told of one student who offered other students $300 to drop out of a class, so he could get the final credit he needed.
This excerpt reminded me of my first day of Introductory Spanish at Montana State University.  That quarter, there was excess demand for slots in introductory Spanish, so not everyone who wanted to take the class could take it.  One student needed the class to graduate, but did not register in time.  His attempted solution: just after the professor handed out the syllabus, the student interrupted the class, saying "I will pay anyone here $500 to drop the class right now, so I can add it.  I need this class to graduate."  No one in the class took him up on the offer.  After he left, the professor turned to us and said, "I guess everyone wants to be here."

On a separate note, the fact pricing additional course offerings is met with resistance and protest is something that the market design literature -- which is hot research right now -- has recognized, and attempts to address.  When market participants reject prices as a viable allocation mechanism, resources must be allocated in some way.  That's where market design can come in.

Tuesday, April 10, 2012

What I am reading: Threatening Entry

Does the mere threat of entry cause existing companies to price more competitively?  In 2008, Chad Syverson and Austan Goolsbee published a fascinating paper that provides a direct and positive answer to this question.  The paper -- "How do Incumbents Respond to the Threat of Entry?  Evidence from the Major Airlines" -- uses the particular nature of the expansion of Southwest Airlines into regional routes to identify routes where Southwest is more likely to enter in the future.  Here is their abstract:

We examine how incumbents respond to the threat of entry by competitors (as distinct from how they respond to actual entry). We look specifically at passenger airlines, using the evolution of Southwest Airlines’ route network to identify particular routes where the probability of future entry rises abruptly. We find that incumbents cut fares significantly when threatened by Southwest’s entry. Over half of Southwest’s total impact on incumbent fares occurs before Southwest starts flying. These cuts are only on threatened routes, not those out of non-Southwest competing airports. The evidence on whether incumbents are seeking to deter or
accommodate entry is mixed.
How do Syverson and Goolsbee distinguish threatened entry from actual entry?  A figure (screenshot from this link) is useful to see this.

In sum, Syverson and Goolsbee find that Southwest's effect on rival prices, largely takes place prior to Southwest's actual entry when Southwest is merely threatening entry.

Saturday, April 7, 2012

Should this philosophy be applied in economics seminars?

An interesting perspective from the Supreme Court:
"We have a lifetime to go back in chambers and to argue with each other," he said. "They have 30, 40 minutes per side for cases that are important to them and to the country. They should argue. That's a part of the process....I don't like to badger people. These are not children. The court traditionally did not do that. I have been there 20 years. I see no need for all of that. Most of that is in the briefs, and there are a few questions around the edges."
Tip O' The Cap to Ryan for the pointer.