Tuesday, July 30, 2013

Tony Talking Traffic

Paul Krugman complains about traffic and sprawl:
Consider the following thought experiment: you are driving on a road — let’s arbitrarily call it Interstate 91 — and must choose a lane. Traffic is so heavy that you can’t really change lanes thereafter. But there are many bad patches along the road; half of the distance can be covered at 60 miles an hour, but the other half only at 15. 
You might imagine that your average speed is halfway between 15 and 60, but a little thought shows that this isn’t true: your average speed is only 24 miles an hour. Also, the lanes aren’t perfectly correlated: sometimes your lane is going 60 while the next is going 15, sometimes it’s the reverse. Again, you might think that this means you spend equal amounts of time watching the other lane whiz by and whizzing by yourself, but not so: you spend four times as much time watching the other guys race past. 
And this creates intense frustration and anger, a sense that it’s grossly unfair that you are in the wrong lane. This sense persists even though (a) you have worked out the analysis above, and realize that in principle the lanes are equally good or bad and (b) you have in fact been playing leapfrog with the same Boltbus the whole way, so that you know that in fact neither lane is better. No matter; you are angry, frazzled, and late for your family event. (Which you make up for by having a good time, and drinking enough wine that it’s past 9 when you realize that you didn’t post Friday Night Music). 
But it’s a good thing I didn’t ride the train (which for complicated reasons wasn’t an option); after all, that would have diminished my individualism.
Having grown up in Montana (rural), moved to Chicago (urban), and now, moved to Colorado (mixed), I can understand both sides of this debate.

On one hand, the rural side of me knows that it is impossible to find a convenient bus or train route between any two "major" towns in Montana.  For example, if you want to pick up grandma from Billings on your way to see the parents in Helena, and then just send grandma back on a bus or train, here are your options: (a) drive her back - a 3.5 hour journey each way, (b) drive her to Butte and have her take the Greyhound bus - 1 hour of driving each way, a 5 hour bus ride for grandma, (c) no train options available unless you know the conductor on some commercial train, (d) put grandma on a "one-way" flight to Billings, where she'll have to change planes in Denver or Seattle, time in transit ~ 7 hours.

Each of these choices (plane, car, and bus) involve around the same amount of travel time, and none are convenient, but a road trip would actually give us more options.  For example, we could stop for lunch along the way while the closest thing to that on the plane is the complimentary biscotti, and I don't even want to know what's happening on the bus.  I think this is precisely the type of tradeoff that George Will has in mind (and Paul Krugman ridicules).  When it comes to traveling town-to-town, you don't want to be stuck taking the bus or train.  This is a tradeoff that rural Americans (who have few shared town-to-town transit options) understand, but urban Americans take for granted.

Why is the nearest bus in Butte (60 miles away from Helena)?   The route from Helena to Billings was shut down for safety concerns, but it really comes down to profitability.  What about the plane route?  Why are there no direct flights?  There used to be a direct flight, but the airline that offered that flight pulled the plug due to lack of demand.
Even $20,000 to $25,000 in financial help from Helena’s airport failed to tip the flights into profitability, Mercer said. “We were giving them free landing fees, mostly free rent, we spent about $10,000 on marketing and supplemented the costs of ground handling,” he said.
It simply isn't profitable to offer these transportation options in rural areas.

On the other hand, the urban side of me gets Krugman's point.  There is nothing that will suck the life out of you more than being stuck on a truly congested Interstate.  Even worse, if you're driving, you have to pay attention.  If you're taking the train, you avoid the congestion and you can open your laptop to do some work.  It might take the same amount of time to go by train or by car, but train-goers will arrive rested and productive while car-goers will be frazzled.

For certain regions of our country (connected only by congested pipelines, or frequent and harried plane routes), train transit and high-speed rail make a lot of sense.  And, expanding the range of shared-ride options would create value in terms of reduced congestion and happier travelers.  That said, none of these regions are in Montana, so I can understand why people with a rural mindset tend to recoil at the thought of expanding these options (with which they have little experience).

The problem, I think, is that not everyone has a full appreciation for the rural advantages of individualized transit at the same time as having a full appreciation for the urban advantages of shared transit options.  In the end, the debate over sensible public transit options ends up having the tone of ridicule (or condescension) because neither side really understands the other side's perspective.  And, that's a shame because this is a case where both sides have something reasonable to bring to the table.

Thursday, July 25, 2013

A Voting Rule Where Turnout Matters

One of the financial stories I have been following is the leveraged buyout offer of Dell Computer by founder Michael Dell and private equity firm Silver Lake Partners.  Some background from The Economist:
THE fate of one of the world's iconic tech companies is in the balance. On July 24th shareholders of Dell will be asked to vote on a proposed $24.4 billion management buy-out put together by Michael Dell, the company's founder, and Silver Lake, a private-equity firm. If the deal is approved, Dell will slip into the shadows of private ownership, where Mr Dell and his allies are betting they can revive its fortunes. If the transaction is vetoed, the outcome is likely to be a messy stalemate that will deepen Dell’s woes. 
The vote will be a close run thing. Initially due to take place last week, it was postponed by Dell’s board when it became clear that Mr Dell and his supporters needed more votes to carry the day against Carl Icahn, an activist investor, and a bunch of investment firms such as Southeastern Asset Management, who believe that Mr Dell’s offer is too low. Mr Icahn has floated a plan that would involve Dell retaining a stockmarket listing and taking on debt to pay those investors who wish to sell $14 a share for their holdings. He is also proposing to offer a warrant with a strike price of $20, for every four shares held.
There have also been concerns over how large institutional investors like BlackRock and State Street would vote.  If you're interested in learning more, you could spend half a day reading about the intricacies of the deal.

Today's news, however, is more to the point.  Apparently, Michael Dell and Silver Lake delayed the vote on the buyout proposal, but because of their voting rules. Abstaining from voting would count as a "no" vote, and that was going to matter for the outcome of the vote.  To maneuver a change in the voting rules, Dell/Silver Lake sweetened their offer.
Still, the new bid may amount to a nickel-and-dime attempt at changing the goalposts late in what would be one of the largest private equity buyouts in history. The revised offer of $13.75 a share increases Dell's buyout price by approximately 0.7% or $150 million. 
Silver Lake and Michael Dell are asking that along with the increased offer, a special committee conducting Dell's sale agree to revise the merger agreement so absentee votes at the shareholder meeting aren't counted against the takeover consortium. It is reported that about 20% of Dell's shareholders were absent the July 18 vote, creating a roadblock for the private equity buyers.
According to the Wall Street Journal, the fraction of no shows was more like 27% when the buyout group was expecting 10-15% no shows.  Not surprisingly, turnout really matters in elections where you vote "no" if you don't show up.

Monday, July 22, 2013

Smart Pricing: Customer Satisfaction or Competition

In picking up this morning's Wall Street Journal, I was delighted to see an article entitled "How Companies Can Get Smart About Raising Prices," until I read a passage that gets pricing exactly backwards from how pricing is taught in introductory economics:
It's also important to consider which products get a price increase. Think about this: If a food company has vegetables and ice cream in its stable of products, which one should get a price increase? 
The ice cream. Everyone, even people who are financially strapped, needs staples, so it's important not to price them out of reach. On the other hand, indulgences like ice cream, cookies and cosmetics are discretionary purchases, so people tend to be less price-sensitive when they buy them.
So says The Journal: when the time comes to raise prices, companies should raise prices more on goods that people do not need (like ice cream) in order to keep prices low on staples (like veggies).  And, this is obvious.  I mean -- just think about it.

OK.  Let's think about it.  Let's make an assumption that there are two goods in the world: nutrition and treats.  People need nutrition, but they don't really need treats.  Thus, if you raise the price of treats and nutrition by one percent, people will tend to cut back on treats more than they cut back on nutrition.  This is precisely the opposite of the article's claim.

It turns out that researchers have devoted quite a bit of time to understanding how price sensitive are consumers of ice cream and vegetables.  For example, this article from the Journal of Dairy Science estimates the demand for different ice cream categories (bulk ice cream, novelty ice cream, and ice milk/sherbet), and compares to another prominent paper in the literature:
The own-price elasticities from the uncompensated demand ranged from -1.00 for bulk ice cream to -1.28 for ice milk or sherbet to -1.96 for ice cream novelties.  Similar to our study, the own-price elasticities of Maynard and Venkat Narayanan (2002) for ice cream (-1.30), sherbet (-1.43), branded frozen novelties (-2.39), and private label frozen novelties (-1.59) were all elastic and close in magnitude.
Let me translate.  When you raise the price of ice cream by one percent, the quantity of ice cream that consumers want falls by more than one percent regardless of which category of ice cream is considered.  Moreover, fancier varieties of ice cream (i.e., branded frozen novelties) have more price sensitive consumers.

So, ice cream has price sensitive consumers.  How about vegetables?  On this point, here's a post by Matt Yglesias.  The graphic is most interesting, so I'll reproduce it here.

The elasticities on the figure are quite a bit smaller than -1 (my version is blurry, but the Yglesias has a clearer figure).  Notably, fruits and veggies have inelastic demand (ranging from -0.32 to -0.70), which dooms public policy that is designed to get us to eat our fruits and veggies.  That doesn't stop policymakers from trying to subsidize us to eat more fruits and veggies, but it is a difficult course of action.

Back to The Journal's article, the author gets the price sensitivity of consumers to ice cream versus veggies exactly wrong.  And, this isn't rounding error.  If we look at the best estimates of what consumers do, consumers of ice cream are more than three times more price sensitive than consumers of vegetables.

Now, what does this say about optimal pricing for the company that sells only ice cream and vegetables?  Not much, actually.  The elasticities I've reported are aggregate market elasticities.  Firms have another set of considerations to worry about; namely, competition.  If Firm A raises prices, do competing firms do the same?  Are there close competitors in the ice cream market... in the vegetable market?  This depends critically on how well-differentiated the firm's products are from the competition.  

One possibility: the vegetable market is much more competitive than the ice cream market.  I suspect this is true.  This is more casual introspection than reliance on numbers, but it seems to me that brand matters a lot more in the ice cream market than it does for vegetables.  Thus, competition is likely more fierce for consumers of vegetables.  Hence, the company that sells both veggies and ice cream may want to raise prices on ice cream, but not because consumers are more price sensitive to the product category (and hence, will be priced "out of reach" as the article describes), but because the market for staples tends to be more competitive.

If the time comes to raise prices, I might recommend raising prices on veggies (the article's casual conclusion), but my reasoning is dramatically different and points to a key deficiency in the article.  It is the vicious hand of competition - not customer affordability - that makes it unwise to raise prices on vegetables rather than ice cream.  Other firms and how they compete matters a lot, and this is too often overlooked in advice on how to price.

Friday, July 19, 2013

Common Scents: When Bacon Lovers Lobby for Property Rights

Apparently, not everyone loves the smell of bacon.
The trouble began in May, when this city's health department shut down a popular restaurant called Bacon Bacon after neighbors' complaints caused a permit delay. The neighbors' concern: the scent of bacon grease was blowin' in the wind. 
Now bacon lovers have found out, and they're raising a stink. 
Ahead of a permit hearing scheduled for Thursday, nearly 3,000 bacon advocates have signed a petition in support of Bacon Bacon. Phylis Johnson-Silk, who lives around the corner and loves the place, is making signs that say, "Bacon rules!" and "Really? You complained to the cops that you smelled bacon?"
This was from the Wall Street Journal, but there is a related, ungated article at the San Francisco Chronicle (written in May).  An interesting fact from the Chronicle piece:
A neighbor filed a discretionary review appeal a year later. That triggered an automatic hearing before the Planning Commission. Discretionary reviews can be expensive, time consuming and discouraging. In this case, Angelus said he was well aware that the ventilation needed to be upgraded, and he was ready to do it. 
"I need to do that anyway," he said. "I just wasn't going to do it until I knew it was approved." 
But he can't get the permits as long as the discretionary review hangs over the restaurant, so they're at a stalemate. On Friday, Angelus closed the cafe. 
Angelus said the new ventilation system "will totally take care of it," but Patterson said an air "scrubber" would be a better option. He said his client is willing to pay most of the cost of installing the scrubber, roughly $8,000.
The Bacon, Bacon case reminds me of Coase's Jolly Anglers example in The Problem of Social Cost (see pages 14-15).  In a nutshell, as Coase described, the Jolly Anglers were brewing beer as part of their club, but to do so, they had to ventilate their cellar.  This ventilation of the cellar introduced a fowl smell into a neighbor's yard, and the neighbor filed a suit to stop the ventilation.  In the end, the court concluded that the Jolly Anglers had the right to ventilate, essentially bestowing a right over the air (or at least smells introduced to it).  The Jolly Anglers case was in 1890.

Although the two cases are 123 years apart, the Jolly Anglers and Bacon, Bacon are quite similar.  Beyond their common smell-thy-neighbor theme, both cases are about externalities and the assignment of property rights.  In particular, who has the right to the air?  Coase's larger point in the article was that externalities -- such as the "fowl smell of bacon" -- are reciprocal in nature.  It is equally valid for the owner of Bacon, Bacon to cry out that the neighbor's complaint is infringing on his right to do business as it is for the neighbor to complain that the smell of bacon infringes on his right to fresh air.  Both parties have a right, but those rights are in conflict.

In this Coasean context, the Bacon, Bacon protests illustrate how important transaction and enforcement costs are. If it were clear who had the right to the air in the first place (Bacon, Bacon or the neighbor), the issue would have been resolved without a fuss and at lowest cost (that's the Coase Theorem), possibly through installing that $8000 air scrubber.  As it is, imperfect enforcement and the tendency to bend to the will of the Bacon, Bacon lobby implies that Bacon, Bacon protests (plus t-shirts and lobbying) are worth it.

If only the town council could commit to a decision at the outset, Bacon, Bacon would have less of an incentive to make a fuss in the first place.  Nevertheless, given the popularity of bacon, it is hard to imagine that this incentive would completely vanish.  This has been aggravated by fact that this has become a media bonanza, and has proven to be good advertising for Bacon, Bacon.  Now, that's something worth making a fuss.

Friday, July 12, 2013

On Foreclosures, Liens, and Innovating Around Red Tape

I read an interesting article in Wednesday's Wall Street Journal about foreclosures in the Las Vegas real estate market.  Some key points from the article (not sure if the link is paywalled. I'm a new WSJ subscriber):

  • Las Vegas was one of the worst examples of overbuilding in the lead up to the 2008 housing price collapse and foreclosure crisis.  In retrospect, it is no surprise because Las Vegas was overbuilt.  In the wake of the housing price collapse, the severity of the problems in Las Vegas was greater than in other jurisdictions in the United States.
  • In response to subsequent problems (e.g., the robo-signing scandal of 2010), the State of Nevada passed a law (A.B. 284) that targeted foreclosure fraud with aggressive (and ambiguous) language that includes jailing bankers who are not in strict adherence to the law.
  • The result of the law was a steep drop in foreclosures -- an 88% drop in default notices in the first month the law took effect -- but not such a sharp change in the number of properties in default.
  • Although the number of properties in default was about the same, the number of foreclosures for sale drastically decreased.  A large number of houses remained vacant.
The article is interesting in that it goes on to describe how this law has indirectly become a boon for builders and owners of non-foreclosed property.  At the same time, the number of vacant, foreclosed properties on the market was creating problems for neighborhoods and homeowner's associations.  This brings me to the most interesting quote in the article, and the reason for my writing this post:
A lag in foreclosures has had other deleterious effects. Homeowners' associations aren't collecting dues from borrowers who are behind on their mortgages. Some associations have begun taking advantage of their rights to file liens ahead of the bank—and then sell the liens to investors, who pay a few thousand dollars for the right to take control of the home until the bank forecloses. 
Investors buy the liens "in the hopes that the mortgage is going to be lost in la-la-land, and the bank won't foreclose for six months or two years," says Richard Weiss, a real-estate investor who said he has taken ownership of around seven properties. While waiting for the bank to get its act together and foreclose, "you can do whatever you want—put a tenant in there and collect the rent," says Mr. Weiss. 
Investors "know they can rent out these properties and get a cash flow without having to spend much money," says Xenophon Peters, an attorney who represents clients facing foreclosure at the law firm Peters & Associates LLP. He says a few large investors have been buying up hundreds of the liens. The practice is "terrible" but legal, he said. "They're just taking advantage of the law."

In my mind, the terrible part of this situation is that the house is vacant, abandoned, and reducing the neighborhood's value because of an ill-conceived law.  The heroes in this story are the HOAs and investors who have innovated around the law to mitigate some of its adverse effects.

Thursday, July 11, 2013

The Colorado Car Dealership's Dilemma

Thanks to an excellent column in Sunday's Denver Post by Dave Maney, I now know why we did none of our recent car shopping on Sunday.  In Colorado, car dealerships are prohibited from being open on Sundays.  He also offers an interesting explanation for the law:
Car dealers can't open for business on Sundays in Colorado, even though Sunday shopping for everything else is now deeply ingrained in our culture. That's because of Title 12, Article 6, Part 3 of the Colorado Revised Statutes, unabashedly called the "Sunday Closing Law." It says, simply, that you can't have a car dealership open on "the first day of the week commonly called Sunday." Really? Those darn legislators! Is it to keep us all religiously observant and mindful of the Sabbath, or does it help car dealers keep costs down by being open only six days a week?
If you have taken a standard economics class, you'll recognize the basic structure of the game that the car dealers are playing with one another.  It is the prisoner's dilemma!  

To give some numerical context, suppose that two dealers are competing with one another, Mazda and Ford, and that the only margin of competition is whether they choose to be open on Sunday.  Suppose that weekly revenue is $70,000 if both Mazda and Ford are open on Sundays.  If both dealerships are closed on Sunday, they still each make $70,000 per week because car shoppers just adapt to the inconvenience.  However, if one dealership is open on Sunday and the other is closed, that dealership gets all of the business for the day: Open $80,000; Closed $60,000 (note: I'm assuming $10,000 per day in revenue).

Suppose also that each day of being open costs the dealership $5,000.  Then, both Ford and Mazda make $35,000 in weekly profit if they're open on Sundays, but they each make $40,000 in weekly profit if they're closed on Sundays.  On the other hand, if Ford is open on Sunday, but Mazda is closed,  Ford makes a profit of $45,000 ($80K-$35K) while Mazda makes a profit of $30K ($60K-$30K).  Here are the payoffs summarized in a normal form game:

As you can see from the game, Mazda has an incentive to be open if Ford is Open ($35K > $30K) and if Ford is Not Open ($45K > $40K).  The same applies to the Ford dealership.  In the language of game theory, both have a dominant strategy to be open on Sunday.  That is, the Nash equilibrium is (Open, Open) with payoffs of ($35K, $35K), even though both Ford and Mazda would make greater profit if neither dealership were open.  

From the standpoint of the dealerships, there is a strong incentive to steal business from the other dealership by opening on Sunday.  This is a dilemma because if the dealerships could coordinate on not opening on Sunday, both would be better off (at the expense of consumer convenience).  And, what better way to coordinate around closing on Sundays than to pass a law that prohibits being open.

I'd like to close with one observation on the realism of this explanation.  Maney's description acts as if car dealerships have a lot of costs to save by not being open on one day of the week, but as we all know, car salesmen work on commission.  Commission sales means a large fraction of the costs that dealerships are independent of when the dealership is open: it doesn't matter to the dealership's cost (or a salesman's earnings) how much was sold on Sunday versus other days of the week.  

Sure, car dealerships have other costs that depend on being open, but labor costs have to be important to their bottom line.  Given this observation, car dealerships strike me as an odd industry to be motivated enough by cost savings to insert this legal provision into the Colorado code.  On this basis, I would expect not-on-Sunday provisions to be more common among non-commission industries, but in Colorado, this provision is specific to car dealerships.  Perhaps it is the Sabbath that closed Colorado car dealerships after all.

Tuesday, July 9, 2013

A Proposal for Interstate Traffic Enforcement

A thought occurred to me while driving across the country from Chicago to Colorado.  Why do we enforce speed limits using highway patrol officers, anyway?  At the margin, isn't there a better use for police officers?  Let me preface my proposal by saying that it is probably politically untenable, but that doesn't mean it isn't worth thinking about.

Consider an alternative enforcement system where the traffic authority installs cameras at each Interstate access point (onramps and exits), and regularly at 10 mile increments.  These cameras take pictures of license plates and register the time each car passes through each checkpoint, and these locations and times of passthrough are reported to a centralized computer system.  Given this information, the computer can automatically work out an average speed for each increment of Interstate traveled for every car on the Interstate.  

If you get from checkpoint to checkpoint too quickly, you have obviously been speeding, and the computer sends you a ticket in the mail.  No fuss, no ambiguity, no discrimination by any demographic category, and no gaps in enforcement.  It would be clear what is a speeding violation, you would have perfect (or near perfect) enforcement of speeding rules, and as a result, you could never rely on the excuse that others were speeding and weren't caught (alternatively, you could take comfort in the fact that anyone driving faster than you also got caught).  Moreover, the system would allow you to "decriminalize" speeding so to speak.  That is, because it is so cost-effective to police speeding at a near-perfect enforcement rate, the speeding ticket fine could be reduced so as to achieve the desired effect -- consistent adherence to the rules of the road.

Once such a system is installed, there are some other advantages.  For one, you could be more flexible with speed limits than "don't go above 75 miles per hour."  Instead of the standard system, you could actually include a speeding price schedule.  If you want to speed, you'll have to pay for it, and the traffic authority could post prices for speeding just like toll roads post tolls.  

In setting the price schedule, you would obviously want to make it expensive to travel too fast, but then, the speeding issue becomes one of setting prices rather than upping patrols.  For example, between 75 and 85 miles per hour, the speeding fee could simply be paid in money.  Above 85 miles per hour, you might have to start taking points from the driver's driving record.  Either way, the fact that the system allows a plethora of enforcement options is a nice feature.  In this way, adding a little technology could free up patrol resources for other tasks while improving Interstate traffic enforcement.

And, about the startup cost of this system, it might not be so bad.  Colorado already has a license plate toll system for its tollways (and it works quite efficiently), so expanding the idea to the rest of the Interstate highways seems like a minor step.  After all, it is a toll system where the toll depends on the speed you travel.  If other states do not already have similar systems, they could follow Colorado's example.

An additional advantage of such a system is that it would make it easier to police car thefts (as long as thieves take the Interstate for some part of their joy ride), and to track down fugitives.  On this note, I'm sure there would be objections to this proposal by people who value their privacy.  For the system to work, it would have to record who you are (i.e., whose car is registered to whom), where you are traveling and at what time, and how quickly you traveled from point to point.  I'm not a privacy law expert, but there seem to be some principles of privacy at play.

Whether or not it violates the letter of privacy law, my proposal probably would be dead on arrival in any legislative chamber.  Nevertheless, it begs some important questions.  Would you rather have a completely non-discriminatory, but near-perfect enforcement mechanism that knows when and where you take the Interstate?  Or, would you prefer a regime where most people speed, and as a result, traffic police have to pick and choose who they apprehend for traffic violations (potentially on the likelihood of apprehending people for other crimes committed, which might give leeway for demographic profiling)?  

It is not clear to me which system I prefer, but the automatic checkpoint system has some things going for it.

Sunday, July 7, 2013

Zooming in Changes Your Perspective: An Example

When reading Paul Krugman's blog this morning, I was struck by a particularly interesting graph.  This is the rate on a 30-year fixed rate mortgage from the past 12 months, taken from FRED:

Krugman's post is about the terrible taper -- that interest rates on home mortgages have skyrocketed since the Fed has been discussing tapering off its bond purchases.  The key line Krugman offers, "Do you really think that this will have no effect? Really, really?"  Given the graph he presents and his tone, it's hard to argue with this.

As my wife and I took out a home loan during this time, I decided to investigate further -- maybe look at the 15-year rate and write a post about how we were lucky to lock in when we did (just before rates shot up).  When I got to the FRED website, this was what I found to be the default graph for a 30-year fixed mortgage (actually, I looked at the 15-year mortgage first, but decided to pull the 30-year rate to compare with Krugman's post):

Alternatively, if you want to say something about Bush's policies, you could go back to Bush's first inauguration:

Or, if you want to say something about the financial crisis, you could go back to Obama's first inauguration:

Now, I'm not a macroeconomist, but I don't recall what is special about June 2012 to use as a baseline for 30-year mortgage rates.  It seems to me that bond buying, stimulus of all sorts, weak demand, and the like predates June 2012.  From his post, it looks like Krugman picked June 2012 because that's when some commentators began "talking of tapering," but it's not clear to me this is the right baseline.

From any of these alternative timeframes, interest rates today look relatively low.  I'm not sure that putting the rates in historical context does much to refute Krugman's point that the recent increase in rates matters, but at least, it plants the seeds of doubt about the magnitude of the effects we can expect.  In contrast to what your eyes tell you from looking at the first graph, today's rates are not an unprecedented high.  Rather, rates from the past year were an unprecedented low.  This is a case where zooming in changes your perspective.

This all reminds me of an excellent post by Justin Wolfers at Freakonomics, "How to Spot Advocacy in Science: John Taylor Edition."  As John Taylor had a reasonable response to Wolfers, I'm sure Krugman has a reason for his choice as well.

Saturday, July 6, 2013

Remnant Economics: Tales from the Carpet Store

One of the joys of moving into a new home is that you get* to do a lot of shopping.  As a result of our recent move, I'm spending a lot of time in furniture stores, car lots, home goods stores, appliance stores, and today, carpet stores.  To me, one of the great things about doing all of this shopping is that it gives me an opportunity to learn about trades/professions I do not know much about.  So, carpet... flooring... In my adult life, I have never shopped at a carpet store.  What's so interesting about the flooring industry?

As some background, our new house has some newly refinished hardwood floors that we'd like to protect.  We want to keep the hardwood because it looks great, but we want to protect the floors while bringing some warmth and texture into the room.  I'm no interior designer, but I'd say that calls for some nice rugs.  My wife Shanna agrees, and that reassures me because she reads a lot about this stuff.

But, this isn't an interior design post about which rugs to buy.  This is a post about some interesting economics in the carpet/rug industry.

When you go shopping for an 8' by 10' rug, you're talking about spending $500 if the sale is good.  Good quality rugs can be expensive.  If you're a savvy shopper, you might consider the alternative of going to a carpet store, buying an 8' by 10' patch of carpet, and having them finish the edges to custom-make yourself a rug.  The carpet stores we tried will do this, but unfortunately, if you pick decent quality carpet, that's going to get expensive too.  When we priced it out, it was slightly more expensive to pick a new decent-looking carpet to finish into a rug.  From a pricing standpoint, this makes sense: Finishing your own rug gives you freedom to pick exactly the fabric you want while picking a rug from the rack or from a catalog will typically restrict your options to what is available.  The carpet factories know this, and they've set their prices accordingly.

Buried in the back of most carpet stores, there's a third option.  Remnants!  Remnants are pre-cut patches of carpet that are not big enough to carpet a room (and thus, would not work for a standard carpeting job), but they are big enough for most standard sized rugs.  It turns out that carpet factories end up with a lot of remnants when they fill orders of odd sizes (e.g., 180 feet of carpet when a roll is 190 feet).  Thus, they end up with scraps, which they roll up, cover in shrink wrap, and throw into the remnant bin.  When the remnant bin gets full, they call up carpet outlet stores and offer them a screamin' deal to take the remnants off of their hands.

Because the remnants are just the right size to make standard rugs, the result of these carpet factory leftovers is the opportunity for some discount rug shopping.  The remnants are often a mixed bag, but there is some high quality carpet available.  It should be no surprise that we took this hidden third option.  In the end, we purchased a remnant that was big enough to make an 8' by 10' rug for our living room as well as a standard-sized runner for the kitchen.  If we shopped in the front of the store, this would have cost us nearly $750, but because we used a remnant, we paid just over half that price.

I'm still digesting this interesting market structure myself, but the existence of high-quality remnants lends itself to an interesting question: Wouldn't it be profitable for the carpet factory to intentionally create a lot of remnants so as to engage in price discrimination?  The sales pitch is that these remnants are low value to the carpet factory once they've been cut, so they're offered as a discount, but an equally-good explanation for the existence of remnants is that the carpet factory intentionally made them instead of making them into rugs so that they could target just the right consumers for discounts.  Either way, we're happy consumers.

*Some people might prefer to use the word "have," but I actually enjoy shopping in unfamiliar stores.

Thursday, July 4, 2013

Happy Fourth of July

Happy Independence Day, America!

For a glimpse into what I did today to celebrate our nation's independence, here's a picture:

Yes, that's a line -- actually two adjacent lines.  Everyone in the line is waiting for "free" pancakes at the annual 4th of July Superior Colorado Pancake Festival.  

Given that this is an economics blog, I could go on about how the pancakes weren't really free because I had to wait in line, but we had a great time at the festival, and a big part of that fun was people-watching and listening to music while waiting in line for pancakes.  Moreover, it seemed like the whole town of Superior showed up.  A great time was had by all!

Wednesday, July 3, 2013

An Addendum: Framing and the Upsell

In my writeup about our new car negotiation process, I stuck primarily to discussing the choices that we made.  I alluded to some of the tactics that car dealerships use on their side of the negotiation table, but I didn't belabor or bemoan these tactics, mostly because I figure that they are well understood.  

Here's a simple observation to put car price negotiation in perspective.  Most people buy cars infrequently, and hence have little experience when it comes to negotiation.  Car dealerships do it all the time, every day, repeatedly, and their livelihood depends on it.  As such, they have car price negotiation down to a science.  If it is a dealership that has been around for a while, you can expect them to be very good at it.  In other words, my previous post isn't so much about bamboozling the car dealership as it is about making sure that you are not bamboozled... too much.

A corollary to the "car dealers are good at negotiating" theorem is that it pays to look closely at their tactics.  In our negotiations, I noticed more tactics than I could recount in one blog post, and I'm sure they slipped even more by me, but one tactic stood out as particularly effective.

After you've hammered out the final price, financing terms, monthly payment, etc., it is time to sit down with the finance guy.  Make no mistake.  He's a salesman too, and this is part of the game - to sell you on something that you really shouldn't be buying in the first place.  In our case, he was selling extended warranties and service plans for the car.  In broad brush terms, here's the choice he presented us.

Premium: Seven-year bumper-to-bumper warranty, Supreme maintenance plan, Chip coating the car, gap insurance, window tinting, Ultimate Protection Plan (in case supreme maintenance isn't enough), and some other option I'm forgetting.
Almost Premium: Seven-year bumper-to-bumper warranty,  Supreme maintenance plan, Chip coating the car, Ultimate Protection Plan (in case supreme maintenance isn't enough), and some other option I'm forgetting.
Less Than Premium: Seven-year bumper-to-bumper warranty, Supreme maintenance plan, and Ultimate Protection Plan.
Not Premium, but Good: Seven-year bumper-to-bumper warranty, and Supreme maintenance plan

In addition, he added that we could create our own package by selecting any of the programs in the Premium list individually.  He admitted that not all options are for everyone.  He even got the chance to say, "I couldn't sleep at night if I sold you gap insurance.  It's just not a good deal for you."  The remaining options must have passed his filter, so they must be good, right?  Not exactly.  To see what goes wrong, here's how I could frame the same choice over options and add-ons.

Standard. Five-year 60,000 mile drivetrain warranty, Five-year 60,000 roadside assistance, and three-year 60,000 mile bumper-to-bumper warranty.
Upgrade.  Five-year 60,000 mile drivetrain warranty, Five-year 60,000 roadside assistance, seven-year bumper-to-bumper warranty, and pre-paid oil/other fluids changes (this is the Supreme maintenance plan).
Primo Upgrade. Everything in Upgrade, plus whatever features you want to add on.

My "Upgrade" option is exactly the same package as the dealership's "Not Premium, but Good" option.  The dealership's framing is carefully orchestrated to sell extended warranties to people who haven't given it much thought.  The dealership is wielding two behavioral economic tricks in this framing: they order the choices and present us with irrelevant options.  By presenting us with options and extravagances we don't need first and then working down to a "slight" upgrade, the dealership is putting the extended warranty and service plan in the context of all of the other options we could add.  In this context, the warranty looks attractive.

On the other hand, in context of the coverage we already have, the upgrade doesn't look especially attractive, especially when it costs 15-20 percent of the full price of the car.  Context matters a lot.  It is no wonder that the salesman didn't include the Standard package explicitly in the list of packages to present to us.

If I didn't appreciate the behavioral economics behind it, I would just think this practice is downright shady.  To be clear, I still think it is shady, but at least it gives me an example of how context can matter for economic choices.