Economists Do It With Models

Well kids, it’s that time of year where I am working to finish a book draft when I should be on the beach somewhere. What this means for you is that you get to be the guinea pigs for my musings on the music industry to some degree. (The book is about the economics of the music industry.) So here’s how this is going to work: I’m going to give you an excerpt that I think will be interesting to you, and you can warn me if it bored you to death instead. You can also tell me if you think of any stories that you’ve come across that might belong in such a book.

This excerpt is about contracting and how even successful organizations seem to be pretty bad at it sometimes:

In his memoir The Soundtrack of My Life, record executive and founder of Arista Records Clive Davis ruminates on, among other things, the perverse incentives that poorly thought-out contracts can create. As part of Arista’s growth strategy, Davis decided to partner with L.A. Reid and Kenny “Babyface” Edmonds as well as Sean “Puffy” Combs in order to diversify its capabilities and reach new markets. As per the emphasis of Arista’s parent company, Bertelsmann, on internal growth as opposed to acquisitions, Davis decided to support Reid and Edmonds by bankrolling their LaFace Records as a joint venture rather than waiting to see if the label succeeded and then acquiring it at a potentially high multiple of earnings or true value later. Similarly, Davis worked with Combs in a joint-venture fashion to found what would be called Bad Boy Records.

Davis was soon dismayed to learn, however, that the start-up costs for these joint ventures were coming out of his personal equity interest in Arista (such that the inevitable start-up losses were being charged to him), whereas the cost of an acquisition would have come out of the organization’s coffers more generally. Specifically, Davis was essentially financing the joint ventures himself but wasn’t the only beneficiary of the eventual upside, and, as a result, Davis had actually been given a disincentive to behave in a way that was in line with the overall company’s goals and values. Given that Davis was the primary decision maker in these matters, Bertelsmann was very fortunate that Davis wasn’t mindful of this part of his contract until after the joint ventures were already underway. (I suppose the implicit management lesson is that, if you’re going to put perverse incentives in a contract, try to make it so the other party doesn’t notice!)

To the parent organization’s credit, it eventually listened to Davis’ reasoning and agreed to change the contract structure to provide proper incentives, but not without more than a little pushback and a trip to Germany on Davis’ part. It’s truly surprising, sometimes, how much of a discrepancy there can be between the stated goals of an organization and the outcomes that these same companies are willing to pay for.

In case you’re curious, the memoir overall reads a bit like a laundry list of all the artists that Clive has signed over the years (though you’ve probably heard of him most with regard to Whitney Houston), but I’m finding it quite interesting for two (nerdy) reasons. First, Davis talks enough about the workings of the industry that it becomes pretty clear what the role of a record label was (I hesitate to say “is” for various reasons), especially where it comes to matching artists with songs. I already knew that this happened a lot in the pop music world, but it was interesting to see how much of that went on in rock, country, etc. (Sidenote: How many of you knew that Elton John hasn’t written his own lyrics in, like ever? As an economist, I applaud the use of efficient division of labor in such cases.) Second, it’s kind of eye-opening to be smacked in the face with how central recorded music was to the profits of the music industry- there’s a passage in the book, for example, where Davis describes Sarah McLachlan’s touring strategy as a way to grow a fan base and make money, and it’s written with a tone of “oh, isn’t that quaint,” whereas now that is the lifeblood of the majority of music careers.

It would also figure that I learned the detailed history of Biggie versus Tupac from an old white guy with a degree from Harvard Law School. Street cred, right there, ladies and gentlemen.

So, it’s that time of year again, when, as a complement to June wedding season, the media is inundating its readers with stories related to marriage. (Yes, those were all different links, and that’s just a small sample from one source.) I usually don’t pay much attention (get married, don’t get married, invite whomever you want, it’s really none of my business), but there was one article that caught my eye for more than a second, entitled “Diamonds Are A Sham And It’s Time We Stop Getting Engaged With Them”. Now, I am certainly not entirely unfamiliar with the DeBeers diamond monopoly (I read a case on it as part of an MBA course that was part of my grad program, so I’m obviously a total expert), and I know why monopolies are economically inefficient, but I was unaware that it was also DeBeers who convinced men (and, by extension, women) that diamond engagement rings were necessary:

Until the mid 20th century, diamond engagement rings were a small and dying industry in America. Nor had the concept really taken hold in Europe. Moreover, with Europe on the verge of war, it didn’t seem like a promising place to invest.

Not surprisingly, the American market for diamond engagement rings began to shrink during the Great Depression. Sales volume declined and the buyers that remained purchased increasingly smaller stones. But the US market for engagement rings was still 75% of De Beers’ sales. If De Beers was going to grow, it had to reverse the trend.

And so, in 1938, De Beers turned to Madison Avenue for help. They hired Gerold Lauck and the N. W. Ayer advertising agency, who commissioned a study with some astute observations. Men were the key to the market:

Since “young men buy over 90% of all engagement rings” it would be crucial to inculcate in them the idea that diamonds were a gift of love: the larger and finer the diamond, the greater the expression of love. Similarly, young women had to be encouraged to view diamonds as an integral part of any romantic courtship.

And so on. The whole article is pretty interesting, particularly the part that explains why high retail markups and the prevalence of non-investment-grade diamonds make for a crappy resale market for diamonds. (This is particularly important information for potential diamond purchasers, since I’m guessing that the jeweler isn’t going to warn you about the lack of resale value during the sales process- if anything, he’s likely to tell you the opposite. Also, this information totally blows holes in my previously held belief that men were supposed to spend a lot of money on engagement rings so that the woman could sell the ring and support herself for a while if the guy broke off the engagement.)

As a nice reminder that monopolies and anticompetitive behavior generally aren’t welcomed in the United States, DeBeers is currently sending out checks to compensate people who overpaid for diamonds because of DeBeers’ monopoly power, as per the outcome of a 2008 class-action lawsuit. (Note, however, that the dollar amount of the checks- some as small as $48- probably doesn’t cover the full amount of the monopoly markup.) And you wonder why I joke that someday I want to receive an engagement car (not for store of value reasons so much as usefulness reasons, obviously)…and you have to admit that you can see the ad men for Lexus totally jumping on that bandwagon.

As is the usual for this site, I try to look around for appropriate cartoons, videos, etc. to go with the topics…I poked around a bit, and I think that this is the most appropriate option for an economics-y audience:

As an added bonus, if the diamond example ever gets old in your class, here are 6 other monopoly examples you likely haven’t considered using. I have to admit that I’m quite surprised that DeBeers is not on that list. (HT to Tim Cooke via Facebook for the tip!)

One of the key differences between traditional and behavioral economics is that, while the assumptions of traditional economics stipulate that people always have the cognitive and psychological faculties to make the choices that are in their long-term best interests, behavioral economics focuses on identifying the situations in which these assumptions don’t hold. For example, traditional economists would likely be in favor of the following product:

(HT: Freakonomics)

The logic seems simple enough- if you want less of something to happen, charge more for it. (This is just another way of saying that, except in very particular circumstances, demand curves slope downwards.) Behavioral economists, on the other hand, would likely be suspicious of one’s morning ability to make rational choices. In their view, bounded rationality or bounded cognition could make this alarm counterproductive, since people would likely be too groggy to properly evaluate the price of snoozing (and thus exhibit little change in snooze behavior) but would be out more money than before. (It is sometimes said that behavioral economists use the term “bounded rationality” as a nice way of saying that people are stupid, and, I don’t know about you, but I’m pretty damn stupid in the morning.)

This example also, randomly enough, illustrates the importance of the counterfactual, or relevant comparison scenario. Compared to an alarm clock with a regular snooze button, this one seems to have some potential advantages. But why is this the comparison group? Why not compare this alarm to one where there is no snooze button? (Yes, I get that the snooze button is the status quo, but it doesn’t mean that there aren’t better alternative options out there.) Maybe people would be more likely to get up on time if they didn’t trust themselves to snooze for a short time without the aid of the clock. (Yes, I realize that you could just set the alarm again for 10 minutes later- or 9 minutes…why is a snooze always 9 minutes? Was this defined somewhere that I don’t know about? Anyway, I’m pretty sure that by the time you go to all the trouble of resetting the alarm you would be awake enough to realize that you need to get out of bed and not snooze anyway.) Personally, I think that this guy should be the comparison group:

The logic is essentially analogous to what I outlined above- the alarm clock runs away when it goes off, so by the time you find the snooze button you are likely either awake enough to realize that you shouldn’t be snoozing or awake enough to not want to snooze in the first place. In fact, I could envision a superior alarm clock that is a combination of these two items- the clock would run away so that you are coherent enough to make an intelligent decision regarding whether or not to pay to hit the snooze button. Boom- business idea right there, folks.

Update: Of course I would be outdone two days after I post about economist-friendly alarm clocks. Behold a money-shredding alarm clock:

Just think of the implications for the money supply. (Furthermore, I love that there are comments about the legality of the product on the video’s YouTube page.) I am hereby naming this product the anti-Bernanke clock.

As some of you likely know, I am the economics guide for About.com, so I write articles and blog there in addition to writing here and a few other places. (In general, I try to pick and choose what is appropriate for each site.) You may have noticed that I do list recent material from About.com on the left sidebar, but I feel like that’s easy to overlook (and it’s pretty much invisible to RSS subscribers). I do post a lot of that content on Facebook, Twitter, and Tumblr, but I wanted to give you some highlights here as well. So here are the highlights from this week so far:

• The Economic Inefficiency of Monopoly
• A Very Earnest Message From a “Job Creator” to the Senate

You can also check out the site directly at economics.about.com.

The market for introductory economics textbooks is pretty crowded, but there is at least one new one coming onto the market soon:

If you’ve ever used a textbook as an instructor rather than as a student, you are probably aware that there are lots of supplementary materials- solutions manuals, test question banks, and so on- that serve as companions to the textbook and that are given to the instructors at no charge. (In case you were curious, copies of the textbook are also given at no charge, and, although it’s technically prohibited, there are plenty of instructors who sell the free books to the used book brokers that are constantly stopping by our offices. Yep, those exist.) If you are a student, I am not going to explicitly encourage you to try to find copies of such materials online, but I am going to mention that a lot of the materials are out there.

Have you ever wondered who writes all of these supplemental materials? People like me, apparently:

I suppose if you’re a good enough student it’s only a matter of time until you get paid to essentially read textbooks and do problem sets. I contend that there are far worse ways to earn a living.

What I found most interesting about the experience, however, was the insight that it gave me into the textbook market. On some level, I’ve always known that there is inefficiency in the textbook market due to the fact that the decision makers (i.e. instructors) aren’t the payers/end consumers (i.e. students). Among other things, this means that instructors don’t have a particularly strong incentive to care how much the textbooks that they are assigning cost, so textbooks are more expensive than they would be in a well-functioning market. (Luckily there are considerate instructors out there who do care to some degree whether they are sending students further into the poor house. Also, if this sounds familiar, it’s because you’ve been doing your reading on the healthcare industry.)

What I didn’t realize until I started teaching large courses, however, is the degree to which instructors are courted by the textbook publishers- remember the stories about how pharmaceutical companies used to heap lavish perks on doctors in order to get on their good sides so that they would prescribe more of the company’s drugs? Yeah, it’s kind of like that, except that the sales reps that are constantly contacting me are way less hot than the typical pharma girl. (No offense to the textbook reps, it’s just that the pharma girls are pretty far out there on the spectrum.) I’m not complaining about the free books, food, booze, conferences, etc., mind you, I just thought it was worth noting.

What I *am* going to complain about is the fact that the decision-making authority regarding textbooks is becoming, in an increasing number of circumstances, even more removed from the end consumer. One strategy of Pearson Education, for example, is to sign contracts with university administrators that require instructors to use Pearson textbooks (presumably only for classes where Pearson has textbook coverage). What this means, obviously, is that instructors can’t always assign the text that they think is best, and, in an important number of cases, can’t even assign textbooks they’ve written themselves, at least not without forgoing royalties and, in one case a little birdie told me about, “donate” said royalties to the university. In what may or may not be related news, Penn State signed such a contract with Pearson and the first author of the above textbook is now employed by the University of Kentucky. Students, I encourage you to play a potentially fun game- check out the textbooks you’ve used recently in various courses and see if they are disproportionately Pearson textbooks. If so, ask your professors if they are obligated to assign Pearson texts and see what they say- I’m very curious. (It’s too bad you can’t text your professors and then send me the responses a la Nathan Fielder.)

This system is obviously problematic on a number of levels, not the least of which being that it creates incentives to engage in rent-seeking behavior at the expense of actually producing products that are better for students. (I’ve used Pearson’s products, and, while a number of the textbooks themselves are quite good, the online materials leave much to be desired. And I’m not just saying that because I do review work for Pearson’s competition. ) So, next time you’ve wondering how textbooks could possibly have started climbing over the $200 price point, just think back to this discussion.

For what it’s worth, the publisher of the above book (W. W. Norton and Company) is an independent publisher and seems pretty legit- their biggest claim to fame is that they were the ones who gave Michael Lewis a deal for Liar’s Poker, and he’s stayed with them ever since, which I figure is a good signal. Also, they throw kickass parties.

Update: I guess I shouldn’t be surprised that people are asking how this compares to the Mankiw textbook that is often featured on this site. Fair question, though it’s hard to give a fair answer because a 6th edition of Mankiw isn’t really comparable to a draft of a 1st edition of Mateer/Coppock. Like Dirk Mateer’s web site, his book is focused on giving examples related to pop culture and generally being relatable to students. I think the best way to put it is that I will probably continue to use Mankiw for my own reference but would be inclined to use Mateer/Coppock for a survey course for non-majors. It’s important to keep in mind that differentiation does in fact exist in the world of introductory economics textbooks, so both instructors and consumers should do their homework to find out which version is appropriate for them. I think the only subject where I could universally recommend a single undergraduate textbook is econometrics, where the text by Wooldridge reigns supreme, in my opinion.

Another Update: Apparently people followed up with Dirk regarding his move from Penn State. So let me see if I’ve got this straight: Penn State thinks that professors benefiting financially from writing a textbook that was customized for the course that instructor is teaching is a conflict of interest, but the university itself getting kickbacks from a publisher for mandating the use of particular textbooks is A-OK. As noted in the comments, students at Penn State really valued Dirk’s presence, and it’s sad that rent-seeking behavior by publishers (and rent-accepting behavior by universities) did in fact factor in his decision to move.