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Economic News, Data and Analysis

NET Institute

I just got this email from Prof. N. Economides at NYU. It looks like he is starting an interesting new institute.
Networks, Electronic Commerce, and Telecommunications,(“NET”) Institute
Dear Colleague,
I am writing to announce the creation of NET Institute, the Networks, Electronic Commerce and Telecommunications Institute. The NET Institute is a non-profit institution devoted to research on network industries, electronic commerce, telecommunications, the Internet, “virtual networks” comprised of computers that share the same technical standard or operating system, and on network issues in general. The NET Institute will function as a world-wide focal point for research and open exchange and dissemination of ideas in these areas. The NET Institute will competitively fund cutting edge research projects in these areas, and it will organize conferences and seminars on these issues. See http://www.NETinst.org.
The NET Institute will fund a number of scientific research projects in the areas of network industries, including wired and wireless networks, “virtual networks,” electronic commerce, telecommunications, and the Internet. Proposed research may be either theoretical or empirical, and may also analyze issues of public policy and antitrust. The deadline for proposals is May 5, 2003. Details on the requirements are at http://www.NETinst.org . Please distribute this information to researchers who may be interested to get funding for their research in these subjects.
Thank you.
Best regards,
Prof. Nicholas Economides
Director, NET Institute

Filed under: Economics, Economists, Economy, Microeconomics, Teaching, Technology

All That Glitters

Why the heck is gold still seen as a “safe haven” investment? Gold prices are rising on war fears, but have fallen $50, or about 13%, over the past month. (See article below.)
Looks to me like gold prices are more of a betting-on-war casino game.
Central Banks and international organizations (like the IMF) own – literally – tons of the shiny stuff. The gold would be much better used if it were made available to the public in the form of jewelry, electronics, etc., rather than sitting idle in vaults around the world.
How much better? Somewhere around $355,885,676,597 better. Don’t believe me? Run the simulation yourself!

Forbes.com: UPDATE 4-Gold edges up as Iraq on brink of war
LONDON/HONG KONG, March 19 (Reuters) – Safe-haven gold attracted fresh buying on Wednesday as Iraq appeared to be on the brink of war, traders said.
Gold prices were expected to be skittish as a U.S. deadline for Saddam Hussein to go into exile by 0115 GMT on Thursday ticked away.
The precious metal, which traditionally acts as an insurance policy for investors in times of trouble, had the potential to advance further if war broke out.
“The use of military action against Iraq is pretty much a foregone conclusion now and the start of which will give gold an upwards surge,” said James Moore, metals analyst at TheBullionDesk.com.
[Gold up about 1$ to 338.75, but down from 288.50 last month.]
During the 1991 Gulf War, gold prices initially spiked at the start of allied military action to evict Iraqi forces from Kuwait but then quickly slumped as the campaign proved to be a swift victory.
Gold gained $45 to $415 when Iraqi forces invaded Kuwait in August, 1990, then fell by $40 to $366 when the allied campaign started in January, 1991.

Filed under: Economics, Microeconomics, Policy

NCAA – Best Monopoly

Robert Barro gives the NCAA the “best monopoly” award.

Filed under: Microeconomics

Unemployment Spell

Here’s a useful reminder that there is more to unemployment than the headline unemployment rate.

Joblessness low, but lasts longer | csmonitor.com
-snip-
Normally, the higher unemployment goes, the more time the average worker spends unemployed. That’s what happened during the late 1960s and 1970s. By November 1982, when unemployment hit a postwar high of 10.8 percent, the average jobless stint reached 20 weeks, eight weeks longer than during the recession of the early ’70s.
In the 1990s, that relationship began to break down. In a joint study last year, economists Katharine Abraham and Robert Shimer found that unemployment fell to levels of the 1960s, yet the jobless stint remained 50 percent longer. The biggest change: a huge jump in workers unemployed six months or more.
-snip-

Filed under: Data, Economics, Economy, Microeconomics, Recession

Price Controls and California Electricity

The Policy Challenge

The problems with the California energy market have recently been a fixture of news reports. While the causes have been relatively well understood, and the consequences – blackouts and sky-high prices – are obvious, there is much debate over the solution.

In the long-run,
more power plants would help the situation; and many are already on the
way. But what can be done in the short run?

Grey Davis,
the Governor of California, has been pushing a policy of limiting the prices
of wholesale electricity. Federal regulators at the Federal Energy Regulatory
Commission (FERC) have partially adopted this idea.

In general,
when markets are functioning well, economists rarely support price caps
– or any kind of price controls.  I’ll take a brief look at the
basic economic arguments against price controls, and also point to a case
in which production might actually be increased by a price cap.

Interestingly,
price controls in California might be able to kill two birds with one stone
– in the short-run, it might be able to both lower price as well as
increase the quantity supplied to the energy market.

But before
we get to the good, lets take a look at why we should be wary of price caps.

What’s
wrong with a price cap?

Competitive
markets (under certain conditions) tend to “work” – that is, they tend to
produce the “right” quantity of a good or service. The amount of production
will be such that value to the consumer is greater that the cost of production
for each unit.  

Government
intervention via a price control will distort the market outcome and will
thus cause the market not to work. In the case of a (binding) price cap,
sometimes called a price ceiling, the policy may cause the quantity of the
good supplied to decline. This is because sellers will have less of an incentive
to supply the good to the market.

*In the
California case, the current (6.24.01) “cap” policy is called price “mitigation” and is actually
much more complicated (see below).

At the same
time of the decline in the quantity supplied, the price cap will cause the
quantity demanded to increase. The result will be a shortage – quantity
demanded will exceed the quantity supplied.

In this
case, the reduction in the amount supplied will be inefficient for the following
reason: with the price cap, there are people willing to pay a higher price,
and suppliers who are willing to produce at the higher price. This means that
there are transactions that would benefit both buyer and seller that are
not being undertaken. The loss in value from these forgone tractions is called,
in econo-speak, a deadweight loss (DWL).

The graph
below shows the basic points from above. A perfectly competitive market
will in equilibrium achieve a price and quantity, P* and Q*. A price cap,
Pcap, will lead to a reduction in the quantity supplied to Q2. The result
is a shortage, and a decline in efficiency in the amount given by the shaded
area.

This is
the basic argument against the imposition of price controls. The problem
with this argument with respect to the situation out west is that the California
electricity seems to be far from a well functioning competitive market. 

In the next
section, I’ll give an example of how price controls may actually increase
the amount of electricity supplied, and thus provide a better outcome than
the market.

*The
regulations being imposed by the FERC are not exactly a price cap as described
here. Instead the policy is called price “mitigation” which attempts to limit
price spikes in the spot market in certain circumstances. See the FERC press
releases in the links section for more details.

What’s
good about a price cap?

The previous
section looked at how a price cap might decrease quantity and hence reduce
the efficiency of the market. On the other hand, the price cap is good for
those consumers who are able to purchase electricity at the lower price.
However, in the case above, there is also a shortage – not everyone is able
to consume as much as they would like.

The previous
argument supposed that the market, before price controls, was operating efficiently.
One reason that the market may fail to achieve the efficient outcome is if
the suppliers have some degree of market power – that is, if the suppliers
have the ability to influence the market price.  

There is
some evidence that this has been the case in the California energy market.

Paul Joskow,
a professor of economics at MIT, in congressional testimony stated that there
was “…abundant evidence that market power problems were exacerbating an
already bad situation.” In addition, there have been allegations that power
companies intentionally reduced the production of electricity, by shutting
down plants, in order to push prices up. See the links section below for
the news reports.

If producers
do have the ability to raise prices, then it may be the case that price controls
may actually increase the amount supplied to the market.  

Without
price controls, electricity producers face a tradeoff. If they increase production,
they can sell more electricity, but the price will be forced down. Given
this tradeoff, producers have an incentive to reduce the supply in order
to get a higher price for their output and perhaps greater profits.

However,
if there a price cap is put place, the suppliers no longer have the ability
to push up the price, and thus have no incentive to reduce the quantity that
they produce! 

This situation
is illustrated in the graphs below. The first graph shows a market in which
suppliers have some market power – such as when one firm has a monopoly.
The result is a decline in the quantity of electricity produced, from Q*
to Qmon, as the firm drives up the price, to Pmon, in order to maximize profits.

The second graph shows the result when there is a price cap. In this case,
the firm can no longer push up prices, and so has no incentive to reduce
production. The result is a desire to have greater production, at Q (supply,
cap). So long as the price cap is sufficiently high, that is, above the marginal
cost of the producer at the unregulated level of output, MC, there will be
an increase in production. 

In reality,
the market structure for electricity is more complicated, but to the extent
that there is a significant degree of market power, price controls may increase
the amount of power produced.

In addition,
market power by suppliers creates inefficiency in much the same way as the
price controls in a competitive market. By suppliers restricting quantity,
there is not enough electricity produced. In this case, price controls create
a more efficient outcome! 

So perhaps
price controls aren’t so bad. However, the next section suggests a reason
why price controls may pose a long-run danger.

Prices play a very important role in determining the allocation of resources in the economy. High prices relative to costs indicate that more resources should be devoted to production in that area, and thus serve as a signal to firms to increase production or enter the market. It is therefore very important to get prices “right” so that we have the appropriate amount of resources devoted to production of the various goods in the economy.

Freely functioning competitive markets do a fairly good job of getting prices right, and so we should always be careful when imposing some rule that alters the market’s ability to find the appropriate price.

Importantly, as time goes on, as technology and other factors shift supply, and as tastes and the development of alternatives shift demand, the “right” price may change. This is what makes many price controls “ugly.” We may be good at setting a price control that does an ok job in the short-run, but history suggests that it’s much harder to figure out how prices should change over the long run.

In addition, getting the price “wrong” becomes more costly as time goes on, since resources are more mobile in the long run. We should be very wary about and kind of long-term price controls.

The California energy crisis seems to be a short-run problem, in need of a short-term solution. Price controls are generally seen (if having any benefit at all) as primarily a short-term solution, with potential harmful long-term consequences.

The “ugly” aspect of price controls comes when a short-term fix becomes a long-term policy.

Primary
sources


FERC – Federal Energy Regulatory Commission
 

  • Commission 
    Extends California Price Mitigation Plan for Spot Markets to All Hours, All 
    states in Entire Western Region (
    PDF file
    )
  • April 
    25, 2001 California wholesale markets (
    PDF file
    )
  • June
    18, 2001 Extension to Western States, 24 hours (
    PDF file
    )


Grey Davis


Department of Energy


California Energy Commission
  

Background

Market
Power: News
      

Other


Testimony
by Paul Joskow of MIT:

“The
causes of California’s electricity crisis are complex, reflecting a 
combination of bad market design, bad regulatory design, unanticipated changes 
in basic supply and demand conditions, and supplier behavior which rationally 
took advantage of opportunities created by these conditions to further increase 
market prices”

A good
deal more inforamtoin can be found at
  Prof. Joskow’s website.
 

A different 
approach – how about a windfall profit tax?

Energy Price Controls: Been There, Done That
by Robert Litan and Philip
Verleger of The Brookings Institution


Economics of Deregulated Power Markets


DOE: Status of  State Electric Industry Restructuring Activity
 

Cool!


Electric system status in CA.
(From California Independent System Operator)

Filed under: Microeconomics

Microsoft Anti-trust Trial

Interview with Nicholas Economides

Last Friday, Judge Jackson anounced his decision on the “findings of
fact” in the Microsoft case. An expert on Industrial Organization and the
Microsoft case, Professor Economides of the Stern School
of Business at NYU has again agreed to answer some questions on the trial
and the findings.

Links:


Nicholas Economides is a Professor of Economics at the Stern
School of Business, New York University. He earned his Ph.D. from University
of California at Berkeley and previously taught at Columbia University
and Stanford University.

Economides has published extensively on networks, network pricing, market
structure and other topics. He has edited a special issue of the International
Journal of Industrial Organization
on Network Economics and is currently
working on a book entitled The Impact of the 1996 Telecommunications
Act
to be published by the American Enterprise Institute and MIT Press.

He also maintains web sites on the Economics
of Networks
and on the current Microsoft
Legal Battle
.

Photo courtesy N. Economides

What were the expectations for the judge’s decision?

Let me first note that I am not now and have never been involved in
any litigation involving Microsoft.

When Judge Jackson announced some time ago that he would release his
decision on findings of fact before his decision on the findings of law
(which are typically released together), many thought that the judge’s
decision on the “findings of fact” would be moderate, and the two parties
would be urged to settle the case before the release of the “findings of
law.” The incentive for Microsoft to settle before the findings of law
are released would have been to reduce the probability of civil antitrust
suits that would be based on a decision by the judge that found Microsoft
guilty of monopolization and other wrongdoings. (Remember the judge’s findings
of fact do not constitute a conviction.) There are two incentives for settling
by the plaintiffs. First, there does not seem to be a remedy that would
take care of the antitrust problems without creating possibly bigger efficiency
losses (see further analysis below). Second, it is desirable to reduce
the expenditure of the public’s money. Thus, on the eve of the judge’s
decision on findings of fact, the expectation was that the decision would
be moderate, so the parties would settle. The decision was expected to
be adverse for Microsoft because the judge had let it be known that the
decision would be announced on a Friday at 6:30, after the close of the
main US financial markets. Hence, the judge was expected to rule moderately
for the plaintiffs.

 

What were your initial reactions to the judge’s findings of fact?

The “findings of fact” as decided by the judge on November 5, in almost
all points, are favorable to the plaintiffs. In fact, it is hard to find
even one major allegation for which the judge did not decide on facts that
directly support the plaintiffs’ positions. The judge was unusually harsh
to Microsoft.

 

What were your subsequent reactions to the judge’s findings of fact?

In closer examination, the “findings of fact” are weak and not very
well justified.  The judge fails to argue convincingly about:

  1. The “fact” that consumers were harmed by Microsoft’s actions;
  2. The “fact” that Netscape posed a real threat to Microsoft’s operating system,
    and that therefore that the browser integration in Windows was done to
    thwart such competition.

Were consumers harmed by Microsoft?

The judge finds the “fact” that consumers were harmed.  The plaintiffs’
lawyers (including the US Attorney General) hailed the judge’s findings
of fact as “a great victory for American consumers.”  But is it really? 
Microsoft gave away the browser.  Before Microsoft pursued this policy,
Netscape was a monopolist in the browser market charging $40-50 per unit. 
Consumers have directly saved about $2 billion by Microsoft’s free browser
distribution and bundling policy that the judge found to be anti-competitive! 
Why does this benefit to consumers escape Judge Jackson’s notice?

Moreover, consumers have directly benefited from the relatively low
price of Windows ($40-50 to computer manufacturers) compared to historical
prices of operating systems and current prices of other operating systems.
For example, IBM was selling OS/2 (which ran much fewer applications than
Windows) for hundreds of dollars. Some Linux packages (that are essentially
add-ons to the free Linux source code) that run very few applications (compared
to Windows) sell for $150. If Microsoft can exercise all this monopoly
power as the judge finds, why is Microsoft so benevolent and does not charge
more?

The judge found that Microsoft had the ability to exercise pricing power
but does not fully do so.  This is very hard to believe.  Presently
Microsoft is worth $400 billion, with the Windows division and the applications
division worth each about half of that.  So, the Windows division
of Microsoft is worth about $200 billion with Microsoft charging $50 per
Windows 98 unit.  The same division would be worth at least $400 billion
if MS charged $130 per Windows 98 unit.  The judge’s findings of fact
imply that Microsoft forgoes an increase of its market value by $200 billion
so that it can act anti-competitive and extend its monopoly power in other
markets.  This is almost mathematically impossible because the value
of MS from all the other markets (including markets with no allegations
of anti-competitive acts) is $200 billion. So, Microsoft charges way below
the monopoly price and consumers benefit from it.  Before DOJ splits
Microsoft into three parts, it better make sure that the triopoly price
with each baby MS having only one third compatible applications is in fact
lower than what MS charges now.

 

Was Netscape a serious threat to Windows?

I seriously doubt it.  Netscape had not even taken the preliminary
steps to create a rudimentary operating system that would run on top of
its browser.  Although a possibility of the creation of such system
existed (based on Java or otherwise) in principle, there was no evidence
that Netscape was on its way to doing so.

 

Do you think a settlement is now more likely?

No.  Given the across-the-board siding of the judge with the plaintiffs,
a negotiated settlement seems extremely unlikely in the short run. The
terms of a settlement would be based on the “findings of fact” that are
very adverse to Microsoft. Microsoft is unlikely to settle on terms implied
by such adverse findings. Moreover, in a similar case about 15 months ago,
the Appeals Court ruled that Microsoft had the right to include whatever
it wanted in the PC Operating System, including its browser. So, Microsoft
can reasonably expect that the same Appeals Court will rule similarly on
appeal, reversing a significant part of the findings of fact of Judge Jackson.
On the other side, there are 20 plaintiffs (USDOJ and 19 States). It would
be hard for all 20 to agree on major concessions in settlement talks given
the very favorable findings of fact. Thus, Microsoft is likely to wait
for the final ruling on liability, fight the remedies battle, and keep
appealing.

 

Are there any additional factors that are likely to weigh in the
probability of settlement?

There are two additional factors that make it more likely that Microsoft
would prefer to wait. First, Microsoft has argued in court that the landscape
changes quickly and radically in the software industry, citing the Netscape
buyout by AOL and Sun. The longer the duration of the case, the more likely
it is that more such radical changes will happen before the final decision
is made. Second, it is likely that the final appeal will end during the
next US Administration. This may be beneficial to Microsoft, since a different
Administration may be much softer on antitrust issues.

 

Is there any factor that may increase the incentive of Microsoft
to settle?

A conviction of Microsoft on monopolization will open the doors to private
antitrust suits against Microsoft.  This could be costly to Microsoft,
but, in my opinion, it is not of critical importance to Microsoft. 
The most crucial issue for Microsoft is how to make sure it preserves and
appropriately utilizes its management.  Federal litigation has imposed
on Microsoft the threat of a breakup that could cripple Microsoft’s ability
to manage itself efficiently.  Microsoft clearly sees this as a threat
and will fight it.  At the same time, Microsoft should guard against
paying too much attention to private litigation rather than to the software
business.

 

How damaging is the report to MS’s legal case?

The judge finds solidly for the plaintiffs.  However, the judge’s
argumentation is weak and may be reversed on appeal.  The lack of
a clear identification of victims of Microsoft’s actions, and the lack
of presentation of convincing evidence that consumers were harmed are key
weaknesses of the report.  Microsoft may have a good chance of a wide
reversal.

What criteria should be applied in determining remedies?

In defining remedies, the following criteria should apply. First, appropriate
remedies have to be proportionate to whatever liability is finally established.
Second, remedies also must be consistent with a strategy that prevents
Microsoft from repeating whatever activity is found to be illegal in the
case. Third, remedies have to be in the public interest and should help
rather than harm consumers. In other words, the treatment should heal rather
than kill the patient. Fourth, remedies should minimize other interference
in Microsoft’s business, and in the business of the rest of the computer
industry. Thus, when defining remedies one has to consider:

  1. What specifically Microsoft is convicted of doing illegally;
  2. Which specific remedies would prevent Microsoft from committing the same
    crime or crimes again in the future;
  3. Which remedies help consumers; in discussing whether or not a remedy helps
    consumers, one has to consider its effects on prices, on compatibility,
    on variety and quality, and on the speed of innovation;
  4. Which of these remedies creates the least interference in the legitimate
    business of Microsoft and the rest of the computer industry;
  5. Which remedies preserve and enhance incentives for innovation and technological
    progress.

What other considerations should apply in determining remedies?

Long before the present antitrust suit took shape, a loose coalition
of IBM, Sun, Oracle, and Netscape was formed to fight Microsoft. This coalition
has played a very significant role in bringing antitrust issues involving
Microsoft to the attention of Congress and DOJ. In many ways, this coalition
helped DOJ create and fight the case against Microsoft, even providing
the idea of the Boies-Fisher team that had fought for IBM in DOJ’s antitrust
suit against IBM in the 70s. At the time of the remedies determination,
it is crucially important that remedies are not imposed for the benefit
of competitors (including those of this coalition) but rather for the benefit
of the consumers and competition.

 

What remedies have been proposed and how do you evaluate them?

A number of remedies have been informally proposed by sources close
to DOJ. These remedies range from mild to very severe. The various remedies
also differ to the extent that each deals with horizontal (within the same
market) or vertical (across complementary markets) issues.

Two remedies on business conduct have been proposed.

Conduct remedy 1: Impose various restrictions on the contracts
that Microsoft can write with sellers of complementary goods and with competitors.
This is a likely remedy that is easy to tailor according to the violation.

Conduct remedy 2: Force Microsoft to disclose the APIs (definitions
of the interface) that allow it to include Internet Explorer in the operating
system. Microsoft routinely discloses APIs that hook applications to the
operating system and allow for interoperability. Currently, Microsoft does
not disclose the APIs that tie together parts of the Windows operating
system, which includes Internet Explorer. If the APIs that hook Internet
Explorer to other parts of the operating system are disclosed, Netscape
(and any other browser) can get the same interoperability with Windows
as Internet Explorer. Such disclosure would solve all technological bundling
problems.

Four structural remedies have been proposed.

Structural Remedy 1: Force Microsoft to give away the Windows
source code, or license it to successful bidders in an auction imposed
by the government on Microsoft. Windows code may be worth as much as $200
billion. No company can bid that much. Practically speaking, only a handful
of foreign governments can bid that much. This implies that the source
code of Windows will be sold forcibly at a small fraction of its worth.
Thus, this is a severe remedy that takes away the intellectual property
of Microsoft. It will severely reduce the incentive for innovation, since
dominant firms will no longer be guaranteed with certainty the value of
their intellectual property. Moreover, source code evolves in time. Over
time, different firms will add to and alter the Windows code. Soon, incompatibilities
will arise. Applications vendors will have to write different applications
for each version of the evolving version of Windows. It was exactly this
problem that made Unix a failure in the individual consumer market. It
is unlikely that all applications will be written for each of the incompatible
versions of Windows. If, when there are three incompatible versions of
Windows, each version has 1/3 of the applications, the benefits to a consumer
from using a PC are reduced by 66%! By no means would this be a victory
for the American consumer! In summary, auctioning the Windows code will
result in incompatibilities that harm consumers and increase the cost of
applications.

Structural Remedy 2: Break up Microsoft according to lines of
business. This remedy is favored by the software association. Remedies
that break up a company in any form are very severe. They are likely to
severely damage the company, and they usually accomplish little or no more
than alternative remedies. Microsoft is an entrepreneurial company that
is run by very few top executives (about twenty). This makes it flexible
and efficient, qualities that the DOJ should try to preserve, although
Microsoft’s competitors would probably like to extinguish. Breakup along
lines of business is a very severe remedy. Its function can be accomplished
by disclosure of APIs instead.

Structural Remedy 3: Break up Microsoft in three equal parts,
with each part containing an equal amount of each business. Like other
breakup proposals, this proposal may kill the managerial flexibility and
efficiency of the company. Moreover, as with the auctioning the code proposal,
one expects that significant incompatibilities will result within a short
period of time. Incompatibilities harm consumers by significantly reducing
the benefits that consumers get from applications, as explained above and
by increasing the cost of applications. Finally, it is unlikely that this
industry structure will result in significantly lower prices, since Windows
prices are presently low, and each of the resulting three companies will
have a much smaller scale of production. From a legal standpoint, this
proposal has the weakness of also breaking up the applications division
of Microsoft, although monopolization has not been established in applications.

Structural Remedy 4: Break up Microsoft along lines of business
(operating systems and applications) and then break the operating systems
division in three equal parts. Like other breakup proposals, this proposal
may kill the managerial flexibility and efficiency of the company. It is
also likely to result in incompatibilities, as explained above, with significant
reduction of benefits to consumers, and increases in the costs of application
development.

 

What do you think is the most likely outcome?

DOJ proposes structural remedies in an attempt to force Microsoft to
settle.  But the game is more complicated.  And, DOJ lawyers
are amateurs in games of strategy while Gates and his top executives are
professionals.  Microsoft has managed over the years to snooker practically
all the major players in the computer industry, including IBM, Apple, and
Compaq.  If history is any guide, Microsoft will wait until the present
US Administration fades into history, and will try to cut a deal with the
next Administration.  I believe that a conduct remedy, such as contract
restrictions possibly enhanced with API disclosures, is the most likely
outcome.

Filed under: Microeconomics

Mean Vending Machines

This past weekend the news wires were all buzzing about the latest idea
to come from the world of soft drinks. Coca-Cola is apparently considering
creating a new kind of vending machine that would test the outside temperature
and adjust the price of a can of soda upwards when it is warmer outside.

Here’s some of the typical reactions to the idea:

“a cynical ploy to exploit the thirst of faithful customers”
(San Francisco Chronicle)

“lunk-headed idea”, (Honolulu Star-Bulletin)

“Soda jerks” (Miami Herald)

“latest evidence that the world is going to hell in a handbasket” (Philadelphia
Inquirer)

“ticks me off” (Edmonton Sun)

What did they think the Coca-Cola company was doing anyway? Selflessly
providing the world with a glorious beverage to further the goals of all
mankind? Why should all these people be suddenly offended by a company
trying to maximize profits?

“Price discrimination” is the term economists use to describe the practice
of selling the same good to different groups of buyers at different prices.
In the Coke case, the groups of buyers are segmented by the outside temperature
(i.e. Jill when it is hot outside vs. Jill when it is cold). If possible,
a company would like to charge a high price to those who place a high value
on the good, while charging less to those that do not.

So, are you personally offended by Coke’s plan to charge more for soda’s
when it is warm outside? Well, you had better get over it pretty quickly,
there is already plenty of price discrimination out there, and there is
MUCH more to come.

Rampant Price Discrimination

Price discrimination is quite common. Ever wonder why hardcover books
are produced first and are so much more expensive than paperback books?
Or, why it is so much cheaper to buy airline tickets far in advanced? Or,
why there are student discounts? Or, why matinee prices are cheaper for
movies? Ever tried to buy a soda from a vending machine at a hotel or at
a movie theater?

All these examples are attempts by sellers to charge different people
different prices for the same good.

Much of the price discrimination in the economy may in fact be quite
hidden. How do you know that the Crate and Barrel catalogue you just received
has the same price for you as for someone living in another zip code? Perhaps
those with a 90210 zip code see higher prices on their catalogues.

Why is the Vending Machine different?

In principle, the temperature sensitive vending machine is no different
from any other form of price discrimination.

Although, I do think the idea that the process is automatic generates
some additional discomfort – it is the idea that technology can effectively
gauge our buying interests. The heat sensitive machine is a small step
toward applying machine “intelligence” to profit maximization.

If you think that the vending machine idea is worrisome, just wait –
the internet will be the most sophisticated price discriminator the world
has ever seen. Smart vending machines will be the least of your worries.
Online vendors such as Amazon.com may know quite a lot about you – your
past purchasing habits, your internet preferences, your zip code, etc, 
– and they may want to use this information to adjust prices. Did you buy
a Stephen King book last month? Maybe you’d like to buy another, more expensive,
Grisham novel this month with a smaller “discount” chosen just for
you.

The internet is much better than the “real world” at price discrimination,
because it is so much easier to change prices. In fact they can set a price
just for you. It’s hard to imagine a traditional store doing this (“Hey,
here comes John. Quick, raise the price of the new Krugman Book.”). But
for an on-line e-commerce store, this is feasible and, with a clever programmer
on the payroll, quite easy.

Not all bad: Discrimination means increased efficiency

Actually, price discrimination can actually increase the overall efficiency
of a market.

A loss of economic efficiency may occur when a company has some abililty
to set prices and there is no discrimination. The seller must pick a price
that balances their desire to charge a high price to those that really
want a product, with their desire to sell a higher overall quantity to
those that are not willing to pay very much for it. Because of this, there
are trades which would benefit both buyer and seller that do not happen
– the resulting price is “too high” and the total quantity traded is “too
low”.

By identifying individual groups of consumers, a seller can provide
an additional unit at a lower price to someone who before would have been
priced out of the market. The company would now be willing to do this since
they would not have to sacrifice profits by lowering prices for the high-demand
group.

In the Coke case, some consumers – those who drink Cokes on hot days
– will be worse off since they must pay a higher price, while some consumers
– those who drink Coke on cold days – will be better off since they
will receive a lower price. The Coca-Cola company, of course, will be better
off.  The sum total will be positive (pick your favorite Introduction
to Economics textbook to see why).

Would you really be as offended if it was described as a discount on
cold days?

So, if you are still stewing about the potential of higher Coke prices,
I suggest you stock up the refrigerator and put some of that retirement
money into Coca-Cola stock.

Comments?
Is Coke evil? Post in the Forum.


More Features

More Links

Veja, a Brazilian magazine initially got the ball rolling when it published
details of the new machine from an interview given by Doug Ivester, Coke’s
chairman. Here is a sampling of the stories and commentary that followed.

Coke’s
Automatic Price Gouging


Have
a Coke, and Big Brother is sure to smile


The
Irish Times – Coke’s chilling concept


Coke:
It’s the real (greed) thing


Miami
Herald: `Soda jerks:’ Coke tests machine that raises prices in hot weather


Toronto
Star: News Story: Some like it hot at Coca-Cola – October 29, 1999


Edmonton
Sun – Greg gets peeved

Filed under: Microeconomics

Microsoft Anti-trust Trial

Interview with Nicholas Economides

The trial of US vs. Microsoft is scheduled to resume again on June 1.
Professor Economides of the Stern School of Business
at NYU has again agreed to answer some questions on the trial. The interview
is broken into three parts. Basic Analysis, Remedies, and After Effects.

 

Nicholas Economides is a Professor of Economics at the Stern
School of Business, New York University. He earned his Ph.D. from University
of California at Berkeley and previously taught at Columbia University
and Stanford University.

Economides has published extensively on networks, network pricing, market
structure and other topics. He has edited a special issue of the International
Journal of Industrial Organization
on Network Economics and is currently
working on a book entitled The Impact of the 1996 Telecommunications
Act
to be published by the American Enterprise Institute and MIT Press.

He also maintains web sites on the Economics
of Networks
and on the current Microsoft
Legal Battle
.

Links:

Photo courtesy N. Economides

The Microsoft anti-trust trial is set to resume
shortly. Do you think a settlement is likely?

First, let me make clear that, I am not involved in any litigation involving
Microsoft. In expressing these opinions, I rely only on public information.
I have not seen any privileged information that the parties have filed
in the case. I maintain a web server on the Internet on the “Economics
of Networks
” which contains an extensive discussion of the US
v. MS trial
and the proposed remedies.

A settlement seems extremely unlikely because the positions of Microsoft
on one side and the US Department of Justice (USDOJ) and the States on
the other side seem so far apart. The lack of progress toward a settlement
is really unfortunate because, as we will see below, there is considerable
difficulty in finding appropriate remedies if Microsoft is found guilty.

Why are the two parties’ positions so far apart?

Microsoft did a very bad presentation of its case in the trial this
far. Instead of bringing Bill Gates as a live witness, Microsoft relied
on a videotaped deposition that discredits him. At various points during
the trial, the judge seemed to disbelieve Microsoft witnesses. This makes
it more likely that the District Court judge will rule against Microsoft.
This has heartened USDOJ and States’ lawyers who now are likely to ask
for very severe remedies, including a breakup of Microsoft, huge fines,
and a forced auctioning of the Windows source code.

At the same time, last summer’s decision of the Washington DC Appeals
Court gives hope to Microsoft that it will prevail at the Court of Appeals.
Moreover, since the proposals of USDOJ and the States are so extreme, Microsoft
has little to lose by not settling. In some sense, things can only get
better for Microsoft in the second part of the trial, given the bad impressions
of the first part. It does not make sense for Microsoft to settle now with
onerous terms. Instead, I think that Microsoft will wait to see the judgment
of the District Court, appeal, and see how that goes.

What do you see as having been the main strengths
of the Government’s Case thus far?

The government has relied to a large extent on internal Microsoft e-mails
that discussed strategies towards various competitors. The government has
also focused on various contracts between Microsoft and its clients alleging
anti-competitive behavior. I think that USDOJ and the States are likely
to prevail in some of the contract issues.

What do think is missing from the Government’s
Case?

There is an underlying current of predation in the government complaint,
but it is never clearly articulated. The predation idea is that MS gives
away the browser now, so that it becomes a monopolist and leverage this
power now and later. The government could have made the argument that,
because of network externalities, the Areeda and Turner criteria do not
apply (or should be modified). [In the widely accepted Areeda and Turner
criteria, a requirement to show predation is charging below cost].

The government also decided to bring this case as if computer software
were a perishable good, while in fact, software is a durable good. This
affects the case on market definition, ability to charge monopoly prices
depending on the existence of a used goods (secondary) market, and level
of monopoly prices.

What do you see as the main strengths of the Microsoft’s
Case thus far?

One of the most important defenses that MS has articulated was that
it was not pricing as a monopolist, that is, that the price it charges
for Windows is low compared to the monopoly price. But, in discussing this
issue in Court, Microsoft made the claim that the monopoly price was $2000
for Windows 95 or 98 while MS was charging computer manufacturers only
$50. This claim was based on an analysis of Prof. Schmalensee and his associates
that treated software as a perishable good. The $2000 number was so unrealistic
that the judge questioned Prof. Schmalensee specifically on this point
and appeared to be unconvinced. [This is an example of legal fumbling:
an argument that is essentially correct (that MS is not charging the monopoly
price) is exaggerated to such an extent that it loses its credibility.]

There are two other potential strengths of the MS case. One is the innovation
argument. MS has argued that it is promoting innovation. Somehow, its economic
experts have not argued convincingly on this point. The other potentially
good argument for MS has hardly been made in Court: MS provides de facto
compatibility which is valuable to society. This issue is discussed in
detail below.

What do you think is missing from Microsoft’s
defense?

Microsoft failed to bring forward in the trial the issue of compatibility.
MS provides de facto compatibility through its Windows operating
systems. Backward and forward compatibility are crucial for software markets.
Compatibility is an important benefit to society that could get quickly
eliminated if MS is broken into competing pieces. In some sense, MS is
ignoring one of the best defenses it has arising from the fact that computer
software has network externalities.

The second important failure of MS’s defense has been that it ignored
that software is a durable good. It is totally absurd from an economist’s
point of view that both sides are arguing the case as if software were
perishable, like fish or fresh bread. But software is durable and does
not get diminished by use. Software manufacturers have to compete against
themselves to sell to purchasers of their older version. The economics
of durable goods are quite different than the economics of perishable goods.
Both sides are really fighting a case about an imagined market of perishable
software goods – a market that does not exist.

Do you think the AOL/Sun/Netscape deal will substantively
affect the case?

No. In my opinion, the AOL/Sun/Netscape deal, by itself does not significantly
alter the landscape of this litigation. However, during the trial, the
judge said in court that he thought that the AOL/Sun/Netscape deal
did change the landscape of competition in this market. Partly because
of these remarks of the judge, Microsoft’s defense in the second part of
the trial will focus on proving that the AOL/Sun/Netscape deal changed
the landscape of competition, and that, since things change so rapidly
and unexpectedly, the government should not intervene.

Assuming that either MS is found guilty on one
of the charges, or that an agreement is reached in which MS agrees to some
form of remedies, what should be the goals of any remedies? From the perspective
of promoting economic efficiency, what should be the goal(s) of policy
in such cases in general?

The remedies fall into two broad classes – first there are those that
attack the business side of MS by restricting their contracts or splitting
the company along various lines of business. The second broad class attacks
the control over the technology by either forcing MS to release or license
the source code, or disclose proprietary information (APIs). The remedies
can also be divided into those that affect conduct and those that affect
structure. For example, a restriction on contracts is a conduct remedy,
while a breakup is a structural remedy.

Assuming that liability is established in at least one or more part(s)
of the case, when defining remedies one has to consider

  1. what specifically Microsoft is convicted of doing illegally;
  2. (which specific remedies would prevent Microsoft from committing the same
    crime or crimes again in the future;
  3. what remedies help consumers;
  4. which of these remedies creates the least interference in the legitimate
    business of Microsoft and the rest of the computer industry; and
  5. which remedies preserve and enhance incentives for innovation. In discussing
    whether or not a remedy helps consumers, one has to consider its effects
    on prices, on compatibility, and on variety.

In our previous discussion
you mentioned that you did not expect the outcome of the case to result
in any significant change in the market structure in the OS market and
other software markets. Do you still feel this way?

Yes, if one looks forward to the final appeals decision. But, although
my expectation is the same, there is much more uncertainty now than there
was before the start of the trial on the final outcomes.

What remedies proposals have been made?

The following proposals have been made:

  1. Impose various restrictions on the contracts that Microsoft can write with
    sellers of complementary goods and with competitors.
  2. Force Microsoft to disclose the APIs that allow it to include Internet
    Explorer in the operating system.
  3. Force Microsoft to give away the Windows source code or license it to bidders
    in an auction.
  4. Break up Microsoft according to lines of business (operating systems and
    applications).
  5. Break up Microsoft in three identical parts, with each part containing
    an equal amount of each business (not clear how to break Bill Gates in
    three identical parts).
  6. Break up Microsoft along lines of business (operating systems and applications)
    and then break the operating systems division in three identical parts.

Which do you feel is more likely given the current
state of the trial?

Unless MS does much better in its presentation in the second part of
the trial, I expect that the District Court will find MS guilty of some
of the accusations. I also expect that an across-the-board conviction is
likely to be reversed by the DC Court of Appeals.

What are the pros and cons of each category of
remedy?

The following table assesses the costs and benefits of each of the proposed
remedies and my assessment of the probability that each of these remedies
would be imposed and that they would be upheld on appeal. The probabilities
of the various remedies actions add to 50% because I believe that Microsoft
has a 50% probability of acquittal.

 

Criteria

Filed under: Microeconomics

The Rise of On-Line Auctions

Going, going, gone!

While auctions have been around since at least 500 B.C. the widespread
use and growth of the internet has greatly increased the popularity of
this kind of market. EBay alone has
about 1.8 Million items up for sale.

You can find anything from 5$ mugs to stock
shares
being auctioned off on the web. Most of the auctions are the
standard “English” auctions where there is a single unit being sold and
the highest bidder wins. Several of the other sites, however, are branching
out to other kinds of auctions. Amazon.com and eBay, for example, give
you the option of choosing a standard auction style as well as a Dutch
auction
if you are selling more than one unit.

As these auction sites mature, it will be interesting to see if they
branch out and offer different
kinds
of auctions. All of the auctions so far seem to be as simple
as possible in order to entice people to participate. However, I suspect
as the bidders become more sophisticated, there will be a wider range of
auctions offered.

One interesting aspect of the auctions on-line is that they are almost
always open – that is, you can see the bids of others. In addition
to being a tool for selling, these auctions also seem to be a source of
information on the value of various items up for sale. One interesting
exception is the upcoming
auction
of shares in Ravenswood
Winery
where the bids are sealed.

The theory of auctions, once accounting for uncertainty, risk, and private
information can be immensely complex. The economics literature has devoted
much time and space and even part of a Nobel
Prize
to the theory of auctions – both design
aspects as well as bidding behavior. The FCC
Auction
has led to a cottage industry within the field. Some of the
more interesting work is happening in the experimental
economics
field where various designs are tested with live subjects.

See below for some of the interesting links on auctions.

See Also

Filed under: Microeconomics

Taxing the Internet

“Tax free Internet!” is becoming the new rallying cry of computer users
everywhere. HR 1054 has been dubbed the Internet Tax Freedom Act and is
gaining support in the House and Senate and seems to be supported by the
president. But are there any good economic reasons behind treating the
Internet as a special good?

This feature takes a brief look at optimal commodity tax design, and
how the Internet may fit into the tax bundle.

To head off a couple of criticisms at the start and to get a discussion
going, I am going to ask you to assume that 1) we need to raise some money
via sales taxes, and 2) we should do so in the most efficient way possible.1
I hope to thus head off the argument that goes something like: taxes are
evil; therefore, taxes on the Internet are evil. Once we get beyond this
we can have a real discussion on the merits of taxes on the Internet vs.
taxes on other products.

The General Problem: Coffee and M&M’s

Lets start from scratch with a simple hypothetical situation in order
to get a better idea about how and why the Internet should or should not
be taxed. 

Consider a problem that a company, let’s call it the Ramsey Corp., is
facing. The corporation needs to raise 10$ per person to pay for a new
water cooler for their break room. They decide to use a “sales tax” on
the coffee and M&M’s sold through the vending machines to do this.

Say that all the employees earn the same income, and consume only M&M’s
and coffee at work. The employees are not known for being morning people,
and so need to drink 2 cups of coffee every morning, almost regardless
of the price. The M&M’s provide a nice sugar high in the afternoon,
but the amount the employees buy depends a lot on the price — mmm, M&M’s,
I’ll be right back…

The president of the company, Dr. Ramsey, wishes to raise the money
so as to keep his employees as happy as possible. How should he set the
tax rates on coffee and M&M’s?

If he mostly taxes the coffee, the employees will grumble and end up
paying the 10$ per person when getting their morning coffee, but their
consumption of coffee and M&M’s will remain mostly unchanged.

If he mostly taxes the M&M’s, the employees will again grumble as
they end up cutting back on their M&M consumption and up paying the
10$ during their afternoon sugar fix. In this case, the employees not only
pay the 10$, but they also experience a greater “distortion” in their
behavior
when they cut back on their usual afternoon chocolate.

The employees are better off in the first case when the coffee is taxed,
and their routine is not disturbed. Mr. Ramsey being a nice boss, should
decide to tax the coffee.

More generally, imposing a tax usually involves some amount of “distortion”
to behavior, and the less the distortion the better. This solution is what
economists call an “inverse elasticity” rule. Those goods that are most
sensitive to prices (demand elastic) should be taxed least.2

FYI, here is the Ramsey rule for n commodities in all its glory:

 

Taxing Internet Service

From the example above, we see that if the Internet were just an ordinary
commodity, we would not necessarily like to tax it at the same rate as
other goods. If Internet access is very price sensitive, then we would
want to tax it less than other goods. On the other hand, we should tax
it more heavily if consumer demand does not vary too much with prices.

I am unaware of any studies looking at the price sensitivity of Internet
usage – but at this level of analysis, there should at least be some positive
level of taxation.

“But”, you say, “the Internet is not just an ordinary commodity”.
As I see it, the Internet is different from a standard commodity in (at
least) two fundamental ways. First, the Internet can be thought of as a
“market” – a place where buyers and sellers can meet, exchange information,
and trade. Taxing the Internet or Internet access can be thought as a hindrance
to the formation of an relatively more efficient market and thus not desirable.

Second, the Internet contains significant Network
Externalities
— where the addition of another Internet user increases
the value of the Internet for all current users — in which case it may
be desirable to actually subsidize Internet access rather than to tax it.

These arguments seem to me to be sufficient to keep the tax collectors
away – at least for the time being.

Internet Commerce

Another related taxation issue is whether Internet Commerce should be
taxed. This seems like a rather clear situation. From a sales tax perspective,
I see no real difference between ordering something from a catalogue or
from a company over the phone, and ordering something via the Internet.
It seems reasonable to use the same taxation laws that currently exist
for Internet commerce.

If the two systems were to differ, then there would be an added incentive
to move commerce onto the Internet, even if it is not efficient otherwise.
There would also be an incentive to dodge taxes by simply moving current
commerce to the Internet.

This isn’t to say sales taxes for catalogue or phone ordering is the
best or even a good system3 
– it’s just that the two should be the same. If the debate over Internet
commerce prompts a (good) revision in the relevant taxes for other sales
mediums, then this is to be commended.

On the other hand, if the Internet were in the situation in which it
lacked a critical mass of both buyers and sellers to really get the Internet
marketplace going then there might be a good argument for no taxes – or
even subsidies to get the “infant industry” off the ground.

This seems to be president Clinton’s attitude: “We can’t allow unfair
taxation to weigh [the Net] down and stunt the development of the most
promising new economic opportunity in decades”.

 

Other links

Footnotes: 
1I will confine the discussion to optimal
commodity taxes. Experienced economists will be groaning about now – “oh
no, he’s going to try to explain the Ramsey rule in plain english”. As
much as I’d love to tackle the Ramsey general optimal commodity taxation
problem and the Diamond-Mirlees multiple household and production elaboration
– that’ll have to wait for another time. 
2The “Ramsey rule” is considerably more
complicated with many more subtleties than the simple story told here.
Cross price elasticities, multiple households, etc., are important when
deriving the optimal tax – but the insight is roughly the same as presented
here. Strictly speaking the inverse elasticity rule is only valid if the
cross elasticities are constrained to zero. 
3In particular, since sales taxes are
levied at the state levels, there is substantial competition among states
to attract companies. This means that firms have incentives to locate in
places that they would choose in absence of the tax system. Dealing with
sales taxes in 50 states may also be a significant burden.

Filed under: Microeconomics

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