Monday, July 25, 2011

The More They Spend, The More Things Stay the Same

Matthew Yglesias and Matthew Cameron are upset how Amtrak is over-paying for trains that will be obsolete. They are so upset, they think Amtrak should have more money. Wait, what?

I don’t particularly want Amtrak to do more with less. I’d like it to do much more with more.
Matt made a good point over the weekend about the need for Amtrak to put its unfortunately meager budget to wiser use than purchasing expensive, soon-to-be-outdated locomotives.
"With more?" "Meager budget?" Perhaps instead of assuming Amtrak is underfunded while operating in this stifling bureaucracy (Cameron blames the Transportation Department for forcing Amtrak to spend the way it does), let's get the incentives right. If an organization's stupidly spending money, the answer is not to give them more. More money under a failed system is just more waste.

No Philip, There Are Rational Expectations

Philip Pilkington at Naked Capitalism has an article which might as well be titled "Watch Me Confuse Theory with Reality." The complaints are familiar: neoclassical economists assume people are perfectly rational and they have all the needed information to make a decision but its possible to think of times when that's not true so the whole idea is stupid. Advertising is often used as a counterpoint and this article is no more original in that regard. It also has particular problems with rational expectations which predicts that people will try to minimize their error when they are trying to forecast the future.
The fundamental point here is that people – be they consumers or producers, investors or forecasters – often act in an almost wholly irrational manner; one that is quite open to manipulation. And once we allow for this the very premise upon which rational expectations theory rests upon falls to pieces.
I like to keep my blog posts short so let me set aside a few issues: the area of imperfect information is a big field in economics, neoclassical or otherwise; advertising has useful functions such as signalling quality (you spend more on ads to demonstrate you're putting a lot behind a product) and conveying information; and rationality in economics is a very low bar (you do what makes you happiest given your constraints and desires).

More fundamentally, rationality is a general guideline which explains the vast majority of the average person's behavior very well. Precisely because it works so well, we don't notice it because errors are more memorable than successes (and for good reason since making an error suggests we need to re-evaluate how we make a decision in that sphere of our life). For example, today I bought a bagel sandwich for breakfast. I've bought such sandwiches many times in my life and enjoyed them so I rationally believed I would enjoy this one. I was right. I also bought it on a banana nut bagel. I've never had such a bagel before but I like bananas, nuts, and the combination of banana and nut so I believed, again recalling my previous experiences, that I would like this. I was right. I also bought a Diet Coke with my bagel sandwich, a drink I've consumed many, many times before. Again, it was enjoyable. Had I not read Naked Capitalism's article, I never would have given my purchases today a second thought.

Do me a favor and think of all the things you bought today. I'm not just talking about your morning coffee or the toll you might have had to pay to get to work. What about the water that came out of your shower? Electricity? Gas? Trash bags? Internet service? Phone service? Netflix account? (Note some of these things you bought earlier so you could use them later, including today.) Most of these things you don't think about and you probably don't know the price for many of them off the top of your head. You might say this violates rationality and that if people behaved like economists say they do, The Price Is Right would be a very easy game show. You'd be wrong.

We don't know these prices, or think about the purchases, precisely because we are rational. For the vast majority of us, what we are willing to pay (our reservation price) is far greater than what these things cost to purchase (the market price). In other words, there is no question we want to buy them. If there is no benefit to contemplating something but a definite cost (as there is contemplating how happy we are with our phone service or the precise price of water), we don't do it. And that leads us to forget how rational we are.

The advertising argument deserves special mention, since I hear it so often. It is the stock response to the rationality skeptic. Let's consider it carefully. If it were true that people are constantly misled by advertising, if we waste billions each year mindlessly pursuing images of sex and stature, then there would be no product development. Indeed, there would be no products. Everything we buy would be empty boxes with pretty pictures on them. Yes, this is absurd but pointing out the logical extreme highlights just how far away we are from this. Advertising takes up a small portion of a company's budget. Macy's spends 5% of its sales on advertising and that's quite a bit for retail. Wal-Mart spends closer to 0.4% and, of course, Wal-Mart's much larger than Macy's. Packaged goods (whatever that means) can get as high as 10%. Product design and development easily hit the same percent in sales (here's some numbers from Canadian companies) with some sectors such as aerospace and computers reaching well over 15%.

Remember, history's awashed with failed products that had lots of advertising. Several blockbusters and dozens more TV shows utterly fail each year. New Coke also comes to mind. One estimate claims 65% of new products fail (some estimates put it as high as 95% but those tend to come from "how to improve your product" websites so take that with a grain of salt). Yes, many of those products suffered from a lack of advertising but some of them were just bad. Let's not forget Borders recently shut down.

Again, our brain can fool us on such minor issues: we remember the purchases we regret (and by no means does neoclassical econ suggest people make zero mistakes) but there are many, many products we see ads for but don't succumb to. I was in Abercrombie and Finch the other day. Its walls were covered with half naked models. Its aisle filled with attractive salespeople. Its shelved filled with $80 pants. As usual, I bought nothing.

Thursday, July 21, 2011

Moon Walking

The Times has a short article on the Google Lunar Prize: $20 million to the first team to land a spacecraft on the moon and explore 500 meters. The article's largely about the very different approaches people have, not in getting there but how they intend to make money beyond the prize. One wants to sell cargo space to the Moon, another wants to do lunar mining, another wants to send American Idol contestant there (I'm for that) by transmitting the sound waves of their voices through the lunar surface and see who sounds best (oh, never mind).

This really highlights how far we've gone since 2004, when the Ansari X Prize awarded $10 million to the first private group that could get to space. It was all about how they are going to get their. I remember hearing very little about the post-Prize business plan.

But the biggest obstacle of all still looms: funding. Still, a lot of these guys are backed by a member of the super-rich. It reminds me one of the under appreciated benefits of having a bunch of very, very wealthy folks: they are willing to pay god-awful amounts of money for high-tech gizmos, allowing them to be affordable for the rest of us just years, rather than decades, later.

Friday, July 08, 2011

Oil Companies As Profitable As Newspapers

According to Yahoo! Finance, both oil companies (Major Integrated Oil and Gas) have the same profit margin as newspapers (Publishing-Newspapers): 6.5% (for each dollar in sales, 6.5 cents is profit).

I'd still rather have stock in Exxon than The New York Times.