No Real Heroes: Reading "Barbarians at the Gate"

Reading this, my wife asked if I liked the book, and what it was about.

My quick answer was that it was the real life version of American Psycho.

Maybe that is too harsh a criticism. I know Ellis was mocking this milieu when he was writing his books in the late 80s and early 90s. He has a lot of crossover between characters in different situations, and shows how small the Wall Street world of the time was, but also how faceless. The only difference is that in this book there is not a lot of murders, real or imagined.

It actually took me a while to finish this book. I’m just young enough I don’t remember the RJR Nabisco buyout, and I had never heard of Ross Johnson before reading this book. My memory of Barbarians at the Gate was an advertisement for the movie on TV.  Basically it took me a whole to read because there was no good guy to root for. Everyone had some weakness, and the narration didn’t construct the story of the buyout in such a way that it was the vindication of Kravis or the downfall of Johnson. It felt indifferent and impersonal – here’s a thing that happened. I don’t know if that was intentional by the authors or not. The one thing that really comes out from the book is that the whole LBO or private equity industry looks bad.

I think the authors wanted to show how bad the LBO industry was. If that was the goal, they succeeded. It did die down for a while. But the real funny thing is that the amounts that are supposed to seem obscene now seem tiny after the financial crisis. I’m not going to a 1989 inflation calculator to get the real terms of the buyout, but 25 Billion in nominal terms just seems small. The authors touch on this in the afterward.  

The short termism and the greed that are illustrated here are still in play on Wall Street. Kravis is still doing buyouts. The names of some of the firms have changes. The suits look a bit different. The securities laws have been amended.

The barbarians still wait.

Brief Defense of the Avid Amateur

 A cross post from my Noah Smith fan blog, "Entitled to Noahpinion"

I was thinking about Noah's post where he was curious about amateurs with an interest in economics, and it got me thinking.

A lot of the early post-enlightenment advances in science were made by avid amateurs in fields as varied as geology, zoology, and chemistry.

When I think of guys like these (and they were mostly guys) I think of someone like Joseph Priestley. He isolated Oxygen, amongst other claims to fame.

But he wasn't a scientist as we know it. He was Minister. (Lots of churchy guys going cool science stuff, like Mendel).

So basically the idea of scientist doesn't come around until there is institutionalized science. Then you can throw up the walls and point at the avid amatuer and call him a birdwatcher and not a zoologist.

This also is the case in economics. The early econ stuff is narrative. There's not a numbers. But you math it up a bit and use differential calculus the you can draw a sharp line. If you're not doing math, you're not an economist (Not to speak ill of math and graphing, it still can illustrate important concepts to entry-level students).

Denying Market Entry Through Advertising

 

Brick By Brick

          Robert Smile surveyed over three hundred companies on their use of entry-deterring strategies. His findings are reproduced in Besanko et al. (2013). Smile examined the use of these firms in terms of the learning curve, advertising, patent acquisition, limit pricing, and excess capacity. All of these were examined in terms of the use for new products and existing products. The data are pretty clear in that use of advertising is the predominate entry-deterring strategy used by companies in the sample. Companies use intensive advertising in 62% of cases with a new product and in 52% of cases with existing products (p. 219).

Use of entry barriers exist because there is a profit advantage in controlling market share. Entrants to a market move the supply curve to the left but do not necessarily move the demand curve. This means that ceteris paribus, the equilibrium price of the product under consideration will be lower than it was before a rival firm’s market entry, and the quantity demanded will be divided between the incumbent and the new entrant. This drives down both profit and revenue. A rational actor will work to limit entry to their market.

The main problem with some of the options in limiting market entry is that they do not necessarily work in a dynamic system. If a firm either tries to keep prices low to prevent entry or maintain excess capacity, they may seem to make sense in a toy model with two time periods, but the actual market is changing and exists in a world of infinite time periods. Over time, if a firm were exercising limit pricing as a monopoly with limit pricing, it would see zero economic profit. If it were instead willing to share the market, as an oligopoly, then they would be able to see some profit above zero (Besanko et al. pp. 208). The same applies for holding excess capacity. A firm cannot be expected to hold that capacity forever. And as the saying goes, what cannot go on forever, will not.  The fact that these options do not necessarily work ties in with the fact that in many countries such theoretically anti-competitive practices are illegal.

The other side is looking at what works and what is used. Firms predominately use advertising to create product differentiation and limit market entry. A look at the top advertisers will illustrate this. Of the top twenty-five advertisers, several industries stand out. The cell phone industry’s big four are all represented. The list also includes five automakers, three insurance companies, five large retailers, two fast food companies, and three tech companies. The only real surprise is that there is only one beer company (“America's 25 Biggest Advertisers”). The common feature is that these are some of the biggest companies in America, so they can afford to spend a lot on advertising, but they all compete in fairly concentrated markets. Advertising is not just a way to maintain and steal market share from competition firms, but it creates a barrier to entry. To be fair, some of these industries have high barriers to entry for a new firm, but it also impedes other nation’s companies from market entry because the brands are part of the environment in a way that a new entrant could only hope to be. In terms of protecting market-share, advertising and marketing is the smart move for any executive.

References

Advertising Age. (2013, July 8). Infographic: Meet America's 25 Biggest Advertisers. Advertising Age. Retrieved from http://adage.com/article/news/meet-america-s-25-biggest-advertisers/242969/

Appleby, J. (2014, May 2). New hepatitis C Drugs’ Price Prompts an Ethical Debate: Who Deserves to Get Them? Washington Post. Retrieved from http://www.washingtonpost.com/business/new-hepatitis-c-drugs-price-prompts-an-ethical-debate-who-deserves-to-get-them/2014/05/01/73582abc-cfac-11e3-937f-d3026234b51c_story.html

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.

Innovate or Die

Clear to blue. Breakthrough!

Over time, a firm competing in an industry that is competitive will tend towards zero economic profits. Over the long term, that means there will be exit from firms that have higher marginal costs, as they will lose money as a price taker.

If a firm wants to remain a going concern and they are not just a commodity producer, they should ideally become a monopoly, so that they can set their price and quantity. That task is too easily said but is difficult to accomplish. Any monopoly at a large scale will face regulation and excessive attention from the state in terms of prices and quantities produced.

Instead, what a firm needs to do is to be constantly innovative. By being constantly innovative, they can use first mover advantage to gain a temporary monopoly on their new concepts. Even better is if a firm can use state protections like patents, which grant a temporary monopoly on a product. One example is Viagra. Viagra was the first drug that was popularly used to treat erectile dysfunction in the United States. Its introduction was unlike any other drug in recent memory, and it led to jokes and magazine covers. It also led to sales. Though there are now competing drugs, Viagra is not just a chemical compound; it is a brand in itself. It still controls almost 50% of its market, and in 2012 brought in over two billion dollars for Pfizer (“Viagra”).

The problem is that those temporary monopolies lapse. Drug companies have to keep drugs in their research and development pipeline because Viagras are few and far between. Many promising compounds flame out somehwhere between the lab and human testing. Therefore, to maintain its market position, drug companies have to innovate. Alternately, they buy smaller companies working on promising compounds. The reality is that the monopoly granted by a patent is temporary. The patent for Viagra will run out in 2019 (“Viagra”), and Pfizer will have to replace that two billion dollars with something else. Other companies will be able to make the chemical equivalent of Viagra and the profit on Viagra will be lowered. There are other strategies that drug companies use to extend their monopoly on drugs: they will reformulate the delivery system and then rebrand it as something like “Viagra Extended Release”. Moves like this stem the fall of economic rents from the patent protection and the fading brand, but they are no substitute for new innovation and differentiation.

A final thing to consider is the pricing on your temporary monopoly. If a drug company has created some potentially life-saving compound, the price of that compound would perhaps have a perfectly inelastic demand curve. No matter what price the company charged, the demand would be everyone who had the disease. Something close to this has happened recently. Gilead released Sovaldi. It is a twelve-week regime that has a much higher cure rate for Hepatitis with few side effects than current treatments. Gilead used its monopoly to set the price high: 84,000 for the twelve-week-course. That comes out to about a thousand dollars a pill when the marginal cost of the making those pills is much less. This pricing has brought out extra-market forces to bring pressure on the company. (“Who Deserves to Get Them?”). A quirk of the pharmaceutical industry is that many of its products are not paid for by the end user, instead it is government agencies and insurance companies. Around the world, they are imposing various forms of political pressure and price controls on the drug. In spite of this pressure, Gilead realized over ten billion dollars in revenue on Sovaldi alone (“Sales of Sovaldi”). Even though there was much clamor, the company made the profits by their innovation. In addition, they are not done. Gilead has more drugs in the pipeline for when Sovaldi is tapped dry.

References

Appleby, J. (2014, May 2). New hepatitis C Drugs’ Price Prompts an Ethical Debate: Who Deserves to Get Them? Washington Post. Retrieved from http://www.washingtonpost.com/business/new-hepatitis-c-drugs-price-prompts-an-ethical-debate-who-deserves-to-get-them/2014/05/01/73582abc-cfac-11e3-937f-d3026234b51c_story.html

Pollack, A. (2015, Feb 3). Sales of Sovaldi, New Gilead Hepatitis C Drug, Soar to $10.3 Billion. The New York Times. Retrieved from http://www.nytimes.com/2015/02/04/business/sales-of-sovaldi-new-gilead-hepatitis-c-drug-soar-to-10-3-billion.html

Wilson, J. (2013, March 27). Viagra: The Little Blue Pill That Could. CNN. Retrieved from http://www.cnn.com/2013/03/27/health/viagra-anniversary-timeline/index.html

Tit-for-Tat Pricing

How Much is that Seat?

 

The smoke-filled room of lore, with big cigars and big men setting prices in their waistcoats and pocket watches drinking scotch, is over – if it ever existed at all. Instead, there is much more transparency about prices that are set and more sophisticated theories of firms and how they should act to maximize profit.

            That said, the best way to maximize profit would be to act as a price and quantity setting monopoly. Since that is not allowed, the second best option is for the market as a whole to act as if it were a single monopoly or a cartel (Besanko et al. p. 235).

            The disconnect can be solved in that pricing decisions are made all the time, based on different inputs. Every firm in a monopolistically competitive market will want to maintain the price that they would be able to get in a monopolistic market. The same firm also wants as much market share as possible to gain market share, the firm would have to drop its price. The issue with this is that if one firm drops its price, the next firm can also drop its price up to their marginal cost. A situation where all firms have dropped their prices to their marginal costs leads to much lower profits for the market as a whole, even if sales are greater. In this situation, what firms want to do is play a game of follow the leader to the point where the price is back to where it would be in a monopolistic environment. One firm can raise their price, and sacrifice market share. Once one firm has increased its price, there are two things that can happen. Either the competing firms in the market can raise their prices to the level the first firm did, or they will not. If prices are not followed, the first firm can lower its prices to the level of the other firms. If the other firms follow the first firm, all the participants in that market benefit from the increased revenues. This process can be repeated up to the point where the price level is at the monopolistic price. This is considered “tit-for-tat” pricing (Besanko et al. p. 238).

            The most common example of an industry that uses tit-for-tat pricing is the airline industry. Though they differentiate themselves on service, the large airline companies have a relatively homogeneous product. What they do is take a person from point A to point B. There are also a limited number of routes that can be flown, as most cities have only one airport and these airports have a finite number of gates. Planes are also expensive and there are regulations on the routes foreign carriers can fly in the United States, so the domestic carriers can price as if they were a monopoly fairly easily. This is helped by the fact that their pricing is not transparent (“Airlines reveal ticket pricing strategies”) and two seats on the same plane in the same section may have sold for vastly different prices. The airlines can and do monitor price changes of their competitors in order to maximize the profit from each flight. As the industry consolidates, coordination will be aided by fewer market participants and lower marginal costs as merged companies exploit back office synergies.

References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.

Sumers, B. (2013, June 30). Airlines Reveal Ticket Pricing Strategies. San Jose Mercury News. Retrieved from http://www.mercurynews.com/ci_23572144/airlines-reveal-ticket-pricing-strategies