Friday, August 31, 2007

Valuing old age

Health insurance is a very interesting area of study, throwing up multiple challenges. Insurance companies are forever trying to reduce their costs, by screening out people with higher potential health costs. But they face a fait accompli in higher medical costs, with their aging clients. There is an excellent article in the NBER on this debate "The Value of Life Near its End and Terminal Care", by Gary Becker, Kevin Murphy, and Tomas Philipson.

The authors claim, "Medical care at the end of life, which is often estimated to contribute up to a quarter of US health care spending, often encounters skepticism from payers and policy makers who question its high cost and often minimal health benefits. It seems generally agreed upon that medical resources are being wasted on excessive care for end-of-life treatments that often only prolong minimally an already frail life. However, though many observers have claimed that such spending is often irrational and wasteful, little explicit and systematic analysis exists on the incentives that determine end of life health care spending. There exists no positive theory that attempts to explain the high degree of end-of life spending and why differences across individuals, populations, or time occur in such spending. This paper attempts to provide the first rational and systematic analysis of the incentives behind end of life care. The main argument we make is that existing estimates of the value of a life year do not apply to the valuation of life at the end of life. We stress the low opportunity cost of medical spending near ones death, the importance of keeping hope alive in a terminal care setting, the larger social value of a life than estimated in private demand settings, as well as the insignificance in quality of life in lowering its value. We derive how an ex-ante perspective in terms of insurance and R&D alters some of these conclusions."

Update
Economists Charles I Jones and Rober E Hall, in The value of life and the rise in health spending, argues that as societies develop and incomes grow, the premium attached to extending our lives increase. They ask, “As we grow older and richer, which is more valuable: a third car, yet another television, more clothing — or an extra year of life?” They claim, "Standard preferences—of the kind used widely in economics to study consumption, asset pricing, and labor supply—imply that health spending is a superior good with an income elasticity well above one. As people get richer and consumption rises, the marginal utility of consumption falls rapidly. Spending on health to extend life allows individuals to purchase additional periods of utility. The marginal utility of life extension does not decline. As a result, the optimal composition of total spending shifts toward health, and the health share grows along with income. In projections based on the quantitative analysis of our model, the optimal health share of spending seems likely to exceed 30 percent by the middle of the century."

Wednesday, August 29, 2007

Slum Regeneration

It is a common refrain that houses allotted to the urban poor are sold immediately after its allotment, and the allottees then move to another squatter settlement and become applicants for housing again. The presence of rennovated and in some cases fully reconstructed housing units in weaker section housing colonies are cited as a failure of Government policy in preventing such transactions. However, my contention is that such transactions and the consequent renewal are inevitable and even desirable, and therefore ought to be welcomed.

The more strategically located areas in slums like road margins, junctions etc, are especially vulnearble to being sold or leased out. Typically, the buyer converts at least a portion of these houses into shops or small commercial establishments. Often, more than one house is purchased and get amalgamated into a single unit. But the internal lanes of these slums continue to remain more or less the same, and the turn-over rates are marginal.

There are a number of reasons for welcoming such transactions and consequent renewals. Most importantly, they bring in valuable economic multiplier to the local slum economy. Very often these new settlers are responsible for setting up essential commercial establishments like grocery stores, medical shops, and various services. Without these shops, the slum dwellers often have to travel long distances to procure all their daily and other requirements. This can be best explained with the help of the following parable.

Slumland is a poor country, with a predominantly agricultural and mininng economy. It relies on imports to satisfy all its requirements of capital goods and consumer durables. Its communist Government exercised stringent trade controls, and this spawned a flourishing black market. Then, with the collapse of the Soviet Union and the subsequent fall of the communist Government of Slumland, the new Government opened up the economy. Movement of goods, labor and capital was liberalised, and the Government reached out to invite Foreign Direct Investment(FDI) to Slumland. The economic growth soon reached double digits and the country started booming.

Now replace Slumland with any slum and the external investors and FDI with outsiders purchasing houses in these slums, and things fall into place. The investment by outsiders, even if by purchasing the houses allotted to urban poor, is desirable and has many immediate and long-term multiplier effects on the economy. In fact, it is even essential for the development of the slum since such economic activities cannot find local investment from within the slum. And finally, as is the case with FDI coming to Slumland, it is certainly important that certain regulations govern the terms of these housing transactions and its subsequent use.

Apart from the obvious direct benfits from the commercial and other service establishments set up by these outsiders, there are other indirect benfits brought by them. It brings in better schools and hospitals, banks, and other Government and private institutions. It also brings in consumers with higher purchasing power, whose spending power can sustain these services. Just as external investors brings in new and the latest technology and higher economic growth to Slumland, these outsiders purchasing houses in slums bring in economic regeneration and growth to the slum.

This also produces an economically efficient solution by allocating the scarce slum resources more efficiently. These road margins and junctions are the most valuable lands in the slum, and it is only appropriate that these locations be used for those activities that maximize the social utility. The poor, original house allottee gets a good deal, with the sale of the allotted house fetching a value few times more than the actual unit cost of the house. The purchaser gets a valuable piece of real estate with great potential for future growth and which is ideal for his economic use. The slum community gets useful and necessary commercial establishments, which would otherwise not have been established. Nobody is made worse off and it is a win-win situation for all the stakeholders.

Though there is a regulatory solution to this, I have my apprehensions. It involves earmarking such potential locations along road margins and junctions for auctioning off for commercial development. This is something similar to allocating land for Special Economic Zones (SEZs). There are a number of practical problems associated with such solutions. There is also a very serious danger of failing to meet any of the objectives, faced as it is with a set of strong counter-incentives. It may therefore be appropriate that slums develop organically as small open economies, and not as models of development thrust from above.

Tuesday, August 28, 2007

Superstar effect

Economist Sherwin Rosen observed how the big stars of soccer and major league baseball, commanded huge salaries and other remuneration. He tried to explain as to why a small number of people earn the lion's share of remuneration and dominate the fields in which they engage. This has commonly been referred to as the "winner-takes-all" effect. Such markets are common in film and music industries, and is increasingly taking over the market for CEOs, financial managers, media personalities etc.

"Winner-take-all markets have proliferated in part because technology has greatly extended the power and reach of the planet's most gifted performers....Now that most music we listen to is pre-recorded...the world's best tenor can be literally everywhere at once.” Alan B. Krueger's studies of the concept of the "superstar" in popular music indicate that "the top 5% of revenue generators took in 62% of concert revenue in 1982 and 84% in 2003", as demand for "superstar" performers increased.

Now, I can understand Tiger Woods or Roger Federer or Michael Schumacher or Justin Gatlin commanding huge salaries or appearance fees. They all participate in individual sporting events, where success is easily measured. But how does one explain the huge salaries paid to football or major league baseball stars? Surely a Thierry Henry or Zinadine Zidane or Barry Bonds or Alex Rodriguez or Roger Clemens are not ten times better than their teammate who earn ten times less. So what explains this differential?

For one, both in football and major league baseball, superstar players often get recruited to boost the image and the hype surrounding the team, which attracts more spectators. By bringing in more people to watch the team, the superstar commands a larger audience than his mere mortal team mates. This higher audience naturally translates into greater revenues at the trunstiles, thereby justifying the massive premiums given to superstars. But this however does not explain the disproportionately high salaries paid to these super stars.

These superstar players have a more important attraction for the good teams. There is very little difference between the major contenders in any league. This means that the teams are on the lookout for anything that gives them the tiniest of edges, that places them ahead of the leading pack. Superstar players often provide that critical edge for these teams, and hence become very valuable for the team. In fact, they even become the difference between winning and losing for these teams. An economist would say that the superstar player has a much higher Marginal Benefit than any ordinary player. Sherwin Rosen therefore observes that "small differences in talent at the top of the distribution will translate into large differences in revenue."

Marginal Benefit of a good or a service refers to the incremental utility or benefit obtained for every additional unit of the good or service consumed. Generally, the Marginal Benefit of goods decreases with every additional unit, which explains the Goosens' First Law of diminishing marginal utility. But the superstar provides the critical tipping point, in terms of performance potential, that would mark a team out from its competitors. Therefore his Marginal Utility for the team becomes very high and higher than that of any of his team mates, and the salary reflects this premium.

Sunday, August 26, 2007

Moral hazard in financial transactions

It is bailout time again. Every time Wall Street sees the writing on the wall, the hitherto hallowed principles of free market are consigned to the dust heap and the clamour for tax payer sponsored bailouts starts. It happened with the Argentinian Tequila crisis and the LTCM collapse in the 1990s, with the likes of WorldCom and Enron at the turn of the Century, and is getting re-enacted with the sub-prime mortgage lenders. The entire Wall Street cast led by the major Investment Banks, hedge funds, private equity firms, commercial banks, real estate developers, mortgage lenders, rating agencies, accountants etc are now busy making a case for the "B" word.

John Paul Getty famously said, "If you borrow $100 from a Bank, you have a problem. But if you borrow, $1 million from a Bank, then the Bank has a problem"! This captures the essence of one of the most important concepts in modern finance, Moral Hazard. If the Banks have a problem, Wall Street is not far behind. This means that the likes of Alan Greenspan, Ben Bernanke and Hank Paulson, have to surely step in. (Remember the "Greenspan put", the very epitome of "moral hazard" at work) Translation: taxpayers' money has to be rolled out to bail out the irresponsible and greedy lenders, or else we risk endangering our entire economy, or so the wise men say.

Moral Hazard refers to the phenomenon wherein the re-distribution of risk through a transaction, adversely affects the incentives of economic agents involved in the transaction. It arises when parties to this transaction have assymmetric access to information, which is crucial to the success or otherwise of the transaction. The world of finance is rife with numerous examples of moral hazard problems like insurance, lending and securitization, investment decisions etc. The most classic moral hazard issue arises when greedy lenders throw out due diligence standards and pour money at anybody willing to borrow, in the firm belief that the system will not, or cannot afford to, let them fail. The recent decision by the Federal Reserve to cut the discount rate by 50 basis points to 5.75% is only the latest instance of confirmation of this belief. The sub-prime mortgage lending debacle is an example of moral hazard caused by a firm conviction among all the agents, that the Government will step in if thngs go bad!

The enormity of this moral hazard scandal is staggering. First, the mortgage lending agencies like Fannie Mae and Freddie Mac, threw caution into the wind by lending massively to individuals and institutions with very dubious credit histories. With interest rates at historic lows, the Wall Street Banks lent heavily to corporate sector and private equity firms and hedge funds, to finance their megalomaniacal share buybacks, M&As and LBOs. The Investment Banks, Private Equity Firms, and Hedge Funds, flush with funds from high net worth individuals looking for high yields in a low return market, floated high risk, high return investment funds, which bought mortgage-backed, structured credit derivatives and other exotic financial instruments.

The crime does not stop with Wall Street's big Investment Banks. As Paul Krugman observed, "Rating agencies like Moody's Investors Service, which get paid a lot of money for rating mortgage-backed securities, seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the 1990s, the accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest -quality, AAA assets."

If you have not got a feel of the sheer madness of the situation, try this out. Assume MyBank lends $100 to a A, B, C, D, E and F, with credit histories in the descending order. In fact, though E and F are known defaulters, MyBank is not concerned because they get a markup of atleast 300 basis points on such lending. MyBank in turn takes this loan off its balance sheet, by selling it off to Nobody's Bank. It in turn dices the loan and packages them into structured Collateralized Debt Obligations (CDOs), with different payment tranches, and sells it off to Everybody's Bank and investors like P,Q, and R, who have invested through the hedge fund floated by Everybody's Bank. (In fact, with the liberalization of restrictions on mutual funds and pension funds, many of them, who deal with investments of small investors, have taken substantial stakes in such hedge funds and private equity funds)

The risk has therefore been transmitted across the entire system, from MyBank to NoBody's Bank to Everybody's Bank, and finally to P, Q, and R. Now if E and F defaults, as they invariably should, the Ponzi scheme collapses. P,Q, and R ends up paying for the greed and irresponsibility of MyBank. Meanwhile seeing the success of MyBank in getting away with this roulette, more bankers enter the picture. This draws out more defaulters like E and F. The bubble grows. As is evident, in any such financial transaction, there is a need to put in place safeguards and undertake due diligence at every level, to minimize the moral hazard and disincentivize agents.

Government investments are a less discussed example of moral hazard. Such decisions are more likely to be flawed for a number of reasons. Such decisions are invariably taken based on incomplete information and on extraneous political or other considerations. But the most critical moral hazard danger comes from the fact that nobody owns the investment capital. The investment capital is somebody else's (tax payer's) money, and the bureaucrats making the investment decision have no incentive nor disincentive in making informed and optimal choices.

Thursday, August 23, 2007

Welcome change in Cricket

The Subhash Chandra sponsored Indian Cricket League (ICL) has set the cat amongst the pigeons, and brought Indian cricket to a crossroads. And I will argue, for the good of Cricket. For a very closeted sport, confined to a miniscule number of nations, and run secretively and inefficiently like personal fiefdom by a cabal of mainly non-cricketers, cricket needs this wake-up call. More so Indian cricket.

The immediate trigger for the the formation of ICL can be traced back to the denial of exclusive telecast rights on international cricket matches in India to Zee TV. In teh seventies, Australian Kerry Packer had floated a rival cricket league after being denied telecast rights. Ditto with Subhash Chandra. It may also not be off the mark to claim that the main reason for the impulsive reaction by the BCCI stems from the fact that there is now a major threat to its monopoly over the biggest revenue stream into cricket, television rights. But there are other more important issues.

Competition in any major popular sport - football, hockey, rugby - involves international, domestic league and international club-level matches, and individual players represent both the national and club teams. But cricket lacks an international club level competition. In fact, even the domestic leagues in many countries like India, are dismally uncompetitive, as to often render such matches meaningless. This results in lack of depth in the game in these countries, reflecting in the poor bench strength of teams like India. Even where there are strong and competitive domestic leagues like in Australia, the absence of international competition and exposure leaves the players not fully prepared to face the challenges posed by international test and ODI matches.

Rebel leagues like the ICL and that floated by Adam Sanford in the Carribean, will undoubtedly provide a much needed stimulus to the weak and unprofessionally organized domestic leagues and also prepare players to face the rigours of international cricket. These developments also carry the seeds for the emergence of a full fledged international club-level competition. International cricket between nations will continue as the premier attraction in the sport, and no private league, however rich, can replace it.

There was a time when, like in cricket today, footballers were at the mercy of national football administrators. Thanks to the growth of competitive football leagues in every major footballing nation, this is no longer the case. The emergence of National Leagues in football and hockey in India, have increased incomes for football and hockey players and, given some of the recent football results, may also have improved playing standards. It is a testament to the vice-like grip BCCI has on Indian cricket that it has taken this time for a rival cricket league to be floated.

Given that cricket is as much a commercial activity as entertainment, the emergence of a break away league is not unexpected. The commercial objectives of the organizers of ICL can be achieved only by getting more people through the turnstiles and commanding very high premiums for match telecast rights. They know fully well that no amount of attractive packaging and scheduling can make up for lack of quality in the games. It is in their interest too that the game of cricket develop greater depth within countries and also cover more countries. This will attract entreprenuers and investors to leverage the enormous commercial possibilities for developing the game and then profiting from it.

This development is only the latest in a trend of more efficient commercial exploitation of Cricket. It is only a matter of time, before national cricket administrators step down from their high pedestals and acknowledge the reality of such renegade leagues. It is only a matter of time before the exclusive monopoly of these self-appointed guardians of the game comes to an end. The day is not far when, like football, cricket too will have its international club competition.

The inexorable logic of the market cannot be stopped from running its full steam, especially on an activity which competes with popular cinema, as the premier entertainment platform in India. Competitive domestic leagues will improve standards and make the game of cricket more attractive. It will also surely make cricket administration and organization much more efficient. The players will be better paid, more facilties will be developed and game will grow more evenly within and across countries. It will ensure that while cricketers provide entertainment to their audience, cricket itself will be administered professionally and efficiently as an economic enterprise.

Tuesday, August 21, 2007

Sincerity and hardwork are positive externalities

This post will claim that sincerity and hardwork are positive externalities and will be under supplied if left to the market mechanism. Also, lack of sincerity and laziness provide negative externalities which will be similarly over supplied by the market. With the existing incentive structure, we therefore will have a market failure in the supply of our most essential work impulses.

Let us examine the market in sincerity and hard work in Government jobs. Very few will dispute the fact that both these attributes are vital to quality service delivery for any level of activity. A sincere and hardworking Government official does his or her work faster and more efficiently, thereby enhancing the productivity of Government. Further, in keeping with the 80:20 rule, they end up doing the work of the lazier staff too. For example, I am convinced that whatever efficiency Vijayawada Municipal Corporation (VMC) claims, can be attributed to the hardwork and sincerity of 40-50 of its 4000 odd employees. I am sure the case is not much different in other Government organizations.

Sincerity and hardwork shown by any Government employee is of more benefit to the system than to the employee himself. Even with the additional work output and higher efficiency, the employee gets the same returns by way of salaries and promotions. His hardwork and sincerity is indispensable to the Government in getting its work done and also concealing the gaping "effort hole" left by the lazier employees. The sincere and harworking employee thereby acts as Reginald Jeeves to the Bertie Wooster's among Government employees!

Perversely enough, sincerity and hardwork encourages and even rewards free-riding. It incentivizes the lazier and insincere officials to shirk their work, in the sure expectation that it will in any case be done by someone else. The lazier and insincere employees get the same salary and promotions as the more hardworking and sincere ones do, and that too by shirking work!

It is therefore clear that the Marginal Private Benefit of sincerity and hardwork is much less than its Marginal Social Benefit. Further, the Marginal Private Cost of hardwork and sincerity are much more than its Marginal Social Cost, which is closer to zero. Eco 101 textbooks describes such situations as examples of market failure. Market failures call for market intervention to correct the incentive structure. Positive externalities should be signalled and incentivized, while negative externalities should be costed, with the agent bearing the cost. How can this market intervention work? Who should intervene in this market?

Any prescription for correcting this market failure has to surely account for the differential abilities and attitudes of individuals, and put in place an incentive structure that reflects this reality. This would entail introducing the likes of performance based promotions and monetary incentives and penalties.

Saturday, August 18, 2007

The economics of booms and busts

The ostrich is back and singing the denial tune again! Consider Bubbleland, a country experiencing the following macro-economic context:

1. The current account deficit is at 6.1% of GDP or $857 bn and is growing
2. Trade deficit for 2006-07 was $827 bn
3. The total external debt is over $ 4 trillion
4. Foreign Central Banks finance more than 60% of the current account deficit
5. Foreigners own $ 2.2 trillion of Bubbleland's Government Treasury Bonds
6. Gross Domestic Household savings, as a percentage of GDP is on negative territory. Consumers are on a consumption binge, financed by borrowing and the wealth effect of capital gains on equities and housing.
7. Interest rates at historic lows, as also bond yields
8. Private sector investment is at an all time low. Corporate spending as a share of GDP is at its lowest in 25 years.
9. With peak capacity utilization, corporate profits are at their highest. But the companies are utilizing the profit surplus to buy back their shares and for takeovers.
10. Bubbleland's currency is at its weakest in decades, declining against all the major currencies.

If the aforementioned macroeconomic characteristics and context were placed as a case study in an Eco 101 class, there could be only one prognosis. A hard landing, with the possibility of a fairly long recession. Now replace Bubbleland, with United States of America, and your Eco 101 fundamentals take a u-turn! Even distinguished financial managers and academicians like Hank Paulson and Ben Bernanke claim that things are under control, and there is no need to panic. There can be only two answers to this conundrum. Either Eco 101 is wrong, in which case let us consign Paul Samuelson to the dustbin, or Ben and Hank are imitating the ostrich, in which case, we have a serious real world economic problem staring at us!

America does not do anything in half measures. In the past two decades, the American economy has been through a roller-coaster ride of booms followed by busts. The late nineties saw an IT and corporate investment splurge and a stockmarket boom, generously assisted by 16 consecutive doses of the Greenspan medicine of interest rate cuts. When the dotcom bubble burst deflating the equity markets, the real estate market heated up. The resultant wealth effect spawned a massive consumption binge. The low interest rates fuelled a massive credit boom, which in turn led to frenzied mortgage lending, share buy-backs, Mergers and Acquisitions (M&As) and Leveraged Buyouts (LBOs).

Nouriel Roubini says, "There is a difference between crises of liquidity and crises of insolvency. Liquidity crises are those in which firms and individuals have a cashflow problem; interest rate cuts help them through the tough times. Insolvency crises are much more serious; slashing rates makes no difference when people are going bust. The LTCM collapse was a liquidity crisis, and what's happening now is an insolvency crisis."

The list of those who have gone insolvent or on the verge is impressive - household consumers, mortgage lenders, real estate agents, investment banks dealing in credit derivatives, hedge funds and private equity firms who traded structured credit derivatives backed by mortgage loans...!

Friday, August 17, 2007

Productivity in Public Service Delivery

This post is in continuation to a previous post exploring the reasons for the poor quality of service delivery in Education and Health Care by Government agencies. This post will go further and argue that the quality of public service delivery is a major problem and challenge with most, if not all public services, and it will continue to be so. More so in developing countries. This post is also a response to the oft repeated, ignorant ramble in the media and among our opinion makers about the inherent inefficiency of Government systems. The villain is variously the politician or the Government official, but never the civil society.

My firm belief is that any judgement of our Government, its agencies, and personnel has to be done in the context of our civil society. It is cliched to say that in a democracy the people get the Government they deserve, and in many respects it is not too far from the truth. Here is why.

Any Government process has to meet the twin test of being standardized and having the lowest possible transaction time and cost. This dual test is a delicate balancing act, since any attempt to dilute one will have serious repurcussions on the other. If we try to make the procedures more rigorous, so as to eliminate all attempts at distortion and corruption, we will end up increasing the transaction times and costs. On the other hand, if we give a go by to procedures and established norms so as to expedite quicker service delivery, it will only open up the system to more rent seeking and malfeasance.

That there is potential for productivity and efficiency improvements in Government is self evident. There are a number of areas where even simple productivity improvements can have very large and visible/felt impact on the quality of service delivery. Improvements are possible both in the processes and the functionaries operating the process at each level.

I have attempted re-engineering of these processes and protocols involved in the issue of a birth or death certificate, trade licence, building permission, property tax assessment, title transfer, water and sewerage connections, and a few other public services delivered by an Urban Local Body. But surprisingly enough, apart from small tinkering, the established process and protocols for the delivery of these services are fairly efficient and effective. (However it is undeniable that the complexity of multiple bureaucratic layers certainly increases as we go up in the hierarchy to the State and the Central Governments) But with the functionaries, there are serious problems.

The most common and important Government welfare services are those like education, health care, anganwadis (child nutrition), Public Distribution System (PDS), issue of legal certificates like birth and death registrations, and other regulatory certifications. These are services where there is a direct interface of the individual citizen with Government agencies, and these functionaries are the public face of the Government. Their behaviour and attitude is taken to represent the repsonsiveness of Government itself to issues concerning its citizens. It is commonplace for citizens to experience difficulty in accessing these services and therefore carrying bitter memories of their interface with the Government. Invariably, in most instances of accessing such services they are dealing with individual Government functionaries. This experience can vary from inefficiency and lethargy, to rampant corruption.

As is evident, all these welfare and civic services delivered by Government and its agencies are labor intensive. The quality of these services are critically determinant on the personal initiative and ability of the field functionaries. In many ways, the most important functionaries of the Government, with respect to delivery of civic services, are those at the cutting edge of executing works or delivering them. Unfortunately, it is this category of officials who are the least motivated and the most inefficient. Even simple productivity improvements will have a dramatic impact on their work output. For example, all of them invariably have very poor work and time management skills, and there is limited emphasis on work quality. Their exposure to the latest and more efficient work organisation techniques and methods is limited, and this results in considerable duplication and easily avoidable time wastage. Very few officials at the field level are conversant (though most of them have been given the basic training in computers, less than 10% are able to use it in any meaningful manner, and the rest use it as a substitute for the typewriter!) with the use of the computers and the latest communication and other technologies, which can substantially improve their work output.

We therefore have a serious problem with the quality of service delivered by these field functionaries. Bureaucratic supervision and monitoring, coupled with use of technology through computerization etc, can improve efficiency and control lethargy and corruption only to an extent. The rest depends on the individual at the cutting edge of service delivery. It is impossible to have such micro-level supervision of every employee. In fact, very often in our quest for more transparency and efficiency, we end up adding more layers of bureaucracy.

To address this micro-level challenge, we need to develop more effective incentive-penalty structure for Government functionaries. More about this in another post. And more importantly, we need to inculcate a sense of civic responsibility and duty, among our citizens. The civil society has to become more responsive and robust, so that its members who become Government functionaries, exhibit a sense of civic duty in their workplace.

Wednesday, August 15, 2007

Comparing the Bush and Clinton economies

There is a very interesting analysis in the BBC by Steve Schifferes, "The end of American Dream?"
The article, based on recent research by the Economic Policy Institute, brings out a series of very interesting statistics about how the US economy during the Bush administration stacks up against the Clinton administration.

1. During the five years from 2000 to 2005, the US economy grew in size from $9.8 trillion to $11.2 trillion, an increase in real terms of 14%. Productivity - the measure of the output of the economy per worker employed - grew even more strongly, by 16.6%. But over the same period, the median family's income slid by 2.9%, in contrast to the 11.3% gain registered in the second half of the 1990s. The wages of households of African or Hispanic origin fell even faster. And new entrants to the labour market fared particularly badly.
2. Average hourly real wages for both college and high school graduates actually fell between 2000 and 2005, and fewer of the jobs they found carried benefits such as health care or company pensions.
3. The incomes of the top 20% have grown much faster than earnings of those at the middle or bottom of the income distribution. The income of the top 1% and top 0.1% have grown particularly rapidly. From 1992 to 2005, the pay of chief executive officers of major companies rose by 186%. The equivalent figure for median hourly wages was 7.2%, leaving the ratio of CEOs' pay to that of the average worker at 262. In the 1960s, the comparable figure was 24.
4. For real household incomes, the median point - the level at which half of households earn more and half less - has actually fallen over the past five years. That marks a notable contrast with the 1990s, when the economic boom boosted both jobs and incomes.
5. The share of income distributed between profits and wages becoame more skewed. The share of corporate profits increased sharply, from 17.7% in 2000 to 20.9% in 2005, while the share going to wages has reached a record low.
6. Overall job growth in the first half of the current decade has been just 1.3%, compared to 12% in the 1990s.

Tuesday, August 14, 2007

A case for an Obesity Tax

In an article published in the New England Journal of Medicine of July 26,2007, titled The Spread of Obesity in a Large Social Network over 32 Years, Professor Nicholas Christakis and James Fowler from the Harvard Medical School and the University of California, San Diego, have found that obesity has a striking dependence on social ties. The article has already generated its fair share of internet debates.

The researchers studied a densely interconnected social network of 12,067 people assessed repeatedly from 1971 to 2003, and observed a total of 38,611 social and family ties in this sample. They also looked closely at the influence of gender, smoking, socio-economic status, and geographic distance.

Their conclusions are very interesting. If an individual's close friend becomes obese, that person’s chances of becoming obese increases by 57 percent. Similarly, it the individual's sibling is obese, his chances of being obese increases by 40 percent. Further, if the spouse is obese, the chances of the partner being obese increases by 37 percent. Therefore, when any individual gains weight and becomes obese, he or she dramatically increases the chance of their friends, siblings and spouses gaining weight. The study goes further and concludes that, more closer the social network or the relationship, greater the weight increase effect! As if to reinforce the importance of social networking on obesity, the study also found that the person’s neighbor, if not a part of his or her social network, has no effect!

Interestingly, the statistics show that friendship is an even more powerful influence than marital and familial relationship. In fact, in comparison to others, marital influence seems to have the least effect on obesity. The sibling influence would seem to indicate some evidence of biological influence, though the social influence of friendship seems much more deeper. This again confirms that contrary to received wisdom, we are not just driven by our genes, no matter how "selfish" our DNA might be. Our relationships with others, particularly non-genetically-related friends, can count for more.The research also shows that the impact on obesity is not lessened if the friends live near or far from each other.

To quote Christakis, "What we see here is that one person's obesity can influence numerous others to whom he or she is connected both directly and indirectly. In other words, it's not that obese or non-obese people simply find other similar people to hang out with. Rather, there is a direct, causal relationship. Most likely, the interpersonal, social network effects we observe arise not because friends and siblings adopt each other's lifestyles. It's more subtle that that. What appears to be happening is that a person becoming obese most likely causes a change of norms about what counts as an appropriate body size. People come to think that it is OK to be bigger since those around them are bigger, and this sensibility spreads."

The study reveals that gender also plays an important role in obesity. In same-sex friendships, individuals experienced a 71% increased risk if a friend of theirs became obese. However, for different sex friendships, there was no significant association. Among friends of the same sex, a man had a 100% increase in the chance of becoming obese if his male friend became obese, whereas the female-to-female spread of obesity increased by only 38%. This pattern was also observed in siblings. Here, if a man's brother became obese, his chances of becoming obese increased by 44%. Among sisters, the risk was 67%. Friends and siblings of opposite genders showed no increased risk. It however found that smoking behavior is not instrumental to the spread of obesity.

The authors rightly claim that obesity is no longer a clinical problem, but a major public health and social concern. Over the last 25 years, the incidence of obesity among U.S. adults has more than doubled, shooting from 15 to 32 percent. In addition, roughly 66 percent of U.S. adults are considered overweight. It has already severely dented health improvements in developed world, and is threatening to do the same in the developing world.

We therefore have an interesting situation, where obese individuals have a perverse effect on their friends and relations. In other words, obese individuals provokes a negative externality. Further more, these obese individuals generating the cost, does not pay for the huge social and economic costs inflicted by him on the external environment and society. Have we not seen the same elsewhere with pollution, parking, over fishing etc?

Economic theory would argue about the need to internalize all external social costs, so as to reduce a negative externality. Such internalizing of external social costs is done through imposition of a Pigouvian tax. So how about an "Obesity Tax" on obese individuals? Unlike other taxes, this is unlikely to have much distortions, given its evident ease of targetting and checking evasion.

But there are difficulties. It has been well documented and acknowledged that obesity could have genetic causes, which are outside the control of the obese individual. Further, making obsese individuals pay for the social costs of their obesity would be tantamount to asking those affected with health problems due to a polluting factory, to pay the external cost of the factory's pollution. So, who should pay for the social costs of obesity? It can be argued that the junk food and other obesity promoting foodtuff vendors are making their huge profits at the cost of the consumer's health as well as at great social cost. We have a typical problem of free-riding. Should they not be paying the Obesity Tax, which could then be used to fund research and health care on obesity related problems?

Update 1
Recent research by Harvard economists, Edward L Glaeser et al, points towards cheap prices for high-calories as the reason for America's obesity problem. This seems to empirically validate the need for an Obesity tax that would raise prices and cut down the over consumption!

Update 2
New York state plans to fight obesity by taxing sugary soft drinks such as Coca-Cola and other soda, the consumption of which has been directly linked to childhood obesity.

Update 3
Janet Currie, Stefano DellaVigna, Enrico Moretti, and Vikram Pathania have an NBER working paper where they write, "Our results imply that policies restricting access to fast food near schools could have significant effects on obesity among school children, but similar policies restricting the availability of fast food in residential areas are unlikely to have large effects on adults".

Monday, August 13, 2007

Religion in promoting social change

The Italian Prime Minister, Romano Prodi, last month called on the Catholic Church to exhort its followers to pay their taxes. This was made in response to the rampant tax evasion among Italians (evidence that tax evasion is not the exclusive preserve of the developing countries!). Mr Prodi complained, "when I go to mass, this subject is scarcely ever touched on in the sermons". Apart from its obvious financial implications, tax evasion has evident moral and ethical ramifications, in so far as it encourages free-riding. The honest tax payers end up paying for the evaders also. Tax evasion is therefore sinful! This is a welcome digression from the usual religious debates of our times.

It is an example of perfect harmony of views and convergence of interests between the temporal and the spiritual authorities. There are many other social, political, and legal issues where there exists potential for similar convergence of interests. Littering and pollution are common examples of activities with huge social costs but significant private benefits. Both have moral and ethical implications in that it adversely affects parties who are not in any way involved with those activities.

Controlling activities like litterring, polluting, and more generally those imposing substantial costs on the society, are a major challenge facing our cities. There are numerous such free-riding activities in our cities that are examples of privately imposed social costs - setting up a noisy welding shop in a residential area, encroaching the road margin with a telephone booth, hawking on footpaths and thereby obstructing pedestrians, letting out sewerage directly into the open drain. Further, the social costs imposed by these activites fall more disproportionately on the poor than the rich. It would not be incorrect to even claim that these activities exacerbate poverty! Regulation and penalties have a limited and only incremental effect on controlling such actions. These actions are individual centred, and exercising any control over it requires influencing individual mind-sets. Here religion scores over anything else.

Given the profound influence of the clergy over laity, it will surely be effective if our religious institutions were to preach the virtues of issues like paying taxes and refraining from littering and polluting. In fact, I will stick out my neck and argue that such moral suasion is a much more effective instrument in addressing these issues than any Government policy. I am convinced that a pastor extolling the importance of keeping surroundings clean and refraining from litterring, or more generally indulging in any activity that would impose social costs, would be a more powerful force for social change than anything in the Government armoury.

To those atheists and Marxists, here is a very strong rationale for the existance and utility of God!

Wednesday, August 8, 2007

Statistics in Cricket

We live in an age when greatness is determined more by the immediacy of our experience of an event or sporting achievement, rather than by any sense of historic perspective. In the circumstances, we need to be careful about selecting the context and the parameters for judging sporting performances.

To take the example of cricket, statistics are often very deceptive and tends to give the impression that we are presently witnessing the "age of batting". For, never in history have there been so many batsmen with batting average above 50. This warrants a more careful selection and application of batting and bowling statistics. It is unarguably true that bowlers try their hardest when bowling to the best batsmen, and batsmen are most watchful when facing the best bowlers. Further, batsmen and bowlers summon their best when facing adversity. The true test of character of a cricketer is measured by his performace when the team is facing the prospect of either losing or winning a match. The basic idea is simple, each sportsman tries his best and strives to excel when fighting with his back to the wall.

There are the usual filters like batting average when playing away from home, fourth innings average, average (and proportion of runs) in matches won, average against the stronger teams etc. But to separate the truly great from the statistically great we need to be even more selective. How about calculating the batting and bowling averages by controlling the following parameters.

1. Batting average while following on
2. Fourth innings batting average when the team is fighting to win or save a match
3. Batting average when the conditions are wet and cloudy
4. Batting average when the average innings score of the match is less than 250
5. Batting averages when the opposition, batting first, has run up a huge (500 runs and above) first innings score
6. Batting average when half the team is back in the pavilion for less than 100
7. Batting averages in the first innings when a team wins the toss and asks the opposition to bat
8. Bowling average when bowling to force a win
9. Bowling and batting averages in the deciding test of a series
10. Bowling average after winning the toss and putting the opposition to bat
11. Bowling average when your team has batted first and has been bowled out for less than 250 runs

This is not exhaustive, but will surely throw up some very interesting stats. I am looking forward to comparing the averages of Sachin Tendulkar, Sunil Gavaskar, Viv Richards and Don Bradman by controlling the aforementioned parameters.

Monday, August 6, 2007

Mother of all buybacks!

In what could turn out to be the "Mother of all share buybacks", Blackstone is reportedly considering the buyback of its shares, recently issued in an IPO. Daniel Gross explores the potential of this profit opportunity in an article, "Blackstone, Meet Blackstone", in The Slate.

This possibility only highlights the potential for similar adventures by smart financial managers at other private equity firms or hedge funds. The modus operandi could be something like this - identify an under valued or ailing firm; take it over with debt, and LBO; lay-off workers and spin-off unprofitable units, to dress up the balance sheet; hype up the "success", as build up to an IPO; get the firm listed at a high enough price; wait for reality to dawn, market to play itself out, and skeletons to tumble out; when share prices start falling, step in with a buy-back offer.

Consider this example. Assume publicly listed Ailing Associates 1.0 with 1 m listed shares and a Rs 10 share, trading at a discount of Rs 5. Then Predator Private Equity firm sets up Predator SPV, which steps in to take Ailing Associates 1.0 private, with 80% debt. The SPV equity is Rs 1 million and debt Rs 4 million. The value lost by public investors is Rs 5 million, and this is effectively transferred to the SPV. Then Ailing Associates 1.0 is restructured with 1000 workers laid off, and its balance sheet dressed up with some innovative financial engineering. Ailing Associates 2.0 is now the toast of global financial markets. After six months, an IPO of Ailing Associates 2.0 is announced with 1 m shares offered at an initial offer price of Rs 20, so as to raise Rs 20 million. After three months of the IPO, the honeymoon is over and reality dawns. The share prices of Ailing Associates 2.0 dives to Rs 10, thereby wiping out Rs 10 million of investor assets. Predator SPV now steps in with an offer to buy back the shares. The 1 million shares, issued for Rs 20 million, are now bought back for just Rs 10 million, with the same 20:80 debt-equity ratio. The equity share of the SPV in the buy back being Rs 2 Cr.

The balance sheet of these transactions is something like this. Investors in Ailing Associates 1.0 and 2.0, invest Rs 30 million and loses Rs 15 million. The Predator PE firm and its high net worth investors makes a total investment of Rs 15 million and gets ownership of Ailing Associates 2.0 (worth atleast Rs 10 million) plus a profit of Rs 20 million, raised from investors during the IPO. On top of this 1000 workers are laid off. Economists will invoke Joseph Schumpeter and justify this as "creative destruction". But in reality, it is a moot point as to whether this is "creative destruction" or "creative theft"!

In a matter of few months, a PE firm or hedge fund could possibly make a tidy profit by transferring money from investors to itself, with no substantial value addition. The afore-mentioned example is outlined only to illustrate a possibility, however remote. Increasingly, the lines between financial engineering and gambling or even cheating is getting blurred!

Sunday, August 5, 2007

How incentives matter in Regualtory Policy?

There is an important economics lesson to be learnt from the regulated taxi and auto hiring system in place in many Railway Stations and Airports. The taxis and autos are all pooled into a que and then allotted customers at the hire counter depending on arrival of passengers. After dropping their fares, the autos and taxis rejoin the line to await their next turn. The customers pay upfront the standard fares for their respective destinations at the hiring counter. The accounts of each driver are maintained and their shares distributed at the end of each day.

What struck me about this arrangement, is its incentive structure. The customers are not cheated nor made to wait, as the fare is notified and there is a continuous and regular supply line of vehicles. The auto and taxi drivers benefit from the disciplined arrangement of an assured market, instead of jostling with each other for customers. The taxi drivers most benefitting from this arrangement are those drivers, who in an environment of open competition would not stand much of a chance against the more enterprising drivers.

Critics would say that this arrangement would benefit the lazy and inefficient drivers at the expense of the more hardworking and enterprising drivers. But this argument is untenable since the total number of customer trips possible remains the same under any arrangement. Therefore the more hard working and active drivers will continue to get more share of the trips than their less enterprising counterparts. But the less efficient and lazier drivers are assured atleast a basic minimum of trips. This arrangement meets the dual test of efficiency and fairness, while at the same time not distorting the incentive structure. This incentive structure passes the basic fairness test of equality of opportunity. It is a good example of a regulated free market.

In contrast, a free market in taxi and auto hiring would have driven out the weaker and lazier drivers and placed the customers at the mercy of rapacious taxi and auto drivers. Even among the more enterprising drivers, the intensity of competition would have led in undesirable results. There would be no winners, and every one would be a loser.

There is a lesson to be learnt from this in policy making and regulation. We need to structure incentives in a manner that enables the poor and the less advantaged to atleast access and participate in the market. But at the same time it should not penalize or disincentivize the more enterprising participants. Reconciling these two objectives will be the critical determinant of any regulatory policy.

Thursday, August 2, 2007

Sub-prime lending now, private equity next?

Sub-prime mortgage troubles in the US are reverberating in stock markets across the world. The emerging markets have seen a flight of the Foreign Institutional Investors (FII) in the past two weeks, and our own BSE Sensex fell over 600 points yesterday, closing below 15000. What is even more worrisome is that the worst may be yet to come!

The issue under scrutiny, sub-prime mortgage loans, were given on the increased value of houses, during the recent real estate bubble in the US and elsewhere, and to those with bad credit histories. With the real estate market booming and interest rates at all time low, the American banks went on a lending spree in the first half of the decade. But now, with the real estate bubble having burst and interest rates on their way up, sub-prime mortgage loans are starting to show up, as borrowers start defaulting and the value of collaterals start falling alarmingly.

The last two decades have seen inflation (we even had theories proclaiming "the end of inflation"!) and bond yields remaining at low levels, leading to historically low interest rates across the globe. Low interest rates have impacted the saving and spending behaviours of both consumers and companies in many ways. Companies have massively leveraged their balance sheets for takeovers and inorganic growth. Many public listed companies have borrowed heavily for buying back their own shares, so as to boost their earnings per share. Consumers have been borrowing and spending merrily, in one of the biggest consumption booms ever. They have also been borrowing heavily to purchase houses, thereby generating a real estate boom. Thanks to all these, personal borrowings have long since crossed sustainable levels.

Low interest rates, which made borrowing for purchasing houses easier and also the spectacular growth in mortgage loan lending, fuelled the real estate bubble. This bubble in turn generated a positive income effect, which first lifted to the consumption boom in the US to a new trajectory and then sustained it. The wealth effect and the resultant consumption boom in the US, coupled with robust economic growth in China and India led emerging economies, resulted in sharp rises in commodity prices, with prices of metals like copper reaching historic highs. Further, global stock markets, especially in the emerging economies, breached their highest levels.

The period also saw the emergence of private equity firms as major players in the global financial markets, with far reaching consequences. From less than $10 bn in 1991, private equity funds have gone on to raise more $459 bn in 2006, and is expected to raise more than $500 bn this year. In fact, private equity fund's share of global Mergers and Acquisitions (M&As) has grown from 2% in 1998 and just 4% in 2001, to over 25% in 2006. More than a third of the S1 trillion in M&A activity in 2007 has been funded by private equity.

The massive private equity led M&As and Leveraged Buyout (LBO) boom in the US and Europe has been driven mainly by the prevailing low interest rate regime and the massive growth of the credit markets and credit instruments. With global interest rates at historically low levels, banks have gone overboard in lending to these private equity firms. They have also borrowed money heavily from the capital market, and purchased under valued companies or have taken a large number of public companies private. The credit markets have given these banks and other lenders the ideal platform for transferring credit risks from their balance sheet, thereby enhancing liquidity. The low rates have also meant that investors, especially the high net worth ones, are forced to lookout for more remunerative investment options. This hunger for more attractive alternate investment options has in turn spawned the development of many exotic financial instruments.

The corporate sector too has not stayed away from the party, and have been running up unprecedented profits for the past five years. In fact, but for the rising surpluses of corporate America, the American current account deficit would have been even worse. This is the dividend from the massive capital investment, especially in technology, by American corporate sector in the nineties and the corporate restructuring in the aftermath of the late nineties tech bubble. As part of the restructuring there were massive layoffs and outsourcing of activities, and companies hived off unprofitable segments of their business.

But unfortunately, while corporate profits have soared in the first decade of the new millennium, it has not been accompanied by proportionate increase in capital investment. Instead of using the low interest rates and the rising surpluses to make capital investments for future growth, the US corporates have been living off the excess capacity generated during the tech boom of nineties. Taking advantage of low interest rates, the private sector has borrowed heavily and also used a substantial portion of their profits, to buy back shares and invest in M&As and takeovers, which in turn have contributed to further rise in share values. This means that the private sector, especially in the US, is badly positioned to face any climb down from the peak of the business cycle.

All this good news from the global financial markets generated a virtuous cycle, that lifted the business cycle into its peak. In fact, in many ways this business cycle can be interpreted as the climax of a process that saw the emergence of financial markets as the critical determinant in the fortunes of the global economy. It is also the ultimate evidence of the fact that the manufacturing sector has eclipsed the financial sector in the pecking order.

Now dark clouds have started gathering on the horizon. The business cycle appears to have passed its peak and corporate profits in the US are already showing signs of slackening. The real estate bubble has burst and the sub-prime mortgage lending market has started unravelling and is beginning to show its effects on the global financial markets. If inflation concerns and the weak dollar pushes up the interest rates further, it could spark off massive mortgage defaults and could hit the financial markets even more.

It could also affect the over-leveraged private equity firms and hedge funds, and the banks who have lent them, thereby setting off ripples in the global financial markets. The over-leveraged takeovers and mergers by private equity firms and others, once hailed as testimony to the genius of modern financial engineering, could start looking silly and foolish. Stephen Schwarzman could become the Michael Miliken of our era! This could have a 'contagion' effect on the financial sector, especially the banks which have financed this boom and also purchased risky credit instruments like Collateralised Debt Obligations. Witness the recent collapse of funds floated by investment banking major Bear Stearns. (as somebody famously said, "If I borrow Rs 1000, I have a problem. But if I borrow Rs 1 million, the bank has a problem!")

The investor and consumer expectations are also not encouraging. Interest rates are expected to go up, as the inflation pressures become stronger. Anticipating this, the bond markets have already fallen sharply, raising yields and the cost of borrowing. The rising interest rates and the consequent higher interest repayments, coupled with the lower real estate asset values, will definitely slacken the capital gains based consumption growth in the US, as the reverse of income effect begins to exert itself. The high interest rates could squeeze the much needed investment in manufacturing sector where capacity utilization is at its peak. Finally economic growth will be affected with the prospects of a recession, which in turn could drag the global economy down.

Therefore the sub-prime bubble may only be the tip of the iceberg. The private equity and the general mortgage lending bubbles could also be on the way to getting deflated. The multiple effects of weakening dollar, rising current account deficit, rising bond yields (or increasing spreads), will increase the pressure on interest rates. The cheap debt that fuelled the LBO and M&A boom will be more difficult to come. Already there are enough signs of investors shunning corporate debt market, and this could seriously affect investment.

Given that the massive investments by private equity firms and debt financed share buy backs by corporates, have played significant role in propping up share prices, the equity markets will also get adversely affected. With higher interest rates and collapse of the housing market, home equity borrowing, a major source of funding for domestic consumption, could fall sharply and even collapse. In any case, we are looking at interesting and tumultuous times ahead!

Wednesday, August 1, 2007

Jobs in Private Equity Firms

There is an interesting article in The Slate, "Look Who's Starting a Hedge Fund!" by Daniel Gross, about the hottest opportunities available for out of work politicians and bureaucrats. Among all professions, politicians and bureuacrats, are uniquely positioned to exploit the advantages of the "Network Effect". The private equity firms stand to benefit from the network externalities generated by such individuals, by way of their being known to a large base of potential customers. This creates a postive feedback loop attracting larger number, richer and more reputed customers to the firm.

Mr Gross makes a few predictions for the next year and ahead.
"As more big institutional investors such as pension funds allocate capital to hedge funds, we should expect more such career switches. By 2009, it wouldn't be surprising if investors were listening to sales pitches for CRAM (Condi Rice Asset Management), Dick Cheney's Buckshot Capital (sole holding: Halliburton), and the Stuff Happens Global Fund, an arbitrage operation run by Donald Rumsfeld."

There is one name Mr Daniel Gross missed out, and he is presently looking for a job -Paul Wolfowitz. How about this name "Wolfowitz-How to screw up your investment" Fund? By 2009 we will have another big noun looking for a verb, George W Bush! I will not be surprised if in return for the beneficence showered on them during the last 8 years, the Texan oil companies come up with a Fund to manage their already massive and ever growing surpluses, and nominate George W as its its Manager or Director!

Pricing flight and cricket match tickets

There is an interesting contrast about the way cricket match tickets and plane tickets are priced. Plane tickets, especially of the low cost fliers, are priced very low if the booking is done well in advance. The ticket price keeps increasing as the date of journey approaches, and it is the highest on the day of travel. In contrast, the tickets of cricket matches (and also popular enetertainment shows) are priced very high initially. However, as the date approaches and if there is limited demand, the organisers generally lower ticket prices.

Now, both flight and cricket matches appear to have the same economic characteristics - fixed number of seats, and if seats are not filled there will be losses. Before we go any further, let us examine as to why there exists a differential pricing strategy, or price discrimination, for these two categories of tickets. We all know that consumers have varying utilities associated with the consumption or possession of the same good or service. This manifests in their exhibiting varying willingness to pay, in terms of demand prices, for the same service or good. The supplier or producer can maximize his revenues by capturing as many consumers as possible, and all at their respective maximum willingness to pay.

The cricket match or enetertainment show organisers have a problem in identifying the right ticket price. If they price it too low, all the tickets will be sold out quickly, and they would have lost out income from those who would have been willing to pay substantially higher prices for the ticket. On the other hand, if the tickets are priced too high, there is the possibility of inadequate demand at that price. The challenge for the organiser is to find the price or prices, at which he is able to capture the full willingness to pay of all the customers. Therefore, he deliberately keeps the price a little high so as to lure out all those with higher utility for viewing the match, and hence willing to pay the higher price. The organiser takes stock as the match date nears and if the tickets remain unsold in significant quantities, he lowers the price to attract more demand.

In contrast, the customer profile and demand motivations for flight tickets are different. Low cost carriers, in particular, price tickets very cheaply as the booking opens. This is to attract all those holiday and other fixed schedule travellers, who look for bargains and the cheapest options. Business and other official users who cannot fix their schedules in advance, would in any case be willing or indifferent to paying the actual or even higher prices to make the trip. By raising prices as the date of journey approaches, the plane operator is trying to capture this unique differential willingness to pay of his customer base. The operator has to make a judgement call on whether he will be able to make more money by the aforementioned differential pricing scheme or by filling more seats by keeping the prices uniformly low. In practice, it has been found that the former is a far more remunerative strategy.

The cases of cricket match (or entertainment shows) and flight seats are excellent examples of how price discrimination can minimize deadweight losses and help capture the full value for the organizers. The problem with price discrimination is the difficulty in identifying the right pricing strategy, whose failure can cause huge losses to the organizer.