The paradox of schools choice revisited

Diminishing returns is a feature of many things in life. School quality is one example. It is already widely acknowledged that a significant part of learning takes place outside the classroom through parental and peer engagement, and other off-classroom sources. This also means that incremental school quality beyond a certain level is unlikely to have any effect. 

This point about the importance of school quality is brought out in a new paper that uses data from parental preferences, peer quality, and causal effects on outcomes for applicants to New York City's centralised high school assignment mechanism,

School choice may lead to improvements in school productivity if parents’ choices reward effective schools and punish ineffective ones. This mechanism requires parents to choose schools based on causal effectiveness rather than peer characteristics... We use applicants’ rank-ordered choice lists to measure preferences and to construct selection-corrected estimates of treatment effects on test scores, high school graduation, college attendance, and college quality. Parents prefer schools that enroll high-achieving peers, and these schools generate larger improvements in short- and long-run student outcomes. Preferences are unrelated to school effectiveness and academic match quality after controlling for peer quality... 

Moreover, no subgroup of parents systematically responds to causal school effectiveness. We also find no relationship between preferences for schools and estimated match quality. This indicates that choice does not lead students to sort into schools on the basis of comparative advantage in academic achievement. This pattern of findings has important implications for the expected effects of school choice programs. Our results on match quality suggest choice is unlikely to increase allocative efficiency. Our findings regarding peer quality and average treatment effects suggest choice may create incentives for increased screening rather than academic effectiveness. If parents respond to peer quality but not causal effects, a school’s easiest path to boosting its popularity is to improve the ability of its student population. Since peer quality is a fixed resource, this creates the potential for socially costly zero-sum competition as schools invest in mechanisms to attract the best students. MacLeod and Urquiola argues that restricting a school’s ability to select pupils may promote efficiency when student choices are based on school reputation.

The results of the new study and its concerns about zero-sum competition among school managements is confirmed by anecdotal and other qualitative accounts of how the best schools in India compete to attract the best students. This, in turn, allows them to command a disproportionate fee premium. The quality divide gets exacerbated in the process, leaving the best performing children in a few schools and the rest to struggle in the large majority. 

I have blogged earlier, using the logic of Schelling's chessboard experiment, to argue that school choice is likely to lead to 'emergent outcomes' that may be far less benign than expected. This is a wonderful game illustrating the point. See more on school choice here. 

The US-Russia relationship is a hostage to Trump-bashing

Arguably one of the two most important international strategic relationship, between the US and Russia, has become a hostage to US domestic politics. 

Even liberals, who otherwise would have supported efforts to improve relations, are now blinded by their hostility to the President and are likely to see red in anything that is conciliatory and aimed at improving relations. Egged on by the media, all sides in the debate have boxed themselves into corners from where compromise looks very difficult. As President Trump has himself said, it is now virtually impossible for his administration to make any effort to improve relations. Or as Edward Luce writes, "Donald Trump is never likely to emerge from the Russian shadow". 

The debate has now degenerated into one where even the mere contact with designated Russian diplomats, a normal course of activity, has come to be viewed with extreme suspicion. The travails of Sergey I Kislyak, the Russian Ambassador in Washington, is symptomatic,

He has told associates that he will leave Washington soon, likely to be replaced by a hard-line general... For Mr. Kislyak, Washington is no longer the place it once was. It has become lonely, and he has told associates that he is surprised how people who once sought his company were now trying to stay away.

This is really unfortunate. It is difficult to not get the impression that Kislyak is a victim of his own success. He has done exceptionally well what every diplomat ought to be doing, expand your country's influence by cultivating important contacts in your host country. 

I am certain that Russia tried to influence the elections. But is there anything odd about that? Russia must have tried to influence every US election and vice-versa. It is no secret that US has supported the likes of Anatoly Chubais and Yegor Gaidar and theirs and other dissident political formations for years. Just recently, President Obama lent his weight behind the No campaigners in the Brexit vote in UK. The CIA has a very long history of trying to influence elections across the world from Philippines to Iran to Panama. Other countries do the same in countries with strategic interests. Real politik dictates that there is nothing unusual about this. 

Where the story can become poisonous is if the influence was used to campaign for their preferred candidate, the attempt succeeded, and the successful candidate is now willing to do Russia's bidding. In other words, Russia used its influence to instal their proxy in the White House. 

This means that despite candidate Trump's low electoral prospects, the Russians had enough conviction and backed him to pull it off. And that Trump is effectively a Russian stooge, at the least willing to compromise US interests in return for personal factors or succumb to blackmail. Even with Buzzfeed and other salacious stuff going around, I am not yet willing to buy this story.

I am inclined to believe that only a small proportion of people go this far, in suspecting their President of being a stooge. The vast majority feel indignant at Russian attempt to influence the elections. These two are qualitatively different positions, though lumped together and conflated by media characterisation. This is unfortunate since the latter, indignation, while understandable is ill-informed, and ought not to be a cause for holding the Russia-US relationship hostage.

Thomas Schelling insight of the day

From this obituary by Henry Farrel,

The U.S. stationed a small garrison in Berlin, which was embedded deep in East German territory, and indefensible against any serious attack. As Schelling described it, these soldiers’ job was not to defend the city but to die if it were attacked. This would then trigger a large scale U.S. response, since no U.S. president could tolerate the USSR killing American soldiers and not retaliate. Hence, by the logic of credible threats, the USSR would not attack Berlin, since it knew that the U.S. would have to punish it harshly, since it had effectively bound itself to deliver on the implied threat. Similarly, Schelling argued that the loss of thousands of American soldiers in the Korean War was a small price to pay if it preserved the U.S. reputation for resolve.

This explanation of Schelling's chessboard experiment, one of my favourite economic concepts, is brilliant.  A DIY version here. The exposition of such counter-intuition is a genius at work!

The challenge with early restructuring of debts

Indebtedness and deleveraging have been an important global economic concern in recent years. Several Eurozone countries, none more than Greece, suffer from massive debt burdens. The Chinese economy is struggling on the back of heavily indebted corporates and local governments. Closer home in India, the fate of "House of Debt" companies are just a more high-profile reflection of broader corporate indebtedness. In all three cases, creditors, primarily banks, are the obvious counterparties suffering the losses. 

There is little prospect of any satisfactory denouement to this problem. Worse still, the policies being followed do not appear to be doing much good. Currently, in all these cases and more, the strategy has been to reschedule loans in the hope that with time recovery will take hold and deleveraging will happen through growth. This assumes that the debt troubles are essentially a liquidity problem - either firms have illiquid assets or the asset revenue streams are further in time - and not one of solvency. 

But what if the latter were true? What if a large proportion of the underlying assets have negative values and the debts cannot be serviced under any circumstances? This assumes significance since it is now widely accepted that the Greek debt burden is just unsustainable and increasingly evident that the same is the case with Chinese local governments and many large infrastructure projects in India. In this case, rescheduling would not only be kicking the can down the road but also increasing the final tally of losses - interest, cost escalation, partial default provisioning etc. In the circumstance, the best approach would be to strip shareholders and have creditors take haircuts. 

Economists have accordingly advocated that the Eurozone debts should have been restructured with haircuts and forgiveness. In fact, economists like Ken Rogoff argue that the Great Recession should have been countered with not just quantitative easing but more importantly, policies that nudged governments into buying back risky debts and lenders into writing-off some part of their loans. The conventional wisdom is that this is an ideological battle between those advocating the wait-and-watch and restructuring strategies. 

Maybe, but for the political decision makers, there is another important consideration. Governments would find it difficult to offer taxpayer's money to bailout bad investments and their respective promoters, investors and lenders. The lurking feeling would be that these reckless and greedy stakeholders are being bailed out. Also baked into this dynamic is the moral hazard associated with bailing out bad investments. 

A bailout becomes possible only when the costs of the stand-off become egregiously damaging to the economy. A settlement, with losses imposed on the stakeholders, then becomes politically less unacceptable. 

Accordingly, though many of the stressed projects are insolvent and cannot be revived without haircuts and contract renegotiations (extend tenure or raise tariff or viability gap funding), it is unlikely to happen till something definitive happens. This includes the developer defaulting completely or going bankrupt, or creditors offering haircuts, or the cumulative drag of all the projects on the sector becomes unbearable. Till then, the promoters and creditors invariably hold out, in the expectation that things will improve or the government will blink. 

Not only would the total cost of a final settlement be much higher, the private benefits from the bailout would outweigh the private costs due to the delay for all the private stakeholders. Coupled with the taxpayer-financed bailout, everyone is left worse off,  similar to a game of Prisoner's dilemma with its inevitably sub-optimal outcome. This is the insurmountable transactional challenge with political and social bargaining in any such situations. 

Rational expectations, behavioural biases, and official transfers

Public corruption is the flavour of the season in India. A series of high profile corruption scandals across the country have ignited an intense debate about corruption in public offices. It has spotlighted attention on the pressures faced by public officials and about their frequent transfers if they fail to oblige their political masters. In this context, here is a Game Theory analysis of one way in which the brunt of such transfers are faced by upright officials. 

Consider the examples of Mr Honest Babu and Mr Corrupt Babu. As their names suggest, the former is scrupulously honest whereast the latter belongs to the opposite camp, and their respective reputations are accordingly well established. Both are Municipal Commissioners in two large neighbouring municipalities. As with all such jobs, they face a constant array of requests from political representatives on behalf of specific persons for individual favours.

They include requests for building permissions or layout approvals, property tax reductions, concessions on water or sewerage connections, transfer requests of officials, and so on. Some of these requests are genuine and deserve consideration, whereas, the majority are predictably without merits. Now both Commissioners face repeated such representations from Mr Percentage Mantri, the Municipal Minister. However, the nature of the requests going to the respective Commissioners through the Minister vary considerably based on expectations formed about these officers (based on their reputations) by applicants.

In case of Mr Honest Babu, applicants realize that he will personally follow-up and clear all genuine representations made to him, irrespective of whether it comes from the Minister or not. This message soon gets internalized and genuine applicants approach him directly. Others route their applications through the Minister and they invariably get rejected. Therefore, since only representations without any merit go through the Ministers office, all of them get rejected.

In case of Mr Corrupt Babu, applicants realize his willingness to indulge the requests, irrespective of merits, in return for bribes. But the bribes are often exorbitant if they approach him directly. Representations received through the office of Mr Percentage Mantri get favorable treatment. In such cases, the bribes are either waived off or are considerably reduced. Naturally, most representations, including the genuine ones, are routed through the Minister. And most of them get done.

Mr Percentage Mantri, prima facie percieves that while Mr Corrupt Babu indulges all his requests, Mr Honest Babu refuses everything. His office and those around him, who stand to benefit the most from the bribes collected from such representations, instigate the Minister against his honest Commissioner. He forms the impression that the latter is biased against him and therefore steps up efforts to get him transferred.

The example is a highly simplified illustration of a rational expectations and cognitive bias driven challenge faced by honest officials when discharging their responsibilities. There are two forces at work here.

1. In both cases, people quickly form expectations based on the respective administrative styles of officers and route their requests accordingly. The final outcome of this is that honest officer gets more requests directly, while the requests to the corrupt officer generally get routed through the minister. 

2. The Minister and his coterie - being unaware about this realignment of expectations and resultant changes in the pattern of routing requests (and the resultant changes in the conditional probability of positively actionable requests reaching each officer) - perceive one officer to be rejecting a disproportionately higher number of requests. In simple terms, the Minister's coterie develops an impression about Mr Honest Babu based on a representativeness bias.

I am not blind to the fact that the aforementioned analysis does not acknowledge for the blatantly illegal requests. Such requests are most likely to always originate or be routed from the Minister's office, irrespective of the nature of the officer. And the honest officer will invariably reject such requests whereas the corrupt man would oblige them. However, with such cases, Ministers too form rational expectations about officers (and the near certainty of them being rejected) and are therefore less likely to route such requests to them.

Electoral bribery - a tale of two games?

Anecdotal evidence from electoral politics in many Indian states appears to indicate that all the contesting candidates pay reasonably similar amounts of cash bribes to all the voters.

On the face of it, this appears surprising since only one candidate can finally win the electoral race and the electoral race is high stakes and ultra-competitive. In the circumstances, conventional wisdom would have it that atleast some candidates renege on their bribe payments. Further, there should have been a bidding war among contestants to outbid each other in the payment of bribes. So what is the underlying story? Why do "all candidates" bribe "all voters"? Why are the bribes "reasonably similar"?

I am inclined to believe that there are two games being played here. On the one hand, candidates have to weigh the consequence of not making payments given the uncertainty associated with the response of the other side. On the other hand, candidates face the possibility of a potential bidding war in bribe payments.

Consider the first game, which is a defection game. Candidates rationalize bribing voters on the ground that voters have been socialized into expecting bribes and are likely to react negatively (turn against them) if their expectations are not met by any of the candidates. The undeniable reality of an availability bias associated with electoral bribing means that there is a strong likelihood for voters to form expectations about receiving some amount as a bribe. In fact, this expectation is likely to be more pronounced with the incumbent legislator.

The trend is widely pervasive in most parts of India, so much so that any candidate who defects, by not paying or paying less, is perceived to face certain defeat. The table below models a two-candidate electoral game where the decision point is about whether to bribe or not.



This brings us to the second game, the co-operation game. Interestingly, political parties too appear to have internalized the dynamics of the electoral game. Given the inevitability of bribe payments, all of them realize the massive costs associated with a bidding war where one party tries to outbid the other. Since these games are all repeat games, with the same parties fighting over multiple elections, there are sufficient incentives for all sides to embrace an equilibrium and co-operate. The result is an implicit understanding about the magnitude of their bribe payouts. The table below captures this game.



However, there is a small Bayesian twist to this tale which highlights the slippery slope down which both candidates and voters have slipped. Since all parties bribe voters, and voters have to make an electoral choice, they end up making their actual choices based on other considerations. But this choice is conditional on the receipt of bribes. In other words, while voters may make their choice based on several factors, this choice is mostly restricted to those who have paid the bribes. If this line of analysis is true, then all candidates end up defecting and bribing, resulting in a Nash equilibrium. Ironically, atleast in the short-run, the real winner in this is the voter!

So, conditional on receipt of the bribes, what are the factors that drive voting choices? A few intuitive answers include those who paid the larger amount, those perceived as leading the electoral race, those who have struck a chord with some local or emotional issue, and sometimes even those who are perceived as extremely corrupt. Given this, do we have a window of opportunity here to align the individual incentives of voters with general public interest and drive the agenda of contesting candidates accordingly?

Optimizing transportation networks

I have blogged earlier about this (pdf here) fascinating study of unco-ordinated transportation systems by Hyejin Youn, Michael T. Gastner, Hawoong Jeong. They analyzed the 246 road links and 88 nodes of Boston's transportation network and their conclusion is striking and has significant lessons for urban transport planners,

"Uncoordinated individuals in human society pursuing their personally optimal strategies do not always achieve the social optimum, the most beneficial state to the society as a whole. Instead, strategies form Nash equilibria which are often socially suboptimal. Society, therefore, has to pay a price of anarchy for the lack of coordination among its members. Here we assess this price of anarchy by analyzing the travel times in road networks of several major cities. Our simulation shows that uncoordinated drivers possibly waste a considerable amount of their travel time. Counter intuitively, simply blocking certain streets can partially improve the traffic conditions. We analyze various complex networks and discuss the possibility of similar paradoxes in physics."

They find that contrary to conventional wisdom, the interaction of utility maximizing road users do not result in optimal traffic outcomes. Transportation flows can in reality be far from optimal even if all individuals search for the quickest paths and if complete information about the network and other users’ behaviors is available. In other words, "traffic networks can be inherently inefficient". In a game theoretic framework, they find that the Nash equilibrium (arising from self-interested road use decisions of driver) is different from the social optimum (minimized cost to society per unit transport time).

The study highlights the importance of the Braess Paradox which states that adding capacity to a network in which all the moving entities rationally seek the most efficient route can sometimes reduce the network’s overall efficiency. The graphic below highlights how certain road links add to traffic congestion due to drivers propensity to selfishly optimize on their travel times (which ironically enough, in turn results in higher travel times for the collective).



In many respects, urban transport market is a classic free-market of vehicle and road users - completely unregulated, but rife with information asymmetry (among drivers). Which routes to use and which to not use at any point in time? Which routes are best traversed through public transit as opposed to private vehicles? Which roads can be made one-way? How do we regulate vehicle flows in a road circuit?

The larger lesson it conveys to urban transport planners is about the importance of co-ordination among vehicle-users in reducing traffic congestion. Such co-ordination can be achieved by both bridging the information asymmetry between drivers and through interventions to optimize flows within transport networks.

In the prevailing "build your way out of traffic congestion" paradigm, there is very little attention paid to bridging this information asymmetry and scientifically optimizing the configuration of traffic flow networks. It is therefore not surprising that, like other unregulated free-markets, market failures (manifesting as traffic congestions) abound in this market.

The third batting power play and game theory!

One of the interesting debates on the sidelines of the Cricket World Cup relates to the timing of when batting team captains should use their third power play (PP) of five overs. The third PP, to be availed at the request of the batting team, imposes a restriction that the fielding team can have only three fielders outside the thirty yard circle.

The dilemma for batting captains is to use it earlier, say in the 30-40 over period, or preserve it for the slog overs. Apart from the argument that since the ball is changed in the 34 th over (and since a harder ball is easier to hit), it may be effective to take PP early, there has not been much analysis of the issue. However, a simple balance sheet of the costs and benefits of both alternatives to each side reveals that the choice is not as hard as it appears.

The benefits for the batting side are several and significant

1. With or without field restrictions, slog overs are a form of PP in themselves, atleast from the mental frame of the batsmen. It may therefore be more effective to take an early PP and get more runs earlier than otherwise would have been the case. The batting team effectively gets two PPs! The batting team can also carry the momentum on to the slog overs - the bowling side will have to mentally recover after the PP.

2. The bowling side is forced to call on its best bowlers much earlier than they would have preferred. Typically, the best bowlers have three spells - opening burst, slog overs, and a containing or wicket searching spell in the middle. If the PP is taken in the slog overs, it coincides with the bowlers final planned spell. However, an early PP, especially if the bowler has already completed his middle spell, can wreck the best laid plans of the bowling captain. Forced into dividing their ten overs into four spells, the best bowlers will have less overs for the slog.

3. Even without field restrictions, slog overs generally yield more runs. The incremental benefit, in terms of runs scored, with PP restrictions are not likely to be substantial. However, in the earlier overs, without field restrictions, batting sides are likely to score only modestly (3-4 runs an over in an average scoring match and 5-6 runs an over in a high scoring one). The incremental benefit of early PP is therefore significant.

4. Finally, the harder the ball, the easier is it to strike. Since the ball is replaced in the 34 th over, it is surely more sensible to opt for an early PP.

The negative side of the equation for the batting side is the risk of losing wickets in the PP and being left with limited fire-power to take advantage of the slog overs. However, this is more a question of the batsman's judgement of the PP situation, an issue of mental orientation. An element of representativeness bias in the batsman's mind anchors the third PP to slog overs.

It needs to be borne in mind that batting PP are not slog overs. In slog overs, batsmen throw caution to the winds safely in the knowledge that the end of the innings is near. But early PPs are followed by more overs. The risks being taken need to be weighed accordingly.

Consider this 2X2 matrix of the two alternatives - early and slog overs PP - from the perspective of the batting and bowling sides.



As can be seen, the early PP is the dominant strategy for the batting side - for the batting side, its benefits are singificant while for the bowling side, the costs are just as high!

Dominant strategy for strikers - shoot to the center?

I had blogged earlier that despite the dominant strategy for football goalkeepers facing a penalty strike was to stay at the center, keepers preferred to dive randomly to the right or left since they feel greater regret at letting a goal in after standing still in the centre compared with jumping either side.

Steven Levitt and Stephen Dubner examined the same psychology from the perspective of the penalty strikers and found that they "are generally reluctant to aim penalty kicks at the center of the goal even though the data show that is the most effective spot". And their explanation is on similar lines,

"He may think that if he kicks down the centre and the keeper does manage to stop it, the kicker will look like an utter fool... A penalty kick down the middle has the same private benefit as a goal to the left or the right, but a miss down the middle has a greater private penalty: it may well define a player’s career. And so he acts according to his own private benefit, not the greater good, and fires away to the left or the right. If he misses there, the moment will be remembered more for the keeper’s competence than the kicker’s ignominy."

Why a nuclear-free world cannot be stable?

A nuclear-free world may look morally and politically appealing and is unquestioningly accepted as the ultimate goal. However, as Thomas Schelling (via Marginal Revolution) brilliantly illustrates, it could unleash forces of instability that would make the world more dangerous. The risk of "known-unknowns" of the present world would be replaced with the far more dangerous uncertainty of "unknown unknowns" of a supposedly "nuclear-free" world.

As Prof Schelling argues, former nuclear nations cannot unlearn their nuclear expertise and will remain "latent nuclear powers" with ability to rapidly mobilize both fissile materials and other required materials and knwoledge to assemble their nuclear capacity. And on the face of the slightest threat of war, they would have the temptation/incentive/pay-off to defect from any disarmament agreement.

The painstakingly established rules of the deterrence game, with its concept of strategic readiness - configure strategic nuclear forces to provide reasonably comfortable assurance against surprise or preemption, with appropriate command and control - among all the actors concerned, will need to re-develop before the stability of a strategic equilibrium can be achieved. He writes,

"In summary, a "world without nuclear weapons" would be a world in which the United States, Russia, Israel, China, and half a dozen or a dozen other countries would have hair-trigger mobilization plans to rebuild nuclear weapons and mobilize or commandeer delivery systems, and would have prepared targets to preempt other nations' nuclear facilities, all in a high-alert status, with practice drills and secure emergency communications. Every crisis would be a nuclear crisis, any war could become a nuclear war. The urge to preempt would dominate; whoever gets the first few weapons will coerce or preempt. It would be a nervous world."

A matrix of the strategic game, involving India and its ex-nuclear partners, under the aforementioned conditions would look like this



In other words, a world without nukes has all likelihood of being a throw-back to the uncertainty of the immediate post-war era. In due course, the non-proliferation movement will get revived to contain the then covert nuclear programs of the same violators. History would have turned the full circle.

Traffic patterns and Braess paradox

An interesting study on traffic patterns in Boston, New York and London has found that individual drivers using navigation devices (including GPS devices that give real-time traffic updates) that guides them to the quickest routes, paradoxically ends up slowing everybody down. The study illustrates it with this example,

"Imagine two routes to a destination, a short but narrow bridge and a longer but wider highway. Let’s also imagine that the combined travel times of all the drivers is shortest if half take the bridge and half take the highway. But because each driver is selfishly trying to seek the shortest route for himself, this doesn’t happen. At first, everyone will go for the bridge because it’s shorter. But then, as the bridge becomes backed up, more drivers start taking the highway, until the congestion on the bridge starts to clear up. At that point more drivers go back to the bridge, which then becomes backed up again. Eventually, the traffic flow settles into what’s called the Nash equilibrium, in which each route takes the same amount of time. But in this equilibrium the travel time is actually longer than the average time it would take if half of the drivers took each route."

This finding is an excellent illustration of the Braess Paradox which states that adding capacity to a network in which all the moving entities rationally seek the most efficient route can sometimes reduce the network’s overall efficiency.

However, under such circumstances, it is possible to reduce travel times by closing a few roads, since it leaves individual drivers less able to selfishly optimize their routes. The simulation models in the study shows that un-coordinated drivers waste a considerable amount of their travel time and that simply blocking certain streets can partially improve the traffic conditions. They write,

"Un-coordinated individuals in human society pursuing their personally optimal strategies do not always achieve the social optimum, the most beneficial state to the society as a whole. Instead, strategies form Nash equilibria which are often socially sub-optimal."

Behavioural psychologist John Staddon of the Duke University has written about "shared streets" that involve removing all traffic controls – lights, signs, road markings, and even the distinction between streets and sidewalks – can actually make traffic move more smoothly, as well as cut down on the number of accidents and increase the area’s economic vitality. It is felt that the lack of traffic signs "makes vehicle drivers take personal responsibility for directly negotiating with the pedestrians, cyclists, and other cars around you, instead of, say, gunning it through an intersection just because you know you have the light".

An anecdotal example of the success of such anarchical traffic models is the "roundabouts" (whose only rule is to give way to traffic coming from the right) in Central Delhi, which despite the absence of guiding signages and traffic lights and the fear of collision that strikes a vistor, has been remarkably effective in minimizing traffic accidents.

Update 1
London is experimenting with doing away with traffic signals, so as to instil a bit of indecision in all road users’ minds to create a safe environment.

Electricity market trading strategies

The proposals by the two functioning power exchanges in India to offer term-ahead electricity contracts offers interesting possibilities. However, I am inclined to a model that combines features from both proposals. Designing a market by accounting for the reactions and counter-reactions of the various market participants being an extremely complicated task, this may be treated as an amateur attempt. So comments and counter-proposals are welcome.

Though exchange based trading of power has been in vogue in India for slightly more than a year, they constitute just 0.3% of the total consumed power in the country. Two power trading exchanges - Indian Energy Exchange (IEX) and Power Exchange of India (PXI) - are presently operational, and they trade only day-ahead contracts (for delivery next day). Further, of the total short term power trade, exchanges form just 9%, while bilateral trades (for terms upto one year) form 50% and Unscheduled Interchange (UI) (settlement of real time grid imbalances by frequency-based pricing mechanism) forms 41% (figures from April, 2009).

The fundamental requirements for the success of power trading exchanges, like that of any other trading exchanges, are
1. Adequate quantity of power to be traded (or liquidity)
2. Large enough number of sellers and buyers (so as to ensure competition)
3. Availability of transmission facilities so as to materialize the trades

Unfortunately, the Indian market suffers on all the three counts, with the liquidity problem being the most excruciating. The net result has been a marketplace which is illiquid, inefficient, and vulnerable to anti-competitive practices. Hitherto exchanges have been trading only day-ahead contracts, while the longer term contracts are executed over the counter through licenced traders. In order to improve liquidity in the market and increase its depth, both the power exchanges have put forward proposals for term-ahead forward contracts.

The proposals for price discovery for the Term Ahead Markets (TAM) being proposed by the two power exchanges are as follows

IEX
Proposes a two part trading - a double-sided, sealed bid auction followed by continuous matching trades. Every day, both buyers and sellers would simultaneously submit bids in closed covers during specified time period. The bids are then matched to calculate a uniform equilibrium price, which is the price of the last accepted bid. This is a form of Dutch auction. The uniform price nature of the auction would tend to encourage sellers to bid close to their marginal cost of production, and thereby facilitates more efficient price discovery. Once the market is cleared, all the remaining sellers and buyers are pitted in a continuous matching trade where the highest buy order is matched with the lowest sell order.

In the context of a deficit power environment and state utilities faced with demand that cannot be refused (due to political compulsions to provide assured supply), this market design does favor the seller in so far as it leaves the buyer with limited information to base his bid. Any high bid by a desperate buyer will profit the seller and create a "winners curse" for the buyer.

The continuous matching bid process, where price discovery is likely to be more efficient, is a welcome feature. However, this can also encourage both sellers and buyers to hold out during the double-sided closed-bid auction, in the hope of getting a better deal during the continuous matching. Safe in the assurance that they will have another opportunity, sellers will have no incentive to quote close to their marginal cost. Similarly, in their desperation to close their deficit and the uncertainty surrounding the availability of power after the first round auction, buyers may end up being forced into quoting higher prices to grab as much as they can.

PXI
Proposes to have separate sell and buy sessions. First, the sellers simultaneously place their closed bids during a specified time period. Then the sell orders are opened and disclosed and the buyers use this information to simultaneously place their bids in closed covers. The sell bids are then opened and the lowest priced sellers are matched with the highest priced buyers and the seller is paid the price bid by the buyer.

In regular pay-as-bid auctions, the lowest bidding seller is matched to the lowest bidding buyer at the market clearing price, and so-on. This incentivizes sellers to bid as close to the market clearing price as possible, irrespective of their marginal cost of production. The variation of price matching proposed by the IEX seeks to minimize this incentive distortion by reducing the incentive for sellers to guess the market clearing price and thereby bid accordingly (as in the regular pay-as-bid auctions). This cycle is then repeated in a second matching run where first the sellers and then the buyers modify their original bid prices.

This market design is more favorable for the buyers, in so far as they now have some information to base their bids. Sellers also have an incentive to quote close to their marginal cost given the fact that buyers can see all sale offer prices before making their own bids. This in turn dis-incentivizes competing sellers from pricing themselves out with very high bids and also encourages them to bid closer to their marginal cost to maximize their chances of winning the bid.

The biggest fault with this market design is that the entire market surplus is cornered by the sellers/producers. As can be seen from Figure 1, in a uniform, marginal pricing arrangement (as done by the auction in IEX), both the buyers (who were willing to pay higher than the market clearing price) and the sellers (who were willing to supply at lower than market clearing price) enjoy their respective surpluses as indicated in the graphic.
Figure 1

However, in the IEX model in Figure 2, by paying the lowest bidding seller the price agreed by the highest bidding buyer, the entire surplus gets transferred to the seller, and so on. In other words, the buyer/consumer surplus will also accrue to the sellers.
Figure 2


The two critical issues are the auction design which facilitates price discovery and the actual price fixation. So how about a market design that takes in the first from PXI and the second from the proposal of IEX? In other words, separate closed bid sell and buy sessions and the price being fixed at a uniform market clearing price. A continuous matching process may be a better alternative to clear the residual that does not get cleared in the first round of auction.

It however remains to be seen as to the extent of impact the deficits and the needs of the state utilities exerts on the market participants. If the market is illiquid and sellers perceive desperation on the part of buyers to get power at any cost to meet their local political compulsions, then any market design will always be vulnerable to being gamed. Such signals sent by the buyers and received by the sellers can have a feedback effect that amplifies the signals and leaves the market even more distorted in favor of sellers. Incidentally, given this eventuality, a simple uniform price bid with continuous matching trade to clear the residual is the best alternative.

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Unschedule Interchange (UI) is a frequency-linked real-time pricing mechanism to operate and settle the electricity demand-supply imbalances in the grid at any point in time. The grid imbalances at any time are transacted as effective spot transactions for immediate delivery, with the prices determined by the grid frequency. This arrangement has been in successful operation for sometime now to settle the imbalances in the Central Generating Stations (CGS) pool. The frequency-linked rates are determined by the CERC.

Google Vs Microsoft - a race to MAD?

The Cold War and the nuclear arms race between the United States and the Soviet Union had generated a considerable body of research on the dynamics of all such competitions between two agents. It was argued that the rapid accumulation and diversification of the respective nuclear arsenals by both nations, whose only logical climax could have been a form of mutually assured destruction (MAD), was intended to keep each other in check.

This is exactly what Robert X Cringely appears to think of the battle between Microsoft and Google over various computer and internet applications.

Cringely feels that the competition by Microsoft and Google to release their own versions of applications to compete against established products of their competitor is aimed more at keeping their competitor on its toes than at capturing the market. He sees such salvos as attempts to remind each other of their respective prowess.

He writes, "Microsoft makes most of its money from two products, Microsoft Windows and Microsoft Office. Nearly everything else it makes loses money, sometimes deliberately. Google makes most of its money from selling Internet ads next to search results. Nearly everything else it does loses money, too."

After having unleashed its Chrome web browser against Microsoft's Windows Internet Explorer and its Android smart-phone operating system against Microsoft’s Windows Mobile, Google has now unveiled its Chrome Operating System (initially for use in low-cost portable computers called net books) against Microsoft's Windows OS. Microsoft has not been far too behind, having already released its new search technology, Bing, against Google's world beating search engine.

Admittedly Google claims that its Chrome browser and OS are a step towards moving from the age of PC-computing to web-based "cloud computing". There is a strong belief among some obaservers of computing that Chrome moves us further away from running code and storing our information on our own PCs toward doing everything online — in the cloud — using whatever device is at hand.

Managing a Foreign Policy Stalemate

The Indian Government has asked the Pakistan Government to extradite some of the top extremists, including Dawood Ibrahim and the LeT chief Maulana Masood Azhar, wanted in India for terrorist attacks on Indian soil. The Pakistani Government has predictably enough refused. Both countries have taken public stances on these issues and effectively boxed themselves into two corners from where a modus vivendi appears remote. The public quibbling over the veracity of the evidence incriminating these extremists is clearly a smokescreen to paper over the reality. We have a classic foreign policy stalemate.

Let us analyze the stalemate. In the face of mounting public opposition and evidence linking the Mumbai attacks to Pakistan, Indian Government has little choice but to demand action against the perpetrators, now freely moving within Pakistan. The continuing strong influence of the army and the counter-intelligence agency ISI in the domestic political balance of power in the country, ensures that it will be impossible for any Pakistani Government to hand over these terrorists to India. In fact, given the long and dirty history of the army and ISI using these extremists to forment civil strife in India, it will be suicidal for any Pakistani establishment (now or later) to hand over them.

In other words, India wants action taken against these terrorists while Pakistan cannot afford to let India lay its hands on these terrorists. These are core realities that cannot be wished away. We have a classic game theoretic framework, where two agents are facing each other with each one expecting the other to blink first. India threatens to go to war if its demand is not met, while Pakistan refuses to hand over the extremists. Any solution has to be achieved keeping in mind this contextual framework.

The only solution appears to be one where Pakistan puts these extremists under trial and take strong action against them (including if need be execution), without handing over them to India. This could satisfy both countries, without compromising on their core public positions. If the Pakistani Government is reluctant to put them under trial within the country, then they can be tried in a third country (like US). The trial and punishment to these elements will also go a long way in helping Pakistan make a break with its unsavoury past.

Incidentally, the army and intelligence agencies within many countries have a tried and tested method for disposing off such past friends who have now become liabilities - bump them off! Such instances, where the trial of rogue elements whose testimony can create domestic political problems within a country, highlights the utility of a formal international mechanism to facilitate secret trials in third countries.

All of this ofcourse pre-supposes that the Pakistani Government is no longer involved in supporting extremist activities in India. If Pakistan is continuing to provide material support for terrorism on Indian soil (and if this is true, then we can safely conclude that the army and other rogue elements are running the Pakistani State and the civilian Government is a mere facade), then it is different matter and it will be naive for the Indian Government to expect that diplomacy will achieve the desired objective. A military solution (either directly or through the US) will be the only alternative left. The other alternative would be for a Noreiga-style abduction of these extremists from Pakistani soil by Indian intelligence agents!

As an afterthought, by prevaricating and delaying, India may have closed the option of airstrikes on targets in Pakistan. This option was open, without too much international outcry, only in the immediate aftermath of the terrorist attacks. A surgical strike in the first couple of days could have passed through without mch international opposition.

Ultimatum game and the bailout

Stephen Dubner compares the public opposition and resultant Congressional rejection of the $700 bn bailout package to the ultimatum game.

The ultimatum game is an experimental economics game in which two players interact to decide how to divide a sum of money that is given to them. The first player proposes how to divide the sum between themselves, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. The game is played only once, and anonymously, so that reciprocation is not an issue.

The Congress perceives the public as feeling that under the bailout proposed, Wall Street will benefit to the extent of $90, whereas they will get a mere $10. The perception of sheer inequity and unfairness of this proposal, despite being mutually beneficial, is an important reason for the Congressional rejection.

Analysing the Iran-Israel nuclear stand-off

Well respected Israeli historian Benny Morris writes in an NYT op-ed that it is inevitable that Israel will mount an attack on Iranian nuclear facilities in the next four to seven months. He also hopes that the pre-emptive strikes are successful in atleast significantly delaying the Iranian nuclear program, failing which the region faces a near certain nuclear holocaust. This is understandably the Israeli view now, when Iran is in the process of acquiring nuclear weapons, but has not yet acquired it.

Prof Morris discounts the possibility of the Americans mounting air strikes to take out the Iranian nuclear capability, given the mess in Iraq and Afghanistan. The article has contradictions at certain places. On the one hand while he claims that any pre-emptive airstrike would achieve the purpose only if it takes out Iranina nuclear capability, he also concedes that the Israeli military and airforce does not have the intelligence and strikeforce required to completely eliminate Iranian nuclear capability. Therefore the Israeli attack will only leave things in a limbo, exacerbating the instability, and making Iranians even more determined to continue their nuclear program.

His contention that the best possible outcome would be for Iran to back off from its nuclear program, while being best from Israeli point of view, will always be unstable given the Middle Eastern reality. It will continue to keep the balance of power tilted decisively in favour of Israel, and always leave wide discontent in the Arab world. This unstable balance will result in the nuclear program getting revived in Iran or eslewhere.

Benny Morris' is the perspective from TelAviv. Here is what the nuclear stand-off matrix would look like, taking into account the view from Teheran.



Here is the classic stand-off. Israel does not trust the "fundamentalist, self-sacrificial mindset of the mullahs who run Iran" and believes that the Iranians will make good their promise to "wipe out Israel from the face of earth" once they acquire nuclear weapons. Iran in contrast, feels that it is never safe and will continue to have a weak negotiating position, both with Israel and more importantly US, in a scenario of nuclear weapon assymetry.

Further, the Israeli fear that the Iranians may mount a nuclear attack on acquiring nuclear weapon capability, may be misplaced. This will surely not gain the support of any of the other Arab powers. The Middle East politics has moved a considerable distance from the early days of the Palestinian intifadah of 1987. The numerous rounds of negotiations between both sides, directly and indirectly, since the Oslo accords, have been positive developments when seen in the overall perspective of the tumultous history of Middle East for the past 63 years.

There are many reasons to suspect that, ironically enough, the persisting nuclear and resultant political imbalance may be a strong contributor to the continuing support for militant groups like Hezbollah and periodic bouts of open hostility and verbal skrimishes between both sides. A nuclear Iran may have the impact of substantially toning down the Arab bellicosity and increasing their self-confidence and bargaining position in dealing with Israel. The example of Pakistan, vulnerable to the same levels of perceived militant Islamic influences, is a case in point. Once the nuclear assymetry with India was bridged, sometime in the early to mid-nineties, and the local balance of power restored, the verbal aggression subsided.

There is an undefined level of restraint that Arab governments, including Iran, have exercised in recent years, when translating their words into actions. Thus even as public opinion was strongly in favor of Osama Bin Laden and Saddam Hussein, all the Arab governments refrained from even supporting, leave alone acting in favour of them.

It is clear from the game matrix that Middle East suffers from a major "confidence deficit" between the Israelis and Arabs. Since the Yom Kippur war of 1973 (the pre-emptive air attack on the Iraqi Osirak reactor in 1981 was a smaller one, given the context), despite periodic cross-border air-strikes by Israel and retaliation by Arabs, there have been no major wars directly between Israel and the Arabs. The American led misadventures since the early nineties, during which they were often seen pursuing Israeli political agenda in the region, did open up some of the wounds. But on the whole, by Middle East standards, over the past three to five years a low intensity equilibrium has been stabilizing. The wounds of history, while too deep to heal easily, were surely getting some semblance of treatment.

Any Israeli air attack on Iran will have to be seen in this context. It needs to be borne in mind that, unlike the other Arab nations, Iran is the ideological fountainhead of pan-Islamic Nationalism and its (populist) definition as the anti-thesis of the Israeli and Jewish identity. It is in this background that we need to analyze any consequences of any Israeli pre-emptive attack on Iran. It will be catastrophic and long-lasting. It will almost invariably suck in the other Arab states, and become the first direct war between the Israel and Arabs in 35 years. The time healed wounds of the last attack 35 years back, will get immediately re-opened.

What Middle East needs is more time, so that the mutual confidence will increase. Till a critical mass of mutual confidence, between Israel and atleast a couple of major Arab powers, gets established the low intensity conflict will continue. The major powers, especially America, needs to do everything it can to prevent any mis-adventure by Israel that would uspet the delicate equilibrium, and take the reqion back to 1973.

Update 1 (28/3/2010)
Times draws attention to a Brookings Institution simulation of an Isreali attack on Iran's nuclear facilities.

Incentives in Elections

The logic in this post is slightly vague at at a few places. Though I am still searching for a few answers, I am convinced there are ways out. But it flags off an important dimension to future electoral reform policies.

It is commonplace in even informed circles to attribute all the ills facing our country to politicians. The middle class see the ubiquitous politician as the embodiment of all that is bad about our political system. They are perceived as corrupt, venal, rapacious in their plunder of the public resources, prevent honest officers from discharging their duties, and so on. My very firm belief is that this may be a very simplified and uncharitable judgement, which overlooks the incentives and disincentives facing a politician.

I shall assume that a politician is a rational economic agent, out to maximize his objectives. Edmund Burke famously said, "The duty of a politician is to win elections". A politician is therefore driven by the ultimate objective of winning over his electorate. This remains true even today and is the fundamental choice facing any politician. To this, we may also add that the politician also faces ample incentives to make money.

I will outline two broad strategies that can be applied to winning elections. There may be variants between Strategy I and Strategy II, but a typical electoral strategy falls somewhere in between the two. Strategy I is the regular stereotype of how a candidate fights elections.

Strategy I : The politician offers inducements or allurements like liquor or cash to win over the voter. Though the typical candidate spends a fortune in such transactions, these inducements are transitory. Even after spending this money, he is not sure of bagging the vote, since his oppponent can pay a little more and outbid him. There is a very real danger of the candidate losing his money and the election too.

Strategy II : In contrast, if the politician fulfills an important felt-need of the village, say a school building or drinking water bore or distribution line, the villagers feel gratified and owe him a debt. This translates into a more enduring and stronger relationship between the politician and the voters in the village. There is a greater probability of them voting for him than if he had resorted to the first strategy. Apart from striking a more durable contract with his voters, the politician benefits in two ways from this strategy.
1. He saves the huge amount he would otherwise have had to spend in buying off his voters.
2. He also pockets his share of commission from the contract awarded to execute the engineering work.

Quite often, this strategy runs into trouble as the executive machinery and administration are not able to deliver on the promise. At other times, the work executed is of very poor quality, and the school building develops leaks after six months. In both cases, the politician gets disrepute and loses his electoral appeal. He is then left with no choice but to return to his original strategy of buying off his electors. Therefore it needs to be kept in mind that the officials and the administration plays a critical role in helping or failing the political representative.

As can be seen, Strategy II is easily more beneficial to the incumbent. He can have the best of both worlds - minimize his expenditure, and increase his chances of victory. But implementing Strategy II requires the support of the bureaucratic and administrative machinery, who are responsible for delivering on the promises made by the politician. This is in turn gives them an incentive for posting capable officials (who are more likely to be reasonably honest) in important positions, thereby reducing cronyism and its attendent corruption.

What are the objections? The major argument against Strategy II is that it always favors the incumbent. Further, since the opposing candidates cannot use this approach, they fall back on Strategy I. Behavioural economists have documented that people tend to forget older gains and be more attracted to the latest gains (since cash and liquor inducements are made just before the voting process). Further, they also acknowledge personal gains more than social or civic gains. This makes the incumbent wary of the inducements offered by his opponents. There is therefore an unstable equilibrium about this arrangement. If the incumbent finds that his opponent gaining ground by resporting to unscrupulous vote buying strategies, he may be forced to defect.

The response to this objection is two-fold. One, if the incumbent is able to fulfill the felt needs of his electorate, then he surely deserves to be re-elected. After all, the whole process of democratic elections is to find out the candidate who can deliver on his promises. If we have a candidate who is able to deliver on his promises, which are in turn reflection of the electoral demands, then where is the need for a replacement? For any opposing candidate to succeed, he has to possess attributes and faith of his electorate that are superior to that possessed by the incumbent.

Two, the opponents should also adopt the same strategy as the incumbent and become rational agents. They should identify the most important felt-need of the village or locality, and make its fullfillment one of their major poll planks. They now benefit from the same advantages as the incumbent - saving the money spent buying voters and rents from contractors. Further, the opponent even gains an advantage over the incumbent, in that he is now promising something which the incumbent failed to deliver. All this will also incentivize candidates, especially in local body elections, to focus on important local issues and needs, thereby making elections more meaningul and issue oriented. And there are no shortage of important felt-needs in every area or village, for all candidates to espouse.

The benefits of such competitive populism on the society and polity are enormous. The challenge now is to make the politician a rational economic agent and get them to abandon Strategy I and adopt Strategy II! Or in other words, get all candidates to play the same game and not defect! More of this in a later post.

How lawyers increase divorce burdens

There is an interesting study by Austrian economist Halla Martin, Divorce and the excess burden of lawyers, which explores how divorce proceedings end up dividng assets. He argues that in any divorce, both parties "encounter incentives as in the classical prisoners’ dilemma."

The conclusions are that "it is financially beneficial for the wife to hire a lawyer, if she expects their husband not to. The lawyer increases the wife’s alimony award in this case by 5.4 percent of the husband’s income. This is equal to an average present value of 15,320 euros. For all other combinations we do not identify any causal effect of the involvement of lawyers on the division of matrimonial property. The child-support award and the alimony award would have been precisely the same as in the case where neither spouse had hired a lawyer.

There exists also no benefit of the engagement of lawyers in terms of more sustainable divorce settlements over time. Therefore, many spouses incur substantial lawyer fees without any benefit. On top of that in most of the cases lawyers prolong the divorce process. This excess burden of lawyers increases both the private and public cost of divorce. In the case
where both spouses hire a lawyer, the highest lawyer fees accrue and the divorce process is extended unnecessarily by about 2 months. In order to overcome this worst case we suggest to change the institutional setting so that as many of these couples as possible choose to hire a joint lawyer. A joint lawyer does not alter the divorce settlement either, should charge a lower fee and most importantly does not unnecessarily delay the divorce process. In any case it should be guaranteed that in a case of a conflict of interests a joint lawyer should step down according to professional ethic rules."

Husbands therefore end up paying the smallest alimony when no lawyers are involved. If the husband hires a lawyer, but his wife does not, the alimony payment rises (and then there are fees to be paid, too). If the wife hires a lawyer, or the couple hires a joint lawyer, the husband forks out still more. Worst case scenario for hubby is if both sides hire their own lawyer. On top of that the proceedings are longer and more expensive.

Tim Harford cautions from reading too much into the results, since it is not clear whether the lawyers cause poor settlements for husbands, or whether husbands hire lawyers when things look grim!

Optimal strategy for goalkeepers-stay at center!

A couple of Israeli researchers have some evidence to suggest that goal keepers save more goals when they stay still, instead of jumping to the right or left. Their analysis of 286 penalty kicks taken in elite matches around the world showed that keepers saved 33.3 per cent of penalties when they stayed in the centre, compared with just 12.6 per cent of kicks when they jumped right and 14.2 per cent when they jumped left.

The researchers believe the anomaly may be a reversed manifestation of what is known in economic psychology as the inaction effect or the omission bias. That is, people tend to suffer more regret after a negative outcome follows something they've done, compared with something they haven't done. In the case of keepers, the researchers surmised, they feel greater regret at letting a goal in after standing still in the centre, compared with jumping. If the ball ends up in the back of the net after they've jumped, at least it will have felt as though they had made a decent attempt to save it.

There is an article on the same subject by Tim Harford, World Cup Game Theory, in which he argues that, "Game theory, applied to the problem of penalties, says that if the striker and the keeper are behaving optimally, neither will have a predictable strategy... Professionals such as the French superstar Zinédine Zidane and Italy's goalkeeper Gianluigi Buffon are apparently superb economists: Their strategies are absolutely unpredictable, and, as the theory demands, they are equally successful no matter what they do, indicating that they have found the perfect balance among the different options."

Mundra Port & SEZ IPO

The Initial Public Offering (IPO) of the Mundra Port & SEZ Ltd, promoted by the Adani family, was wildly oversubscribed at 115 times. The port itself is located about 70 km from Bhuj in Gujarat and will handle 30 mt of cargo this year, and the funds are being raised to help Mundra set up cargo and coal terminals, besides infrastructure for the SEZ. It is the first port and SEZ company to be listed. Mundra Port is primarily engaged in providing bulk cargo services, container cargo, crude oil cargo and value-added port services, including railway services between Mundra Port and Adipur.

The Red Herring Prospectus for the IPO describes it thus, "In accordance with Rule 19 (2) (b) of the Securities Contract (Regulation) Rules, 1957 (“SCRR”), this being an Issue for less than 25% of the post–Issue capital, the Issue is being made through the 100% Book Building Process wherein at least 60% of the Net Issue will be allocated on a proportionate basis to Qualified Institutional Buyers (“QIBs”), out of which 5% shall be available for allocation on a proportionate basis to Mutual Funds only. The remainder shall be available for allocation on a proportionate basis to all QIBs, including Mutual Funds, subject to valid bids being received from them at or above the Issue Price. If at least 60% of the Net Issue cannot be allocated to QIBs, then the entire application money will be refunded forthwith. Further, up to 10% of the Net Issue will be available for allocation on a proportionate basis to Non-Institutional Bidders and up to 30% of the Net Issue will be available for allocation on a proportionate basis to Retail Individual Bidders."

The IPO had sought to raise about Rs 1770 crore ($446 mn), by selling 40.3 million shares at Rs 400 to Rs 440 apiece. The massive oversubscription meant that the investors bid for 4.6 billion shares by depositing $51 billion. The Qualified Institutional Buyers’ (QIB) portion was subscribed nearly 160 times while the High Net Individuals (HNI) portion has been subscribed 156 times, while the non-institutional segment was subscribed by nearly 11 times.

When the shares got listed on 27.11.2007, the performance was even more spectacular. The shares, which were initially priced at Rs 440 ($11.06) got listed at Rs 770 ($19.35), and touched 161.4% to Rs 1150 ($28.90) on the Bombay Stock Exchange. It reached Rs 962.90($24.20), up 119% on the National Stock Exchange. This spectacular listing was despite the benchmark Sensitive index going down 0.6% at 19,127.73 during the day and a trend of overall weakness in the markets. More than 14.8 million shares got traded during the day.

DSP Merrill Lynch & Co, Enam Securities, JM Financial Consultants, SBI Capital Markets and SSKI Corporate Finance arranged this share sale through 100% book building route. DSP Merrill Lynch, JM Financial Consultants and SSKI Corporate Finance were also the global coordinators for the IPO. But despite the presence of all these big names, this IPO has failed to garner a good deal for the promoter. The underwriters clearly failed to gauge the market sentiment and underpriced the offering, thereby causing considerable loss to the promoters. The share closed at Rs 885.65 at BSE on 29.11.2007, or slightly more than double the issue price. At this price, the lead managers failed to mobilize atleast an additional Rs 1770 Cr, which was left on the table free! In other words, the transaction was not an economically efficient one and resulted in considerable deadweight loss.

In any IPO, the company going public would seek to get the highest offer price so as to maximize the amount raised. The underwriters, while also seeking to maximize the amounts raised, are concerned with ensuring that they do not price it so high that the IPO is undersubscribed. There is a price determination problem. This is compounded by an inherent moral hazard problem, as the underwriters have an interest in pricing the offer at a not so high price, so that their favored clients (mainly QIBs) are rewarded when the shares get listed. These clients in turn return the favor by giving the underwriters lucrative investment banking business. Everybody - underwriters, their clients, and investors - are happy, leaving only the promoter hard done!

In the traditional book-building route for an IPO, the lead underwriter sets an initial filing price, then takes provisional orders from institutional investors that it uses to gauge demand. The filing price can be adjusted upward if demand is strong enough, but in general the offering price for a company going public is considerably below the market-clearing price. As a result, investors who are able to get in on an IPO have a very good chance of reaping some easy gains, thereby opening up the possibility for considerable fraud. In fact, IPOs, especially of the more well run and fundamentally strong companies, are very attractive to investors, in particular the institutional ones, due to the potential "first day pop" of instant bonanaza, arising from a higher listing price than the offer price.

As compared to the underwriter determining the rate, a better option is the Dutch auction , which leaves the price discovery role to the market. In this method, the price is essentially determined by the investors, who submit the highest price they're willing to pay and the number of shares they want at that price. The people who bid the highest (and, if they bid the same price, the earliest) gets allotted the shares in the descending order of the bids till all the shares are allotted. However, no matter what you bid, the price you pay is the lowest price that any investor who got shares bid.

There are also other methods of issuing an IPO. The hgh profile and highly successful, Google IPO of 2004 is the most famous example. The Google IPO was a "sealed-bid, uniform-price" auction. The bidders make their bids in sealed covers. The Google auction first eliminated all bids it considered "speculative" and then priced the IPO at or near the auction clearing price, the level at which there is enough demand to sell the shares. The valid bids were then arranged in the descending order of bid price and irrespective of the individual bid prices, the shares were allotted at the price at which the last share was bid or at which the market got cleared. In other words, to "win" shares, the bidder needed to bid below the speculative price and at or above the IPO price. A brief description of the other auction variants are outlined here.

Though there are some reservations, auctions are a superior way of pricing an IPO because no one gets shares on the basis of who they know, and because it ensures that the company going public isn't going to leave too much money on the table by going public at a lower price than the one the market was willing to pay. It eliminates the moral hazard problem and lets the market do the price discovery.