What does Apple sell?

Not iPhones and iPods, but "pricing" (via Freakonomics)! So says a Businessweek article that examined Apple's strategy of using "pricing decoys, reference prices, bundling and obscurity" to increase the attractiveness of its products.

The iPod Touch media player has been revamped at three price points - $229, $299, and $399 - all costing more than the iPhone (iPhone 4 with more features comes at a much lower price of $199), which does everything the Touch can plus make phone calls. The $399 and $299 price models serve as decoys, to be used as reference points, to increase the attractiveness of the cheaper version.

Another application of a high reference point is the strategy of launching products at an artificially high price (to capture the initial burst of consumers with higher willingness to pay) and then rapidly lowering that price - iPhone cost $599 when it first hit the streets, while today at $199 it appears like a steal.

Clearly distinguishing itself from the rest of the market makes it difficult to establish an external price reference point for any Apple product, at least in the immediate aftermath of its launch, and thereby makes it possible to push through the price premiums. Obscurity of the product therefore makes it easier for customers to embrace Apple's prcing.

Finally, an Apple product is never an one-off buy, but is followed by a series of downstream expenditures - data and voice phone contracts, song purchases, video rentals, and advertising clicks. These services are bundled into the original purchases with a back-loaded payment structure.

More illustrations of price referencing (all from Freakonomics). First, decoys



Reference point pricing...



... and more reference point pricing



And the increasingly popular pay-what-you-wish!



Update 1 (19/9/2010)

Tim Harford has this nice summary of different pricing strategies that exploit various cognitive biases - endowment effect, anchoring, social approval, bundle freebies etc. He points to infomercials - "The TimCo smokemaster doesn’t retail for £200; it doesn’t retail for £100; it doesn’t retail for £50... (anchoring to a price of £200)... if our lines are busy, please try later” (social approval)... the smokemaster is not available in regular stores (loss aversion)... but wait! When you buy the TimCo smokemaster you get the TimCo soup knife absolutely free (complex pricing and use of 'free')". He also points to drip pricing which combines many of these effects,

"Customers agree to pay a price only to discover that there is a charge for delivery; another charge for paying by credit card, and another for insurance. Drip pricing taps into the endowment effect, because customers feel that they have already made the decision to purchase; it creates loss aversion because customers commit time and effort to the search before being hit with extra charges; and it is a form of complex pricing which makes it hard to compare offers."

Basel III norms

The Basel III banking norms, intended to make the global banking industry safer and protect economies from financial meltdowns, has been finally agreed to by central banks and banking regulators from 27 major countries. The culmination of the two-year long process, undertaken by the Basel Committee on Banking Supervision, comes after intense debate between those demanding tougher reserve requirements and their opponents arguing that such norms would adversely affect banks' profitability and stifle financial innovation.

Fundamentally, the new standards will considerably strengthen the reserve requirements, both by increasing the reserve ratios and by tightening the definition of what constitutes capital. It will more than triple the amount of capital that banks must hold in reserve to absorb losses, in order to force them to maintain a larger cushion against potential losses.



The proposals increase the common equity reserve (or Core Tier 1 capital, calculated as a percentage of risk-weighted assets), the least risky form of capital, from 2% to 7% of their risk-weighted assets. Add in a 2.5% conservation buffer, banks will need 7% common equity, 8.5% Tier 1 capital, and 10.5% Tier 2 capital reserve. Further, there is also a counter-cyclical buffer of 0-2.5%, to be set by individual national regulators, which accounts for any irrational exuberance during the good times. This means a potential loss-absorbing capital requirement of upto 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

The new norms also introduce a Tier 1 leverage ratio of 3%, which would limit banks to lending 33 times their capital, which represents a cap on bank risk irrespective of the impact from the higher capital numbers. Though this ratio, intended as a backstop to the risk-based measures, is targeted to be achieved only by 2018, the banks will need to disclose their leverage ratios from 2015.

However, as the timetable below shows, banks have been provided a lengthy transition period, nearly a decade, to adjust to these tougher norms. Some of the provisions do not take full effect until the beginning of 2019, so as to comply with some of the strictest rules. January 1, 2013, has been set as the deadline for member nations to begin to phase in Basel III rules.



Mark Thoma has this nice analysis of the the new norms. Simon Johnson advocates the Hanson-Kashyap-Stein view that banks should be required to hold enough capital at the peak of the cycle so that when they suffer losses they still have enough capital (and are not forced into distress sales) so that the markets do not think they will fail. This points toward at least 15 percent Tier 1 capital being required in good times; the most forward-looking officials in Group of 20 countries may aim for closer to 20 percent.

Update 1 (18/9/2010)

Felix Salmon writes that Basel III does "a bad job of reducing unforeseeable risks", with the result that "banks are incentivized to load up on the kind of securities which can blow up in unforeseeable ways". And one of the ways in which it causes this is by continuing up the possibility of gaming risk measures. Like Basel II, the proposed arrangement too leaves risk measurements to the discretion of individual banks. As Noah Millman writes, "Since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk".

Update 2 (19/9/2010)

Economist points to analysis by Credit Suisse which shows that all but the shakiest European banks will meet these requirements by 2012, with many of them already meeting them.

The economics of bribing and what to do about it

Been sometime before I blogged about one of my favorite topics - the dynamics of corruption! Here is an attempt to answer the most persistently frustrating of socio-economic problems - why do people pay bribes and how can we restrain such payments?

The story goes like this. Buyers of the myriad government services, like those of any other product in a market, face similar demand-supply curves. As evident from the figure, those buyers above A in the demand curve (numbering Q1) are willing to pay more than the price fixed for the service/product, P1. This willingness to pay at the margins opens up opportunities which middle-men and bribe-takers exploit.



Citizens (buyers) lying on the upper-side of the demand curve are willing to pay more than the government prescribed user fee of P1. Therefore the area of triangle ABP1 (shaded) constitutes the full rent market.

Here is an attempt to apply the principles of economics to address the problem of bribe payments. While these suggested solutions will not in anyway eliminate rent-seeking, they will align incentives for all stakeholders in a manner so as to certainly reduce the likelihood of rent-seeking behavior. The first approach addresses the demand-side (rent-givers) and the second manages the supply-side (rent-seekers).

One, Econ 101 teaches us that markets do a good job of price discovery and too low a price causes incentive distortions. For various reasons, the prices fixed by governments are most often too small, leaving rent-seekers with ample opportunity to exploit (as indicated in the graphic above). For example, electricity connection charges are very low and government machinery is invariably over-stretched. Buyers (with a much higher willingness to pay) are therefore incentivized to pay a rent-premium to access the connection faster and without any inconvenience.

The solution is to have a differential pricing mechanism (a two-price arrangement), with a higher priced premium service delivery channel that would seek to capture higher willingness to pay consumers. They would pay double or triple the amount (to be fixed based on the demand for the service and the ability of the system to deliver the premium service) to have the same service delivered at their door-step and within 24 hours. This hassle-free window would cater to those citizens with higher willingness to pay. It reduces the possibility of rent-seeking by institutionally capturing the higher amounts that people are willing to pay. See this and this.

Two, Econ 101 also tells us that markets provide competition which arbitrages away certain types of inefficiencies. So if one supplier provides widgets at $5, whereas the others are willing to sell it for $3, the former will be priced out of the market. Since government is the monopoly supplier of these products, direct external competition is impossible. The solution is therefore to have multiple channels (within government itself and also outsourced alternatives) to deliver the service so as to generate some level of competition.

Multiple channels within the same department - either at different locations or at different levels - provides citizens with a choice. The dynamics of this choice is often adequate to arbitrage away rent-seeking opportunities. Outsourcing (see this example) also helps avoid the critical citizen-government interface which is most often the origin of corrupt practices.

If the sale of all government services/products are subjected to this twin test, it would considerably lower the likelihood of rent-seeking behaviour - both eliminating it in some places or atleast minimizing the amounts extracted.

Household balancesheets in the Great Recession

Richard Koo, an analyst with the Nomura Securities, has argued that the the current recession is characterized by a combination of falling asset prices with high indebtedness among both businesses and households, which in turn forces them to stop borrowing and pay down debt. In such "balance sheet deflation", which is strikingly similar with Japan's experience in the nineties, the economy plunges into virtual bankruptcy as borrowers start defaulting, the government inevitably emerges as borrower and spender of last resort. He has argued that the battered balance sheets of businesses and households can be repaired only with fiscal policy, especially since monetary policy has lost traction.

A nice graphics (via Mark Thoma) captures the extent of damage suffered by household balance sheet during the current recession in comparison with earlier ones. In both the 2000 and current recessions, while asset prices dropped (due to stock market and real estate collapses respectively), liabilities have remained constant, thereby battering the balance sheets.





As can be seen, household balance sheets suffered the worst damage in the past two recessions, which were asset-bubble crash induced ones. In both cases, the declines were much larger and more long-drawn out. This also means that unlike earlier recessions the quick V-shaped recovery is less likely since the households have to spend time repaying debts and repairing their balance sheets (through higher savings) before consumption can return to normalcy.

In this context, Mike Konczal points to the distributional dimension of this balance sheet crisis that clearly indicates that unlike those at the top and bottom (whose debt burdens have not changed much), those at the 20%-90% range of household income range have been badly bruised, both in terms of debt as a share of assets and incomes.





In other words, the "consumer debt problem in the economy really is a debt problem for the middle class", one that has the potential to "sap middle-class families’ spending power for perhaps years to come".

Further, the middle-class has suffered more than the wealthy from the housing crash because middle-class families tended to rely more on their homes to build savings through rising equity, whereas the wealthier had a much larger and more diverse portfolio of assets — stocks, bonds, etc. — which have mostly bounced back significantly this year.

In the circumstances, and I am inclined to Konczal's arguement in favor of lien-stripping - "the most sensible way to get through this debt is to have well designed mechanisms for writing down housing debt, where homeowners take a penalty and creditors get an excessively large claim on future housing price appreciation". Such measures are more effective than tax cuts in so far as tax cuts in repairing the balance sheets in so far as it directly addresses the debt problem. Mark Thoma points to Joseph Stiglitz who has advocated mortgage write-downs,

"For one out of four US mortgages, the debt exceeds the home’s value. Evictions merely create more homeless people and more vacant homes. What is needed is a quick write-down of the value of the mortgages. Banks will have to recognize the losses and, if necessary, find the additional capital to meet reserve requirements."

And as Mark Thoma writes,

"Japan made the mistake of allowing balance sheet problems for both households and banks to linger and the result was a prolonged recession. We seem to have gotten the message about banks... but the message that households need just as much attention seems to be harder for policymakers to get. We need policies to stimulate demand, and on top of that, we also need policies that accelerate balance sheet repair. One without the other gives up important synergies, and prolongs either the length or the depth of our problems."

Konczal also makes the case that since the upper 10% of income earners do not face such problems (in fact, their leverage and income-debt ratios appear to have improved), they could provide the spending power to help fuel an economic recovery. It also means that any tax cuts for them would only provide benefit them without any incremental benefit for the economy.

Update 1 (18/8/2011)

Household balance sheets remain over-leveraged in the US, indicating that it will be some time before recovery can really kick-in.

More on US income inequality

Several fascinating graphics in Slate illustrating the Great Divergence of widening income inequality in the US. The economic history of the US over the past seventy years is the "Great Convergence" (1940-73, coined by Claudia Goldin of Harvard and Robert Margo of Boston University) of incomes of the first forty years, followed by the "Great Divergence" (1979 onwards, coined by Paul Krugman) of the past thirty years.



In 1979 the top quintile's income share was eight times that of the bottom quintile, while it rose to 14 times by 2007. The top quintiles share increased only slightly relative to the middle quintile, rising from three times in 1979 to four times by 2007. These trends reflect in large part a growing "college premium." Since 1979 the income gap between people with college or graduate degrees and people without them has grown. The moderately skilled middle class is hollowing out.



Among all developed economies with income inequility problems, the US easily tops the list in being the most unequal economy. This chart shows select nations where the income share of the top 1 percent was highest in 2005.



Update 1 (19/10/2010)

Chad Stone writes, "the average middle-income American family had $13,000 less after-tax income in 2007, and an average household in the top 1 percent had $782,600 more, than they would have had if incomes of all groups had grown at the same average rate since 1979".





Update 2 (7/11/2010)

Nicholas Kristof says that inequality in the US has reached a "banana republic point where our inequality has become both economically unhealthy and morally repugnant". The richest 1% of Americans now take home almost 24% of income, up from almost 9% in 1976. The CEO’s of the largest American companies earned an average of 42 times as much as the average worker in 1980, but 531 times as much in 2001. From 1980 to 2005, more than four-fifths of the total increase in American incomes went to the richest 1%.

A recent paper by Robert H. Frank of Cornell University, Adam Seth Levine of Vanderbilt University, and Oege Dijk of the European University Institute found that inequality leads to more financial distress. They looked at census data for the 50 states and the 100 most populous counties in America, and found that places where inequality increased the most also endured the greatest surges in bankruptcies.

Update 3 (30/3/2011)

Economix writes that the top 1 percent of earners receive about a fifth of all American income; on the other hand, the top 1 percent of Americans by net worth hold about a third of American wealth.





Update 4 (16/4//2011)

Series of graphics from CBPP on income inequality in the US and the role of taxation system.

Update 5 (7/6/2011)

The chart below shows how far things have moved off their traditional ratios in terms of US incomes. The top 1% are earning more income, and keeping more of it, than anytime since the roaring 1920s.

Third party assessment in government

Here is my Mint op-ed that makes the case for using third party agencies to provide feedback on the quality of public service delivery and thereby improve the effectiveness of our supervisory bureaucracy.

Detectives to supervise service delivery

It is widely acknowledged that the biggest failure of our government bureaucratic machinery lies in its inability to ensure the effective implementation of the myriad welfare and development programs.

Traditional supervisory mechanisms within the government suffer from numerous deficiencies. Apart from the badly mis-aligned incentive structure, dys-functional chain of command, and poorly motivated individuals, existing supervisory architecture is inherently over-burdened and over-stretched in many dimensions. Field supervisors invariably have too many locations, spread over too large an area, with a vast variety of activities, and all this without adequate training, logistics and resources.

In this context third party assessment, by a professionally competent and independent agency, has the potential to improve the quality of public service delivery and program implementation.

The theoretical case in favor of an external assessment is unexceptionable. It flies against any logic to have a supervisory mechanism constituting the very same people whose services are being monitored. Such independent monitoring is all the more important given the unmistakable shift in focus from a merely quantitative to a qualitative assessment of government's activities.

One of the biggest breakthroughs in improving the quality of public construction works in recent years have come from the introduction of mandatory third party quality control checks. Typically government departments call open competitive tenders and contract out engineering works - roads and drains, water and sewerage, buildings, etc - for execution through contractors and then the regular department officials supervise the quality of execution.

However, this arrangement posed the inevitable conflict of interest, wherein the supervisory engineers often colluded with the contractors to dilute the quality of works. In the circumstance, third party quality audits, consisting of random and surprise inspections of works at each stage, by competitively selected external agencies, emerged as a preferred strategy to elicit an independent feedback about the quality of works. In recent years, this has become a mandatory requirement in all projects being implemented by both central and most state governments.

Extending the logic of TPQC beyond engineering works, it is natural to deploy it in an independent assessment of various government programs. The services of independent agencies can be utilized to obtain feedback about the functioning of institutions like schools, hospitals, and even various government offices, apart from the quality service delivery in various government programs. They can range from the specific - which teacher, doctor or official is taking bribes or irregular in work or ineffectual, quality of a work or service delivered etc - to the general - sources of leakages or bottlenecks or delays in the delivery of a service, inefficiencies within the system, and so on.

Instead of the third party assessment duplicating the existing regular supervisory mechanism, a mandate involving randomly sampled inspections may be adequate. The certainty of follow-up action, punitive or remedial, on its findings will be powerful enough deterrent to ensure its effectiveness.

The critical ingredient for success in this market is integrity and credibility of the agency. In other words, third party assessment agencies are in the business of selling integrity. In complex socio-political environments, where the avenues for incentive distortions are numerous and mostly unanticipated, managing such a business can be a herculean task.

Most often, a successful engineering TPQC agency, which starts off as a team of a handful of committed people with exceptional integrity, loses the way as it expands to take in more work. In a rapidly emerging market, where success immediately begets more success, with a resultant proliferation of business opportunities, firms often bite off more than they can chew and in the process end up diluting their standards and ultimately losing credibility. With time, many of these firms end up being indistinguishable from the government supervisory mechanism.

Rigorous internal quality controls are therefore fundamental to success in this business. Once lost, credibility is very difficult to recover. The general lack of qualified professionals, coupled with the need to attract people with integrity and keep them honest, would require the development of a robust business model.

All this of course assumes that the head of the institution is himself committed towards improving the system, an itself often debatable premise. However, it cannot be denied that third party assessment equips officials with a hitherto unavailable and powerful force multiplier that dramatically increases their span of control and thereby supervisory effectiveness. In other words, all things being equal, effective use of third party assessment has the potential to considerably improve the quality of government service delivery channels.

Critics would surely allege that this is a back door entry of private agencies into the basic governance functions itself. However, it needs to be borne in mind that the success and widespread adoption of TPQC with engineering works has not generated voices calling for scaling back the regular engineering supervision.

However, it is important to be clear about their scope of work and objectives, so as to ensure that it does not become an excuse and cause for further erosion of the already weak regular supervisory systems. Fundamentally, the outputs of the third party agency should be a feedback for only the highest level of administration, preferably only the Head of Department, and should complement, not supplement, the role of the regular supervisory architecture. A third party assessment service would differ from a regular survey (or opinion poll), in the continuing and qualitative nature of the engagement with the agency.

For all those venture capitalists, in search of an idea to fund, partnership with the government in the creation of a competitive market for independent service quality assessment would do more than any other innovation to atleast partially address the persistently stubborn implementation failure of Indian bureaucracy.