Continuous Productivity

Moneyball Missed the Reserve Clause?

Great article arguing that although baseball is an inefficient market, it is not a completely free market:

The problem with likening the market for baseball players to an equity market is that the former is not a genuinely free market. The reserve clause binds players to the team that drafted them for the first six years of their career; during this time they cannot become free agents and sell their services to the highest bidder. So the intrinsic value of a highly productive player will rise, but he will not necessarily be paid his market value until he has completed his “indentured servitude” (as Lewis termed it). Thus it is not surprising that while payroll cannot tell us anything about wins, it does a pretty good job of predicting a team’s average age: young players are much cheaper.

To understand how much the reserve clause matters, let’s look at the young talent on the Oakland squad Lewis chronicled. Shortstop Miguel Tejada hit 30 home runs for the low, low price of $290,000 in 2000. Two years later, when he won the American League MVP, he made only $3.5 million (I know, but it’s all relative). His free agent contract, which he signed with the Baltimore Orioles after the 2003 season, was for $72 million over six years. Eric Chavez (whom the A’s actually did sign to a long-term market-value contract in 2004) produced 32 home runs in 2001 for $625,000.

Mark Mulder, Tim Hudson, and Barry Zito, the A’s “big three” pitchers, led the team to the 3rd, 2nd, 1st, and 1st American League ERA ranking, respectively, from 2000 to 2003. In 2001, when the A’s won 101 games, the combined salary of Tejada, Chavez, MVP-runner up and all-star first baseman Jason Giambi, Mulder (21 wins), Hudson (18 wins), and Zito (17 wins) was under $8 million. In the first year after each player’s “indentured servitude” ended, the six made a total of $43 million. The A’s won even though they were poor because they did not have to pay their young players what they were worth.

Giambi, who won the MVP in 2000, epitomizes the economics of baseball. He joined the Yankees as a free agent after the 2001 season. In that first year with his new team, he made more in salary than in the seven years he spent in the A’s organization combined. This turned out to be some deal for Oakland. As the San Francisco Chronicle’s Vlae Kershner recently pointed out, Giambi produced about half of his career home runs and RBIs in an A’s uniform. For that output, the team paid about 9 percent of his career earnings (up to the end of last season).

Just as the A’s could not have afforded to compete without the reserve clause during their “moneyball” run, no small-market team could compete without it today.

Geitner Plan Explained

One of the best explanations of the government involvement in attempting to stabilize the economy:

Q: What is the Geithner Plan?

A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

Q: Where does the trillion dollars come from?

A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.

Q: Why is the government making hedge and pension fund managers kick in $30 billion?

A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.

Q: Why then should hedge and pension fund managers agree to run this?

A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.

Q: Why isn't this just a massive giveaway to yet another set of financiers?

A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

Q: Why do we think that the government will get value from its hiring these hedge and pension fund managers to operate this program?

A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.

Q: So the Treasury is doing this to make money?

A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.

Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?

A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lazy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.

Q: So?

A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.

Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?

A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.

Q: Oh.

A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.

Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.

Q: This sounds very different from the headline of the Andrews, Dash, and Bowley article in the New York Times this morning: "Toxic Asset Plan Foresees Big Subsidies for Investors."

A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?

Q: No.

A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.

Obesity and Oil Again

Typical of McKenzie's interests is a recent paper that notes the average weight of Americans has increased 24 pounds since 1960, and how that has had a direct impact on gasoline prices. He contends Americans are using 1 billion gallons more gasoline per year hauling all that extra weight around, and airlines are using 1 billion gallons of additional jet fuel. And that extra demand contributes to the rising costs of gas (BusinessWeek.com, 6/3/08). 

"My inconvenient truth for Al Gore is you can save polar bears by going on a diet, at least if it's done nationwide," says McKenzie.

I can see the obesity and oil thing becoming an increasingly common theme given how intuitively easy it is to explain to the layperson.

Vegas Economics

I knew that getting into anything in Las Vegas was expensive.  I just never really went through the revenue model in my head.  Had I done that, I would have realized that cash is exchanged at an unimaginable rate in Vegas:

Sources have been telling me that doormen at several clubs are clearing $8,000 to $10,000 a night before they share tips. So much cash is pouring in that some doormen are making $400,000 to $500,000 a year, several nightclub executives told me.

Irrationally Rational

An excellent article at The New Yorker reviewing a couple of books on behavioral economics:

From the perspective of neoclassical economics, self-punishing decisions are difficult to explain. Rational calculators are supposed to consider their options, then pick the one that maximizes the benefit to them. Yet actual economic life, as opposed to the theoretical version, is full of miscalculations, from the gallon jar of mayonnaise purchased at spectacular savings to the billions of dollars Americans will spend this year to service their credit-card debt. The real mystery, it could be argued, isn’t why we make so many poor economic choices but why we persist in accepting economic theory.

The bold above is mine to emphasize what every business person already knows.  People, in fact, are far from rational actors.  Whether it's "investing" in tech stocks in the late '90's to the recent real-estate "flipping" boom, people have shown their inability to act rationally.  So, it shouldn't really be a surprise that we will add books to our purchase at Amazon to get free shipping.  The interesting part is that we seem to be systematic about our irrationality.  That is, we seem to make the same mistakes over and over:

“Our irrational behaviors are neither random nor senseless—they are systematic,” he writes. “We all make the same types of mistakes over and over.” So attached are we to certain kinds of errors, he contends, that we are incapable even of recognizing them as errors. Offered FREE shipping, we take it, even when it costs us.

In fact, smart business people have already exploited our inherent biases in their pricing strategies:

This effect is called “anchoring,” and, as Ariely points out, it punches a pretty big hole in microeconomics. When you walk into Starbucks, the prices on the board are supposed to have been determined by the supply of, say, Double Chocolaty Frappuccinos, on the one hand, and the demand for them, on the other. But what if the numbers on the board are influencing your sense of what a Double Chocolaty Frappuccino is worth? In that case, price is not being determined by the interplay of supply and demand; price is, in a sense, determining itself.

To conclude:

“If I were to distill one main lesson from the research described in this book, it is that we are all pawns in a game whose forces we largely fail to comprehend,” he writes.

We Need to Pay for Things We Don't Use

Thanks to the always wonderful Kedrosky blog, I was led to this article about us delusional humans.  One short paragraph sums it up:

The economics of health clubs are simple: you need thousands of members who never come. The gym could never accommodate them all if they did.

The article also has a link to a study that basically says that we are overconfident about the amount of self-control we have.  Even when we think we will go to the gym regularly, we don't.  Beyond that, we refuse the cancel our membership even when it would be much cheaper to pay by the day:

Two Californian academics, Stefano DellaVigna and Ulrike Malmendier, studied three US health clubs and discovered that 80 per cent of members used the gym so infrequently that they would have been better off paying the $10 fee for each individual visit. Many also left substantial gaps between their last visit and cancelling their membership.

Maybe Expensive Wine Doesn't Taste Better

I had previously linked to a study about the physiological effects of expensive wine on brain scans.  Alex Tabarrok has an excellent response to the study:

Living in a market economy the association in the brain between price and quality is constantly reinforced so it's not surprising that sometimes the brain can "jump the gun" in expectation.  But don't imagine that the association can be easily exploited for long.  Why do you think these sorts of studies always use wine?  Could it possibly be because most people can't tell the difference between a cabernet and a merlot let alone between higher and lower quality wine?   But try telling people that a $5,000 car is $45,000 and let's see if the medial orbitofrontal cortex lights up with experienced pleasantness.

Expensive Wine Tastes Better

A very interesting study by a few Cal Tech academics indicating that people think wine tastes better if it is priced higher.  It doesn't surprise me that people perceive expensive wine tastes better and would indicate as such on a survey.  It does (somewhat) surprise me that there is a physiological reaction to the wine price:

The testers' brains showed more pleasure at the higher price than the lower one, even for the same wine, Rangel reports in this week's online edition of Proceedings of the National Academy of Sciences.

Clearly, that is one of the huge pricing advantages of the luxury market - the ability to price perception and prestige.  It's still intriguing to note that the brain reacts to these factors.