Thursday, April 27, 2006

Chain of Fools

Did you get the chain email urging you to join the ExxonMobil boycott? If not, here's the letter. Why boycott ExxonMobil? Seedy dealings with corrupt government? Repugnant disregard for the environment? Nope. The chain mailers are simply engaged in what has become a rite of spring in America: whining about high gas prices.

Are you outraged by the prospect of four bucks per gallon? Well, don't click the forward button just yet. Take a moment to consider the economics behind the chain mail gas proposal. Here's the strategy according to the chain mailers. First, millions of boycotters stop buying gas from ExxonMobil stations. Next, freaked out ExxonMobil executives slash gasoline prices in an attempt to lure back customers. Then, other gas stations freak out too and slash their prices in order to keep their customers from going to ExxonMobil. And, Shazam! We're back to driving our suburban assault vehicles for a dollar per gallon.

Let's give the chain mailers the benefit of the doubt and assume that they can muster the social networking required to pull off a massive boycott of ExxonMobil gas stations. (Successful boycotts typically need an extremely important issue for protesters to rally around.) Ask yourself some questions in order to think about the pitfalls of the chain mail scheme:

1. If, miraculously, lots of people stopped going to ExxonMobil for gas, where would they buy gas? What would happen to gas prices at other stations as people substituted away from ExxonMobil toward other brands in order to comply with the boycott? Would gas prices rise or fall?

2. How long is the boycott supposed to last? That is, how much does Exxon have to cut prices before boycotters can buy Exxon gas and trigger a price war? (Boycotters will have to go back to Exxon to trigger the price war--if other stations knew that no one would buy gas from Exxon, they'd have no incentive to cut their prices.) If ExxonMobil reacted to the boycott by making small price cuts, would some people abandon the boycott early?

3. Suppose ExxonMobil cuts prices by a lot and the boycotters allow themselves to go back to Exxon. Some gas stations might drop prices a bit in order to stem the flow of traffic back to Exxon, but as people went back to Exxon in order to reap the rewards of cheaper gas, what would happen to gas prices at Exxon stations? When the dust settles on the whole boycott would gas prices be any lower than they were before?

4. Ohio State University economist Tim Haab has a message for would-be boycotters who'd like to see lower gas prices: don't drive so much. Listen to his Morning Edition interview on NPR. Who keeps oil prices high: demanders or suppliers? President Bush said the United States has an oil addiction. What energy policies would effectively ween us off of our oil habit?

Want more on the economics of gas boycotts? Check out Tim Haab's blog posts.

Bee County, Texas went so far as to pass a resolution in support of the chain email's scheme.

Jacob Weisberg's Slate column discusses the Congressional stupor created by rising gas prices.

Topics: Gas prices, Supply and demand, Incentive

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Wednesday, April 26, 2006

"If We Start with Sheep, Then Next It's the Cows and Horses."

Recent visitors to the New York Times website saw a very odd picture: sheep wearing blankets sporting the logo of, a Dutch hotel web site. Since they've been advertising on livestock, visits to the hotel's site have gone up 15%. (Imagine the increased visitorship from the cover photo on!) You can read the article here; there are lots of semi-clever puns about things like drivers making "ewe-turns" to read the advertisements, so prepare to groan.

Beyond the humor value of the article, there's actually a serious economic point to consider. We learn in economics that the invisible hand of the market will guide competitive companies to seek out any chance to make profit. We also learn, when we study externalities, that one person's economic activity can have an adverse effect on others, and that such activity should be regulated. Indeed, some towns are already banning the practice of advertising on sheep; according to the article, the mayor of the town quipped, "My first reaction was a smile; it is very creative. My second reaction is that we have to stop this. If we start with sheep, then next it's the cows and horses."

It's not exactly clear what the externality is in this case, though. Let's assume (we're economists, after all) that the sheep don't care whether the blanket they wear has a logo on it. Who suffers? The farmers make a few euros without any effort. The website attracts more traffic. The advertising agency which thought up the concept, Easy Green Promotions, already has goals of expanding to 25,000 branded sheep. Who is the mayor of Skarsterlan to stand in the way of economic progress?

Perhaps the best way to consider the question is to think about the tradeoff that any society faces between its own cultural traditions and economic efficiency. Perhaps there is some utility to be gained by thinking that a drive through the Dutch countryside might yield some bucolic views of sheep still unadorned with advertising.

1. Missing markets cause economic inefficiency, but sometimes the non-existence of markets is a good in and of itself. For example, would the world be a better place if one purchased a spouse, rather than finding one through courtship and dating? What are other examples of missing markets that should perhaps remain missing?

2. What are the benefits and costs of preventing trade in goods and services that society deems unpleasant? Sheep with logo blankets are an innocuous example; child pornography (or worse, the child sex trade) is anything but innocuous. Where should society draw the line, and how?

3. In the case of the sheep, it seems likely that there is, in fact, a very small negative externality felt by hundreds of drivers, but a concentrated profit for a few small individuals. Does the Coase Theorem apply in this case? Are transactions costs low enough for ranchers and advertisers to negotiate compensation for all of those people who prefer an advert-free countryside? How does the existence of a town mayor who represents the desires of the populace at large change your answer?

Topics: Microeconomics, Efficiency, Invisible hand

Monday, April 24, 2006

Are You Being Served?

Brandon’s post last Thursday touched on globalization and the anxiety created by outsourced jobs. While fears of outsourced radiology jobs have been overstated, the anxiety over globalization is real, and for some other industries so is the outsourcing. So, how can the U.S. labor force cope with these trends?

According to President Bush, education is the best response to globalization, allowing American workers to “fill the jobs of the 21st century.” The key is for workers to retool themselves for jobs that are unlikely to be shipped overseas. Where do you find such jobs? Many academics and corporations think the answer is a developing field of study called services science, which combines quantitative methods with technology and management.

Remember, Adam Smith once called services the parasite of the economy. But, with over 75% of the U.S. workforce employed by the service industry, services science is designed to improve efficiency and create new opportunity in a variety of industries including health care, transportation, customer service, etc. Several prominent universities (including Cal-Berkley, Stanford, North Carolina State, and Georgia Tech) are now implementing courses and devoting research resources to services science, while IBM leads the business-to-business charge, having seen half of its business become services.

Many are applauding this co-evolution of business, technology, and education, including OECD economist Jerry Sheehan who said, “This is how you address the global challenge. You have to move up to do more complex, higher-value work.”

Of course if that doesn’t work … who knows, maybe livelihood insurance is just around the corner.

1. What role did services science play with the Apple iPod?

2. Which workers will services science benefit the least? Why?

3. How does the theory of comparative advantage help explain outsourcing and the purpose of services science?

4. As more collegiate services science programs develop, will that create more jobs for the existing workforce or only new entrants into the workforce?

If you care to listen to Jim Spohrer, director of services research for IBM, talk about the evolution of services science, link here.

Topics: Globalization, Outsourcing, Services science

Thursday, April 20, 2006

Why Don't We Outsource More Radiology to India?

David Leonhardt's latest New York Times column takes a sober look at the mild hysteria over the alleged outsourcing of radiology work to India. Radiologists diagnose diseases and ailments by reading x-rays and scans. A few years ago, the notion of Indians doing work traditionally reserved for American radiologists caught the attention of protectionists and free traders alike. Lou Dobbs expressed his typical indignation over the prospect of Indian radiologists stealing the jobs of their American counterparts, while George Will applauded the outsourcing of radiology as an avenue toward affordable health care. Dobbs and the protectionist camp saw unemployed American radiologists, while Will and the free trade camp saw less expensive diagnoses and lower medical bills.

There's just one problem with the ruckus over radiology outsourcing--virtually no one does outsourced radiology work in India. According to economist Frank Levy of MIT, you can use one hand to count the number of Indian radiologists reading American x-rays and scans. To borrow a sound bite from Dobbs, hospitals aren't exactly "exporting America" on the radiology front. It's also unlikely that George Will's medical bills are going down any time soon--the labor cost savings from all of three Indian radiologists won't add up to much.

1. The mystery is why more radiology work isn't outsourced. As Leonhardt points out, the radiology outsourcing myth picked up steam because the work seems so ripe for offshoring. According to the column, what does radiology have in common with other industries that are outsourcing jobs?

2. If radiology outsourcing makes so much sense, why aren't more hospitals doing it? What trade barriers or occupational licensing restrictions protect American radiologists from competition with their equally talented foreign counterparts?

3. Outsourcing destroys some jobs but may create others. Consider three types of jobs in the health care industry: surgeons, nurses, and radiologists. Why aren't nursing positions outsourced? If radiology outsourcing actually occurred on a broader scale, what would happen to the demand for American radiologists? Might outsourcing more radiology work to qualified doctors in India actually lead to health care industry growth in the United States (think about George Will's claim)? How might more radiology outsourcing affect the demand for nurses and surgeons in the United States?

Topics: Outsourcing, Globalization, Trade, Labor markets


Tuesday, April 18, 2006

Here’s $400 Million for the Memories

Last week, the 2005 retirement package for former ExxonMobil CEO Lee Raymond became public. The retirement package, valued at about $400 million, includes cash, stock, options, country club fees, use of corporate jets, company car, and company driver. In total, Raymond received more than $686 million in compensation between 1993 and 2005. Now, shareholders, consumer groups, and corporate governance experts are asking how much executive compensation is too much.

There are two central theories regarding worker compensation. If there are large numbers of workers and firms, and perfect information about performance, then wages in a market economy reflect the marginal value of each worker. If this were the case, then Raymond, by his presence, must have increased Exxon's value by at least $686 million.

However, if there are small numbers of individuals under consideration, then a "principal-agent" problem arises. Exxon's board wants to encourage its CEO to increase shareholder value, so it must provide a substantial reward for performance. Regardless of whether Raymond himself is worth that amount of money, the promise of the gigantic reward is enough to encourage him to manage the company wisely.

So, which one fits Raymond’s case? Well, Exxon’s market value has risen to $375 billion, making it the largest American corporation, and profits have risen from $4.8 billion to $36.1 billion since 1992 when he took over as CEO. Exxon shareholders have enjoyed 13% returns under Raymond’s tenure, and the $686 million Raymond received over 13 years constitutes less than 2% of Exxon’s net income for 2005 alone. Clearly, Exxon and its shareholders benefited greatly under Raymond’s guidance.

However, no CEO, no matter how brilliant, has a marginal value of $400 million when he's retired. Therefore, the $400 million retirement package must be a reward for past performance. In other words, it is a signal to future CEOs of potential rewards. If they perform as Raymond did, they too will be reaping the benefits long after they've left the company.

1. According to Mark Cooper, research director at the Consumer Federation of America, “He (Raymond) served his stockholders well and the American public poorly.” Whom should a company and its CEO serve--stockholders or society?

2. Is it possible to measure the marginal value of a CEO in the same way one measures the marginal value of a line worker? How?

3. Executive compensation is often determined by corporate boards, who themselves are often friends and colleagues of the CEOs they are overseeing. How likely are they to be impartial in setting compensation packages? What mechanisms could be used to increase their impartiality?

Topics: Executive compensation, Principal-agent relationship

Friday, April 14, 2006

The Beauty Premium

Employers use applications and interviews to estimate the productivity of would-be workers. Problems arise when discriminatory or unwitting employers overestimate (or underestimate) a job candidate’s productivity based on often irrelevant traits like beauty, race, gender, sexuality, or belief system. As Hal Varian points out in his latest New York Times column, economic evidence suggests that beautiful people tend to earn higher wages than their more homely counterparts, even in jobs where looks don't affect performance. Why the beauty premium?

Varian points readers to some research by economists Markus Mobius and Tanya Rosenblat. Mobius and Rosenblat conducted some experiments where subjects were either employers or job candidates. Employers had to estimate the productivity of potential workers. The job in question? Solving mazes--as many mazes as possible in 15 minutes. As part of the evaluation, would-be maze workers had to work through a sample maze and provide the employers with a self-estimate of how many mazes they could complete in 15 minutes. Mobius and Rosenblat found that employers tend to overestimate the productivity of attractive people partly because the beautiful people overestimate themselves. Read Varian's column to get the specifics of the experiment.

1. To understand whether beauty affects an employer's estimate of a would-be worker's productivity, researchers need to define beauty. How did Mobius and Rosenblat determine which of their subjects were beautiful?

2. During the evaluation, candidates had to provide a self-estimate of how many mazes they could complete in 15 minutes. Was there a difference between the estimates of the beautiful and the not-so-beautiful? When the job candidates actually completed the 15 minute maze tasks, was there any difference between the productivity of the beautiful and the not-so-beautiful?

3. The experiment used several different interview methods for evaluating job candidates. Beauty did not influence employer estimates of productivity in evaluations based solely on resumes. Why did beautiful people fare better in phone-based evaluations where the employer could not even see the candidate?

4. Economists Cecilia Rouse and Claudia Goldin found evidence that American symphonies used to discriminate against women in auditions. Their research suggests that the advent of blind auditions markedly improved a woman's chance of selection to the symphony. How should companies structure the hiring process if they want to remain as neutral as possible with respect to traits like beauty, gender, or race?

Topics: Labor markets, Behavior

Thursday, April 13, 2006

Betting the House (Index)

Standard & Poor’s Corp. recently announced it will be carrying new indices that track housing prices in 10 major metropolitan cities and a composite national index, all based upon techniques developed by economics professors Karl E. Case and Robert L. Shiller, author of Irrational Exuberance. Further, the Chicago Mercantile Exchange (CME) will begin trading futures and options based upon the housing indices. Despite being valued at over $21.6 trillion in the United States, Shiller suggests there is an underdeveloped financial market for real estate.

First, a little background--futures contracts and options are derivative securities whose value is derived from the value of other assets (house prices in this example). When an investor takes a position that benefits from the asset’s value increasing, it is called a long position, while benefiting from a decrease in value is a short position.

What does all of this mean? Well, it depends on who you are:

A homeowner thinking of selling in the next couple years--you are worried that the housing market might go sour, causing your house's value to decline. You can take a short position on the index, because it benefits if housing values decrease. If values go down, you have to sell your house for less, but your short position in the housing index makes you money.

An investor who thinks real estate is a good investment but doesn’t have the money to buy property--you want to take a long position, because as housing prices increase, so do your profits from the transaction. Conversely, if you feel real estate is overvalued, a short position could capitalize on falling prices.

The first scenario is an example of risk management and the second is speculation. Simply put, risk management means identifying a risk and taking measures to protect against unfavorable outcomes, while speculation is more like betting that an asset will gain or lose value. Critics are still divided about how successful and liquid these housing derivatives will be, but at the very least these derivatives let a wide range of people actively participate in the real estate market.

1. What reaction does Shiller have to the notion that housing derivatives will add volatility to the real estate market?

2. Suppose you want to buy a house in the next couple of years, but you don’t have enough money together yet to make a deal. You are afraid that by the time you have the money, house prices will be too expensive for you. Should you take a long or short position?

3. Suppose you own a housing construction firm. You are in the middle of building several large developments at great expense. Your biggest fear is that the demand for new housing dries up. Should you take a long or short position?

4. Considering that many people think the housing bubble may be ready to burst, do you think there will be more buyers (long positions) or sellers (short positions) of these securities?

Topics: Risk management, Housing insurance, Derivatives, Finance

Tuesday, April 11, 2006

Globalization Threatening Your Job?

Robert Shiller has an insurance policy for you.

Free trade creates both winners and losers. In terms of jobs, the winners outnumber the losers--free trade creates many more jobs than it destroys. In principle, the winners could completely compensate the losers and still be better off than they were without trade. In practice, we don't see workers in booming export industries going around compensating the unlucky workers displaced by globalization. If global competition overwhelms a domestic industry, workers may find themselves out of work by no fault of their own. As globalization renders their skills obsolete, displaced workers face dimmer prospects for reemployment at former pay rates. For open economies, a tough question arises: Can society reap the ample economic rewards from free trade and minimize the distress of worker displacement in sectors that fail to keep pace with global competitors?

In a recent Project Syndicate column Yale economist Robert Shiller discusses a couple of options for reducing the growing pains of globalization: wage insurance and livelihood insurance.

1. Suppose a worker loses her job in an industry adversely affected by globalization. She accepts a new job, albeit one at a significantly lower wage since the skills she obtained in her former job are no longer as useful. Specifically, she now earns $10 per hour rather than $16. Would government-provided wage insurance cover the entire $6 difference?

2. What type of worker receives wage insurance in the United States? What's the annual benefit cap in the United States?

3. Many jobs offer significant on-the-job training. Starting pay is low in such jobs, but as workers obtain more and more skill on the job, they can expect to command higher wages in the future. Does wage insurance provide a stronger incentive to retrain compared to traditional government vocational training programs? In what way might wage insurance actually discourage people from accepting demanding work that would provide retraining?

Wage insurance is publicly provided. The United States already faces a big social insurance crisis --as baby boomers retire, tax revenues will become insufficient to fund Social Security and Medicare payments to the elderly. In such an environment, earmarking additional tax dollars for another publicly provided insurance program seems unlikely. Shiller argues that livelihood insurance provides a more promising solution because it relies on private markets rather than public coffers.

Under livelihood insurance, workers, insurance companies, and government keep track of occupational income indexes. A worker buys an insurance policy that promises to pay out if the average income in her occupation declines. Workers hold (buy) the policies, insurance companies issue (sell) the policies, and the government simply enforces contracts. The further an occupational income index declines, the more the policy pays out, regardless of the policyholder's employment status. If a worker loses her job in an occupation where average income is rising, the policy pays nothing. Livelihood insurance insures against a decrease in the average income of an occupation, not unemployment.

4. If global forces increase the likelihood that an occupation's average income will decline, the risk associated with the occupation rises, and the price of a policy covering the occupation rises. What does a relatively high-priced policy tell workers about job prospects in the occupation represented by the policy? What signal does a low-priced policy send to workers?

5. If Shiller is right and livelihood insurance can provide mutual benefits for workers and insurance companies, why hasn't the private market seized the opportunity yet?

6. Globalization often puts the jobs of low-income workers in jeopardy. Will workers with especially at-risk jobs be able to afford the livelihood insurance that would protect them against occupational obsolescence?

Topics: Labor markets and unemployment, Free trade, Globalization, Incentives and behavior


If Money Doesn’t Buy Happiness, What Does?

A growing field of economic research is being devoted to the Economics of Happiness. Researchers attempt to understand peoples’ quest for material possessions despite the apparent lack of happiness obtained from them. And, if money doesn’t buy happiness, what does? Marketing applications of happiness research is obvious, as firms spend billions of dollars annually to convince consumers that they need the firms’ products.

However, some researchers suggest that happiness lies in the pursuit of goals, not in the goals themselves. University of Southern California researcher Richard Easterlin theorizes that people are caught in a constant cycle of desire and dissatisfaction. Temporary happiness is possible by striving for and achieving a goal, but inevitably people quickly become dissatisfied with that goal and desire a new goal. Behavioral economists call this adaptation--once you get what you want, it quickly loses its luster.

Easterlin offers a comparison of psychological and economic explanations of happiness in his 2004 article in Daedalus. In the article, Easterlin discusses the effects of income, marriage, divorce, children, etc. on an individual’s short-run and long-run happiness. He references a 1960s international study that identified material wealth, family concerns, and personal and family health as the most important factors (in that order), and examines these factors in terms of happiness today. He finds that family and health circumstances have lasting effects on happiness, while wealth does not.

1. What are the positive implications of the “treadmill approach to happiness?”

2. What are the biggest determinants of your happiness?

3. How could happiness research be used in legal proceedings and pharmaceutical marketing?

Topics: Happiness, Adaptation, Behavioral Economics

Friday, April 07, 2006

Not-So-Cheap Chinese Labor

"We're bullish on Vietnam."

So says Hong Liang, an economist at Goldman Sachs responsible for tracking labor costs in China. A recent New York Times article reports that China's factories can no longer attract a surfeit of low-skilled workers at rock bottom wages. As a result, factory managers hoping to draw labor must offer better working conditions, higher wages, and more benefits. Although a challenge to factory managers, rising labor costs mean better opportunities for low-skilled workers in China and, as Ms. Hong's comment suggests, workers and managers in other economies. The relative stability of labor costs in Vietnam, India, and Bangladesh provide an appealing alternative for international manufacturers concerned by China's rising wages.

Where did the shortages come from? Over the past decade, cheap labor caused lots of companies to build factories in China. China's stock of capital surged with all of the foreign investment. The increase in the capital stock, in turn, increased the demand for labor, as shown in the graph at upper-right. At the old wage, only 500,000 people would be willing to work, but factories would want to hire 700,000 workers. So there's a shortage of 200,000 workers.

Although temporary labor shortages exist in China, there's no reason to expect them to persist in the long-term. The shortages arise because factories wish to hire lots of help on the cheap but more and more workers say "no thanks" to the low wage rates that prevailed for the past few years. The shortage of willing workers at old pay rates puts upward pressure on wages and non-wage benefits as employers scramble to attract more help. Once wages reach their new equilibrium, though, the shortages will disappear.

Why have Chinese workers become more selective? The Times article points to several reasons, including the inward movement of factories to more rural locales, the government's rural development push, an aging labor force, and a rapid increase in college enrollment.

1. By how much have minimum wages increased in big cities like Shenzhen, Beijing, and Shanghai? How do wages for workers in large factories operated on behalf of multinational corporations compare to minimum wages in China?

2. Workers who migrate from the countryside to large industrial centers face opportunity costs: in order to earn higher factory wages in the city they forgo working closer to their homes and families. As the Chinese government reduces farm taxes and encourages economic development inland, the number of rural job opportunities increases. How does inland economic development alter the opportunity costs faced by would-be migrant workers?

3. Other than wage hikes, what are companies like the Wahaha Group doing to attract migrant workers?

4. The declining share of young workers in the labor force is due in part to the rising number of young people who opt for higher education rather than the labor force. By how much did China's university and college enrollment rate increase between 1999 and 2005? How does the falling share of young workers in the labor force affect the supply of low-skilled factory workers? How does the demographic shift affect wages for low-skilled workers?

5. The article mentions that rising labor costs in China will shift the country's international trade flows. How will rising wages and benefits affect the Chinese demand for imports from countries like the United States? As rising labor costs lead to higher production costs, the prices for Chinese-made goods may rise. How will rising prices in China affect American demand for Chinese exports?

Topics: Labor markets and unemployment, International economics, China

Thursday, April 06, 2006

Apple Computer, Inc. Redefines Competitiveness, but in a Good Way

We are used to hearing about anticompetitive practices when companies try to block rival ventures, but Apple Computer has decided to go the other direction. Apple recently announced that its latest line of computers will have software (called Bootcamp) that allows users to install rival Microsoft’s Windows XP operating system. What kind of strategy suggests helping your customers use a rival’s software?

An Apple spokesman said the company believes that Bootcamp will strengthen Apple computers’ appeal by offering Windows capabilities. However, users will have to pay the additional licensing fee if they wish to install and run Windows.

Traditional anticompetitive practices harm rivals’ ability to compete and usually generate losses for society. Instead, Apple’s strategy for dealing with competition isn’t malicious at all. Apple shows its competition a little love by giving Windows operating systems a wider audience. Rather than stifle the competition, Apple hopes to court more users by embracing its competitor's product.

With only 5% of the desktop computer market share, Apple is hoping computer users will appreciate the flexibility that multiple operating systems afford. Now the real question is how many people think that option is worth the additional licensing fee.

1. If a consumer is willing to buy an Apple Computer and buy the Windows license for $142, how much value must the consumer place on the ability to run both operating systems, and why?

2. Why would Apple want to offer users the ability to use a rival operating system? Who wins in this scenario and who loses?

3. Access Google Finance and discuss how the stock market reacted to this announcement. Pull up profiles for Apple Computer, Inc. (AAPL) and Microsoft Corporation (MSFT) and use the 5-day chart view. Scroll to look at the week beginning on Monday, April 3. What happened to the stock prices and what kind of trading volume occurred? How do prices react to new information?

Topics: Competition, Marginal analysis, Apple Computer, Microsoft Windows

Wednesday, April 05, 2006

Writing a Blank Check

To casual observers, Services Acquisition Corp. International’s acquisition of the California-based restaurant chain Jamba Juice may not seem unusual. After all, mergers/acquisitions happen all the time for a variety of reasons (economies of scale, access to new markets, etc). So what business was SACI in that it wanted to acquire Jamba Juice? Why … no business at all.

Services Acquisition Corp. is part of a new wave of “blank check” IPOs, acquisition companies going public with no operations or clear plan, only a promise to acquire other companies within two years. In fact, its June 2005 prospectus only says the management team plans to look at companies in the service industry (no mention of restaurants or similar).

Securities and Exchange Commission (SEC) rules require “blank check” companies to identify a takeover target within 18 months of going public, and deals must be closed within 24 months. If no deal is made, the company must return the investors’ money (held aside in an interest-bearing account) minus some fees and expenses. This can be tricky because, as University of Florida researcher Jay Ritter notes, blank-check executives have “every incentive to do a deal, whether it makes sense or not, because if they don't do one, they give the money back.”

Nevertheless, more than $3 billion has been raised by blank-check IPOs over the past two years and there are no signs of a slow down. Industry opinion about the ventures are split.

1. A moral hazard exists when, after an agreement has been made, one party has an incentive to take an action that it benefits from at the expense of the other party. Identify where a moral hazard may lie for “blank check” companies. Does the magnitude of this moral hazard increase or decrease over time?

2. Some analysts claim the risks associated with “blank check” companies are overstated. After all, if a deal is not made, investors get most of their money back (limited downside risk). Describe a scenario where this might not be true.

Topics: Finance, Initial public offering (IPO), Moral hazard, Incentives, Merger

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Monday, April 03, 2006

A Stock Market for Ideas

A persistent challenge facing corporate America is maintaining a reward system that inspires employees to engage in value-adding behavior. Economic theory suggests this is accomplished by aligning employees’ incentives with the company’s incentives, but the best way of aligning incentives is not always clear. Thus, firms are challenged to design systems that link employee productivity to the company’s well-being, and ultimately to financial incentives for the employees. Anyone who has seen Office Space or The Office knows what can happen when worker productivity isn’t being harnessed and directed.

A New York Times article tells how Rite-Solutions, a Rhode Island-based software company, came up with a unique solution: Mutual Fun, a unique internal “stock market” for their employees to play in. Instead of trading stocks, employees trade ideas. Ideas are submitted and assigned stock ticker symbols. Initial prices are set at $10, but from there it is up to employees to make the market. Popular ideas will attract buyers and that stock’s price will rise. Conversely, ideas failing to garner support will decline in value.

Like real stock markets, supply and demand rules in the Mutual Fun. Ideas are supposed to benefit the firm, and to make sure employees have the proper incentives, Rite-Solutions ties monetary rewards to high-performing portfolios. In other words, employees putting their support behind successful ideas are rewarded for spurring the firm into action.

While most companies operate assuming that big ideas come only from the top, Rite-Solutions co-founder James Lavoie notes, “At most companies, especially technology companies, the most brilliant insights tend to come from people other than senior management. So we created a marketplace to harvest collective genius."

1. What is the most successful stock on Mutual Fun?

2. How might Rite Solutions’ Mutual Fun compare with more traditional methods of issuing stock options or paying bonuses based on current earnings? Consider the difference between short-term and long-term goals.

3. Hopefully employees base trading decisions on some fundamental analysis (which ideas are better) rather than playing the market. How could employees buying underperforming stocks or engaging in herding behavior affect the outcomes of the market?

Topics: Finance, Stock market, Incentive alignment