jamesz

Counter-signalling

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Yesterday’s post on dress codes and signalling drew a comment pointing to Tyler Cowen’s reference to ‘counter-signalling’. TC refers to Steve Jobs dressing down as a counter-signal because he doesn’t need to dress up to show his seniority and importance. It’s a bit of a misleading term because a counter-signal isn’t really a signal at all: it doesn’t convey any information since it is not costly to fake. Anybody can dress down but for many people it’s not conducive to good career prospects. Essentially, Steve Jobs doesn’t need to signal his enthusiasm to his superiors because he has none, so he doesn’t signal at all. The fact that he doesn’t need to signal isn’t itself a signal because anybody can do nothing.

The original paper that this is drawn from goes a little further than pointing out that signalling is unnecessary for some people. It says that when a signal is easy to make – such as wearing a suit – then it is detrimental to high quality people to make the signal. The information conveyed by a signal that’s easy to make is that one is, at worst, mediocre. When you are, in fact, a high quality candidate then it can be damaging to you to be seen as feeling the need to prove yourself to be mediocre. Your optimal strategy is to avoid making the signal at all and look for a better signal of high quality. Thus, the people who end up making a signal are the worst of the people who are able to make that signal.

I guess the implication of this for dress-codes is that the people in nice suits are the lowest level employees who can afford to buy that quality of suit. Once you’re at a level where you can afford better suits you should cease wearing the lower quality suit at all. When you’re at the top and your subordinates wear top-drawer kit then you’re best off avoiding suits altogether and making no signal via your clothing.

Matt Nolan

Infinite time and economics

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I was just looking at an interesting post from Philosophy, et cetera. They are discussing value when we have ‘infinites’. Now if we are looking at points in time with infinite resources this would be pointless for economists, as economics is the study of scarcity. If there are infinite resources, consumption is infinite and value is infinite.

However, they also discuss infinite time. Now if we have a game which is played infinitely into the future how do we decide the optimal choice of an individual? In order to work out the optimal choice of an agent economists will often discount the agents future consumption decisions. This implies that, if the ordering of preferences is expected to stay constant over time, an agent will value a unit of consumption more now than they will at any given point in the future (Ultimately it means that the game provides a finite value even though we have infinite time, as a result these values can be ranked allowing us to choose an optimum). Now exactly how we discount is constantly discussed by economists, especially since the way we commonly discount doesn’t hold true in empirical tests.

Now, even though I have spent a lot of time discussing discounting, that is not what I want to talk about. I want to talk about why and infinite horizon game or choice problem is sensible. Now you might say that no game between agents will be played for an infinite amount of time because everything has an end. However, that is not the way I see it. Infinite time is the idea of unbounded time. If we do not have a definitive end-point then we can view our game going on into infinity.

Let me explain. Ultimately, agents in a game will associated some probability to the game ending during a certain period. In this case they will either believe that their is 100% probability that the game will have ended at some set point, which acts as a boundry and so makes the game finite, or they believe that there is a probability that the game will end at each point in time, but they never associate a 100% probability to the gaming ending at a set point. In the second case we need to look at a infinite horizon game.

The discussion of discount factors is important when we go to look at a person’s choice in this way. In a sense the discount factor represents the likelihood that the game or choice problem will still be going during future periods, as well as a general preference people may have for consumption now instead of consumption tomorrow. As a result, even if we think that saying the current value of a pie in a year is greater than the current value of a pie in 10 years is silly, the fact that I place a higher value on being dead in 10 years than in one means I will value the pie in a year more (as I may never consume the pie in 10 years). Now my consumption choice may still be bounded (as I associate 100% chance of being dead at 800 😉 ). However there are cases where there may be point where a 100% probability is implied, eg the survival of a firm such as the Warehouse.

All this teaches us, is that we have to be careful that the horizon we choose to look over things makes sense, and that infinite does not mean the game or choice problem will never end, just that we are completely uncertain when it will end.

jamesz

Dress codes in the office

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I have always wondered why corporate offices require a dress code for employees, even when the employees never see the outside world. Tyler Cowen blogs about corporate dress and makes a couple of interesting points, but it doesn’t really address my particular curiosity. He’s inspired by a reader who points out not many people are as comfortable in business attire as they are in casual clothes. If a worker is most productive when they are most comfortable then why would you force them to wear a suit?

A common explanation of smart clothing is signaling to overcome adverse selection. People choose to bear the cost of wearing uncomfortable but smart clothes to show how dedicated they are to their job and to gaining a promotion. However, this seems like an argument against dress codes: if people can choose what to wear then it’s easier for the eager employees to signal their dedication to The Company through their choice of clothing. As Tyler mentions, it may even be worthwhile for companies to impose a maximum dress code in order to eliminate the signaling costs that allowing suits imposes upon employees.

Ultimately, I think the reason for dress codes is shrouded in the mists of corporate managerial lore, of which I know nothing. I can’t think of a good reason for it in standard micro theory, and since Tyler Cowen can’t either I’m in good company there. If anybody has a good explanation for this convention I’d love to hear it.

jamesz

De-regulate health care?

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I generally enjoy The Economist’s blog, but I think they’ve taken their free-market philosophy a little far with their post on the “de facto monopoly of the American Medical Association in the distribution of licences to practice medicine.” Their claim is that the AMA extracts large rents from their monopoly and unfairly prevents other from practicing medicine. I don’t know what sort of rents doctors get from their education so I can’t comment on that. A more interesting question is whether it would be efficient to allow a deregulated market in medical practice.

Every time you go to the doctor you are, effectively, contracting for medical services. A well-known problem in contracting theory is lack of verifiability. The problem is that it is very costly to you to find out whether the doctor is providing you with high quality medical services. If you are not yourself trained as a doctor then you have to seek the opinion of someone who is in order to verify the quality of service you received. Even then, there is a question mark over the third party’s credibility: they may want to either protect the reputation of medical practitioners or, alternatively, destroy the reputation of competitors. Even the knowledge that you recovered from illness is not enough since this is a very noisy signal of medical quality. Without specialist knowledge it is impossible to know what the outcome would have been in the absence of treatment. The suggestion that consumers ought to have “choices over traditions of training and styles of care” suffers from the same problem. In the absence of highly specialised knowledge there is no way for consumers to verify the quality of each style of care.

There are two possible remedies to the problem of verifiability: information and regulation. Consumers can be informed by the AMA about the choices they face in a deregulated market or the market can be regulated. Unfortunately, it is simply not possible to become an expert on medical care by reading a couple of pamphlets. Placing the burden on consumers to choose wisely is unlikely to result in an efficient health care outcome. By contrast, regulation puts the burden of choice on experts in the field for whom it is far less costly to evaluate performance. It is quite possible that the rents that the AMA extracts from consumers are far lower than the costs to society of deregulation.

Matt Nolan

The marginal revenue of movies

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I was reading the Dilbert blog the other day, and Scott Adams was trying to talk about a Dilbert movie. Before starting to ask the blogging community whether they thought it would be a hit, he linked to this article, and asked why movie producers keep making so many R rated films, when G rated films gave larger returns. He puts it down to the directors incentives not being aligned with those of the investors. So instead of making a film that will maximise profit, directors make films that maximise the chance of winning awards. This is all very good, and I’m sure that there is an agency problem in film making. However, the agency problem will be ex-post the decision on what type of film to make. It seems to me that if investors felt they would make the most money of G-rated films, they would make contracts with directors to force them to make G-rated film, thereby solving (most) of the agency problem.

Scott Adams has an extremely good understanding of economics (he did do a degree in it), however, in this case I feel that he has confused average and marginal revenue. Now the article states that the average revenue from a G-rated film is greater than the average revenue from a R-rated film. However, when an investor puts money into a film being made, they are interested in the marginal revenue of that film type that is available from the market. The investor is putting money into a project that creates 1 more of that type of film in the market place. In that case the marginal revenue of a film type is what the investor is after.

Now it is possible that the average revenue of R-rated films may be lower, while the marginal revenue of an R-rated film is the same as a G-rated film. All we need for this to happen is the initial returns from the first G-rated film on the market to be higher than the R-rated film, but for marginal revenue to then fall much faster for the G-rated film type than the R-rated film type. I think this is a good description of demand for movies, so people can see them on their TVs in their homes or gardens with the use of accessories as an outdoor tv wall mount for this purpose. Families have a high value for taking their kids along to the first great animated film of the year, however once we get to the 3rd animated film for the month the family will stop going. However, R-rated films tend to get a specific crowd that is interested in that type of film. This crowd is willing to pay to see more movies, but may not be as large as the crowd that goes to the first animated film. Furthermore if there is more range among R-rated films than G-rated films, the set of products we are discussing is catering to a differentiated market. If this is the case, the release of an R-rated film would have less of an impact on the marginal revenue of another R-rated film than would be the case with G-rated films.

However, there are a number of other explanations for the difference in average revenue:

  1. R-rated films are less prone to failure (so the marginal profit can be lower)
  2. R-rated films are cheaper to make (so although marginal revenue is lower, marginal profits are equal)
  3. There is some bias among investors towards R-rated films
  4. There are too few directors and too many investors, and so directors they have some market power. As a result, directors can change the composition of movies

Personally, I think all these things come into play in some way. However, I’m confident that movie investors are often trying to maximise their profit, just like people who invest in companies or houses.

Matt Nolan

Airlines and competition

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I’ve been thinking about the fact that AirNZ is going to shut down Freedom Air in March 2008. With Freedom Air, Air NZ was able to serve the budget end of the market and the higher quality end by selling a differentiated product. However, the company could have simply offered different services in different compartments of the plane, it seems a touch over the top to create a whole separate brand just to get the advantage of price discrimination (at least in this case).

The true purpose of Freedom air was to prevent competition. By paying a whole lot of money to run a cut price airline, Air NZ was able to make it uneconomical for other potential entrants from coming into the market, as their marginal cost was greater than the price they could set when competing with Freedom. The investment in Freedom air acted as a form of commitment. As the investment in capital, goodwill etc for Freedom air was costly to reverse, Air NZ could credibly commit to fighting a new competitor on the Trans-Tasman route through the low prices Freedom charged, rather than just allowing them entry.

However, Air NZ has dropped Freedom right when Virgin was getting in on the act. I expect this is because the costly commitment to fight the new competitor was not sufficient to prevent the new competitor entering. As a result, Air NZ has decided to dump Freedom Air and just accept that there is a new competitor. I guess this is fair enough, as Virgin has some very deep pockets, and if Air NZ decided to fight them they may well be on the losing end. As a result, Freedom Air was a useful mechanism to reduce small scale competition in the market place, but it was not effective at preventing the arrival of one of the big boys.

In the future, I’m sure the case of Freedom Air will be a useful case study in how an incumbent can use costly commitment to prevent the entry of a new competitor. How do you think the commitment game functions in this case?