The price of diamonds

The diamond market is really strange. The wholesale market is dominated by a single firm that basically acts like a monopolist, as it is able to control supplies with large stockpiles (and even get a bailout from the government) and thus sets the prices at will. The resale market is heavily self-regulated to limit the supply from others than the dominant firm (just try to resell your diamond and get more than half what you paid for it...). Thus, if you would want to study price setting in this market, you would want to look at it from the angle of a monopolist trying to maximizing its profit and extracting as much as possible from demand.

Nicolas Vaillant and François-Charles Wolff do none of it. They just apply a hedonic regression and blindly regress selling prices on diamond characteristics. It is interesting that they find that there are some important non-linearities at round carat sizes, but is to be expected given the marketing by the diamond industry. But what quickly put me off in this paper is that the authors do not seem to understand some basics of economics. Here is a quote from the first paragraph:

In 2003, world demand for rough diamonds (US$9.5 billion) was significantly above the diamond supply (US$8.2 billion), so that the excess demand had to be satisfied from producers’ existing stockpiles.

First, by definition, supply includes stockpiles. How one would measure supply by ignoring the stock is a mystery to me. And how could one quantify supply and demand separately like this? In addition, it is not like there is rationing going on, which would justify higher demand than supply, as I cannot imagine that a monopolistic supplier set prices below equilibrium. After this opening paragraph, I cannot trust anything in the paper.

PS: And I just realized this is the second time I criticize a paper by these two authors...

Milk quota markets are not efficient

Many countries have some sort of rationing system in place for their dairy industry, because apparently farmers have a tendency to produce too much milk and depress its price, in the end getting less, I guess because the price elasticity of demand is high. This rationing is typically done through a quota system, and these quotas are sometimes tradable. This last point is important as it makes it possible for the allocation to be efficient: the most efficient producers should indeed acquire more quotas, which they buy from the least productive farmers.

Rebecca Elskamp and Getu Hailu tell us this is not at all what is happening in Ontario, Canada. Elskamp and Hailu identify quota net buyers and sellers and they try to match them with various characteristics. As the milk sale price is uniform, it must have to do with production and costs. The latter do not seem to matter at all. Scale does, though. Thus, if you are a farmer who happens to have an empty barn, you buy quotas whether your costs are high or not. But if you are a very inefficient farmer with high costs, you do not think of selling your entire quota and live from it. Strange.

Should we see more university mergers?

When should universities merge? The recent examples I have witnessed were due to economic hardship, where one college could simply not meet ends and was taken over by another one. There is also a new trend in France to merge universities that had previously been split apart, as part of the eternal higher education reform in this country. Many universities grew so large that they were split along sciences lines (natural, engineering, social sciences, humanities), only to realize that French universities were then really hurting in international rankings. But none of this follows any reasoning about what is best from a social point of view.

Marisa Hidalgo-Hidalgo and Guadalupe Valera try to get to this by using a bit of theory, comparing a university monopoly to a duopoly. A monopoly can bargain better for lower wages and better faculty, and it can create synergies. But a duopoly encourages better competition for excellence. The overall results is that the more heterogeneous universities are, the easier a merger will turn a societal benefit. The current merger craze in France is thus appropriate, but for a different reason.

Yet the model does not allow to take into account some very important aspects of education. Think for example about the diversity of classes than can be offered in a larger institution. And that includes the French mergers, as now there is a potential for students to take classes outside of their field and thus emulate something like a liberal arts education. After all a big drawback of European and especially French education is the excessively specialized education, leading to a workforce lacking flexibility.

American colleges could also benefit from mergers. Think about all these tiny colleges that can barely offer a halfway complete curriculum for the most popular majors. These micro-colleges are expensive for students and pay actually very little to faculty who have to teach extremely varied classes and struggle to do tat well. There is definitely scope for taking advantage of some economies of scale here. But merging large, complete universities, like what the authors have in mind, is definitely less advantageous. Imagine if Columbia University and New York University were to merge. There would be little to gain in a programmatic sense, and I do not think there would much pressure on faculty wages. After all, the market for good faculty is national, if not international.

Complicated auctions are more proftable

There was a time where auction theory limited itself to studying very simple auction, where the subtleties were whether the first or second price should be paid (or the first less an increment). Now, auction theory looks at much more complex mechanisms, for example where bidders may or may not reveal their bids, or whether they are bidding, or where bidding comes with a fix price. Not all these mechanisms try to obtain a surplus maximizing outcome. Some maximize the profits of the seller, sometimes by confusing or even misleading the seller. The most extreme example are penny auctions, about which I posted before (I, II).

Andrea Gallice discusses a variation of the Dutch auction where the current winning bid price remains hidden but can be observed against a fee. This so-called price reveal auction has an additional twist: paying that fee makes the winning bid fall by a predetermined amount. An auction so complex must be designed to maximize someone's surplus. It is the seller. And his profits are even higher if he manages to keep the number of bidders secret. This is not unlike penny auctions, where the profits come from the fees, not the winning bid.

OK, this maximizes profits, but I do not think this maximizes overall well-being. Obfuscation is not likely to be beneficial, and I am quite surprised the author does not address this. Until convinced of the contrary, I am going to assume that such obfuscation is detrimental for society and should be outlawed. And with rules so complex, it would not surprise me that bidders would have a hard time behaving rationally.

The evil of patents

The litigation saga between Apple and Samsung over minute and obvious details of their respective phones makes good entertainment but has little economic value. In fact, it highlights all that is wrong with the current state of the patent system. Sadly, textbooks still teach how temporary monopolies are beneficial for innovation, yet evidence is now overwhelming that they hurt the production of innovation, the use of innovation and well-being in general. I have blogged a few times about some cases and discussed some research in this regard.

Michele Boldrin and David Levine have written a nice summary on where we stand on the usefulness of patents. They have written a very good book about the topic a few years ago (buy it or download it for free, the authors are consistent with their message). The new working paper provides a shorter breviary with the main arguments for and (mostly) against patents, with a few updates from the literature and case studies. The major point is that despite a huge increase in the number of newly granted patents, there is no evidence of increases in R&D expenditures or total factor productivity. In fact, there is a growing consensus that technological progress is slowing down and we should get used to slower growth in the economy. Patent law and practice is at least partly responsible for this.

Shopping hours competition

Firms not only compete with prices, but also with product characteristics. In the retail market, an important characteristic is the opening times. In some areas, for example in much of Europe, shopping times are regulated, the motivation being to give retail workers somewhat "normal" working hours. In some countries, for example the United States, there is much less regulation, and shops have extensive if not around-the-clock hours to satisfy King Customer.

Miguel Flores, who must have won the award for the shortest paper title, studies whether regulation is welfare enhancing when incumbent retailers can prevent entry of competitors by strategically choosing opening times. This essentially comes down to a model of competition through product differentiation. The standard result that regulation is bad when there is little diversity (regulation cannot promote differentiation) and good when there is a lot of it still holds here. The subtlety of the paper is to consider a situation where the incumbent chooses hours of operation, the competitor chooses to enter and its hours, and then they compete on hours. It is thus a two-dimensional space with entry deterrence on one.

Monopoly in health insurance is better

We typically advocate that competition is good, except when it is not, for example in the case of large production fix costs. Such natural monopolies then need to be regulated. Part of the debate on health care in the United States is also about competition: if health insurance is provided by a single entity, it got to be less efficient. Well, there is data that can verify this, by looking at employers that offer a choice of providers and those that do not.

Ilya Rahkovsky does this and comes to the stunning conclusion that insurance providers that have a exclusivity contract with an employer charge about 40% for the same "insurance quality units." How could this be? Exclusive providers tend to provide better quality insurance because they can subsidize it with the premiums of low quality policies. That would not be possible if they were to compete with other providers.

That said, insurance providers must have been in competition in order to obtain the exclusivity contract, so it is not quite true to state that the monopoly is welfare improving. But from the employees' perspective, it looks like a regulated monopoly in the sense that the employer can keep a leash on the insurance company by threatening to change providers, and that keeps the monopolist from exploiting all rents, it even encourages it to show goodwill to keep the contract. With multiple providers, everyone goes for the quick buck and offers lowly policies.

Privatization-nationalization cycles

The past two decades have seen an impressive wave of privatizations all around the world, especially in utilities and resources. This trend has recently been reversed though, with several large nationalization waves, in particular Latin America. This kind of cycle is not new, as especially the gas industry has gone through several waves each way during the last century. Why all this back and forth?

Roberto Chang, Constantino Hevia and Norman Loayza observe that nationalizations typically happen when the price of the output of reference is high and inequality of wages is also high. The opposite is the case for privatizations. They can explain this with a model of a benevolent government that maximizes a social welfare function represented by the average utility of workers. Under nationalization, all workers are paid the same and exert little effort. Under privatization, firms can discriminate workers, who then put more heart at work, creating wage differentials. When prices for the commodity increase, this generates larger rents for the most productive, and inequality increases.

The story is then of a inequality-efficiency trade-off for the government. In the naturalized state, inequality is low, but so is efficiency. If prices are low, it is more important to increase efficiency, and the firm is privatized. But as it becomes more efficient and discriminates its workers, inequality becomes more important, and the firm is nationalized back. And the cycle continues, with an average of 12 years of privatization and 25 years for nationalization. While this is a very stylized story, after all the model assume an economy with a single sector that has no impact on world prices, it is still a compelling story.

Copyright and the lack of competition in academic publishing

The official story is that copyright encourages creators by giving them temporary monopoly rights. The unofficial story is that copyright prevents the diffusion of art and knowledge, and nowhere is it as frustrating as with academic publishing. Commercial publishers sell the research others paid for, and can extract substantial rents because researchers have to publish in established outlets for reputation, tenure and promotion.

Giovanni Ramello remarks that there is another unfortunate consequence of copyright in academic publishing: having been granted some market power, the monopolist will seek to extend this market power through acquisitions and thereby obtain even more dominance. The obvious example is Elsevier, which has reached now a market share that should trigger anti-trust investigations along with profit margin in the order of 30%. The situation is quite bad in Economics, as scholarly societies have done little to prevent Elsevier taking hold of the major field journals, thereby making it essential to any tenure file. And given this, research libraries have no choice but subscribe to those journals, falling in the trap of the monopolist.

In other sciences, I hear the situation is not much better. And I have reported previously about horror stories that still seem to have little impact (1, 2).

In any case, journals are dead to me, for reasons cited above and also because the publishing process is broken, starting with refereeing.

Pennsylvania liquor stores are welfare maximizing

In many countries, and in particular North America, the state holds a monopoly on the sale of alcoholic products. And in those areas, everybody complains how inconvenient the purchase of alcohol is. Of course, this inconvenience is part of the purpose of these state monopolies, along with keeping prices high and keeping the margin for government coffers. But discouraging the consumption of alcohol does not need to be done this way, simply taxing it would achieve the same goals.

Katja Seim and Joel Waldfogel claim that at least in the case of Pennsylvania, the state monopoly is beneficial. Indeed, the layout of the network of stores, and the number of stores is much closer to maximize welfare than maximize profits. Now, of course, we need to define welfare. They measure it à la Hotelling: consumer surplus is based on the price of liquor and the distance between stores and customers, the producer surplus is based on profits, and there is a fix cost of operating a store. In other words, Seim and Waldfogel treat this problem like it would apply to any good. But we are taking about liquor here. And there is a reason we want to regulate it: it generates negative externalities.

Thus, if they find that in Pennsylvania the outcome is close to welfare maximizing according to their criterion, it tells me that there are too many stores if that social welfare measure included the negative externality of alcohol.

The iPhone must have an exclusive carrier

Aren't you angry that the particular mobile phone you prefer has an exclusive contract with a carrier? This limitation of carrier choice seems anti-competitive, if not frustrating. US anti-trust authorities seem to be getting interested in these arrangements and may intervene. It turns out that maybe they should not.

Robert Hahn and Hal Singer say exclusivity contracts are in fact the best thing that could happen for consumer welfare. Indeed, they spur competition through innovation, and the fact that the smart phone industry is innovative is hardly an understatement. Indeed, the exclusive contracts allow manufacturers to share the risk with the carrier, they make sure that both want the success of the new phone, and thus insure better reception and coverage. All this taken together induces manufacturers to take more risk and go for even faster and bolder innovations, which ultimately benefits the consumer.

Why so few drug innovations?

Research and development has an inherent tendency to have a decreasing growth rate. As the pool of things to discover continuously shrinks, it becomes harder to innovate. But we a groundbreaking discovery is made, this opens a lot of new opportunities and one should see a lot of new innovation. But with molecular biology and genomics, the pharmaceutical industry should have seen a burst of innovation, and in particular a jump in innovation productivity. Yet the contrary happened. One argument could be similar to the one that has been made about the productivity slowdown of the seventies, that an groundbreaking innovation like information technology needs time and resources to be understood.

Fabio Pammolli, Massimo Riccaboni and Laura Magazzini claim that this effect is very important. They observe that all the low hanging fruit have been picked in pharmacology and that first have shifted their investment portfolio towards more difficult problems. They suggest that one particular reason to do so is that improving current drugs is not profitable as generics are close substitutes and little rents can be extracted. Thus new classes of molecules are sought.

I would add another development in the field of R&D in general. It has become increasingly difficult and costly to file patents, as the field is littered with "predators" who file vague patents to prevent other from innovating, or to claim royalties. Not only does this increase the cost of innovating, it also increases its uncertainty, as any discovery can be subject to litigation even if it was a genuine discovery. This also encourages laboratories to find new molecules that are much different from existing ones.

Less competition is good for insurance

Competition is best, economists often claim. Except when it is not, for example in the case of natural monopolies, where the duplication of infrastructure is wasteful. THe case can also be made that competition is not as good as one would think in the insurance industry

Giuseppe de Feo and Jean Hindriks explain that adverse selection has worse consequences under competition. Indeed, in a monopoly, the insurance company can make profits on some products which allows to cross-subsidize others. With competition. profits are driven to a minimum, and cross-subsidization is minimal. This is important because cross-subsidies allows to relax the incentive constraint. This provides better coverage for high risks, but lowers participation among low risks.

One aspect that was not mentioned in the paper is that monopolistic insurers, because they have a larger market share, are better able to diversify the individual risk of the insureds. Observationally, this makes them closer to risk-neutral, and thus allows them to offer lower premiums, every else being equal. Of course, they could use their monopoly power to raise premiums, but with smart regulation or threats to entry, this can be prevented and the full social benefit can be obtained.

Optimizing patent law design is hard, why not drop it

Patents are supposed to rewards those successful at developing new technologies by granting them a temporary monopoly on their innovation. We know monopolies are bad for social welfare, in this case because it leads to underprovision of the innovation, and thus the length of the monopoly protection needs to be determined according to all sorts of factors. But patent law provides a uniform length for patents. Is this really bad?

From my reading of the latest paper by Angus Chu, yes. While it seems quite obvious that optimal patent length should depend on the level of competition in a sector, or that latter's market size, what really matters is how much patent length differ, and what a uniform patent length implies in terms of welfare losses. Chu performs in this regard an interesting numerical exercise. In a two-sector model, welfare costs of uniform patent length can reach 34% of consumption if the arrival rate of innovation is five times higher in one sector, and both sectors have the same market share. One could reasonably ask whether it is even worth have patent protection, considering all the other problems they generate (1, 2, 3).

Further evidence on the profit motive of churches

The Catholic Church is facing quite a lot of heat lately, to a large extend because it put the welfare of the organization far ahead of the welfare of its constituents. The Church denies this, of course. It is of interest here whether its other actions corroborate its social welfare motives.

Carla Marchese and Giovanni Ramello find an intriguing fact: since 2005, the teachings of the Pope are copyrighted. Copyright is like a monopoly in that it reduces quantity and maximizes private profits. Why would the Church adopt this model if it were trying to save as many souls as possible? The authors are gentle here and claim that the Church just wants to tax other media outlets that would make money by diffusing the Pope's message. I would not be that lenient. Indeed, this motivation only works if there is imperfect competition across media outlets, and then only under specific conditions. It is true that proceeds can be used to subsidize the Church's own publications, but seeing the profit margin of the Vatican's publisher (16%), it does not look likely.

Static innovation

Technical innovation is good. Monopoly is bad. What about technical innovation by a monopolist? Apparently, the literature on this uses partial equilibrium models, which is silly because general equilibrium effects can be quite important. In particular, it is not necessarily the case that whatever resources the monopolist requires after innovation are a net loss for the rest of the economy. Aggregate capital accumulation may be different, for example.

Shuntian Yao and Lydia Gan thus address the question with a model of R&D where production requires capital, there is a monopolist and a competitive sector, all this in general equilibrium, But the model is static. That is right, the process of innovation is static, innovation just happens spontaneously, and costlessly, I should add. The same applies to capital which drops from the sky when required.

Now, isn't there a literature that has general equilibrium in a dynamic setting? Yes there is: endogenous growth theory, born in the 1980's, which is right after when the literature review of Yao and Gan stops. Even undergraduates know about that.

Open platforms versus cartels in professional sports leagues

What makes a sports league more competitive? More interesting? And more profitable? We have two basic models out there. The European model, with open entry, promotion and relegation on mostly athletic grounds, and the American model, a cartel with regulated entry and no exit except on economic grounds. Basic economics should tell us that an American league should be more profitable but of lesser athletic quality, while the European one should be providing more value, both in terms of quantity and the quality of the good (say, athleticism and entertainment).

Helmut Dietl and Tobias Duschl confirm this conjecture. Indeed, the six top revenue generating teams are European, but some of them are still not profitable, and as in the case of Manchester United, despite significant athletic success. Dietl and Duschl use platform organization, a form of two-sided market theory, to get some better understanding of sports league organizations. In this regard, European leagues can be compared to open source like Linux, open and performing, while American leagues are like Windows, underperforming but most profitable.

Table 2 from the paper summarizes well the differences between the leagues. In European ones, most clubs are members' associations that try to maximize wins. Leagues are open (promotion/relegation), there is full market coverage, hardly any relocations (I cannot think of one), and no salary caps. As a consequence, value (as defined by athleticism or entertainment) is maximized. Contrast this with American leagues, where clubs are privately owned and maximize profits. League are closed, there is rationing, frequent relocation and a salary cap. Thus, American leagues maximize value appropriation.

Microsoft, still the evil monopoly

Let me rant about another evil monopoly, Microsoft. Unfortunately, this is not the first time. The problem with monopolies is that they manage to get away with actions that would never be tolerated in a competitive marketplace. Here are some recent examples regarding Microsoft.

Microsoft automatic updates recently installed updates for the .NET suite that included a Firefox plug-in. Now why would Microsoft bother installing plug-ins for competing products? In this particular case, the plug-in allows websites to install software without the user's knowledge, that is, it creates for Firefox the vulnerabilities that plague Internet Explorer. Users are never prompted about this. Worse even, it does not appear to be possible to remove this plug-in without much trouble (such as downloading additional material from Microsoft). Details.

In view of Vista getting much traction, Windows has been encouraging users to download Windows 7 (release candidate version) for testing (and getting used to). It will stop functioning in June 2010. This will then force users to purchase Windows 7. The installation of any operating system, including a purchased copy of Windows 7 or a return to the previous one, will require wiping clean the hard drive. Thanks. Details (see IMPORTANT).

Microsoft continues to push Windows on manufacturers, making it difficult to buy computers with alternative operating systems, or none. Why would manufacturers go along? Windows is so bloated (along with the ever growing virus software) that it requires to upgrade hardware. And Windows installs typically have a Microsoft Office teaser install, prompting you to buy it after 60 days, while there are free products out there that do the same job (if not better), such as Open Office.

And my previous rants about forced and unnecessary upgrades, abusing patents

The worst bailout of all

Bailouts are difficult to justify in general, because of the adverse effect they have on anticipations and thus the moral hazard they induce. They can only be justified if this moral hazard risk can be outweighed by a strong positive welfare effect. Say, in the case of the bailout of the Big Three car manufacturers, that there is the threat that a new Great Depression would ensue, like Edward Lazear thought when he advocated intervention last September. We can discuss this assessment, and also whether it is a good idea to bail out the financial industry, the airline industry or whoever else is going to line up. But I have just been made aware of the least justifiable bailout of all: Belgium sinking a billion euros into the diamond industry.

Why? Because the diamond industry is a fraudulent operation to begin with. The world market for diamonds is overwhelmingly dominated by the De Beers diamond cartel that forces everyone to sell through it. This allows the cartel to dictate the price, essentially setting it at a multiple of what it would be under normal competition. This cartel was put in place in the late 1800s to preserve prices after major discoveries in South Africa that suddenly increased a lot the diamond supply. When the cartel found it difficult to hold prices in the 1930s, it created the diamond engagement ring, the most successful marketing campaign ever as it created a must have for every fiancée. The latest marketing scam is that "diamonds are forever." Well, actually this is true, as it is extremely difficult to resell a diamond at a price remotely close to its supposed value as diamond sellers have to comply with the cartel. So you are stuck with your diamond forever.

Diamonds, the worst investment ever, now supported by the Belgian government.

Credit rating inflation and naive investors

Imagine that employers determine the quality of job applicants by looking at their GPA (grade point average). Then obviously, colleges would want to give good grades to their students to give them better chances on the job market. To attract tuition paying students, colleges promise good grades. This scheme will work as look as there are some naive employers that do not see that they are getting fooled by grade inflation.

Patrick Bolton, Xavier Freixas and Joel Shapiro argue that this is exactly what happened with the credit rating agencies, which are financed by the very institutions they are rating. And the latter shop around for the better ratings. As long as there are naive investors willing to believe whatever the credit rating agencies say, the rating inflation will continue. The authors show with a model that the optimal policy response is to force disclosure of all ratings. One would not have needed a formal model to realize that. More interesting is that they show that a monopoly can in fact lead to better outcomes, for once, because it does not lead to rating inflation. Monopolies bring other inefficiencies, however, and we are already advocating the public provision of ratings...