Why make wasteful investments?

I've been planning to wrote this blogpost for quite a while now, but this excellent, although longish article at ars technica on the legal details of streaming video finally nudged me into doing it.

In April, Wired magazine ran an article  on a small startup called Aereo. The company has built an impressive data center containing more than ten thousand antennas for tv reception. Using this, the company sells a DVR-like service, whereby their customers rent a personal antenna in the data center. The antenna is connected to what the company calls a remote DVR. Essentially, customers use the service as any DVR, recording TV-shows to it for later watching.

When a customer records a TV-show using the remote DVR service, the show is captured from the antenna the customer has rented, and stored as a separate file on Aereo's servers. Thus, if 1000 customers record Mad Men, 1000 copies of Mad Men are stored on Aereo's servers, so that each customer has his own copy.

From a technical point of view this of course doesn't make any sense. If Mad Men is broadcast from one sender, and 1000 Aereo customers wants to watch it at some time other than specified by the broadcaster, then it ought to be easiest to store one copy, sourced from one antenna, and then stream from this one copy to any of the 1000 Aereo customers when needed. This ought to be the most cost effective solution, a solution recommended by an economist. Let's call it the first best scenario, the one that minimizes social costs for a given outcome.

In contrast, the current technology is socially wasteful, in that it incurs more costs (the building and running of the one-antenna-per-user system) than the first best alternative, while having no additional benefits.

Why don't we see the first best scenario in practice? The simple answer is copyright law, as outlined in the ars technica and Wired articles. To circumvent copyright law, Aereo must essentially replicate the hardware of a DVR in their data center for each customer, at a cost significantly higher than the first best solution. By doing this, Aereo avoids having to pay the broadcasters for their contents.

Looking at the economics of this issue, we can draw some further conclusions. The long-term strategy of Aereo need not rely on the one-antenna-per-customer technology. As long as they are able to attract a large enough subscriber base using the current technology, they should be able to transfer to the first best solution. Why is that?

The first best solution is currently not a profitable option, because the broadcasters will not license their programs cheaply enough to Aereo. (As a technical detail, not to license at all can be interpreted as setting a price of infinity). By building the one-antenna-per-customer solution, Aereo shows the broadcasters that Aereo doesn't need their license, and this establishes a credible threat-point (or disagreement-point) for negotiations between Aereo and the broadcasters.

Thus, assume that the monthly cost of the one-antenna-per-customer technology is $10 more per user than the first best solution. This then means that the broadcasters should grant Aereo a license for use of their contents at a price of less than $10 per user per month. Any licensing fee higher than this would be rejected by Aereo, since it could avoid the license by using it's current technology. For the broadcasters, this would be profitable, since any revenue from this licensing deal would be incremental (over and above) to what they otherwise receive, for in the absence of the license their contents would still be available to Aereo's customers.

So the the one-antenna-per-customer technology, while socially wasteful, should perhaps really be seen as a bargaining device, rather than something intended to be a long term large scale solution. The twist to the story is of course that in order for the one-antenna-per-customer technology to be a bargaining device, it needs to be a viable long term large scale solution as well.

As long as the technology is viable, then the end result ought to be the first best solution, with Aereo paying a licensing fee less than the incremental cost of the one-antenna-per-customer solution. This is an example of the Coase theorem  in action - The parties will trade to the outcome that is overall (socially) most efficient. There are obvious limitations to the theorem in general, and to its implications in this particular case. These will be the subject of a separate posting.

More advertising = More consumption?

A debate about alcohol advertising is going on in Finland currently. Those who want to reduce overall alcohol consumption argue for banning  image promoting advertising (eg. The suggestion that a fox will be sexually more successful if it drinks a certain brand of cider – yes this particular ad was already forbidden). Will this reduce overall consumption? 

The easy answer might seem to be yes. The argument used by many who promote this view (lets call them the “pro ban” people) is what an economist would call a revealed preference argument. The fact that firms advertise suggests that advertising increases profits. From this those in favor of a ban conclude that advertising must increase demand, thereby increasing the total quantity consumed. If this was not the case, then the firms would not advertise.

This argument has a superficial appeal of logic (and economics). At least until we study it more intensely. The fact that individual firms choose to advertise does not mean that this increases the total quantity that eventually is consumed.

One easy, albeit perhaps not entirely realistic hypothetical case that disproves the pro ban argument is one whereby producers compete for existing consumers. By advertising, producer A seeks to get those who used to buy from B to buy from A instead. In this situation the only effect of advertising is to shift demand from one producer to the other producer. Total quantity consumed stays constant.

Lets make the picture a bit more nuanced. Assume that  firms seek to differentiate themselves from each other through advertising (eg. the sexually successful fox case), but at the same time advertising expands the total market. By differentiating himself from A, B can charge a higher price, as consumers now perceive B to be something different from A. Simultaneously, A can also increase advertising, in order to increase demand facing him. With A and B differentiated from each other thanks to advertising, each can charge a higher price. For a given demand, this means lower realized consumption. Call this setup the advertising induced differentiation setup.

On the other hand, if we ban advertising, then the producers will need to compete on price, instead of on image. This results in a lower price, and thus for a given demand increased realized consumption.

Thus we see that the effect of ban on advertising is not unambiguous. To sort out the effect, we need more information.

Lets assume that advertising increases the total potential market size. If this is the case, while consumers’ price elasticity of demand doesn’t change too much, then realized consumption is indeed higher under advertising induced differentiation. 

However, if advertising affects consumers’ price elasticity of demand enough (making consumers less sensitive to changes in price), while potential market size stays the same (or doesn't increase too much), then the realized consumption will be lower under advertising induced differentiation.

Thus, it all depends. The reason that advertising can decrease total consumption is that advertising can differentiate products, giving their producers market power, and thus an incentive to limit production so as to increase prices, in order to increase profits.

Essential facilities, cooperation among competitors and nuclear fuel

Finland currently has two producers of nuclear power: Fortum and TVO. These two companies have formed a joint venture, Posiva to take care of their spent nuclear fuel. Having this done through a joint facility may seem to be in the public interest, as you would want the handling to be done as well as possible.

However, whether this joint venture solution really is in the public interest is called into question with the potential entry of a third nuclear power producer, Fennovoima. Posiva claims that their facility doesn't have room for Fennovoima’s spent fuel. This means that Fennovoima would be forced to make a rather large investment in an own facility in order to start their own nuclear power plant. This puts Fennovoima at a disadvantage compared to the other (nuclear) power companies. It could potentially also deter Fennovoima from entering the market, if the investment in an own facility would be too expensive.

Why is this troublesome? Doesn't Posiva and its owners TVO and Fortum have the right to decide how their facility is used? This might seem a reasonable assumption. However, having two competing companies (TVO and Fortum) form a joint venture to reduce their own costs, while excluding new potential entrants to the market is clearly problematic.

The reduction in costs that the joint venture (or to use another term: collusion) achieves is largely a reduction in fixed, not variable costs of power production for TVO and Fortum. This means that the cost savings that are achieved will not be very well reflected in prices. Thus the benefits will mainly accrue to the owners of the companies, rather than the customers. Additionally, if they manage to exclude Fennovoima, the effect will be that prices will be higher, to the detriment of consumers.

There are a lot of precedents for forcing owners of so called essential facilities to give other actors on the market access to these. One example is the phone network, where local phone companies must rent access to the “last mile” to competitors to allow these to sell broadband access. Enforcing similar policy on Posiva might be sensible. 

If this is not possible, the seemingly rational decision to let Fortum and TVO build a joint facility may not be that good from an economics point of view, if it leads to increased concentration of suppliers. And once Fortum and TVO has learned to collude cooperate in the realm of spent nuclear fuel, there might be fertile ground for cooperating on other issues as well…

Guggenheim, externalities, public goods and game theory

Former journalist and city councillor Nils Torvalds wrote a column last sunday in the newspaper Hufvudstadsbladet on the debate on the planned Guggenheim Helsinki museum. A major motivation for building the museum has been the alleged increase in tourist inflows that the museum would bring to Helsinki. Among the beneficiaries of this we presumably have restaurants and hotels.

Torvalds thinks it shortsighted of these private beneficiaries to free ride by not willing to contribute towards the costs of Guggenheim. In terms of moral, this might be the case. Nevertheless, a lot of investments have similar kinds of externalities, ie. they benefit somebody else than the decision maker (ie. the City of Helsinki in this case).

In theory, it would be good if you could make the beneficiaries of these externalities pay for the benefits they receive. Nevertheless, this is often not feasible. To see why, consider the decision making of an individual restaurateur. His benefits from the Guggenheim is not enormous. And even if it was, what are his incentives to pay for it? Is everybody else's investment in Guggenheim really conditional on his investment? That is, if he were not to invest, will the project falter, and if he is to invest, will it really be build? It would seem unlikely.

Due to these kinds of externalities, investments with this kind of public good features are often financed with tax funds, as the costs are then covered by the general public, who also receives the benefits. And mind you, those greedy, short sighted restaurants are also paying taxes.

Nevertheless, even if we ignore what is practical at the moment and think in moral terms ("The restaurants should pay") we still have some problems with the suggestion. Let's say that the current restaurants and hotels pay for the Guggenheim. Even if we somehow could convince every single restaurant in Helsinki to pony up exactly the sum by which they benefit from the Guggenheim, would we then have arrived at a equitable solution?

The answer to the question must be no. Even if we can force the currently existing restaurants to pay, the alleged influx of new tourists would probably lead to new restaurants being started. New restaurants which wouldn't have started if their older competitors hadn't paid for the Guggenheim. So we're back at the free riding problem. Which really is solved using the public purse. That is of course, provided that it makes sense for the public sector to invest in the project...

Special interests vs. the public interest

Yesterday I blogged about experts and special interests groups lobbying for legislation to increase demand for their services.

A recent related example of this can be found in the regional newspaper Kouvolan Sanomat, where a health and construction expert suggested that all buildings should be subject to a inspection system similar to the one currently in place for cars.

This would surely be a great thing for the special interests the expert represents. Whether it would be it for the taxpayer and/or home owners is a different story. Mandatory car inspections can be motivated by the fact that car usage can impose consequences (externalities) on outsiders.  It is not evident that this is the case for houses.

On regulation and impact studies

Frequently papers and news sites report on various groups suggesting that various impact studies should be carried out when any new legislation or regulations are drafted.

Typically this takes the form of experts in the field, say environmental experts suggesting that any new legislation should be analyzed to see what impact the new legislation may have on the environment.

These kinds of impact studies may occasionally make sense. However, critical journalists should point out that calling for systematic impact studies really also (only?) serves the interests of the experts in the field. Mandatory impact studies carries a cost to the taxpayer, while the experts in the field benefits through higher demand for their services.

In order to mitigate this, my suggestions is that all new legislations and regulations should be subject to economic impact studies, or cost-benefit analysis. This suggestion is of course made only in the interest of the taxpayer. Any insinuations that I propose this because it would benefit me as an economist is cynical and daft.

Culture vs. health care – On conflicts and priorities

Today the report on the Guggenheim’s Helsinki project will be published.  Rumors suggest that the report will find that Helsinki is a suitable place for a Guggenheim museum. A museum that the city of Helsinki should pony up a few hundred millions of euros to build. Spending this much taxpayer money on a museum may seem preposterous to some.

Some have suggested that in a time when the public sector has to save money by cutting down on funding for health care, building a brand new museum for 200-300 million euro is a bad idea.

However, inevitably an argument far too often heard has also been made suggesting that pitting health care against culture is populistic and a false conflict. City council member Laura Kolbe was quoted in the local newspaper Hufvudstadsbladet on January 3^rd as saying exactly this.

Her argument was that since the money for a museum comes from the city’s budget for culture, while the money for health care, comes from another part of the budget. Thus, no conflict between the two!

Charming as this argument may seem to some, this is really not that sensible. Fundamentally, the money comes from the same source, that is the taxpayer. Just because fraction X of the budget this year is devoted to culture and fraction Y to health care doesn’t mean that these fractions have to be the same for all eternity. It’s not as if these fractions were some law of nature that man cannot change.

Thus, as long as the proponents of the museum cannot show that it really is a profitable investment for the city, in the sense that it will bring in more money to the city than it costs, then they should really be honest and acknowledge the conflict.

This is not to say that the museum shouldn’t be built if it’s not a profitable investment from a economic point of view. But if it’s not, then the argument should be made clearly why it is more important than say health care. Anything else is intellectual dishonesty.