Who’s on the hook?

According to this article, student loan defaults are surging (HT: Instapundit)

Perhaps schools should also be on the hook when their former students aren’t able to repay their student loans.

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Something to consider when evaluating business opportunities

From Blake Masters’ notes of Peter Thiel’s (founder of PayPal) class on startups (emphasis added).

Suppose you want to start a restaurant in Palo Alto that will serve only British food. It will be the only such restaurant in Palo Alto. “No one else is doing it,” you might say. “We’re in a class of our own.” But is that true? What is the relevant market? Is it the market for British food? Or the restaurant market in general? Should you consider only the Palo Alto market? Or do people sometimes travel to or from Menlo Park or Mountain View to eat?

These questions are hard, but the bigger problem is that your incentive is not to ask them at all. Rather, your incentive is to rhetorically shrink the market. If a bearish investor reminds you that 90% of restaurants fail within 2 years, you’ll come up with a story about how you’re different. You’ll spend time trying to convince people you’re the only game in town instead of seriously considering whether that’s true.

You should wonder whether there are people who eat only British food in Palo Alto. In this example, those are the only people you have pricing power over. And it’s very possible that those people don’t exist.

Many bad business decisions are based on bad market analysis. There may be a reason why you’d be the only British food restaurant around — nobody wants it.

I see this mistake made often in the business world. Business leaders see something like ‘no British food restaurants around’ and mistake that opportunity for an opportunity like ‘the world really needs an iPod.”

Granted. It is hard to tell those two types of opportunities apart. But, so often is the case that the person making the decision doesn’t consider that they might be wrong, or see if it has already been tried and, if so, consider why it didn’t work the other times it was tried.

They should also deeply consider who will value their product and why, which gets to Thiel’s comment about pricing power. These are the only people who want it.

I can do without potato chips. They don’t do much for me. I never buy them for myself. I sometimes eat them if they come with a meal that was provided for me or if I just feel too lazy to ask for a substitution.

Potato chip companies have no pricing power over me. They can raise and lower their prices all they want, that won’t make me buy any less or any more potato chips. Fortunately, for them, there are plenty of people who do value potato chips and are willing to buy them.

(HT: Marginal Revolution)

Lemonade Stand Economics

Thanks to Russ Robert of Cafe Hayek for pointing me to Jerry Jordan’s Investors Business Daily article,  Government Accounting is Like Lemonade Stand Economics.

I attempted to explain the same topic that Jordan writes about last September in my post, Government is an expense.

My key point then was that GDP is often misused as a measure of health for the economy, but that is like measuring the health of a business by adding its revenues and expenses together.

Jordan explains it better than I did with a lemonade stand example.  In his example, kids invest $10 in a lemonade stand, make $7 back by selling cups of lemonade and folks think that is good because there was $17 worth of economic activity, instead realizing there was a $3 loss.

GDP is not a good measure of the health of the economy because it’s like considering the $17 of lemonade stand spending and saying that was good, rather than realizing that $3 of value was lost in the process.  None of us would last long if we kept turning $10 into $7.  But, that’s essentially what we do when we increase government spending to keep GDP up.

The lemonade stand kids should learn from the signal they received from the market.  The signal is that selling lemonade in the neighborhood is not worth their while because customers do not value a glass of lemonade in that time and place to pay enough for it.

So, the kids should try other things.  Maybe they should try a different drink or different corner.  Or maybe they should offer to do yard work for their neighbors.

They should keep experimenting to discover things that their neighbors do find worthwhile enough to pay enough to make it worth the kids’ while too.  Full disclosure, I tried the lemonade stand experiment a few times too.  I tried it in the street and at family garage sales.  It never produced profits for me.  I did much better doing things like mowing lawns, raking leaves, shoveling snow and assembling bicycles.

We do no good encouraging the kids to keep at turning $10 into $7 to maintain that $17 of economic activity.

The economic way of thinking

Here’s an excellent column, On Truth’s Side, by George Mason University economics professor Don Boudreaux.  I’ve copied the column in it’s entirety under the fold to save for the future.  This is a keeper.

Continue reading

Allocation Through Pricing

Several years ago a friend got me hooked on the annual tradition of buying Beaujaolais Nouveau in November.  This red wine is made from the grapes of this year’s harvest and is shipped out across the world on the third Thursday in November.

It was fun.  For a few years we went together to purchase the wine.  It made for a nice story on Thanksgiving.  And, it was cheap.  I think I recall paying around $5 a bottle for the wine.  But, you had to get there within a day or two or supplies would run out.

Another friend asked me if I bought the Beaujaolais this year?  “No.”  “Why not?”

My first answer was, well it has become too mainstream now.  Everybody knows about it.

Then I thought for a second and continued…

“And, they raised the prices.  At $5/bottle, I’d buy 2 or 3 bottles.  Now the prices are around $10 – $14.  I guess it wasn’t worth it to me.  I have other wines I enjoy more for that price.  Also, I notice you don’t have to get there on day one now, supplies last with the higher pricing.”

I thought back to the story of flashlight pricing at Big Box retailer in Russell Roberts’ The Price of Everything.

After an earthquake, Big Box raised prices.  Of course, that made everyone mad, yet Big Box was the only place in town where you could get what you needed (p. 71).

[Ruth – Econ professor]: “On the night of the big earthquake, there aren’t enough flashlights to go around. At the usual, everyday prices, people want to buy more flashlights than there are flashlights on the shelves, agreed?”

[Ramon – outraged consumer]: “Yes.”

“Given that there aren’t enough flashlights to go around, who should get them?”

“That’s easy.  The people who need them the most.  Not the people who already have one.  Not the people who have lots of candles.  Not the people who are going to sleep most of the night anyway.”

The conversation continued.  Ruth asked how you would decide who needed the flashlights the most.  She points out the problem is knowledge.  You could interview people and see who makes the best case, but Ramon is skeptical that people might not tell the truth.  Ruth adds that along with flashlights you would need to make the same decisions for candles, diapers, portable generators and items to numerous to have any hopes of being effective.

[Ruth]: “If you leave prices alone at their regular everyday levels, who gets the flashlights and the milk and the generators?”

[Ramon]: “The people who need them.”

[Ruth]: “I don’t think so.  If you leave prices alone, the people who get the flashlights are the people who get there first.  When you went to Home Depot, the stuff you wanted was already gone.  But at Big Box, anyone who wanted a flashlight could have one.”

[Ramon]: “If they were willing to pay for it.  That made it harder on the poor people…”

[Ruth]: “Agreed. But for thousands of people, there were flashlights waiting for them.  Remember that knowledge we wanted to have? The knowledge about who needed flashlights the most? When Big Box raises the price of flashlights, someone who had candles at home decided to do without the flashlight and left it there for you on the shelf.  No one had to interview either of you. The higher price induced both of you to act as if you had been interviewed.  The person with the candles, by refusing to buy the flashlight at the higher price, was saying, I’ll pass on buying a flashlight. I’ll leave it for someone who needs it more. But no one begged him to do the right thing or passed a law that would have to be enforced or interviewed him to find out who needed it the most.  The higher price made sure you got the flashlight, that seems pretty just to me.”

With the higher price on Beaujaolais, I decided to pass on it and leave the 2 to 3 bottles I would have bought on the shelf for someone else who valued it more.  I would make due with other wines and without the stories of drinking this year’s harvest.

If you’re still curious about poor people not being able to afford flashlights and would like to know more about what Ruth Lieber says, I encourage you to get a hold of Roberts’ book and read it.

As for me, I’m thinking about buying extra flashlights, batteries and a generator while the prices are reasonable.

Pizza Hut: Price to Value

It’s been fun watching promotions in the food industry over the past few years.

Subway kicked it off a price promotion with their $5 foot long promotion, which seemed to work for awhile.  It was a black swan that was happened upon by a Subway franchisee in Miami.  He put out a sign for $5 foot long sandwiches and earned more money.  Others followed suit and eventually the corporate headquarters picked it up.

But, price is rarely a source of a sustainable advantage.  It may work for awhile, but price promotions is something that is easily copied by competitors and eventually they too will find compelling offers.

The most important thing is the value proposition.

Early KFC began offering $5 meals.  Pizza Hut went to $10 for Any Pizza.  Both seemed to work for awhile.  The $10 Pizza got the mother of my Papa John’s-loyal nephew to try Pizza Hut and he liked it.

Then he came to our house and wanted pizza.  I started to call Papa John’s, but he said he’d rather have Pizza Hut.  It had been 10 years since I tried Pizza Hut because the last pizza I got from there was a grease ball.  I tried some of his Pizza and I liked it. It tasted good.

That’s value proposition.  In the beginning the $10 pizza got my nephew to come in, but it was the good quality pizza that kept him coming back.  Since then, I’ve ordered Pizza Hut several more times, likewise because of the quality of the pizza, not the price.

Pizza Hut advertising seems to reflect this.  Several months ago the advertising focused on the $10 Any pizza message.  A few weeks ago they changed their pricing to $8, $10 and $12.  Still simpler than before, but a little more variation to better align the price and the value.

This past Sunday I saw it come full circle.  Pizza Hut’s ad didn’t mention price.  It explained the value prop:  Good pizza and convenience, in ways people can understand like “this means I can spend more time with my daughter.”

The Other Seth on the Kindle

Seth Godin has some wonderful ideas about what the Kindle should do to beat back iPad.    But, I have news for Seth.  Even a $49 or free Kindle isn’t going to beat the iPad.

Kindle was an awesome product. But, from what I can tell, the iPad is that much better.  The price is relatively immaterial.  Why have two devices that do about the same thing, but one does it much better?

Kindle may be able to occupy a profitable niche for book-0-philes, but unless it pulls an HTC leap in product development, it’s going to lose to iPad.

Kindle is a sunk cost. My guess (and as always, I could be wrong) is that Amazon would better off tying in with the iPad early before Apple’s iBookstore starts taking a chunk of their business.

I wish both devices would support pdf’s better.