Exploiting Customer Errors

I attended a Yale School of Management research workshop by a visiting professor this week. Through a carefully designed experiment, the authors of the paper had found that people make systematic errors in deciding which products they want, depending on how the information is presented to them. Such errors can be exploited by companies who can design their advertisements and other messages using the knowledge of the pattern of errors.

The paper did not, and was not intended to, address two other questions: (1) Is it in the interest of the firms to exploit this knowledge; and (2) If the answer to the first question is yes, should they do so?

To address the first question, one can choose a variety of perspectives on what we mean by "interest of the firm." A broad perspective that includes various stakeholders (e.g., shareholders, employees, as well as customers) would suggest that selling an extra toaster to customers who, in absence of manipulation of information presented to them, would not have bought one, is likely to be a wealth transfer from customers to shareholders, employees and other suppliers of factors of production in its first order of magnitude. In the second order of magnitude, there could be negative (e.g., unused appliances gathering dust in the attic) or positive (e.g., higher direct or indirect employment) effects. Under this perspective, desirability of using the errors of cognition in marketing becomes a complex problem of macroeconomic social welfare analysis.

Under a narrower "maximizing the shareholder value "perspective on "interest of the firm," the firm may be able to increase its profits by manipulating the manner in which it presents information to its potential customers. However, there is considerable literature in management and marketing to suggest that such gains from taking advantage of customer errors are likely to be short-lived, and in the longer run, may well redound to hurt the profitability of the firm. Such tactics and manipulation may divert the attention of the management from products that it genuinely believes best serve the interests of its customers. Moreover, to the extent, the manipulative tactics become known over time, customers may no longer trust the firm, and even turn hostile.

The second question "should the firm choose its actions to exploit any tendencies of its customers to err if it serves its interest, however defined "is more difficult to address. It involves the nature of social contract between firm and society. Taking advantage of others' errors is not illegal, and probably cannot be made illegal without serious problems of definition and enforcement. Should the corporation feel free to engage in an activity if it is not illegal? If the answer is yes, are we willing to live with the consequences? If the answer is no, how do we define and enforce the boundaries of such behavior? Is this something we leave for social mores and norms?

A related question concerns management scholarship. As social scientists, to what extent should scholars think about how their findings might be used in the world of business? Can we foresee their use and consequences of this research? We take credit for our work "new, interesting, important. Are we also responsible for it?

A few years ago when a colleague and I introduced at the School of Management a course on financial fraud, we struggled with the problem of teaching the variety, risks, investigation, and mitigation of fraud without also teaching how to commit fraud and minimizing the risk of getting caught. I wonder if investigation and instruction on human susceptibility to errors of cognition may also present some of the same dilemma for management faculty.

Finally, what is the role of management school in business and society? Are our research and teaching value-free, or do they convey "explicitly or implicitly "dominance of some values over others, and relationships among private and public good. Can and should we link our values to our curriculum and research programs? If so, how?

Look for Winners or Accept the Returns on Market Index

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All the serious money is indexed," Burton G. Malkiel, Princeton economics professor and former dean of Yale SOM, is quoted to have said in Paul Sullivan's February 6, 2010, article in the New York Times. Malkiel's new book, The Elements of Investing, authored with Charles D. Ellis (an active member of the Yale SOM Board of Advisors, as well as a former member of the SOM faculty and the Yale Corporation), suggests that all investors, wealthy included, could do better by investing in index funds. Most people pay dearly for investment advice which is not worth the cost; they are right, of course.

But let us also consider a hypothetical world in which this sage advice was widely accepted and all money was invested in index funds. Index funds economize by saving the high costs of evaluating the individual securities as investment prospects. They act as price takers for the market as a whole, as well as for any individual security transactions needed for rebalancing. This means that index funds transact at prevailing market prices, instead of submitting their own limit orders. How are the market prices to be determined when all traders are price takers?

To the extent market prices of securities closely approximate their underlying but unobserved fundamental values " the well known efficient markets hypothesis " one can indeed save money by skipping the effort involved in finding mispriced securities and resorting to index investing. But if everyone believed in market efficiency, and resorted to this option, there would be no information in the market, and the market cannot be efficient. Market efficiency requires at least some people to believe that it is not efficient, and continue their search for mispriced securities. This is known as the Grossman-Stiglitz paradox.

Fortunately, naturally present noise in markets allows a degree of market efficiency to coexist with the costly search for mispriced securities. "Information people" who spend their time and money on such search are able, on average, to earn slightly higher gross returns at the expense of those who invest without information (e.g., index funds). Only a part of the information produced by the former leaks out to the uninformed investors through market prices, allowing the informed to earn a return on their efforts. However, after the cost of the effort is subtracted, their net returns (on average) are comparable to the returns of the uninformed. Researchshows that on the margin, it does not matter on average whether you choose to look for mispriced securities or invest in index funds.

What is true on average is not true of every individual. Some may have superior capability to identify underpriced securities. However, of the thousands of people who would like investors to believe in and pay for their investing acumen, the record shows that only a small fraction might have valid claims. When one hires an investment manager, it is not easy to distinguish real talent, as opposed to pretense of talent. Even long records of beating the market may be little more than a lucky run of coin tosses " less likely but possible.

Perhaps Malkiel and Ellis have the right advice " stop looking for superior returns, invest in the market index, and passively accept whatever happens to the market as a whole. However, let us hope that not everyone would accept the advice; otherwise the assumptions on which that advice is based will longer be valid. As more money free rides on market information through being invested in the market index, prices become noisier and therefore less efficient, shifting the balance away from index investing. Thanks to this property of how markets function, the volumes of informed and indexed investments tend to retain a mutual balance in which both groups can still earn comparable net returns on average.

Shyam Sunder, the James L. Frank Professor of Accounting, Economics, and Finance at Yale SOM teaches Securities Valuation (MGT 948) in the fall (with Prof. Matthew Spiegel). Teams of two students analyze, report, present, and defend their investment recommendations to convince the class acting as the investment committee of a fund looking for superior returns. Visit the< a href="http://analystreports.som.yale.edu/">course website for selected investment reports from the past offerings of the course.

Dealing with the Too-Big-to-Fail

Can we hope that, in dealing with the  crisis in financial markets, US government has dodged a bullet without inadvertently lighting the fuse to fire a canon ball?

Bear Stearns was judged to be too-big-to-fail because the hard-to-predict network effects of such a failure would have been potentially devastating to the US and possibly the global economy. Therefore, the government arranged a takeover of Bear Stearns by J.P. Morgan Chase and subsidized it with taxpayer money and guarantees.

Having swallowed Bear Stearns, J.P. Morgan has grown. If either of them was too-big-to-fail then, the consequences of letting the combined entity fail would be even less acceptable.

The wizards who run and oversee the financial system permitted creation and growth of, and risk taking by private financial institutions which they knew could fail, but could not be allowed to. Then, at the brink of failure, they combined them into larger institutions subject to the same risk and logic, only at a bigger scale. This is postponing the day of reckoning with compound interest.

After a year of crisis, the world financial system is rapidly consolidating into a handful of US, European and Asian giants such as Bank of America and J.P. Morgan Chase.  In what sense, and for how long will these firms and the economy remain private and capitalistic if they can walk away with their profits, and dump their bad bets  on taxpayers?

The financial private sector can be protected from progressive nationalization by placing limits on the size of firms. Too-big-to-fail, instead of absolute size, can serve as a natural bound on how far private financial institutions are allowed by regulators to grow through organic growth, mergers or acquisitions.

The traditional rationale for intervening in the size of firms has been antitrust "to limit power and promote competition in product markets to promote economic efficiency. Government bailouts of giant financial institutions in order to safeguard the domestic and the global economy suggest another new criterion for reviewing proposed mergers and acquisitions: Will a proposed merger or acquisition create an entity which the government (US Federal Reserve System, US Treasury, European Union, or national governments in Europe as the case may be) will feel compelled to save from failure for the fear of its domino effects? If the answer to this question is yes, the proposal should be disallowed to reduce the chances that the government may have to intervene at some time in the future to save the larger combined firm.

Under this arrangement, the Federal Reserve and Treasury will review all merger and acquisition proposals to certify that they will not result in an entity that is too big to fail.

Since firms could also grow organically, the legislature could require an annual certification from the Fed and Treasury that no firm in the financial sector (defined as banking, investment banking, insurance, mutual, hedge and pension funds, and brokerage) is too big to fail. If a firm is found to have crossed that threshold, it would be required to divest itself in the manner of antitrust enforcement.

Will this leave the European and Asian giants free to crush the American pygmies in the global market place? EU, Japan and China will have to decide for themselves if adopting a similar policy to save the private financial institutions, and reaping the benefits of their efficiency, is in their best interest.

Placing the responsibility of such reviews on the Fed and the Treasury will create an incentive compatible system for these regulators; they would not be able to rush to Congress and the public exchequer when a financial firm is about to go belly up. US Congress will soon consider legislation to commit public funds to save the financial sector. This is also the only time the legislation to limit the size of financial firms can possibly be passed as a part of a rescue package. Ones the public money hss been committed, pressures from the industry lobby will make it all but impossible to achieve this end.

The short-term solutions to the current financial crisis carry the risk of setting us up for even more severe problems later. The time for establishing a mechanism to limit on the size of financial firms to protect the financial system and the public exchequer is now.