Saturday, 23 March 2013

West Ham, the Olympic Stadium, and the puzzle of sunk costs

Yesterday West Ham United Football Club were essentially given the London 2012 Olympic Stadium for the bargain price of £15 million. True, they will not own the stadium, and will have to pay rent. But, this does nothing to alter the basic fact that West Ham has been handed a bargain.
   And its a bargain deal that has annoyed many. The Stadium cost around £500 million to build and converting it into a football stadium is going to cost at least another £100 million. Most of this funding has come from the taxpayer. So, on face value it looks like the UK taxpayer is giving a football club a very big gift - a £600 million stadium for £15 million. To make sense of this we need to think about sunk costs and bargaining. 
    Let's look at sunk costs first. The stadium was built for the London Olympics, and not the benefit of West Ham. Spending £500 million on the stadium was, therefore, arguably money well spent by the British taxpayer. But times move on: the London Olympics has long finished, the stadium still exists, and the question that matters now is what to do with the stadium. The money spent building the stadium is a sunk cost, it's gone, and should not be a factor in current decisions. So, London Mayor Boris Johnson was right to be relatively upbeat about the deal. The taxpayer is going to get a revenue from the stadium that is much better than could have been hoped for without West Ham. 
    West Ham, though, are getting a fantastic deal. They are getting a fantastic, iconic stadium that they could not possibly have afforded themselves. And this will dramatically increase the value of West Ham. Indeed, we already have the example of Manchester City to illustrate how a 'stadium for free' can transform a club - they got the stadium built for the Commonwealth Games and have not looked back. The owners of West Ham have got a very good deal. The supporters will also soon get over the nostalgia for their current ground.
    The deal struck is thus one that benefits the taxpayer a little and benefits West Ham a lot. Why did we end up with such a one-sided deal? Bargaining theory can help explain. The first thing to keep in mind is that while the stadium cost £500 million it is not worth £500 million anymore. Its a liability for the tax payer and worth, say, £200 million for West Ham. So, the parties are bargaining over £200 million. Note that a second potential user of the stadium might have changed this equation but that did not materialize. The taxpayer is in a relatively poor bargaining position because it wants to off-load the stadium and declare the Olympics a success. West Ham is in a much more strong bargaining position because it can carry on using its current ground and does not have cash lying around to pay for the stadium. Its no surprise, therefore, that West Ham gets the better deal.
     This situation can be viewed in terms of the ultimatum game. West Ham offered to give the taxpayer £15 million of the £200 million the stadium is worth to them. The taxpayer can either accept or reject the offer. It makes sense to accept, because £15 million is better than nothing. But, it's annoying to accept because West Ham do very, very well from the deal. So, it's a matter of interpretation whether you think the taxpayer got a good or bad deal.

  

Saturday, 9 March 2013

Free drink anyone

I was in a restaurant the other day, waiting for someone, and could not but help overhear a conversation between a restaurant manager and an elderly lady organizing a dinner party. They were discussing the arrangements for the party, and had just got onto the topic of drinks.
   The manager reminded her that drinks were not included in the package. 'Would she like to prepay for some wine and put it on the table?'
   She said 'no because not everyone drinks wine'.
   'OK, so, would she like to pre-book some wine under the proviso that it only has to be paid for if it gets drunk?'
   Displaying the characteristics of a true game theorist she replied 'well if you tell them they can drink it they are clearly going to drink it aren't they! No, I'm not doing that'.
  The next gambit of the manager was 'you could start a tab at the bar under the proviso that the tab will be split amongst all the guests at the end of the party'.
  To my horror she thought this was not such a bad idea. But, thankfully, she said she would have to think about it.
  How can a game theorist make sense of this exchange? The objective of the manager is to make profit - and that means selling as many drinks as possible. The dinner guests will drink according to the price of a drink. Suppose the 'face value' price of a drink is £2. If the drinks are 'free' - because they have been pre-booked and paid for - then the guests will drink the most. If the drinks have to be bought individually at £2 each they will drink the least. The interesting case is where the tab will be shared. Suppose there are 20 guests. Then the effective price of a drink is £2/20 = 10 pence. Which is as good as 'free'. So, from the manager's perspective splitting the tab is as good as the drinks being pre-booked.  The guests are going to drink a lot more than if they had to pay for it individually.
   From the guests perspective the tab is the worst outcome. They still have to pay for drinks but the incentive structure means they will drink a lot. Specifically, each drink costs every guest 10 pence each. So, if a guest has another drink that costs him 10 pence, but also costs the other guests £1.90. There is a negative externality. Indeed, the drinks tab is a common resource which will be over-exploited by the guests. The guests would be better off if they had to pay for their drinks individually. For example, suppose that at a cost of £2 each guest would have 3 drinks and at a price of 10 pence have 6 drinks. The total cost per guest is £6 if drinks are paid for individually and £12 if drinks are on the tab.
   From the perspective of the elderly lady organizing the party, there are mixed incentives. Clearly, if she doesn't pay for drinks then she's better off. Her main concern will thus likely be how much the guests enjoy the evening. While it may seem good that the guests drink and enjoy themselves, this is a misconception. The tab will almost certainly be antagonistic because of the negative externality problem it creates.    

Friday, 1 March 2013

Bureaucracy

BBC Radio 4 is running a programme next week 'in the defence of bureaucracy' with Gus O'Donnell. I'll listen in, but do not expect to be converted. So, what's the argument against bureaucracy, and how can we frame it in an economic, game theoretic context?
     Let's start with some examples. Without wanting to be too specific, I asked for something from the University last week. OK, but you need to fill in form X. We filled in form X. Yes, but you also need to fill in form Y. Needless to say, by the time this had all played out, I didn't get what I needed in time. Another example. A colleague was visiting recently from abroad and looking for somewhere to stay for 5 months. The estate agents were 'unable to help' because their contracts are for 6 months.
    What binds together both of these examples? In both cases there are rules, fill in form X, or contracts are for only 6 months. In both cases, the rule is pointless. In both cases, the rule is dreamt up by the very department or people that enforce it. This leads to a circularity that is sometimes amusing but all too often infuriating - a person comes up with rule X, and then says 'sorry I cannot do that because of rule X'. It is this circularity that is the birth of bureaucracy.
   Rules are useful. They save on decision costs and create consistency. The problem is when we have rules that make little sense, and when people inflexibly hide behind those rules. Contrast, for example, two experiences with the UK Border Agency. Once we went to Croydon to sort out a visa issue and were turned away because we didn't have a particular piece of paper. Four hours drive, and the best part of a day wasted, for nothing. That's inefficient. On another occasion we found ourselves at Dunkirk ferry terminal without one of our passports. The border agent told us off and then put us on the ferry. She presumably broke many rules in doing that but the outcome was efficient.
   So, rules need to make sense, and there needs to be flexibility. When these two basic principles get lost we have an inefficient bureaucracy. And this is far more likely to happen when an organisation starts to employ people who's sole job remit is come up with and enforce rules. Unfortunately, universities are full of such people, and so are most large organisations. At this point, bureaucracy can start to go well beyond any common sense. Essentially, the organisation can forget what it is for, creating a divorce between the true objectives of the organisation and the objectives many of its employees pursue. A university, for example, should produce quality research and educated students. Any rule should pass the: 'does it help academics do research or students learn' test. To an outsider, however, universities would look more like a form filling factory.
   The basic outcome of this is to lower efficiency. Indeed, one can easily end up with employees who have negative marginal productivity. All they do is slow down employees who are actively pursuing the goals of the organisation. It would be more efficient for society to create a dummy university with no students or academics, but full of administrators (see the Yes Minister episode Compassionate Society). But surely, no organisation can survive employing people with negative marginal productivity? The estate agent, for example, that offered my colleague a contract despite the fact he was only staying 5 months made more profit than those that didn't. Similarly, a university that cuts form filling is at an advantage. There's no doubt that bureaucracy is less in a market based economy like the UK than say Russia. Competition, however, cannot control bureaucracy. Clearly, it cannot in public sector organisations like a university. Even in the private sector the shut down rule - only shut down if price is below average variable cost - means an inefficient firm can survive for a long, long while. Bureaucracy, therefore, needs to be tackled head on in order to increase efficiency. Economic models of the firm also need to recognise the problem of bureaucracy.