3 Sep 2014

Growth Vs Profitability: How can different business orientation distort a supply chain?

The construction of total revenues function is relatively easy. Revenues are the multiplication of price and quantity; and total revenues will depend on the consumer’s sensibility or elasticity to changes on price, what is generally described as demand function. Depending on the degree of market power firms ‘make’ or ‘take’ the price, which determines the quantity. Total revenues have an inverse U-shaped, and they are maximized when the demand is unit elastic. The level of complexity increases when we bring the cost function into the analysis; which is the missing ingredient to profit determination. The optimal price that maximizes profits is more challenging to find, but a standard rule says that price that maximizes profits are (significantly) larger than prices that maximize revenues.

Standard economic theory assumes that all firms are profit maximizers. With the exception of governmental and not for profit organizations, this assumption is probably true in the long run. At some point all companies pursue to produce profits, and ultimately remunerate shareholders. But, what happen when firms participating in the same industry have different business orientation? 

This is what is happening currently in the book industry, with the conflict between e-retailer and publishers. Stakeholders and investors in those companies are completely different and hence they pursue different objectives. While publishers are by nature profit-maximizers and need to remunerate authors and investors in the short run; e-retailers are revenue maximizers, and pursue to increase their installed based of customers and to increase their share value. 

Let’s analyze more in depth the e-retailers strategy with the case of Amazon. Data can be obtained from its annual reports and Nasdaq. Figures attached show:
  1. Amazon has had an exponential growth in revenues from 2000. The average annual growth rate in the period 2000-2006 was 23%, which increased to 28% in the subsequent period, 2007-2013.
  2. There is a huge correlation between revenues and share price. After 2000 the correlation between those figures is almost 95%. 
  3. Amazon is a company that hasn’t had significant profitability from their outset in 1997. From 2003 to 2013 its profit margin rate has been close to 0%, just avoiding losses. 
  4. There is not significant correlation between profit margin rate and market share. 
But, what is the impact of e-retailers’ business orientation on revenues growth in the supply chain? As theory predicts revenue maximizers want to set a smaller price than profit maximizers. This goes against to their providers - the publishers - who have preference for profits. This dispute is distorting all the book industry; and we can see the evidence in press. For instance, the ‘famous’ dispute between Hachette and Amazon, who are currently in negotiation of new agreements on how to price Hachette’s books. 

The dynamic nature of the book industry (i.e. introduction of digital formats) make it very difficult to make predictions about how is going to evolve the power and structure in the supply chain. Some constructs like consumer value, operations, costing, or managerial perceptions, are in clear evolution and change. All these topics will be explored in the following years from different angles, and I expect to add relevant insights within the umbrella of QVaDiS research group and our industry partners.

18 May 2014

Implementation of the streaming business model: add-supported or subscription?

In recent informal meetings with IFPI, the music industry federation, I received a hard copy of their last report on the global industry (Link). This contains valuable information for those interested in producing research about creative industries and new digital business models. The aim of this post is not to present a detailed summary of the report. Instead, I only pretend to highlight an interesting finding, which reflects the idiosyncrasies and differences of European consumers.

The music industry needs to explore further the economic exploitation of digital business models (Link and Link). In this regard, the streaming seems one of the main solutions in terms of revenues. The streaming payment model is radically different from download sales in the way it generates revenues. A download is paid just once, regardless of how times it is listened to. With streamed services, a track may be listened to by an individual hundreds of times, each generating a micropayment. Streamed services can be commercialized with add-supported or premium subscriptions – monthly fee. Let’s see how streaming business models have been implemented in Spain and Germany. 

Spain is one of the countries with the highest piracy rates in Europe (in our previous work estimated in 44%) and the industry needed to offer “free” and “legitimate” alternatives to seduce the Spanish consumers to stop downloading files from not-licensed sites. This fact can explain why the add-supported revenues grew from 19% to 39% of total digital sales from 2009 to 2011. During that period subscriptions grew from 13% to 22%. But the main change was produced after 2011 when huge proportion of music consumers engaged with streamed music. The add-supported sales in 2013 decreased to 24%, while subscriptions increased and generated up to 43% of digital sales. 

Germany is quite a different case. It is one of the countries in Europe with the lowest piracy (in our previous work estimated in 14%, three times less than the Spanish one). Consumers has been significantly more engaged with legitimate digital formats, and that is probably the reason why that add-supported business model had a marginal presence in digital sales, and subscriptions have moved from 39% of digital sales in 2009 to 48% in 2013. 

Subscriptions are the main source of digital revenue in the music industry in Spain and Germany (43% vs. 48%) but the cost of the implementation has been significantly different. It is interesting to see how the pattern is quite consistent in those countries with high (Netherlands or Italy) or low (United Kingdom or Switzerland) piracy rates. The fact that in all those European countries subscriptions-pay monthly is the dominant digital format is also relevant, as it gives a clear indication about the transition of the sector towards a service dominant logic. 

Final note for those interested in piracy rates provided above. Details on the methodology and piracy rates for ten different countries were published in Industrial Management and Data Systems and can be downloaded for free at the webpage of the journal (Link). The article has been downloaded 1691 times in 2013 and awarded as the outstanding paper of the journal that year.

11 Apr 2014

Teaching innovation: Offering teaching materials combining theory and practice

Economic and management textbooks are often difficult-to-digest for students. The links between theoretical developments and practical implications are not clear enough. In the other side case studies developed in well-established business schools have not enough theoretical developments and students must refer to textbooks to extract the main messages and implications of those cases. 

In my view teaching materials can be delivered in other forms, combining the practicality of case studies and the robustness of textbooks. During the last couple of years I have been working with my colleague and friend Dr. Esteban Lafuente in giving form to those ideals. 

At the beginning the project consisted on a series of informal seminars. We invited entrepreneurs to the classroom to explain their cases. We observed high students’ engagement and participation. We made reference to the cases in lectures to contextualize theories. After some informal conversations and the involvement of Prof. Vicente Salas we decided to embark on a challenging and ambitious project, writing a book based on the case studies available. This book has been just released (Link). 

The book contains a unified approach, integrating mainstream economic and management literature to the storyline of three entrepreneurial projects in the new digital economy. The analysed cases are real life stories of entrepreneurs whose businesses operate in diverse economic sectors, including erotic photography, cloud computing, and the certification of innovative projects. 

Theories developed in this book focuses on understanding market dynamics and strategic decision-making processes. We take the perspective of Besanko and coauthors and offer a combination of economic and management theories, among them Porter’s market forces, firm profit maximization models, value chains and valuation of companies. 

As usual practice for high-quality teaching materials we offer model solutions to problem sets and discussion questions to those lecturers interested in using the textbook in their courses. We strongly believe that this innovative book is a perfect complement for modules on entrepreneurship, business economics and operations management. We hope you find the book useful and welcome comments and suggestions for future editions.

24 Feb 2014

I feel like a lab rat

I might confess that in the last week I have been involved in a couple of events described in economic theories giving me the impression that I have been observed by a big brother (or senior researcher) doing real life experimentation. Let me introduce the events in detail.
 
First event: Birmingham with 114 miles of navigable water is said to have more canals than Venice. Fortunately, one of the canals links my flat with the university of Birmingham campus. This canal has a parallel crosswalk and it takes approximately 40 minutes walking. I normally take the train, which is faster, and more comfortable but last Friday I decided to walk over the canal. After a few minutes walk I saw a child of about 5 years in the water, with clear signals of getting drowned. There was no sign of the parents. I collapsed.

Despite the drama of the situation it came to my head the concept of the Hypothetical Bias. It is a concept used to criticize surveys and formally described in academic articles and textbooks as the difference between the predicted and actual behavior of someone facing an extreme situation such as for example having to save a child from cold water. 

I discovered that I am not the kind of person that immediately thrown into the water to save the child. My first reaction was to see if I could catch him from the bank. But he was too far. Just when I was self-convincing to jump into the water a young man arrived and did. Definitely a very brave person. The parents were fifty meters from there playing with their other two daughters and their two dogs. When they realized what happened the child was already safe. 

I do not know what I would have answered in a survey, but quite likely I would have said that I would have thrown to the water immediately. And obviously it would have been a biased response. We also see strong hypothetical bias in elections or buying rare products.

Second event: My father rented a shop in the town center of Barcelona in the early 70s. He has worked there selling newspapers, magazines and books for the last 40 years, and currently at his 62 years of age he only requires 3 years and a half for retiring. A new legislation in Spain directly affects the rental price of his shop. The new act requires "old rents" (before 1986) to pay market prices, which are about six times higher than the current rents. Obviously, he cannot afford market prices, having to quit his economic activity.

But apparently there is still some hope. It seems that there is still a legal possibility of enforcing the actual rent price until the date of his retirement. This opens the possibility of negotiation with the owner of the shop. In this situation we could apply the theorem of Coase, which states that if transaction costs are small enough, bargaining will lead to an efficient outcome regardless of the initial allocation of property. 

To make it simpler let’s imagine that my father pays a rent of 1$ per month and after performing his economic activity has a profit of 4$ per month. According to the owner of the shop the current rental market price of the shop is 6$ per month. Consequently, the total profit with the current situation is 5$ per month, 1$ smaller to the profit generated renting the shop at the market price. In that situation both parties should be better off renting the shop at market price and then negotiate how to share the pie. The Coase theorem predicts they will reach an agreement if the transaction costs (in this case the negotiation costs) are small enough. 

Concluding note: I admit that those events are not as hilarious as I presented at the beginning of the post. Economics as a social science pursues to explain human interactions, and as human being it is totally natural it happens to me. I made it dramatic in order to show that a new way of writing case studies is possible. Most of the current case studies for teaching do not contain theory in them. They limited to provide detailed information of a situation relevant for economics and business. It forces the students to refer to the textbook or teaching notes. This could be simplified integrating the theory into the narrative of the case study, which in turn helps highlighting the relevance and value of having a good understanding of the theory. 

After having said that I would like to make a short survey to colleagues and students. Do you prefer this way of presenting case studies? Do you think they could be a more efficient didactic strategy? Looking forward for your feedback.

10 Feb 2014

Do university lecturers carry their academic research to classrooms?

We must accept that. Most academics –including myself– struggle when they have to write a short briefing of their teaching philosophy . The common answer relates the main two missions of the university: teaching and research. University lecturers are expected to carry the lab –understanding lab as individual academic research– to classrooms. But it rarely happens, especially in undergraduate courses. I recently came across to one interesting exception: The Phillips Curve
 
The Phillips Curve describes a –short-run– negative relationship between inflation and unemployment and received the name from William Phillips who first identified this pattern with empirical-driven study collecting information of inflation and unemployment for the period 1861-1957 in the UK. He did not receive the Nobel Prize, but at least six of the authors building –part of their research– to the better understanding of the relation between unemployment and inflation achieved this award for their contributions. In chronological order: Paul Samuelson in 1970, Milton Friedman in 1976, Robert Solow in 1987, Robert Lucas in 1995, Edmund Phelps in 2006, and finally Thomas Sargent in 2011. All the insights and recommendations from this debate are still important for policy makers when defining their monetary –interestingly the independence of central banks is a consequence of this debate– and fiscal policies. And therefore are relevant for undergraduate and postgraduate students in economics and business. 
 
Apart from the technical details, it is also a great opportunity for students to discover the processes and advances of the academic thinking. To understand how after the discovery of an empirical pattern other authors look whether it is generalizable or not, and some others construct robust theoretical models based on the previous empirical studies. This kind of build-in-academic-debate teaching content can be motivating and encouraging for those students showing a prospect interest in developing an academic career. 
 
In sum, teaching the Phillips Curve is a good illustration of the generation of knowledge. And certainly, we need to see more academic developments like this in textbooks and teaching notes. What in my view it actually means bringing the lab to the classroom.  

20 Jan 2014

Is Facebook a good source for assessing job applicants?

Certainly the selection of personnel is a difficult task, especially now with the economic crisis. Anyone can make the experiment of seeing the disproportionate amount of applicants for each recruiter in webpages like infojobs.

Human Resource departments collect and process all available information of shortlisted candidates. Normally the candidate provides the information, but with the appearance of social media we all leave a trail in Internet. And for certain people this is scary. Some of my friends do not engage in social media because they are afraid about third party judgments. 

So here we have a big question. Does our activity in social media say anything about our professionalism and productivity? Or in other words, is it really worth for human resource managers to check the Facebook page of the candidates? 

This is the same question that arises to Chad H. Van Iddekinge, associate professor in Florida State University. He led an outstanding experiment recently released in Journal of Management. In a first stage they engaged around four hundred students in the experiment, all of them were close to finish their studies and claimed to be active job seekers. They showed the Facebook profiles of those students to eighty-six recruiters with large experience in human resource departments. Those recruiters gave their considerations about the students in the form of detailed ratings. One year after the researchers contacted the supervisors of the one hundred fifty students that were working. They collected information from most of their job supervisors about their performance, also in the form of ratings. 

Once the data was collected they correlated rating from the expert recruiters and supervisors. Surprisingly, they found that the correlation was statistically not different from zero. So, the academic experiment shows that from Facebook profiles we cannot infer the productivity of candidates. 

This is obviously good news for those that suffer from the content they share in social networks. However, I still think we can extract relevant information of candidates with Internet searches. For instance, in those activities that require communication skills, social media could be a good source of information. 

Finally, I wonder what happens with traditional CVs and attached cover letters. Are good source of information for recruiters? Do they outperform social media profiles? Or, maybe social media is just a complement of CVs and that is the reason why expert recruiters (in the experiment) could not identify the most productive candidates? 

These are questions still unresolved. Hope that future research will shed light on these issues, but in the meanwhile we can just share our opinions. If you were a recruiter which would be the data sources you would rely on to take your decision?