Capitalistic Musings
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Sam Vaknin >> Capitalistic Musings
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Non-financial companies, spurred on by legislation, emulate this
approach by constructing "risk portfolios" and keenly embarking on
"enterprise risk management (ERM)", replete with corporate risk
officers. Corporate risk models measure the effect that simultaneous
losses from different, unrelated, events would have on the well-being
of the firm.
Some risks and losses offset each others and are aptly termed "natural
hedges". Enron pioneered the use of such computer applications in the
late 1990's - to little gain it would seem. There is no reason why
insurance companies wouldn't insure such risk portfolios - rather than
one risk at a time. "Multi-line" or "multi-trigger" policies are a
first step in this direction.
But, as Frank Knight noted in his seminal "Risk, Uncertainty, and
Profit", volatility is wrongly - and widely - identified with risk.
Conversely, diversification and bundling have been as erroneously - and
as widely - regarded as the ultimate risk neutralizers. His work was
published in 1921.
Guided by VAR models, a change in volatility allows a bank or a hedge
fund to increase or decrease assets with the same risk level and thus
exacerbate the overall hazard of a portfolio. The collapse of the
star-studded Long Term Capital Management (LTCM) hedge fund in 1998 is
partly attributable to this misconception.
In the Risk annual congress in Boston two years ago, Myron Scholes of
Black-Scholes fame and LTCM infamy, publicly recanted, admitting that,
as quoted by Dwight Cass in the May 2002 issue of Risk Magazine: "It is
impossible to fully account for risk in a fluid, chaotic world full of
hidden feedback mechanisms." Jeff Skilling of Enron publicly begged to
disagree with him.
Last month, in the Paris congress, Douglas Breeden, dean of Duke
University's Fuqua School of Business, warned that - to quote from the
same issue of Risk Magazine:
" 'Estimation risk' plagues even the best-designed risk management
system. Firms must estimate risk and return parameters such as means,
betas, durations, volatilities and convexities, and the estimates are
subject to error. Breeden illustrated his point by showing how
different dealers publish significantly different prepayment forecasts
and option-adjusted spreads on mortgage-backed securities ... (the
solutions are) more capital per asset and less leverage."
Yet, the Basle committee of bank supervisors has based the new capital
regime for banks and investment firms, known as Basle 2, on the banks'
internal measures of risk and credit scoring. Computerized VAR models
will, in all likelihood, become an official part of the quantitative
pillar of Basle 2 within 5-10 years.
Moreover, Basle 2 demands extra equity capital against operational
risks such as rogue trading or bomb attacks. There is no hint of the
role insurance companies can play ("contingent equity"). There is no
trace of the discipline which financial markets can impose on lax or
dysfunctional banks - through their publicly traded unsecured,
subordinated debt.
Basle 2 is so complex, archaic, and inadequate that it is bound to
frustrate its main aspiration: to avert banking crises. It is here that
we close the circle. Governments often act as reluctant lenders of last
resort and provide generous safety nets in the event of a bank
collapse.
Ultimately, the state is the mother of all insurers, the master policy,
the supreme underwriter. When markets fail, insurance firm recoil, and
financial instruments disappoint - the government is called in to pick
up the pieces, restore trust and order and, hopefully, retreat more
gracefully than it was forced to enter.
Global Differential Pricing
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
Also Read:
The Revolt of the Poor
Last April, the World Health Organization (WHO), the World Trade
Organization (WTO), the Norwegian Foreign Ministry, and the US-based
Global Health Council held a 3-days workshop about "Pricing and
Financing of Essential Drugs" in poor countries. Not surprisingly, the
conclusion was:
"... There was broad recognition that differential pricing could play
an important role in ensuring access to existing drugs at affordable
prices, particularly in the poorest countries, while the patent system
would be allowed to continue to play its role in providing incentives
for research and development into new drugs."
The 80 experts, who attended the workshop, proposed to reconcile these
two, apparently contradictory, aspirations by introducing different
prices for drugs in low-income and rich countries. This could be
achieved bilaterally, between companies and purchasers, patent holders
and manufacturers, global suppliers and countries - or through a market
mechanism.
According to IMS Health, poor countries are projected to account for
less than one quarter of pharmaceutical sales this year. Of every $100
spent on medicines worldwide - 42 are in the USA, 25 in Europe, 11 in
Japan, 7.5 in Latin America and the Caribbean, 5 in China and South
East Asia, less than 2 in East Europe and India each, about 1 in Africa
and the Commonwealth of Independent States (CIS) each.
Vaccines, contraceptives, and condoms are already subject to
cross-border differential pricing. Lately, drug companies, were forced
to introduce multi-tiered pricing following court decisions, or
agreements with the authorities. Brazilians and South Africans, for
instance, pay a fraction of the price paid in the West for their
anti-retroviral AIDS medication.
Even so, the price of a typical treatment is not affordable. Foreign
donors, private foundations - such as the Bill and Melissa Gates
Foundation - and international organizations had to step in to cover
the shortfall.
The experts acknowledged the risk that branded drugs sold cheaply in a
poor country might end up being smuggled into and consumed in a much
richer ones.
Less likely, industrialized countries may also impose price controls,
using poor country prices as benchmarks. Other participants, including
dominant NGO's, such as Oxfam and Medecins Sans Frontieres, rooted for
a reform of the TRIPS agreement - or the manufacturing of generic
alternatives to branded drugs.
The "health safeguards" built into the Trade-related Aspects of
Intellectual Property Rights (TRIPS) convention allow for compulsory
licensing - manufacturing a drug without the patent holder's permission
- and for parallel imports - importing a drug from another country
where it is sold at a lower price - in case of an health emergency.
Aware of the existence of this Damocles sword, the European Union and
the trans-national pharmaceutical lobby have come out last May in favor
of "global tiered pricing".
In its 2001 Human Development Report (HDR), the United Nations
Development Program (UNDP) called to introduce differential rich versus
poor country pricing for "essential high-tech products" as well. The
Health GAP Coalition commented on the report:
"On the issue of differential pricing, the Report notes that, while an
effective global market would encourage different prices in different
countries for products such as pharmaceuticals, the current system does
not. With high-tech products, where the main cost to the seller is
usually research rather than production, such tiered pricing could lead
to an identical product being sold in poor countries for just
one-tenth-or one-hundredth- the price in Europe or the United States.
But drug companies and other technology producers fear that knowledge
about such discounting could lead to a demand for lower prices in rich
countries as well. They have tended to set global prices that are
unaffordable for the citizens of poor countries (as with many AIDS
drugs).
'Part of the battle to establish differential pricing must be won
through consumer education. The citizens of rich countries must
understand that it is only fair for people in developing countries to
pay less for medicines and other critical technology products.' -
stated Ms. Sukaki Fukuda-Parr" the lead author of the Report.
Public declarations issued in Havana, Cuba, in San Jose, Costa Rica in
the late 1990's touted the benefits of free online scholarship for
developing countries. The WHO and the Open Society Institute initiated
HINARI - Health InterNetwork Access to Research Initiative. Peter
Suber, the publisher of the "Free Online Scholarship" newsletter,
summarizes the initiative thus:
"Under the program, the world's six largest publishers of biomedical
journals have agreed to three-tiered pricing. For countries in the
lowest tier (GNP per capita below $1k), online subscriptions are free
of charge. For countries in the middle tier (GNP per capita between $1k
and $3k), online subscriptions will be discounted by an amount to be
decided this June. Countries in the top tier pay full price.
The six participating publishers are Blackwell Synergy, Elsevier
Science Direct, Harcourt IDEAL, Springer Link, Wiley Interscience, and
Wolters Kluwer. The subscriptions are given to universities and
research institutions, not to individuals. But they are identical in
scope to the subscriptions received by institutions paying the full
price."
Of 500 bottom-tier eligible institutions, more than 200 have already
signed up. Additional publishers have joined this 3-5 years program and
most biomedical journals are already on offer. Mid-tier pricing will be
declared by January next year. HINARI will probably be expanded to
cover other scientific disciplines.
Authors from developing countries also benefit from the spread of free
online scholarship coupled with differential pricing. "Best of
Science", for example, a free, peer-reviewed, online science journal
subsists on fees paid by the authors. It charges authors from
developing countries less.
But differential pricing is unlikely to be confined to scholarly
journals. Already, voices in developing countries demand tiered pricing
for Western textbooks sold in emerging economies. Quoted in the Free
Online Scholarship newsletter, Lai Ting-ming of the Taipei Times
criticized, on March 26, "western publishers for selling textbooks to
third world students at first world prices. There is a "textbook
pricing crisis" in developing countries, which is most commonly solved
by illicit photocopying."
Touchingly, the issue of the dispossessed within rich country societies
was raised by two African Special Rapporteurs in a report submitted
last year to the UN sub-Commission on Human Rights and titled
"Globalization and its Impact on the Full Enjoyment of Human Rights".
It said:
" ... The emphasis on R & D investment conveniently omits mention of
the fact that some of the financing for this research comes from public
sources; how then can it be justifiably argued that the benefits that
derive from such investment should accrue primarily to private
interests? Lastly, the focus on differential pricing between (rich and
poor) countries omits consideration of the fact that there are many
people within developed countries who are also unable to afford the
same drugs. This may be on account of an inaccessible or inhospitable
health care system (in terms of cost or an absence of adequate social
welfare mechanisms), or because of racial, gender, sexual orientation
or other forms of discrimination."
Differential pricing is often confused with dynamic pricing.
Bob Gressens of Moai Technologies and Christopher Brousseau of
Accenture define dynamic pricing, in their paper "The Value
Propositions of Dynamic Pricing in Business-to-Business E-Commerce" as:
"... The buying and selling of goods and services in markets where
prices are free to move in response to supply and demand conditions."
This is usually done through auctions or requests for quotes or
tenders. Dynamic pricing is most often used in the liquidation of
surplus inventories and for e-sourcing.
Nor is differential pricing entirely identical with non-linear pricing.
In the real world, prices are rarely fixed. Some prices vary with usage
- "pay per view" in the cable TV industry, or "pay per print" in
scholarly online reference. Other prices combine a fixed element (e.g.,
a subscription fee) with a variable element (e.g., payment per
broadband usage). Volume discounts, sales, cross-selling, three for the
price of two - are all examples of non-linear pricing. Non-linear
pricing is about charging different prices to different consumers - but
within the same market.
Hal Varian of the School of Information Management and Systems at the
University of California in Berkeley summarizes the treatment of "Price
Discrimination" in A. C. Pigou's seminal 1920 tome, "The Economics of
Welfare":
"First-degree price discrimination means that the producer sells
different units of output for different prices and these prices may
differ from person to person. This is sometimes known as the case of
perfect price discrimination.
Second-degree price discrimination means that the producer sells
different units of output for different prices, but every individual
who buys the same amount of the good pays the same price.
Thus prices depend on the amount of the good purchased, but not on who
does the purchasing. A common example of this sort of pricing is volume
discounts.
Third-degree price discrimination occurs when the producer sells output
to different people for different prices, but every unit of output sold
to a given person sells for the same price. This is the most common
form of price discrimination, and examples include senior citizens'
discounts, student discounts, and so on."
Varian evaluates the contribution of each of these practices to
economic efficiency in a 1996 article published in "First Monday":
"First-degree price discrimination yields a fully efficient outcome, in
the sense of maximizing consumer plus producer surplus.
Second-degree price discrimination generally provides an efficient
amount of the good to the largest consumers, but smaller consumers may
receive inefficiently low amounts. Nevertheless, they will be better
off than if they did not participate in the market. If differential
pricing is not allowed, groups with small willingness to pay may not be
served at all.
Third-degree price discrimination increases welfare when it encourages
a sufficiently large increase in output. If output doesn't increase,
total welfare will fall. As in the case of second-degree price
discrimination, third-degree price discrimination is a good thing for
niche markets that would not otherwise be served under a uniform
pricing policy.
The key issue is whether the output of goods and services is increased
or decreased by differential pricing."
Strictly speaking, global differential pricing is none of the above. It
involves charging different prices in different markets, in accordance
with the purchasing power of the local clientele (i.e., their
willingness and ability to pay) - or in deference to their political
and legal clout.
Differential prices are not set by supply and demand and, therefore, do
not fluctuate. All the consumers within each market are charged the
same - prices vary only across markets. They are determined by the
manufacturer in each and every market separately in accordance with
local conditions.
A March 2001 WHO/WTO background paper titled "More Equitable Pricing
for Essential Drugs" discovered immense variations in the prices of
medicines among different national markets. But, surprisingly, these
price differences were unrelated to national income.
Even allowing for price differentials, the one-month cost of treatment
of Tuberculosis in Tanzania was the equivalent of 500 working hours -
compared to 1.4 working hours in Switzerland. The price of medicines in
poor countries - from Zimbabwe to India - was clearly higher than one
would have expected from income measures such as GDP per capita or
average wages. Why didn't drug prices adjust to reflect indigenous
purchasing power?
According to the Paris-based International Chamber of Commerce (ICC),
differential pricing is also - perhaps mostly - influenced by other
considerations such as: transportation costs, disparate tax and customs
regimes, cost of employment, differences in property rights and
royalties, local safety and health standards, price controls, quality
of internal distribution systems, the size of the order, the size of
the market, and so on.
Differential pricing was made possible by the application of mass
manufacturing to the knowledge society. Many industries, both emerging
ones, like telecommunications, or information technology - and mature
ones, like airlines, or pharmaceuticals - defy conventional pricing
theory. They involve huge sunk and fixed costs - mainly in research and
development and plant.
But the marginal cost of each and every manufactured unit is identical
- and vanishingly low. Beyond a certain quantitative threshold returns
skyrocket and revenues contribute directly to the bottom line.
Consider software applications. The first units sold cover the enormous
fixed and sunk costs of authoring the software and the machine tools
used in the manufacturing process. The actual production ("variable" or
"marginal") cost of each unit is a mere few cents - the wholesale price
of the diskettes or CD-ROM's consumed. Thus, after having achieved
breakeven, sales revenues translate immediately to gross profits.
This bifurcation - the huge fixed costs versus the negligible marginal
costs - vitiates the rule: "set price at marginal cost". At which
marginal cost? To compensate for the sunk and fixed costs, the first
"marginal units" must carry a much higher price tag than the last ones.
Hal Varian studied this problem. His conclusions:
"(i) Efficient pricing in such environments will typically involve
prices that differ across consumers and type of service; (ii) producers
will want to engage in product and service differentiation in order for
this differential pricing to be feasible; and, (iii) differential
pricing will arise naturally as a result of profit seeking by firms. It
follows that differential pricing can generally be expected to
contribute to economic efficiency."
Differential pricing is also the outcome of globalization. As brands
become ubiquitous and as the information superhighway renders prices
comparable and transparent - different markets react differently to
price signals. In impoverished countries, differential pricing was
introduced illegally where manufacturers insisted on rigid, rich-world,
price lists.
Piracy of intellectual property, for instance, is a form of coercive
(and illegal) differential pricing. The existence of thriving rip-off
markets proves that, at the right prices, demand is rife (demand
elasticity). Both piracy and differential pricing may be spreading to
scholarly publishing and other form of intellectual property such as
software, films, music, and e-books.
Consumers are divided on the issue of multi-tiered pricing tailored to
fit the customer's purchasing power. Not surprisingly, rich world
buyers are apprehensive. They feel that differential pricing is a form
of hidden subsidy, or a kind of "third world tax".
On September 2000, Amazon.com conducted a unique poll - this time among
customers - regarding differential pricing (actually, non-linear
pricing) - showing different prices to different users on the same
book.
Forty two percent of all respondents though it was "discrimination" and
"should stop" - but a surprising 31 percent regarded it as "a valid use
of data mining". A quarter said it is "OK, if explained to users". The
comments were telling:
"I work over 80 hours a week. As a small business owner, I may make
good money, but does that mean I should be charged more than
unmotivated individuals who are broke because they don't want to work
more than 30 hours a week. I don't think so ... Should (preferred)
customers disappear in (the) off-line world? Should Gold Cards or
Platinum Cards disappear? ...
The interesting thing is that discrimination of pricing is very common
in the insurance industry - the basis for actuarial work and in
airlines - based on load factors. The key is the pricing available to
groups of customers with similar profiles ... Simple supply and demand,
competition from other suppliers should offset ... A dangerous policy
to implement ... As a consumer I don't necessarily like it, (unless I
get a lower price!). However, economically speaking, (think of a
monopolist's MR curve) the ideal is to have each person pay the maximum
amount that they are willing to pay."
The Disruptive Engine
Innovation and the Capitalistic Dream
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
On 18 June business people across the UK took part in Living Innovation
2002. The extravaganza included a national broadcast linkup from the
Eden Project in Cornwall and satellite-televised interviews with
successful innovators.
Innovation occurs even in the most backward societies and in the
hardest of times. It is thus, too often, taken for granted. But the
intensity, extent, and practicality of innovation can be fine-tuned.
Appropriate policies, the right environment, incentives, functional and
risk seeking capital markets, or a skillful and committed Diaspora -
can all enhance and channel innovation.
The wrong cultural context, discouraging social mores, xenophobia, a
paranoid set of mind, isolation from international trade and FDI, lack
of fiscal incentives, a small domestic or regional market, a
conservative ethos, risk aversion, or a well-ingrained fear of
disgracing failure - all tend to stifle innovation.
Product Development Units in banks, insurers, brokerage houses, and
other financial intermediaries churn out groundbreaking financial
instruments regularly. Governments - from the United Kingdom to New
Zealand - set up "innovation teams or units" to foster innovation and
support it. Canada's is more than two decades old.
The European Commission has floated a new program dubbed INNOVATION and
aimed at the promotion of innovation and encouragement of SME
participation. Its goals are:
"(The) promotion of an environment favourable to innovation and the
absorption of new technologies by enterprises;
Stimulation of a European open area for the diffusion of technologies
and knowledge;
Supply of this area with appropriate technologies."
But all these worthy efforts ignore what James O'Toole called in
"Leading Change" - "the ideology of comfort and the tyranny of custom."
The much quoted Austrian economist, Joseph Schumpeter coined the phrase
"creative destruction". Together with its twin - "disruptive
technologies" - it came to be the mantra of the now defunct "New
Economy".
Schumpeter seemed to have captured the unsettling nature of innovation
- unpredictable, unknown, unruly, troublesome, and ominous. Innovation
often changes the inner dynamics of organizations and their internal
power structure. It poses new demands on scarce resources.
It provokes resistance and unrest. If mismanaged - it can spell doom
rather than boom.
Satkar Gidda, Sales and Marketing Director for SiebertHead, a large UK
packaging design house, was quoted in "The Financial Times" last week
as saying:
"Every new product or pack concept is researched to death nowadays -
and many great ideas are thrown out simply because a group of consumers
is suspicious of anything that sounds new ... Conservatism among the
buying public, twinned with a generation of marketing directors who
won't take a chance on something that breaks new ground, is leading to
super-markets and car showrooms full of me-too products, line
extensions and minor product tweaks."
Yet, the truth is that no one knows why people innovate. The process of
innovation has never been studied thoroughly - nor are the effects of
innovation fully understood.
In a new tome titled "The Free-Market Innovation Machine", William
Baumol of Princeton University claims that only capitalism guarantees
growth through a steady flow of innovation:
"... Innovative activity-which in other types of economy is fortuitous
and optional-becomes mandatory, a life-and-death matter for the firm."
Capitalism makes sure that innovators are rewarded for their time and
skills. Property rights are enshrined in enforceable contracts.
In non-capitalist societies, people are busy inventing ways to survive
or circumvent the system, create monopolies, or engage in crime.
But Baumol fails to sufficiently account for the different levels of
innovation in capitalistic countries. Why are inventors in America more
productive than their French or British counterparts - at least judging
by the number of patents they get issued?
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