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When discussing game theory, particularly ‘Prisoners Dilemma’, an oft cited real life example is that of carbon emissions control by different nations. Many treaties, agreements have been signed in order to reduce harmful carbon emissions in order to prevent global warming, but without much results.

The time is ripe again to discuss the game in the same context. Barack Obama is planning to visit Copenhagen next month as a show of US’s commitment in efforts to cut down emissions. In the last Kyoto Protocol, US was the only country (among participating countries) that did not ratify the agreement. It is expected that Barack’s presence and commitment will change all that. The article says:

The United Nations’ top climate negotiator, Yvo de Boer, said Mr. Obama’s participation in the summit is "critical to a good outcome."

Assume for a second that US does agree to participate ‘actively’ in reducing carbon emissions, what can go wrong? The answer may lie in the Prisoners Dilemma. Up until now, this game was played among nations sans US and there was an incentive to cheat and not conform to the requirements. As such, countries that did not follow the guidelines were able to extract some benefits that accrued from steps taken by responsible countries. If one of the responsible ones was in fact a large one, the actions by smaller countries were not necessarily taken seriously and the gross impact was negligible. But the net impact, sum of many small countries defecting, was huge. As a result these protocols have not been very effective in curbing the emissions problem so far. See the figure to explain the situation. Note that the numbers are figurative and do not indicate any absolute values.

Now with the entry of US in the fray, the incentive to cheat by the smaller countries will actually increase! Because of US’s commitment, India and China (largest developing nations) will come under much more questioning than before. The result of this would be that these countries will start taking ‘baby’ steps to counter some of the retaliation. As a result of this, the smaller nations, in Africa, the EU, Australia will have an incentive to defect or at least reduce their commitment towards reducing carbon emissions. A lot of focus will be on the actions of more prominent countries, and steps taken by them will have a noticeable impact on the saturation level. Because smaller countries will tend to ‘free ride’ on the steps taken by bigger countries, they will probably reduce their efforts.

Are we forgetting something? Yes. This game is played repeatedly, not once. So don’t all countries have an incentive to co-operate, rather than play truant. From a bird’s eye view, yes. But the assertion can be justified only if we can properly understand the impact of retaliation by the responsible countries in the next round. What kind of punishment is imposed, in terms of sanctions, fines, etc that can prove to be a higher cost that co-operating. The problem facing the planet is grave and hopefully a situation will not play out where both players defect. But the defecting countries can be made to follow is by altering the only variable available for manipulation – the payback for defection.

eBay, as we all know, is the most popular auction site where people put their items on sale. The auction strategy, that allows for proxy bidding, makes the auction second-price, sealed bid rather than English. People who are interested in the item bid for it in small incremental amounts and when the time is up, the person with the highest bid gets the item (provided he has met the reservation price limit, if there is any). As we would typically expect, people bid in small increments deciding to up the price until they reach their estimated value of the item. But most of us get fooled by some ingenious smart person who is waiting until the last second to up his ante and thus snatch away the item from below our nose through a process known as sniping.

In comes Swoopo with an interesting bidding strategy. You actually pay for the bids ($0.60). Note that in these auctions an item is ultimately sold at prices much lower than the retail price (after all, your total price paid includes the money you pay for bidding). But the sellers, the site owners themselves, are here to make a profit. How are they able to do that? One other change from the eBay style bidding is that once you place a bid, the window for bidding increases(by 10 seconds). Sometimes the owners make a profit on an item, sometimes a loss. But overall these people claim to make a profit. Let’s see two examples:

Here, we see that an item, priced at $659, is sold for $5.01. So did the seller make a profit or a loss? This was a penny auction, that means that you can only bid a penny more than the last highest bidder. So $5.01 means 501 pennies which translates to $300.60 earned just through bids. Total money earned by the seller = $305.61. Even if the item was purchased at a 50% discount ($329.50) the seller loses $23.89. I am being conservative in estimating the cost of the item to the seller. Note that these sellers buy items in bulk and get a significant discount.

In the second case (view graphic on the right) we see a different story. Say, the average bid increase was $0.60. So, there were about 206 bids made that earned Swoopo $123.84. Add to that the price paid by the winner which makes the total earnings = $247.68. In this lets say the cost to the seller was 75% of the product price, i.e. $209.25. He has made a profit of $38.43 (higher than the previous loss).

In the end, Swoopo does seem to end up making a neat profit out of its auctions. There is one more thing worthy of pointing here. One of the compliance tactics mentioned by Dr. Robert Cialdini in his book, Influence: Science and Practice, was that of extracting a commitment. In this case, once a bidder pays for a bid, he/she becomes emotionally attached to winning the bid that results in him bidding again and again. His commitment increases, either until the end, or to the point where he really sees where he is headed in. This is like negotiating with oneself – “Just one more bid, then I will stop”. A person should have his BATNA known so that he can stop bidding when the time is right.

I am not done yet. A new site has just sprung up – BigDeal.com. They will actually pay you back the amount you used for bidding, if you lose the auction. Well, how do you think they will make money? The answer may lie in the commitment tactic. You have just become more committed to winning and will bid much higher.

…from my Multinational Firms and Strategy class

We recently had a class assignment – Analyze Alan Greenspan’s decision to keep the interest low for a long time and raising it very slowly. Many say this policy along with a lackluster regulatory policy led to the current housing led credit crisis.

It was a very interesting exercise and though I wasn’t able to reach the “right” conclusion, I felt that the he did indeed keep the interests low for a longer time than needed. This conclusion came based on my analysis of the GDP gap as perceived (based on Taylor rule and then data) by Greenspan vs. my own estimate of the GDP gap. The increasing natural rate of unemployment also provided some direction towards my conclusion. I cannot exactly share my data, charts, and analysis here because … it was an assignment that may be given next year also and I don’t yet know my grades on the assignment .

What I want to discuss here is one of the statements made during the class –  The economists have not yet build a model that can capture the true relationship between Alan Greenspan’s decisions and the housing crisis. My question is – Can such a model be built? Can it be predictive in nature, and not just retrospective? Lets start by asking a more fundamental question…

Can consumer behavior be modeled? To some extent, yes. Marketers tend to model behaviors all the time in order to sell consumers exactly what they want, and do not want, in the most (un)appropriate times. Numerati (Stephen Baker’s book) talks about various such models and how it is revolutionizing the industry. But this behavior is always predicted based on certain other behavioral patterns and not on demographics, access to cash, and spending power (Note that such models also do exist but may not be the right way to segment consumers).

How can you predict what a consumer will do when he is given easy access to large amount of cash? We look for patterns. We look around ourselves and see what do people do in such cases. When a person gets a great job that comes with large salary incentives, what does he purchase first? When a new generation enters the workforce, what do parent recommend them they do with the money earned? When somebody wins a lottery, what is the one thing he invests in? Does ‘buying a house’ answer all the questions above to some extent? Probably yes.

How can we test this hypothesis? Can this pattern be quantified in an equation? Can it lead to building a model that can actually prove that Greenspan is the root cause of this disaster? Thoughts?

Words from our economics professor Ray Hill. He is correct in saying that and I also believe that everyone in business (not just MBAs) should know what inflation is and how to calculate the rate of inflation.

What is Inflation? Per Wikipedia, the definition is – inflation is a rise in the general level of prices of goods and services in an economy over a period of time. So far so good. We all understand this basic concept very well.

Now, how is the rate of inflation calculated? What measures should one use to calculate the rate?  Basically, there are some other measures (or indices) that should be known to you before you decide to calculate the rate. First is CPI or Consumer Price Index – an estimate of average price for goods and services purchased by households. Second is GDP deflator – a measure of level of prices of goods and services that are produced domestically. Third is PCEPI or Personal Consumption Expenditures Price Index – derived from the largest component of the GDP (personal consumption) and measures the change in prices of goods and services consumed by individuals. I will not go into the details of what each of these are and how they differ because lots of literature is already available on the internet.

Calculation of the rate of inflation is very simple indeed.

Rate of inflation (between time period t and T, T>t) = (Value of the index at time T)/(Value of Index at time t) – 1.0

For e.g. – Between December 2006 and 2007, the inflation rate was 4.08% (based on CPI)

But this is where the fun begins. Using these concepts how do you find out what is the real price of a good based on prices in a certain year in the past? Say Coca Cola, 6 pack 12Oz., used to cost 50 cents in 1974 and $1.50 in 2004 (illustrative figures). This $1.50 is the Nominal price of Coca Cola. What is the real price in 1974 dollars? Say the rate of inflation between these time period is 283% (2.83) (this is actually true). Then,

Real price (in 1974 dollars) = Price in 2004/Rate of inflation = 1.5/2.83 = 53 cents. Huh. Not bad is it!

There is another question that begs answering – What index should one use to calculate inflation rate? CPI is measured using a fixed basket..not a good idea because a typical household’s basket of goods purchased changes over time, new products are introduced, and quality of goods changed (for e.g computers, cars…). There have been some changes in the ‘algorithm’ used but still it tends to have an upward bias in the calculation. GDP deflator helps a little bit because it does not rely on a fixed basket but the actual consumption/expenditure patterns of individuals in a given year. This tends to eliminate the upward bias, but not by much.

Some products, specifically food and energy, tend to be affected by supply shocks and the price change may be temporary (we know about the oil prices, right?). So including these components in calculating true inflation may be misleading. If these are eliminated we may be able to see the real picture. This is where Core Inflation, calculated using PCEPI, comes into picture. In fact, Fed nowadays uses this measure to calculate inflation and take monetary decisions.

Note that inflation can be calculated for specific set of assets such as commodities, services, and wages.These set of values are just subsets of the net inflation but the rules of calculations remain the same.

Some important direct links:

CPI (unadjusted) Data Download

GDP Deflator Data Download

PCEPI (Less food and energy) Data Download

News Flash – September inflation data indicated that consumer prices declined 1.3% during the prior 12 months and that core annual inflation, which excludes volatile food and energy prices, rose just 1.5% — well within the Federal Reserve’s comfort range of between 1%-2%.

Hope you now understand what this means…

Yes, problem solving is an art! An art that can be mastered through sheer discipline and rigor. The secret lies in being able to dissect the problem at hand into manageable, logical pieces and then working on them independently. At the end,  fit the pieces into a coherent whole that is nothing but one of the many practical solutions. There is no doubt that you need hard technical skills to work on the pieces, but there is no dearth of information and skills for that requirement. What really differentiates a good problem solver from bad is the beginning and the end.

Last year and most recently, I had the opportunity of attending a workshop organized by Prof. Patrick Noonan on ‘The Art of Problem Solving’. He reiterates the point of breaking down a problem (many times very ambiguous and convoluted) into smaller pieces. Say you are a part of a team asked to devise a long term strategy for a company. There are many ways to approach this problem – some good, some bad. One way is to assign team members to individually evaluate the company performance to date, industry performance, competitor analysis, and so on…Bad. Another way is to properly understand the main drivers of business, strategy of the company so far and its return on investments, awareness of macro/micro economic trends that can affect the business, forecasting outlook for the industry, reviewing current innovations and consumer behavior, and so on…much better. If you carefully compare the first approach to the second, you will see that in the former, each aspect does not contribute to the final solution. Whereas in the latter, each aspect has something to contribute. Understand that frameworks (the former method is a classic application of a classic framework) as taught in classes serve as guides, not as processes.  There is a big difference.

The last step is collating information gathered in a coherent logical way. This is where creativity, gut feeling, and experience plays a big role. Every strategy developed should be tested in such a way so as to suggest some tactical approach that can be quantified and justified. And then there should be another question – what if? Risks associated with each approach should be outlined in as much detail as possible. How you present your solution to the client is yet another step that needs no exaggeration.

There are various resources available throughout the internet for you to read about different approaches and tools to help you practice the art of problem solving. Six Thinking Hats by Edward de Bono, The McKinsey Way, and an upcoming book by Prof. Noonan will serve as good starting resources in case you are interested in fine tuning your skills.

To understand what a 10-K is and what aspects should be read, I will refer to Home Depot’s 10-k document filed on 4/2/2009. As with all filings, 10-K document can be downloaded from the company’s website – in this case, here, or from secinfo.com – for Home Depot here.

A preliminary guide to the report can be found on Wikipedia. We will not cover the basics in this document.

The article on Wikipedia also covers the various sections within a 10-K report. We will delve a little deeper into most of the sections in this guide.

A 10-K document should always be read by a serious investor if he/she wishes to determine the current state of a company. A 10-K will help to gauge the health of a company, its operations, and its various other initiatives. Without a doubt, a single 10-K report is not enough for anyone to come to any conclusions. Typically, one should compare consecutive year 10-K reports so that a definite direction in which the company is going can be determined. At the same time, comparisons should be made with a competitor’s results, industry averages, so as to peg a company in relation to other players in the industry.

Similarly, a 10-K report does not provide any indication of how a company is going to perform in the future. The report only provides information of what has been, not what will be. An investor has to derive intuitive conclusions, based on economic, market, political, and other trends to gauge the performance in the future. Even if the conclusion is well supported by facts, it is impossible to accurately predict anything about the future.

But, with experience, good judgment, and detailed analysis an investor is expected to be right more than wrong most times.

So let’s see what Home Depot’s 10-K report tells us about the company.

Home Depot’s 10-K

Part 1 – Item 1 – BUSINESS

This section of 10-K gives a brief introduction to the company and the industry within which it operates. A very important item, it will help you to know what the company does, where is it located, what are its different product offerings, and who are its customers. This section will also list out different sources of revenue for the company and the various strategies it employs to stay ahead of its competitors. An investor should keep an open eye towards the risks mentioned in this item. Sometimes common sense, it is important to understand the risks because only then will an investor identify the impact of external forces such as market, political, and economic conditions.

Excerpts from Home Depot’s 10-K – Note that this list is not exhaustive. A complete reading of the report is needed to gather all necessary information.

“The Home Depot, Inc. is the world’s largest home improvement retailer based on Net Sales for the fiscal year ended February 1, 2009 (“fiscal 2008”).” – So we know it is the largest home improvement retailer.

“As of the end of fiscal 2008, we had 2,233 The Home Depot stores located throughout the United States…Commonwealth of Puerto Rico…U.S. Virgin Islands and Guam (“U.S.”), Canada, China and Mexico.” – They are present in different countries, mostly around the US. They have entered the China market, one of the fastest growing economies.

“We shifted our focus from new square footage growth to maximizing the productivity of our existing store base… to make them simpler, more consistent and more customer-focused… associate hours to be more customer facing and refocused our efforts…” – This tells us that they had been expanding quite rapidly earlier but have slowed down the process in exchange of increasing productivity at existing stores.

Their customers predominantly include home owners, and professionals in the building industry. We may infer that Home Depot’s business is highly dependent on the housing industry. In the face of any other kinds of products, any downfall in the housing industry cannot be mitigated by any of their other services very easily.

They have 4 categories of products:

· Plumbing, electrical and kitchen

· Hardware and seasonal

· Building materials, lumber and millwork

· Paint and flooring

It should also be observes that all categories contribute almost equally to sales even though plumbing, electrical, and kitchen contributes the largest.

“In fiscal 2008, we reduced our inventory while maintaining a favorable in-stock rate.” – They are in the right direction as they implement better forecasting and inventory management tools.

“We also reduced a number of one-time discount promotions…continued to introduce innovative and distinctive products… we have formed strategic alliances and exclusive relationships with selected suppliers” – If you remember the discussion we had on the retail industry earlier, Home Depot is following certain best practices that will help it differentiate from its competitors and stay ahead of the game. These are – reducing intermittent promotions to avoid stock piling and sell through, introducing store brands to maintain exclusivity, and forming strategic alliances to get better terms and reduced costs.

“…we have three sourcing offices located in the Chinese cities of Shanghai, Shenzhen and Dalian, and offices in …India…Italy…Mexico and Canada.” – Their products are made all over, not exclusively USA or China.

“we continued to make information technology investments…in our supply chain and merchandising tools to improve inventory management capabilities and streamline our operations.” – An analyzed above…

“Our business is highly competitive, based in part on price, store location, customer service and assortment of merchandise.” – Rightly said. We also see the impact of the 4 important characteristics of a retail company on Home Depot’s competitiveness.

Risk Factors

All companies are required to list the various risk factors that could adversely or materially affect its business. Investors should make a close note of all the risks and match them up with their knowledge of the current market conditions. It will help him/her make valuable judgment on a company’s operation in current times. Some of the risks noted in Home Depot’s 10-K include:

“state of the housing, construction and home improvement markets, rising costs, a reduction in the availability of financing,” – We all know what is going on these days. But if numbers have their say, we can probably say that markets are improving and home sales are increasing. This can positively affect Home Depot’s performance in the coming year.

“fail to identify and develop relationships with a sufficient number of qualified suppliers” – Though this is mentioned, unless we see any strained vendor relations in the past, we can say that the management is competent enough to maintain its supplier relationship. Research pertaining to exclusive relationship and its survival rate in the past can be a good indicator of the seriousness of this risk.

“ability to obtain additional financing on favorable terms” – Financing should be available in today’s market as government tries to fuel the economy by providing low lending rates.

“inflation or deflation of commodity prices could affect our prices, demand for our products, sales and profit margins.” – O yes! Gas prices have been fluctuating recently and so are the commodity prices. This can very well affect the transportation, procurement, and maintenance costs and can have a big impact on the business. Investors should pay close attention to this risk.

“ability to attract, train and retain highly qualified associates.” – At least for the near future, this shouldn’t be a problem if Home Depot plays its cards right. There are many talented folks looking for job these days.

“Increased competition could adversely affect prices and demand for our products and services and could decrease our market share.” – Because of high entry cost, Home Depot can be safe from new players. But needs to closely monitor existing competitors and be proactive in implementing it’s own strategies.

“If we cannot successfully manage the unique challenges presented by international markets, we may not be successful in expanding our international operations.” – Home Depot operates only in China apart from nearby countries. It does not have a lot of experience managing expansion internationally. So if it tries to open in other countries, close watch needs to be maintained on its performance, market share, and sustainability. Even a company like Wal-Mart had to leave Korea. It’s not easy.

For a while I have been thinking of writing a Cow guide on ‘How to read a 10-k document’. For that document I wanted to analyze a real 10-k of a retailer as a reference. But I realized that it is not a good idea to read a 10-k document without knowing about the industry itself.

So as first step, I have written very, very broadly (in bullet points) some of the characteristics of the retail industry. I am assuming the readers are a bit knowledgeable about the industry and can extrapolate my short blurbs for their better understanding. Also note that this document is not intended to be read expecting to learn about great new innovations in the industry.

The pdf version of this document is available here.

As promised earlier, here is my first guide. These guides are being prepared as I learn a few new concepts and methodologies during the course of my MBA (during the summer break).

I have also given a name to the series – Cow’s guide to <Subject>…. If you ask me, I may tell you why I have named it such. But for now, just consider it unique. These guides are intended to be a beginner’s reference and should be used as a casual read to get basic understanding of the concepts discussed.

So, here is the first guide – Cow’s guide to Conjoint Analysis. In my document Conjoint Analysis is referred to as applied in Market Research. Conjoint Analysis is extensively used statistical technique to quantify customer preferences for your potential/existing product based on its attributes and values. Attributes are nothing but features of your product and values are the various types (levels) within each attribute. You will understand better once you read my guide.

Conjoint Analysis is a powerful method and is applied extensively in Marketing Strategy, New Product Development, Pricing Strategies, and even Sales Forecasting.

I would much appreciate if you can provide me your feedback on the guide. You can comment on my structure, level of detail, or even the use of language.

Download link –> Cow’s guide to Conjoint Analysis

One of the intentions of this blog was to write about new concepts that I learn while pursuing my MBA. Now, understand that even though I may be writing about specific subjects/topics, I am not a master in them. I am a learner who hopes to build an applicable skill. The articles will be very basic but it will definitely help lay foundations for exploration. I will try to get my articles vetted by my professors and business contacts, as and where needed and possible.

So here is a list of items that I wish to learn and write about in the forthcoming few weeks:

• Conjoint Analysis
• Options Primer (repeat .. Primer)
• How to read a 10K document
• Strategic M&A behavior
• Experience Curve
• Interest Rate and its implications

I may continue to add and cross items from this list as the posts are made. Also note that there may be other random posts other than the ones listed above. If there is any item you wish to see here, please leave a comment.