Embracing Chaos

As the year wraps up, I'd like to share some of the major events that have happened in my life recently.  Many of my readers will be well aware of these events, but I recognize that personal news travels through a variety of channels, and all of those channels are unreliable.  (I'll save the diatribe on why Facebook is a horrible way to keep up with friends for another day.)  For readers who are looking for insightful analysis of technology, my apologies.  Note the "ego" tag.  This is a personal update but does contain a little insight into real-estate finance.

December is often a time of reflection, with good reason.  It's a natural opportunity to consider how things are progressing on a longer time-scale than we often do.  For me, 2009 was a year of making long-term commitments.  I made two huge ones, and I'm extremely happy with both of them.  The process of making these commitments kept me quite busy for almost the entire year.

Most significantly, I married the most amazing woman I know.  Maegan Ashworth and I permanently committed ourselves to each other on September 19th.  Our promises to each other were conversational, humorous, long-winded, personal and deadly serious.  We made them in the most public way we could manage, and were still sad to miss the company of many important people in our lives.  I could fill a book with everything I love about Maegan, but that's even more self-indulgent than I'm willing to be right now.  Suffice to say I am confident this will turn out to be one of the most important positive changes in my life ever.

The real planning for our wedding was compressed into just a couple months because it was difficult to focus on the ceremony while the other major event of the year was uncertain.  But in July we moved into a new house, ending 8 months of ambiguity about where we'd call home.  The process started in November 2008 when we first became interested in the house.  (Just before Maegan and I left for our bicycle tour across Vietnam, where we got engaged.)  It took months to reach agreement with the sellers and then months more to finish the process.  

I went in with a group of friends to buy the house together.  For years we had dreamed of living together in something like an "urban kibbutz".  I've liked that phrase ever since I read it applied to Barack & Michelle's early domestic life.  But for a more complete description of our situation, see our co-habitation blog.  (currently unpublished.  sorry.)

Getting a mortgage was particularly complicated.  The global financial crisis obviously did not help, but our situation was especially difficult.  Living comfortably with lots of good friends requires a big house, which means an expensive house.  In real-estate, expensive is also referred to as "jumbo" meaning that it's too much for any kind of government guarantee.  So banks would either need to make a long-term commitment to us themselves (a so-called "portfolio loan") or re-sell the mortgage to another bank on the secondary market.  We learned that the secondary market was "frozen" to use the popular vernacular, probably at about the same time as one particular bank which had all but committed to giving us a loan.  Another complication was that we needed 3 unrelated applicants to demonstrate our collective ability to pay back the debt, which was unusual enough to make many mid-crisis banks feel extra skittish.  I spent a large part of 2009 working on different aspects of how to finance this house.

Happily the stars aligned one evening when I was walking over to the house of my then-future, now-current roommates.  It was quite common for me at the time to walk those several blocks to sign yet another thick stack of papers to give to some agent or broker or other helpful professional.  Along the way I noticed a four-leafed clover in the grass, and picked it up.  In grade school I spent a surprisingly large amount of my recesses scanning the lawn for these botanical mutants, and once had quite an eye for finding them.  So it wasn't an unusual or significant event for me, but it had been years since I'd found one.  We taped the clover onto the application-du-jour which was going to a small local bank, in an act that signified frustration, exhaustion and powerlessness more than hope.  This bank ended up financing our house.

So that took up most of my year.  Trying to buy a house for about the first half, with moving and settling.  Then a wedding followed by a fabulous honeymoon.

I’d like to share a couple thoughts on Detroit — a couple ideas that
I’m not hearing in the popular or business press, but are important to
understand.

Chrysler goes bankrupt

First some background.  Chrysler is being restructured under
bankruptcy.  This doesn’t mean they’re going out of business.  It means
that they owe more money than they have or will be able to pay.  So
with the help of a judge, they’re sitting down with everybody they owe
money to and telling them frankly “you’re not getting everything we owe
you.  Sorry, but there just isn’t enough to go around.”  So everybody
has to compromise.  The idea is that by striking some bargains to
reduce debt the company can get back in the game and become profitable
again.

UAW owns Chrysler

One of the biggest debts Chrysler has is to the UAW, the United Auto
Workers.  This is the labor union which represents all the
“blue-collar” workers who actually make the cars.  Chrysler owes them
benefits like pensions and health benefits.  Part of the settlement is
that the UAW will own 55% of Chrysler stock.  That’s a majority.  So
the workers will own the company.  Personally I think this is great and
makes a ton of sense, and I’ll tell you why.  But not everybody does.

If you’re lucky enough to be blissfully unaware of labor relations in
Michigan, this is downright bizarre.  Chrylser corporation is
“management.”  UAW is “labor.”  These two groups traditionally have not
gotten along.  I don’t think the word “hate” is out of place.  People
say the UAW will try to unwind this position as fast as they can.  I
heard one “expert” say that the UAW is placed in a position of conflict
of interest representing both Chrysler stockholders and UAW workers.
Why?  Because their responsibility to stockholders is to increase the
value of the company, but their responsibility to the union is to save
jobs, and these two goals are diametrically opposed.

Cooperation is the only way

Hold on.  The goals of the workers and the goals of the company are
diametrically opposed? This kind of adversarial thinking underlies how
Detroit got into trouble in the first place.  In truth the UAW’s goals
and Chrysler “management” goals are very strongly aligned.  This
painful truth of this fact is excrutiating today.  Chrysler and GM are
on the verge of ceasing to exist.  If and when this happens, the UAW
workers will lose their jobs.  What’s bad for management is bad for
labor.  But figuring out how to keep Chrysler building cars that can
compete with Japan and everybody else is a really hard problem.  Solve
it and both labor and management win.  If ever there was a time for
labor and management to come together and cooperate it’s now.  To be
extremely blunt for those still harboring grudges: if you two don’t
figure out how to play nicely together, you’re both doomed.

Historical tensions caused these problems and SUV’s too

Conventional wisdom cites two reasons for why Detroit is in this mess:

• They only built big gas-guzzling cars as consumer preferences shifted towards smaller, more fuel-efficient vehicles
• Union labor costs for things like pensions and health care are so
  high compared to foreign competition that the company just can’t compete

I believe both these are true.  But more interestingly (and something
I’ve never heard reported in the press) I believe there’s a causal link
here.  It is precisely because of these high labor costs that Detroit has focused on building gas-guzzlers. Smaller cars are cheaper and are subject to more intense price competition, meaning the margins are lower.  In business school
we learn about two basic types of product strategies: low cost and
high-end.  In the low-cost strategy you try to be more efficient than
your competitors.  You do things cheaper and still maintain a good
enough product.  This is what Japan did with cars.  But because UAW
kept labor costs high, Detroit couldn’t go this direction.  Their small
lower-end cars would just cost more because of the higher input costs.
So they had to go after a high-end strategy where they made bigger,
more expensive vehicles that came with higher profit margins.

Sophie’s Policy Choice

So UAW workers collectively bargained their way out of jobs.  That is,
they bargained up their salaries beyond what their labor is actually
worth in the modern economy.  So what should we do?  Let the market
correct itself so many of them lose their livelihoods?  Or sustain them
publicly somehow?

There is no easy answer to this question from a policy perspective.
China is facing this same question with hundreds of millions of
uneducated peasant farmers.  A relatively modest investment (on the
national scale) in farm machinery could replace a good fraction of
their output.  But the economically efficient choice comes with a high
human cost.  In this country we believe governments exist to serve the
people.  We’ll see how it does.

I’m sure you know the US economy is in recession, which means the total amount of economic activity is declining.  Last week you might have heard the official numbers on how fast it’s declining.  The big story was that the economy is down 6.2%, and everybody agrees that’s a lot.  Most everybody agrees on what it was that shrank — the GDP, or Gross Domestic Product, which is a strictly defined measure that attempts to sum up all economic activity within the country’s borders.  But subtle differences in wording make it really unclear on actually how fast the economy was shrinking.  For example, consider these statements:

Evolution-like processes exist in many places beyond genetic adaptation of biological species.  We see similar processes in a great many aspects of modern life, generally running many orders of magnitude faster.  Much of economics and business is governed by processes that select for the most successful product or business model or manufacturing process or organizational structure.  Successful practices thrive and out-compete ones which are less effective at meeting human needs and desires.  Warfare has very obvious parallels.  In computer science, user interfaces, programming languages and system architectures all evolve by analogous processes.  Similar effects can be found in governments, religions, cell phone design or city planning, just to name a few more.  The basic idea that human choices lead to faster propagation and increased presence of BETTER STUFF can be seen almost everywhere.  Except in our refrigerators.

Open your fridge.  If you’ve lived with that fridge for a while, there’s a good chance it looks something like mine does.  Shelf upon shelf of half-used bottles and jars of long-lasting meta-foods.  Condiments, salad dressings, jellies, beverages, chutneys, nut butters, salsas, pickled vegetables, etc.  We expect our fridges to be full of food, so this doesn’t in itself challenge the evolutionary principal of selection.  But taking an inventory shows that there is a strong bias towards foods we don’t actually like.  In fact, the typical selection process for foods in our refrigerators tends to concentrate foods we don’t like, thus running backwards to what should intuitively evolve towards a selection of our favorite foodstuffs.  But for a couple very understandable reasons, that just doesn’t happen.

Consider salad dressings.  Most of us like to have some choices when we’re topping our raw vegetables.  So when we’re at the store, we don’t just buy the one salad dressing we like, but will often try a new variety.  There’s a documented psychological principal called Variety Seeking that encourages diversity in buying because people want to explore different choices.  But what happens when we buy a variety we don’t particularly enjoy?  Like that orange blossom vinaigrette or the honey mustard that’s just a bit too thick and sweet.  We try it once, form an opinion, and the next time we have salad we go for the old-reliable Goddess dressing.  So it lingers.  But we don’t throw it away.  Because there’s nothing WRONG with it.  Besides, one day when we have guests over they might prefer a syrupy honey-mustard dressing.  Or maybe we could dip chicken knuckles into it or something.  Plus the combination of preservatives, low-temperature and food that doesn’t promote bacterial growth in the first place means it can stay edible for years.  So their continued presence provides some small marginal benefit of choice.  The only real alternative is throwing them away  (which makes us feel guilty) since there’s no secondary market for used condiments.

Beyond choice, they do provide marginal benefit in terms of ballast for heat capacity.  Refrigerators run more efficiently when they’re full since there’s a larger thermal mass which is more stable.  But this assumes the fridge has ample space for the food that is being cycled through and consumed.  In many households the need to find space for food you’re actually going to eat creates a selection pressure to remove such undesirable foods.  But the door of the fridge is a niche environment that isn’t very well suited to large, short-lived main courses and thus things like eleven different varieties of mustard tend to thrive.

What’s the take-home lesson here?  How do we fight this scourge on our pallets?  Actually I don’t think it’s that big of a problem.  When we need space in the fridge, we find it.  But otherwise we collect things like Mang Thomas All Purpose Sauce, and pickled cherry peppers.   If clutter bothers you, resist the temptation to try something new and stick with something you know you’ll use.  Heck, get a really big bottle.  Or look for similar reverse-evolutionary processes in your medicine cabinet, liquor shelf, or office supplies, and be conscious that you have the power to change things.  Or just accept that sometimes human nature tends to concentrate our surroundings with things we don’t actually like.

Although most corporate mergers fail (often due to mis-aligned incentives on the part of the deal-makers) there is a solid economic foundation for the proposed Microsoft + Yahoo! merger.  Most of their assets will work no better combined than separate.  But the merged Microhoo ad network would be significantly more valuable than the sum of two ad networks alone. 

Why bigger is better for online advertisers

The reason lies in network effects of the online search + advertising industry.  Imagine you’re an ad buyer which is to say you have a service you want consumers to find online.  Unless you’re a huge company, you have limited energy to expend buying your ads.  So rather than buying and managing separate ads from each Microsoft, Google and Yahoo, you’re likely to just deal with a single ad publisher.  The sensible ad buyer will choose the ad publisher which gives them the most value for limited effort. 

Right now the clear choice for an online advertiser is Google.  Because they have the most search traffic, they are best able to reach customers.  Combined with their adsense network, Google clearly has the largest inventory for an ad buy making them the natural choice for anybody not willing to spend a lot of energy managing their online advertising.  This logic underlies the recent acquisitions of Doubleclick, AvenueA/Razorfish/whomever, and now Yahoo!  Network effects in advertising mean that the largest network will be the most sucessful.  So the mergers will continue as far as the anti-trust regulators allow them to until a handful of bitter enemies remain.

This much might be obvious to some of my readers.  But I felt like sharing this analysis since I’ve read nothing in the common press that explains the basic economic motivation of this deal.

Wrinkles, twists

An irony of the network effect comes from the auction nature of keyword buys.  Advertisers bid for the right to get their message in front of customers.  When more advertisers are competing for the targeted eyeballs of consumers, the prices for advertising go up.  This means that prices will tend to be higher on the larger ad networks.  So bargain seekers can get more advertising for their dollar by seeking out smaller networks.  This appears to contradict the logic that bigger is better for ad networks.  But many advertisers are limited not so much by budget but by the ability to reach highly qualified customers.  If you are selling poodle tattooing services in the pacific northwest, odds are you will not hit max out your advertising budget on any of the ad networks simply because not that many people are searching for your services.

I could probably fill pages with speculation about the culture clash between Microsoft and Yahoo and other reasons why it will or won’t work.  But if you’re interested in that stuff, I’m sure you’ll have no problem finding it in the backwaters of the blogosphere.  I can’t help but drop a couple relevant ideas though.  First, from what I hear, the executive management at Microsoft is so dysfunctional right now, Yahoo will provide fertile new ground for their turf wars.  If the top bosses are adept, they will use the many iterations of re-orgs to sluff off ineffective execs to projects where their overall damage can be minimized.  Second, I think I hope Microsoft has evolved enough humility to understand that they’re better off simply shutting down Yahoo’s services than forcing everything to port over to NT servers.  Right, guys?

Disclaimer

I feel compelled to point out that the opinions expressed here are mine and mine alone.  In no way does this article reflect any official position of my employer.  This is my personal analysis of the economics behind the industry I work in.

Please excuse a bit of rambling, but I’ve got a seedling of an idea I’d like to publicly explore.  The classic definition of economics concerns the allocation of finite resources to unlimited desires.  Resources here are physical goods and services that people buy or trade.  There’s only so much stuff in the world that people might want.  If you add up what everybody wants, it’s more than the amount of stuff available to go around — classically it’s infinite.  Economic systems manage this discrepancy.

I increasingly find myself facing a related problem: trying to allocate my finite time to seemingly unlimited desires to do stuff.  As I grow and learn there seems to be no limit to what I want to do.  Similarly, as I grow and learn and the world evolves around me, I seem to be genuinely able to accomplish more things in given amounts of time.  I think this feeds into my desires. 

How can I balance my time between all the professional goals, intellectual challenges, social activities, physical adventures, artistic pursuits, etc. that interest me?  The realization of this parallel between personal economics and classical economics gives me a hint that there are systems out there.  I’m going to think about market-based systems for allocating my time towards achieving my goals.  I wonder if I can do this without explicitly stating and prioritizing them.

Another tool that might be useful include meditation.  These unlimited desires often give me a short-attention span, maybe even A.D.D.  My good buddy Mez suggested some basic meditation as a way to help focus the brain.  I’ve been trying it for the last few days and I can already see some benefits.

I’m going to try applying some economic theory to a classic career decision.  Imagine that you must choose between two possible jobs, let’s call them "Big Company" and "Startup."  Big Company will pay you $100k per year.  Startup can only pay you $50k per year, but with a 10% chance of paying you a $3 million bonus in 3 years.  Which one do you take?  I’ll present an analytical economic framework for making this decision which shows why this decision is ultimately very personal.  For the purposes of this discussion, I’m going to ignore the time value of money — let’s pretend the appropriate discount rate is 0%.  Let’s also make up some excuse why only the next 3 years matters like you’re determined to stop working at that point.

Expectation Value of Money

A basic analysis looks at what your expected income will be over the next 3 years.  Big company will clearly pay $300k.  Startup will pay $150k in salary.  A 10% chance of $3m is worth $300k in terms of its "expected value" following standard statistical methods.  So by this logic, startup is a better bet at $450k over the 3 years.  This analysis is correct and totally appropriate for how a large institution would analyze the trade-off.  But it has a problem when applied to individuals: it ignores the differences between utility and money.

Utility != Money

Different quantities of money have different relative values to people.  Economists express this in terms of "utility."  Most people will find $20 about twice as useful as $10.  Because you can do twice as much with $20 vs $10, we say that $20 has twice the "utility" of $10.  My favorite econ professor refers to utility as "jollies."  Utility is in arbitrary units, but here let’s say $1 is worth about 1 jolly, more or less.  So far this should be totally intuitive.

Things get a little stranger when we’re talking about large quantities of money.  For example, most people would not find $2 billion twice as useful as $1 billion.  For me, getting a gift of one billion dollars or two billion dollars would have almost exactly the same effect on my life — either way I’d be rich beyond my dreams.  The marginal utility of that second billion dollars is worth far less than 1 billion jollies — maybe only another million jollies over the first billion?  So for me, the graph of utility vs. money becomes nearly flat at these extremely high dollar values.

The shape of this curve at "intermediate" dollar values varies a lot from person to person, as does what intermediate would mean.  For example, consider two people — one who is working a minimum wage
job and the other who just made their first million dollars.  A $1,000
bonus would be extremely useful to the minimum wage worker, and almost
ignored by the millionaire.  But to the millionaire, the difference
between $400k and $800k is much more meaningful than it is to the
minimum wage worker.  For them, that much money sounds more like a billion dollars would to me.  Most everybody has a range of money that is too small to matter to them
and a range of money which is so large that differences don’t really
matter either.  Here are some factors that can affect the shape of a person’s utility curve:

• How much disposable income they are used to having
• How much money they have saved
• What expectations they have about future earnings
  • Career growth path
  • Are they expecting inheritance?
  • Pension plan or 401k?
• How much money would be needed to reach financial goals that can markedly affect their quality of life, like
  • Buying a car or house
  • Getting out of debt
  • Putting children through college

As promised, figuring out the shape of this curve is extremely personal.  I’ll describe a technique for doing so numerically at the end, and then I’ll duck.  Here is a spreadsheet {link fixed} that unscientifically attempts to graph what a utility curve might look like for somebody who is financially comfortable, but not exactly wealthy — like somebody who might be considering such a career decision.  And here’s the graph:

Applying Utility to the job choice

You might think that the next step in the analysis is to figure out how many jollies you’d get for the $300k from Big Company and compare that to the $450k from Startup.  Using the above data, this works out to about 649 kilojollies for Big Company and 907 killojollies for Startup, and Startup clearly wins.  These values are the utilities of the expectation values of money, which sounds impressive, but really isn’t very useful.  For uncertain outcomes, you should figure out the utility value of each financial possibility before calculating the expectation value.

Using the above utility curve, the correct analysis involves figuring out how many jollies you would get for each of these three possible outcomes:

• Work at Big Company ($300k = 649 kilojollies)
• Work at Startup with no bonus ($150k = 351 kilojollies)
• Work at Startup with big bonus ($3,150k = 3.25 megajollies)

The appropriate comparison is between 649 kilojollies for Big Company and (0.90 * 351kj) + (0.10 * 3246kj) = 641 kilojollies for Startup, which is comparing the expectation values of utility.  Expectation values are calculated by adding up the products of the probability of each event with the utility of that event.  See how this is different from the utility of the expectation value of money?  You apply the utility transformation before applying the probability weights.  Because the utility transform is non-linear, the operations are not associative, and order matters.  So, the important question is how valuable would that $3 million dollar bonus be to you, and is a shot at it worth the loss of guaranteed salary?

By this analysis, it’s not worth it for our hypothetical job seeker to take the chance.  The 649kj from Big Company is slightly higher than the 641kj from Startup, although it’s really close.  The closeness shouldn’t invalidate the result though.  You might want to check the assumptions used to derive this, but ultimately we have to make choices based on limited information.  We can understand this result intuitively because the sweet-spot on the money-utility graph is in the hundreds of thousands of dollars, not the millions.  This is the order of magnitude of money that would change this person’s life in the most meaningful way.

Tautological Conclusion

This kind of "what if" exercise is an accepted technique for calculating the shape of a person’s utility curve.  Would you rather have $10 or a 10% chance at $100?  Would you rather have $100 or a 10% chance at $1k?  Maybe I’ll put together a spreadsheet that actually uses this technique to find an accurate utility curve.  But you can see that this entire analysis boils down to a realization that you must decide for yourself if the reward is worth the risk.

Haha!  ;^) 

/me ducks

(Hopefully this discussion gives a framework for thinking about such decisions.)