For those of you who prefer to read the document rather than a blog, here is the China, Hong Kong and Taiwan stock compensation white paper in PDF form:
Friday, May 29, 2009
Thursday, May 28, 2009
Ted Chan, Ryan Carag & Sandy Lin
MIT Sloan School of Management
Equity compensation is commonly used in the US to reduce the principal-agency problem and increase employee retention. However, much less is known about the use of equity compensation outside of US but general sentiment is that it’s on the rise. This paper explores the use of equity-based compensation to incentivize executives and employees in companies in China, Hong Kong, and Taiwan.
In the past, limited guidance existed in regards to equity compensation in China. However, many Chinese companies went public on the Hong Kong stock exchange as so called “red chip” companies and such firms have an interesting and varied track record with regards to the success of the use of equity compensation. Relative to mainland China and Hong Kong, Taiwan has had a longer history of stock-based compensation. Taiwan’s tech-boom of the 1990s was driven largely by stock-based-compensation largely in the form of stock-bonuses. The data show a steadily growing number of Taiwanese firms offering some sort of stock-bonus program to either its executives or entire core staff. Studies have also shown that these stock bonuses have been very effective in attenuating many of the principle-agent issues inherent in fixed-wage compensation schemes, both at the executive level and at the staff level of organizations, and in helping Taiwanese firms compete against multinational corporations for top-talent.
Equity Compensation in China in Hong Kong
This section looks at stock option compensation in China and Hong Kong. Because the mainland Chinese equity markets have only recently begun to mature, equity compensation in the mainland is intimately tied to the Hong Kong exchange.
Private Unlisted Companies
Stock options are still difficult to execute in China for firms that are not listed on the Hong Kong exchange. In particular, for private companies not yet listed on the exchange, Chinese employees can only exercise stock options if the underlying stock becomes listed or if the employer is acquired by a listed company. In contrast, in the US, employees can exercise their stock option by becoming shareholders in the company while the company is private. This means that using stock options as a means for employee retention for startups in companies in China is limited by the company’s ability to be acquired or go IPO. Many employees may find stock options not as great as a form of compensation given the risk of prolonged vesting period.
Publicly Listed Companies
Historically, stock options in mainland China were considered nominal incentives because, in the eyes of many, all senior executives at state owned enterprises were selected by the Communist Party under the assumption their stock options would never be fully exercised.Today, the idea of nominal stock options is dead. Among overseas listed SOEs, barriers to exercising stock options have been overcome, and some senior executives have received substantial rewards and have been cashing in substantially on them. (Xiu and Ming, 6/27/08)
In contrast, multinational companies listed in foreign exchanges or larger companies already on the Hong Kong exchange have an advantage in using stock options as a compensation tool over private companies. The Hong Kong exchange is by far the best option for companies on the mainland that wish to use this type of structure. In foreign cases other than Hong Kong, a structure known as Share Appreciation Rights (SARs) are used. A SAR uses a system that tracks stock gains on paper, and pay the employee accordingly. Some times this equity is actually traded by an overseas broker with the employee receiving the proceeds.
Gross and Minot (2008) summarize stock option use in China by multi-national corporations:
“MNCs in China often offer stock options (in one form or another) to managers and key employees. However, not all Chinese employees will necessarily be familiar with them. Even if they are familiar with stock options, they still may not necessarily be interested, since the compensation is delayed. Employees may prefer shorter vesting periods. Still, stock options are continuing to gain ground overall. Depending on the employee, stock options can be a useful method – among others – to encourage employee performance and improve retention.“
In private companies, compensation still tends to be up front for most employees except founders and senior management. Equity compensation is not well understood and because it is not received upfront, it is less popular.
Chen, Guan and Ke (2008) provide a comprehensive analysis of how equity compensation is used in red-chip firms. The Hong Kong Exchange defines a red chip company as one that has at least 30% of its shares held by a mainland Chinese company, with mainland companies in aggregate being the single large shareholders. A company can also be considered red chip if between 20 and 30% of its shares are head by mainland Chinese, and theyhold substantial influence on the board of directors. These can include state-owned enterprises, town and village enterprises in addition to privately owned firms. These companies essentially represent a subset of mainland Chinese firms that have gone public in the more liquid and efficient Hong Kong market. (HKEx Website)
Core et al. (2003) point out a major issue with equity compensation in less efficient markets. If the markets do not reflect managerial actions in equity prices, then the effectiveness of equity compensation must be question. It would in those cases cause deeper agency problems rather than properly aligning incentives. Furthermore, companies running in mainland have poor investor protection with regards to controls and disclosures. This has improved over the past 10 years, but remains an issue. Additionally, many of these enterprises have some element of state control, which also affects the way incentives are structured and managerial decisions are made.
Red chip firms are required to annually disclose their stock option compensation data, making it ideal for Chen, Guan and Ke to study it. During their sample period from 1990 to 2005, there were no Chinese regulations on stock options. Before this period, firms list in China were prohibited from issuing options. Thus, companies who wished to do so had to become red chip firms. At the end of 2005, China implemented a regulation permitting stock option compensation. Citic Securities, a major brokerage, is one mainland Chinese company that has implemented options according to Gross and Minot (2008).
Chen, Guan and Ke point out the regulations on stock options in Hong Kong are relatively similar to the US except for two points. First, no single participant can receive more than 25% of all the securities in a company’s stock option plan. Our interpretation is that this limits companies from concentrating too much interest in the share price in the hands of senior management. Secondly, the exercise price cannot be more than 20% below the average closing price of the stock for the 5 business days immediately preceding the option grant. This limits how far the option granted can be in the money.
Additionally, Hong Kong has relatively simple accounting rules for stock options. The initial grant of options is not a taxable event for the company or recipient, even if the grants are in the money. Hong Kong has low overall taxes (15 to 17%) on income, making it an attractive place to be granted in the money or high upside options.
Gross and Minot also mention that the Chinese government initiated a new plan which allows foreign exchange purchases for the purpose of stock options in foreign companies with prior approval from the government. Procter & Gamble China was the first to participate in this program in February of 2008. (Gross and Minot, 2008).
Effectiveness of Equity Compensation in China and Hong Kong
Chiu, Luk and Tang (2002) found the biggest factors to retaining employees in Hong Kong were:
1. base salary
2. merit pay
3. year-end bonus,
4. annual leave
5. mortgage loan
6. profit sharing
In mainland China, Chiu, Luk and Tang found slightly different:
1. base salary
2. merit pay
3. year-end bonus
4. housing provision
5. cash allowance
6. overtime allowance
7. individual bonus
In both cases, merit pay means variable pay including options.
Xi (2006), cited by Conyon and He (2008) argued that independent directors exist not so much to provide oversight of senior management, but rather to open up connections within the government. In some way, this is not that different from companies anywhere in the world.
Conyon and He (2008) found that at least for CEO, options are working in some respect to align incentives for managers. They found that CEO equity incentives were positively correlated with firm size and firm risk profile. Their paper implies that China’s corporate governance regulations have done well to align managerial interests with the interest of shareholders. This study counters to a certain extent that Chinese corporations are subject to ineffective controls and regulations.
Cultural Issues in the Effectiveness of Stock-based Compensation
For the Chinese, the year-end bonus has traditionally been the way of rewarding employees. This is especially the case for lower level employees in blue collar and retail positions. Paid out around the Lunar New Year, these bonuses are often as much as 40% of pay. However, at a higher level, especially amongst “males, white-collar-employees, high performers, achievement oriented employees and those who already work under a merit plan tend to favor merit pay or the “equity approach”. (Chiu, Luk and Tang, 2002)
Different from U.S. executives, Red Chip firms’ executives rarely exercise vested stock options during their tenures in the firm. (Chen, Guan, and Ke, 2008) The Economist's article, “False Options” suggests that this can be due to cultural norms in China where cashing out on stock options may indicate disloyalty to the firm since once the options cashed out the alignment of ownership and management no longer exists. This calls into question how effective those options actually would be in motivating employees.
Furthermore, employees often do not understand the value of stock options. This however, can be corrected with time as more companies implement equity-based compensation programs and employees become educated in their value as a whole. But, similar to the US, stock options and their lengthy vesting periods are difficult for younger employees to understand. "Stock options don't really work with young people," explained one HR manager. "Saying we'll give it to you in five years doesn't fly. They want options and cash." (Melvin, 2001)
Equity Based Compensation in Taiwan
In contrast to Chinese mainland firms’ compensation, stock-based compensation has been more integral in Taiwan's industry growth, particularly in the tech-space and has been an integral part of the overall compensation for a growing number of firms in Taiwan.
Taiwanese tech-firms such as TSMC used stock-based-compensation as a tool to compete in the labor-force market. During the tech boom of the 1990s, for example, local Taiwanese companies were able to attract and retain top-notch employees through stock-based-compensation, even so far as being able to draw top talent from competing MNCs (Han, Shen 2004).
Figure 1. Number of cash bonus and stock bonus plans in Taiwan during 1990's tech-boom (unit: establishments)
Source: Monthly Bulletin of Labor Statistics, Taiwan
Clearer guidance on treatment around taxation on stock-incentives through the last two decades has made for a fairly well developed body-of-knowledge among hiring companies and their employees.
Stock-based compensation in Taiwanese firms has come largely in the form of stock-bonuses, which while mechanically similar to US employee stock option plans, have a few key distinguishing characteristics. (Han, Shen 2004).
- US Employee Stock Option Plans are typically structured through vesting schedules to be long-term incentives whereas Taiwan's stock-bonuses are in contrast relatively short term, given that the stock-bonuses given by Taiwanese high-tech firms are typically allowed to be sold immediately.
- US ESOPs are structured to encourage future performance, whereas Taiwanese stock bonuses are awarded based on past performance.
- US ESOPs recipients typically have to purchase the stock whereas employees in Taiwan have to make no such payment on their stock bonuses. This should be noted that the mechanics of a typical US ESOP execution allows a simultaneous buy-then-sell transaction where the employee executing the option does not have to make a cash outlay, but there are still differences in tax implications.
- While stock ownership is typically small portion of a US employee's compensation (at least in the immediate term) in Taiwan, stock-bonuses typically represent a very substantial portion of an employee's total annual compensation in firms where stock-bonuses are offered. This is explained primarily by the fact that Taiwanese firms typically pay less that their MNC counterparts, and as such use stock-based compensation to make their overall compensation competitive to those of MNCs. Such a sharing scheme as a higher percentage of employee compensation works particularly well in firms with high profitability and stock prices or in smaller firms who are bootstrapping their growth through profits.
Effectiveness of Stock-Based Compensation in Taiwan
There are arguments for and against stock-based compensation (and firm-performance-based bonus compensation in general) which tend to follow the similar lines in economics discussions.
Arguments for include:
- Since bonus amounts are tied to overall firm performance, bonuses induce employees to exert more effort to improve operational efficiency.
- Since bonus amounts are tied to firm profitability, bonuses can attenuate agency problems found in fixed-waged employment and can reduce the impact of conflicts of interest between principal and the agent. (Han and Shen 2004, Blasi et al., 1996; Kruse, 1993).
- Since the payment of the bonus is a variable portion of the total compensation, the bonus may produce an "efficiency-wage" effect which reduces shirking, turnover and attract better applicants (Han and Shen 2004, Akerlof and Yellen, 1986; Yellen, 1984).
- Bonuses can create group pressure, motivating employees to monitor and push each other to higher performance and to cooperate towards overall better firm performance (Han and Shen 2004, FitzRoy and Kraft, 1986; Kruse, 1993; Levine and Tyson, 1990).
Arguments against bonuses are primarily around the free-rider problems inherent with group-based incentives, given bonuses are tied to overall firm performance. An additional argument against bonuses has to do with the theory of team production (Han and Shen 2004, Alchian and Demsetz, 1972), which says that optimal employee monitoring and management happens when the management has residual equity in the firm. In the case where the employees share the equity (thereby diluting management's equity relative to the case where employees did not receive stock-bonuses), management will have less incentive to monitor and supervise the employees, thereby causing reduced firm performance.
Empirically, Taiwan's high-tech firms have experienced an extremely rapid growth over the past two decades, with many practitioners and academics believing that stock-bonuses have lead to good outcomes with regard to attracting, retaining and incenting firms' human capital. (Han and Shen 2004, Biagioli and Curatolo, 1999; Chen and Wang, 2001; Chiu and Tsai, in press; Tsao, 1999).
Chui and Tsai also found that stock-bonuses have over many years increased the average employee's psychological ownership and organizational citizenship. They also found that given the heavier distribution of stock bonuses to more senior and high-performing employees has shown potential to address the free-rider issues brought up by detractors of stock-based compensation. They found that the growing use of these Taiwanese-style cash and stock bonuses has had continuously positive effects on motivation, attraction, retention and performance of the studied Taiwanese tech-firms.
The growth and potential effectiveness of the Taiwanese-style stock-bonuses to attracting top talent might be shown by the example of Lien-Fa Technology Co., a Taiwanese IC design firm, who gave out stocks worth approximately US $514,285 on average to each of its 248 employees in 2001 and a considerably higher US $739,706 one year later (Han and Shen 2004). More generally, the effectiveness of such compensation structures is that many MNCs such as IBM, which was once viewed as a place for “the special group of preferred employees”, have been seeing “fierce warfare” from local, Taiwanese high-tech firms in hiring top talent. Many MNCs have even lost some high-level, key employees to local high-tech firms, in a striking similarly to the experience of large US high-tech firms to startups.
Effectiveness of Stock-based Compensation: at the Executive Level in Taiwan
In their paper, The Determinants of the Relationship between Top Executive Stock-Based Compensation and Performance Measures: A Study of Taiwan, Hung and Wang examined what effect stock-based compensation had on firm performance. They found that in general, stock-based compensation was effective at the executive level and identified the following four determinants on level of effectiveness:
- The President’s stock-based compensation will be relatively more sensitive to market performance, as compared to accounting performance, the larger the growth opportunities of the corporation.
- The President’s stock-based compensation will be less sensitive to market performance and accounting performance, the larger the size of the corporation.
- The President’s stock-based compensation will be relatively less sensitive to market performance, as compared to accounting performance, the greater the risk of the corporation.
- The President’s stock-based compensation will be relatively less sensitive to market performance, as compared to accounting performance, the larger
- the leverage ratio of the corporation.
The findings are intuitive in many ways, aligning with how much actual direct control executive actions have on the outcome of the company’s performance versus the company’s inherent growth potential through its core-technology, for example. Put in other terms, a fast car can still go relatively fast even it’s not skillfully driven, but will achieve its peak performance, near its limits of control, in the hands of an expert driver.
Effectiveness of Stock-based Compensation at the R&D/Staff Level in Taiwan
In Compensation Structure, Perceived Equity and Individual Performance of R&D
Professional: The Moderating Effects of Achievement Orientation, Uen and Chien examined the effectiveness of stock-based compensation at the R&D staff-level of high-tech firms, examining 258 high-tech firms in China. They found the following correlations:
- Compensation structure has a positive correlation to an employee’s perceived equity
- Employee perceived equity is positively correlated to individual performance
- Individual performance is affected by compensation structure through perceived equity
- The interaction of compensation structure and achievement orientation does influences perceived equity.
In short, they found that employees feeling of the fairness of their compensation to their level of input (effort, seniority, gender, amount of responsibility, working conditions, knowledge, skills, and abilities required by the job) in these high-tech firms was positively affected by their compensation structure's inclusion of stock-based compensation. This backs up Chui and Tsai’s findings regarding the positive correlation between stock-based compensation and psychological ownership.
Conclusion & Recommendation
We conclude from our study of China/Hong Kong and Taiwan that varying levels of maturity affects the effectiveness of stock-based compensation in incentivizing and retaining key employees for both larger companies (MNC’s and red-chip firms) and startups. For more mature markets such as Taiwan, stock-based compensation is an effective tool to attract, incentivize, and retain employees and is used as a tool against losing talent against MNCs. However, in China, the use of stock-based compensation is only implemented since the beginning of 2006 and is currently only limited to red-chip companies and MNCs that are publicly listed, commonly on the Hong Kong Stock Exchange. The use of stock-based compensation for startups in China are not as common because employees can only exercise their option if the underlying stock is publicly listed. However, we foresee that China will update its regulations on stock-based compensation for startup companies in the future to become more similar to the US, and in turn allow startups to attract and retain employees through the stock-based compensation.
“China’s Execs Sweating Over Stock Option”, by WenXiu and Ming Shuliang, Caijing Magazine; June 27, 2008
“Retaining and motivating employees: Compensation preferences in Hong Kong and China”, by Randy K. Chiu, Vivienne Wai-Mei Luk, Thomas Li-Ping Tang, Personnel Review, Vol. 31, Issue 4, Pages 402-431, 2002.
“Stock Option Compensation with Chinese Characteristics: The Case of Hong Kong Listed Red Chip Firms”, by Zhihong Chen, Yuyan Guan and Bin Ke; August 30, 2008. SSRN Working Paper.
Conyon, Martin J. and He, Lerong,Executive Compensation and CEO Equity Incentives in China's Listed Firms; August 31, 2008. SSRN Working Paper.
Hong Kong Stock Exchange, Investor FAQ, Online at http://www.hkex.com.hk/invedu/faq/list_gen.htm
“Retaining Chinese Employees”, by Sheila Melvin; November-December 2001 issue of The China Business Review
Tzu-Shian Han, Chung-HuaShen. 2007. The effects of bonus systems on firm performance in Taiwan’s high-tech sector, Journal of Comparative Economics 35 (2007) 235–249.
By Ames Gross and Shawna Lepage. July 2001. Stock Options in Asia, Pacific Bridge Incorporated Publication online at: http://www.pacificbridge.com/publication.asp?id=63
Jin FengUen and ShuHwaChien. Compensation Structure, Perceived Equity and Individual Performance of R&D Professional: The Moderating Effects of Achievement Orientation. SRS Working Paper.
Yu-Shun Hunga, Taychang Wan. The Determinants of the Relationship between Top Executive Stock-Based Compensation and Performance Measures: A Study of Taiwan. SRS Working Paper.
May 27 2005. PriceWaterHouseCoopers Bulletin. IAS Global Watch.
Tuesday, May 26, 2009
I recently sold out of my US bond portfolios, because I believe inflation is coming and that is going to hurt bond prices in the near future. These were a nice safe harbor during the downturn relative to my other investments, and I wish I had more in them. Barack Obama did what he had to do in using a vigorous Keynesian policy to get the economy re-booted. But he basically printed money. I can't see foreign treasuries continuing to have the same level of demand for the dollar.
Tuesday, May 19, 2009
Obviously, this is a recorded demo, but it still looks pretty darn impressive to me. Thanks to my friend Steve M. for sharing the link.
Monday, May 18, 2009
Tuesday, May 12, 2009
10 pricing mistakes from our MIT Sloan's brilliant Catherine Tucker.
Friday, May 8, 2009
I've been trying to learn some about the iPhone application approval process. Although I don't suspect my education focused applications that cross subsidize education in the developing world will have any trouble getting approved, I have some things in the pipeline for example that are more casual focused that won't be such slam dunks. Here are some interesting and somewhat fun links about how now to get approved and what that can mean.
Amazing: A $999.99 app called “I am rich” that got approved that does absolutely nothing. I don't really object to this app so long as people are fully aware they won't get a refund and that it does nothing, which seemed to be stated pretty clearly. I don't really see how this is that different from a woman buying a $3,000 handbag.
How the slow app approval process can kill companies:
Some of the reason why application developers hate Apple and the iPhone store:
List of killed iPhone apps (many of them deservedly so):
Thursday, May 7, 2009
Today I walked into the Foot Locker in Downtown Crossing and couldn't help but notice this Jason Bay t-shirt. It was priced at $22, but clearly the $22 had been slapped over a $20. I think that pretty well reflects the fortunes of Mr. Bay so far, who is having a great and extremely clutch season for the Red Sox.
Tuesday, May 5, 2009
Here are ten great tidbits from Sandra Moose, who came to MIT Sloan to give a talk on the 2003 FiOS go or no go decision that Verizon had to make. Moose talked about the role of a Fortune 50 director, and how they specifically add value.
Directors need to adjust the way they think about business – Verizon does network build outs that don’t see payback for 12 to 15 years. That’s a hard concept for directors from more traditional business that expect paybacks within five years. You really need directors who are able to grasp that.
With technology investments, there must be a discernible difference in quality – It’s faster? It’s better? Who cares? The customer has to notice a discernible difference in an attribute they value for your technology investment to be worth it.
Look to the balance sheet to understand how agile your competitors can be – Verizon knew their cable competitors wouldn’t make investments in comparable technology which would take away FiOS’ differentiation. The reason was that cable companies are typically thinly capitalized and can’t make large investments like the $22 billion one FiOS was and is.
Boards make business model decisions – Typically, board members who add value understand business models as opposed to the details of the technology. Moose gave Lou Gerstner as an example. Gerstner was not a technologist having come from McKinsey and American Express, but he understood the technology enough to build strong business models around the innovations. Use sub-committees to understand and validate the details of the technology.
Don’t be afraid to ask dumb questions – If you don’t know the answers, chances are others on the board don’t.
Build credibility by dissenting – Dissent when you think it is right and put it down in paper.
It’s different on non-profit boards – On non-profit boards on which Moose serves, there are people who only care about specific causes. And it’s hard to manage this. There needs to business people who will help run these organizations in a way that is sustainable.
A nice way of describing a Director – Sandy called a good Director a “loyal critic”. I liked that.
The dissenter’s gunnysack – If you do dissent without knowing what you are talking about, be aware that you may get “gunnysacked”. This means that they’ll FedEx you a massive amount of information for you to review.
CEOs are getting too busy to serve on multiple boards – With Sarbanes-Oxley and other regulations increasing, CEOs are more focused on their own companies now. Furthermore, with the major incidents like Enron and WorldCom that have occurred, and Director’s liability, being a Director has become more time intensive.
Sandra Moose Biography (from BusinessWeek)
Dr. Sandra O. Moose is the Senior Advisor at The Boston Consulting Group. She joined the firm in 1968, and has been a Director since 1975, and was a Senior Vice President until 2004. Her experience before 1968 was with the Federal Deposit Insurance Corporation, with the Federal Reserve Bank of Boston, and as a Member of the faculty of Harvard University. Prior to this, she was a Senior Vice President from 1989 to 2003 and appointed Chairman of the East Coast. Dr. Moose joined the company in 1968. She serves as the Member of Board of Trustees at Natixis Funds. She also serves as the Presiding Director, Chairman of Nominating & Governance Committee, Member of Executive Committee and Member of Executive Compensation Committee at Rohm & Haas Co. since 1981. Dr. Moose is the Chairman since November 2005 and Independent Trustee since October 2002 at AEW Real Estate Income Fund. She is an Independent Director, Member of Nominating, Governance & Corporate Responsibility Committee, and Member of Finance & Investment Committee at AES Corp. since April 28, 2004.
Dr. Moose also serves as Director of CDC-IXIS Funds, Verizon New England Inc., since June 2000, Verizon Communications Inc. since June 2000, the Alfred P. Sloan Foundation, and CDC Nvest Funds. She is chairman of the Boston Public Library Foundation as well as chairman of the Harvard Graduate School Council. Dr. Moose is also a Director at Loomis Sayles Funds and at 27 investment companies sponsored by The New England Funds. She is a Trustee at IXIS Advisor Funds. Prior to this, Dr. Moose served as a Director at GTE Corp. from 1978 to 2000, The Boston Consulting Group Inc. since 1975. She is an Overseer of the Beth Israel Deaconess Medical Center, a Trustee of the Boston Public Library Foundation, an Overseer of the Museum of Fine Arts, a Member of Visiting Committee at the Harvard School of Public Health and a Director at the Harvard University Graduate School Alumni Association. She was formerly a trustee of Hampshire College and Wheaton College and a director of the Theatre Development Fund. She is also a member of the Committee of 200, a nationwide organization of women business leaders, and the Massachusetts Women's Forum. Dr. Moose was the 1999 recipient of the American Economic Association's Carolyn Shaw Bell award, which is given annually to an individual who has furthered the status of women in the economics profession. She also received the Outstanding Corporate Director of the Year Award in 2004.
Dr. Moose received a Ph.D. from Harvard University. She earned a B.A. Summa Cum Laude in Economics from the Wheaton College and an M.A. in Economics from Harvard University.
I recently read Andrew Sweeting’s paper on Equilibrium Price Dynamics in Perhishable Goods in Secondary Markets for MLB Tickets. I am constantly thinking about dynamic pricing models and Sweeting's analysis is a really interesting one for the secondary ticket market.
It’s an interesting explanation of why ticket prices tend to decline by economically significant amounts – 25% or more, as the time gets closer to the game. This is surprising given some other capacity constrained markets such as airlines charge more as use date approaches. Also, anecdotally we hear stories about very high-demand seats getting very expensive as the date approaches.
Sweeting’s research supports dynamic pricing models where prices are adjusted over time, especially those where an initial offer price is higher further out and then the tickets are offered at lower prices as the date approaches. This is the case because there are actually buyers who have a higher willingness to pay earlier in the ticket sales process (Sweeting argues this is due to search costs and the risk of the lack of future availability).
I believe there is an information gap as buyers, unless they spend a lot of time like us Econ dorks looking at eBay auction data, are not aware of this paradigm. Also, there is a transport gap – paper tickets are hard to move in the last few days.
Sweeting argues that declining prices can only be the equilibrium outcome if people are willing to purchase early when expected prices are relatively high. Consumers should be able to time their purchases. To support his hypotheses, he looked at two markets. One was StubHub, which has only posted prices, not transaction prices, and “Market 2” which sounded a heck of a lot like eBay to me.
Two arguments for falling seller demand are:
1) Seller Explanations: Falling Opportunity Cost and Time-Varying Demand/Revenue Elasticities. To keep it simple, this can be summed up as meaning as the ticket date approaches, the chances of making a big kill and finding a high WTP buyer are lower. And if you don't sell them by the end, you're screwed.
2) Learning by Sellers – All customers have the same reservation value for the item, about which the seller has prior beliefs. Typical pricing strategy starts high, and if they are not sold, then seller cuts price in 2nd period. If the WTP was higher, they’d all buy and all the tickets would have already sold!
So why do people purchase early if prices will fall? Two reasons:
Uncertain future availability – You’re afraid if you don’t buy now, you’ll lose out on getting to take your son to the game on his birthday. If you were an econ dork, you’d worry less about this.
Search costs – It costs you time (and time = money) to sit around trying to win an auction to save some money, or you have to log in again later to get tickets. So just buy ‘em now, pay a bit more and pencil the game in your calendar.
Interesting paper. More on this shortly.
Monday, May 4, 2009
Is this a sustainability idea or is the recession hitting MIT Sloan really hard? Check out this letter from Dean David Schmittlein.