Kurt Johnson

In my experience practice tests for various standardized exams have a significant downward bias (the exception being people who ‘don’t test well’ due to stress or other conditions at the actual exam). This is good strategy for test prep companies since it A) scares people who take a practice exam into purchasing more test prep and B) leave consumers feeling good about outperforming their benchmark instead of being upset about perceived underperformance.

One of the factors for the downward bias is that actual test questions are generally very carefully worded to eliminate ambiguity; practice questions are sometimes sloppily phrased and can be argued multiple ways.

This all comes to mind because I’m on Level 2 of 3 in the CFA exam. Schweser’s study notes and practice exams for Level 1 were quite good. So far Level 2 notes are fairly sloppy and I’ve heard Level 3 are even worse. Is Schweser depending on people to stick with the same note provider once they’ve started the program? There’s not anything to stop people from buying their next level’s notes from a different company (you buy each year independently) but there’s certainly some inertia that makes me want to stick with the style/brand of notes I’ve already gotten comfortable with. Thus it probably is good strategy for Schweser to throw their best talent at Level 1 and compromise quality on levels 2 and 3.

Where else does this strategy apply? Private schools whose students find it harder and harder to transfer after each incremental year in the system?

Susanne snapped this in front of St. Paul’s Cathedral a few weeks ago. Desaturated in Photoshop.

Can Midwest make the 4-wide seat configuration work? 5-wide is an option - ATA uses 3+2; it’s similar to a Super 80/90 where 4 wide in First becomes 5 wide in Coach. Assuming it can set pricing to sell out planes in either configuration, Midwest is forsaking 20% of their revenue and gross margin by forsaking one seat per aisle, implying they need to collect a 25% price premium to break even versus a 5-wide model.

On the surface it looks like the 4-wide configuration is doomed; Airline consumers are notoriously price sensitive, jumping through all kinds of hoops to save $5 or $10. Business travelers will be hard pressed to defend paying a 25% premium for tickets. There are a fair number of people like me that will pay a small premium for the comforts of 4-wide, but I suspect the number who will a 25% premium won’t be enough to support a large airline operation in any one market (and since scale is the name of the game, this means they’re doomed).

However, there is a compelling alternative strategy that could end up making these guys look like geniuses. An interlude:

Suppose you are in an industry with commodity products and low loyalty - an industry where consumers are extremely price sensitive and will switch brands at the drop of a hat to get a better price. If there is a dominant competitor (”Goliath” - 90% market share) and an upstart (”David” - 10% market share) and both competitors offer the same price, Goliath will get 90% of customers and David will get 10%. Now say that David cuts prices by just enough to get customers’ attention: say 5%. This causes perhaps 30% of customers switch from Goliath to David, boosting David’s market share by 300%. By undercutting price 5% David has boosted revenue by 280%. This is an asymmetric opportunity; if Goliath cuts prices by 5% it will likewise capture 30% of David’s customers, but since David only had 10% of all customers to begin with Goliath’s revenue gain from undercutting is actually negative (-1.5%) - it loses more by cutting price than it gains by adding a small number of customers. Thus David has a persistent incentive to cut prices, a little at a time, while Goliath prefers that prices are stable and will never take the initiative in cutting prices. Of course, everyone in the market will end up matching the new lowest price - any pricing advantage David or Goliath have will only last until the competitor learns of the new price and changes their own. This is a fascinating application of game theory, and although I wish I could take credit for it the theory is Bertrand & Edgeworth’s (the cycle of price undercutting is called an “Edgeworth Cycle”) and I lean on empirical observations from several professors.

Here’s the upshot for business managers: for products where Edgeworth cycles occur (notably gasoline and airfare) you need to think in terms of how to acquire market share without starting a price war. Traditionally this has provided justification for loyalty programs (Frequent flier miles), or noncash goodies at the pump (Canadian Tire dollars, green stamps, free stuff with a full tank of gas). Many airlines sell tickets at severely discounted prices to ‘aggregators’ such as Site59.com that are only allowed to resell the airline tickets when they are bundled with a hotel room and/or rental car; since consumers don’t see a price for the airline portion of the bundle the airline can drop the price on surplus seats without starting a price war.

This brings us back to Midwest Airlines. What if there is overcapacity on domestic routes (which there is); if utilization rates for passenger seats is <80% and Midwest can sell out their flights due to their noncash benefit (4 wide seating etc.) then MidWest is potentially profitable - they are collecting more revenue than their 5-wide competitors without starting a price war or having to collect a price premium. They’re using their seating configuration like another airline might use a loyalty program - to attract customers when all competitors offer the same price.

Personally I think this is a weak explanation; it’s easy to shoot holes in this strategy/execution (although I won’t since this post is too long already). What’s a better explanation of why Midwest should think their 4-wide model is a better configuration than 5-wide?

Yesterday was my first day flying Midwest Airlines and I’m pleased enough to name it “Best coach class ever”. For what it’s worth, I’m flying about 120,000-150,000 miles per year right now; if they offered non-stops on my routes I’d gladly switch over and forego the miles on other airlines. What they’re doing right:

1. Brand spanking new 717s. These feel like the BMWs of mass transit; plenty of power on takeoff and very smooth, quiet ride. Because of the short routes they’re not configured with the seatback entertainment that most new widebodies have.
2. 4 across first class seating for the length of the plane. Easily the most comfortable airline seat I’ve ever sat in (first or coach). Unfornately legroom is more in line with coach than conventional first class.
3. Onboard food that’s actually appetizing, unlike the vending machine-style offerings on other carriers
4. Staff that’s as least as good as anybody else’s (on my sample of 2 flights so far).

I don’t know if they’re going to make enough margin to cover their investment - I hope they either thrive or spur competitors to steal their methods and give me a similarly pleasant experience on the carriers I do fly regularly.

I doubt I’ll be diligent enough to post comments on all of the reading lately, but I can at least offer a quick recap.

The Last Valley - Excellent
“How the French lost their colony in Vietnam 1920-1955″
It’s simultaneously fantastic in many dimensions - war story, insight into pre-colonial and colonial Vietnam, context for the US war there, insight into French military organizations in the 1950s (with high levels of mercenary and colonial participation from non-French), etc. I read it once quickly and started to re-read and mark up specific things to quote….but before I finished I lent it to Susanne’s grandfater. He grew up in Hanoi and moved South after the partioning of North and South in 1955 to start working with the new South Vietnamese government. I’m anxiously awaiting his reactions and added context to the topics in the book.

Freakonomics - Very good
“200 page NY Times Magazine-ish piece on economics”
A dedicated post is coming. Short version - it’s interesting stuff but the book only takes a couple of hours to digest, which makes it expensive entertainment at $25. It ended up whetting my appetite on some of the topics so the real value for me may be the footnotes and bibliography so that I can go back and read some of the primary sources. Also see the Freakonomics blog & web site

How We Know What Isn’t So - Interesting.
“Like a book of optical illusions using data instead of optics”
Similar to themes Against the Gods and Fooled by Randomness but presented as pure academic Psychology rather than as an aspect of financial risk management. I’ll try to post a couple of particularly interesting ideas when I get my copy back.

Thinking Strategically - Excellent if you’re interested in game theory but afraid of Greek notation.
“Game theory for MBAs”
The book is written at an “MBA” level; deeper than a magazine article but avoiding the rigorous mathematical treatments that a bona fide student would have to slog through. The book is full of brain-bending examples that defy intuitive solutions; as with learning mathematics the reader probably won’t get much out of the reading unless they pause every few pages to work through the examples and train their mind to fit real-world situations into the framework the author’s are describing.

Quest for Consciousness - Fair to good
“Describing a physiological framework for studying consciousness”
Koch and Crick start with a discussion of what defines consciousness, then dive into how to design experiments to study it and recap existing literature on test results. My trouble with the book is that I don’t feel it was written for me, and I’m not really sure who the audience should be. My best guess is that people with an existing knowledge and interest in neuroanatomy or perceptual physiology.

Global Crises, Global Solutions - Fair.
“Read it online instead”
The Copenhagen consensus lined up a few dozen experts to write papers on how to solve the world’s top ten problems for development - infectuous disease, climate change, civil war, etc. There are points and counterpoints, but one comment I’ve read from several of the authors is that there was a bit of confusion about the direction of the papers; somewhere in the middle of the process the authors were told to frame their proposals as a budget priority exercise and make analyses in cost-benefit terms; i.e., where are the investment opportunities for this crisis? This course change leads to some strained reasoning in some of the papers….I think they’re good, and worth reading, but most of the information in the books has probably made it to online forums and I’d just read about it there instead.

Schweser’s study guide to the 2005 CFA level II exam
“Somebody shoot me before Level III”
I’ve got too many distractions to study effectively for Level II right now; the test is 3 weeks away and I haven’t even opened about 40% of the condensed review (let alone read any of the primary readings or taken a practice test). So the next few weekends are going to suck.