Kurt Johnson

Today’s WSJ talks about a pricing strategy for high cost drugs:

Ms. Oliva, who earns about $40,000 a year managing a clothing store in Long Beach Island, N.J., pulled out her American Express card that day in September and paid, unsure where she was going to find the money for the next week’s supply. Fortunately, the nurse at her doctor’s office found help for her from a charity, Patient Services Inc., which picked up her drug co-payments — $3,800 for a six-week course of treatment.

The twist: The money for her co-payments came from Schering-Plough Corp., the drug’s maker.

To cope with rising medical costs, insurers are requiring patients to pay higher premiums and co-payments for drugs. While poor uninsured patients can often get expensive medicine free from drug companies, people with insurance are increasingly finding it difficult to afford these drugs. In response, drug companies are giving money to charities that are specifically set up to help patients pay such costs.

Under this support system, drug-company money keeps patients insured — and keeps insurers paying for the high-priced medicine.

“It’s a win-win situation,” says Dana Kuhn, co-founder and president of Patient Services, a Midlothian, Va., charity, which solicits money from drug companies. “Patients are helped and companies are helped. They make a small contribution to help the patient and get much more money back when the insurer pays for the drug.

On the surface this sounds a lot like the price discrimination that colleges and universities employ – set a very high nominal price but discount liberally for individuals who prove they cannot afford to pay full price. Drug manufacturers are utilizing insurance companies to create more revenue (i.e., keep end-user prices affordable and collect incremental revenue from insurers) whereas universities utilize government aid and private scholarships. I’ve written about this before.

Philip Greenspun wrote about this years ago:

Suppose you got a brochure from United Airlines listing the fare from Boston to San Francisco as $1 million. However, the brochure stated that “because of our commitment at United Airlines to ensuring that every American gets the transportation that is his birthright, we offer financial aid.” The brochure comes with forms in which you list every scrap of money that you have. You are instructed to send this into United Airlines along with a certified copy of your tax returns so that they can evaluate your need. A few days later, United Airlines writes back: “Great news. We have evaluated your financial situation and have determined that if we take more than $1,000 out of you, you’ll be reduced to the homeless shelter. So we’re awarding you $999,000 in financial aid and you only have to give us $1,000 to fly from Boston to San Francisco.

His whole article on higher education is here but it has some graphics in it that may not be safe for work.

This chart surprised me a little at first – who’d have thought Texas had 4 times California’s rate of mortgages at >90% of value? Isn’t it a little scary that 1/3 of Texas “homeowners” have less than a 10% equity stake in their house – note that this is first mortgages only, no HELOCs or second mortgages are included in the data, meaning this is optimistic if anything.

Read the article from the Dallas fed here. The short story is, all sorts of strange things happen to normal ratios during high rates of housing price growth (i.e., >90% LTV ratios are rare in California because people are adding equity so rapidly through price growth). Although the data is interesting, I’m not sure the article really adds much information as to what will happen when growth slows or reverses…this is the billion dollar question.

This chart is a logical extension:

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?

http://www.washingtonpost.com/ac2/wp-dyn/A38725-2005Apr8?language=printer

Paul Volcker (ex Federal Reserve chairman) is concerned about the continuing US current account deficit and the lack of political initiative to fix it before a crash becomes inevitable (non-technical, from the Washington Post):

The difficulty is that this seemingly comfortable pattern can’t go on indefinitely. I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.

It’s funnier if you imagine it in the voice from the Guinness commercials.

From 1850 but new to me. Bastiat’s petition entitled: A PETITION From the Manufacturers of Candles, Tapers, Lanterns, sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting.

Found via the excellent Mahalanobis blog.

I’ve thought a lot about how US government deficits are going to affect financial markets in the future, specifically the money I put aside to retire on. Here’s my basic fear/expectation: the US government will be unable to control entitlement spending and the commercial sector unable to control balance of trade, leading to more USD denominated bonds and currency being held by foreign investors. Simultaneously we’ll see a growing disparity between Americans who save and those who don’t – savers will have lots of money and non-savers won’t have much at all or have negative worth. What we’re left with is a narrow class of asset holders (foreign investors and a minority of Americans) and a large group of non-asset or net liability holders (the US government and the general public).

Since the US government controls how much currency is printed it’s pretty easy to think that they’d be willing to print more to control deficits. If the majority of voters are not asset holders, the treasury can get away with this since they’re basically ripping off foreigners and the minority of “wealthy” Americans to dig the government out of it’s spending hole (in other words, playing by the rules of a democracy).

What should you/I do to profit if this scenario makes sense? I’m kind of exploring a practical way to short-sell long dated treasury bonds (basically putting me in the same economic position as the US Government). If nothing else I’m trying to stay invested in diversified equities, which will hopefully hedge against inflation much better than holding cash or bonds.

What’s keeping this from coming to fruition? Maybe political pressure in the US to keep nominal interest rates down, which you can’t do if you’re inflating the currency printing more money. Most consumers aren’t going to be happy when mortgage and credit card rates jump, even if they profit on balance from the reduced value of their fixed rate liabilities. Another hindrance could be US political will to keep the dollar as a global benchmark currency, something it couldn’t do if it were to willfully inflate to avoid debt repayment. Finally, although probably least likely, we could see a new age of government fiscal responsibility and/or sharp organic growth in tax receipts from a strong domestic economy.

PS – if anyone has seen/done an analysis on how much of this year’s runup in stock prices is a factor of dollar devaluation I’d be interested in seeing it. I don’t know how much the S&P 500 companies hedge their forward foreign currency earnings, but assuming they’re generally unhedged (and assuming that they get 30% of their gross margin in foreign currency) it seems like 50% of the increase in large cap indexes could be from currency translation of future earnings per se rather than business fundamentals or the demand growth for dollar denominated exports.