Robert Litan: An Economist Walks Into a Bar at TEDxKC (Transcript)

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Robert Litan – Economist

So, there are these two guys that walk into a bar “Damn, not going to go there.” It could be the beginning of a joke. But I really want it to be the introduction to the notion of artificial scarcity. And you’ll see why in a minute.

So let’s go back to the bar. First guy, he approaches the first woman that he sees, offers her a drink. She turns him down. He, then, decides to walk his way down the bar. And, of course, all the women watching this, they see what he’s up to. And they all turn him down.

Now, our guy, I’m going to call him the anti-hero. He hasn’t learned from this experience, in the real world. So he decides to go to the virtual world. He goes to the Internet and joins and he tries the same technique, and sure enough, with the same result. They all turn him down.

So our anti-hero is in trouble. But you know what? is in trouble too. And the reason they are, is that the women who have joined are being inundated with offers for men for dates. They get turned off, they quit. And if they quit, men quit. Cupid is in trouble. Who are you going call, to solve this problem. Know the answer is more obvious than ghost busters. You call an economist. Don’t laugh, you call economists. In fact, you call two of them.

This is Muriel Niederle of Stanford, and Dan Ariely of Duke. And they spend a lot of time, studying the problem of artificial scarcity and abundance, in the online dating context, which is a reason Cupid call them up. And they wanted to know how to fix their problem and the two economists said they had an idea, that was as simple as it was profound. Just put a sharp limit on the number of date offers that men could make to women each month. This is the notion of artificial scarcity. Taking what looks like an abundant resource, which is date offers, and artificially constraining them.

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And the economists said to Cupid that if you do this, the men will take their offer seriously. They’ll look at more than just the women’s pictures and they’ll actually look at their profiles. And the women will know this, and they’ll be more likely to accept date-proposals. Artificial scarcity helped save, and other dating sites that copied the technique.

Today, online dating is a $2 billion industry in North America alone. Now, I want to talk about a lot more than online dating and artificial scarcity. Much bigger topic. I want to try to show to you, how economists and their ideas have contributed to the rise of the entire Internet economy, and to some of the iconic companies within it.

I’m sure that many of you are familiar with the notion of “name your price travel“. That was invented by Priceline. Well, “name your price travel” was really not the key to their success. Because, if you could name your price, what price would you bid? Zero, right? Or one or two. And obviously the airlines or the hotel chains would not accept the offer.

The key to Priceline was not their great advertising. It wasn’t the fact that you could do searches online. Know the real key to Priceline success, by the way it’s a $60 billion company, market cap today. The real key is they make you this proposition. They say that if you bid a particular price for a hotel room or a flight, and Priceline decides to accept it, you’re bound to pay it. This is called the conditional price offer. And basically, what it does, it induces you, as the traveler, to take your offer seriously, in the same way that the artificial restrictions on the dating proposals at did for men.

So who is the brilliant guy behind the conditional price offer? He’s a smart guy, but Captain Kirk was not the inventor of the idea. He was the pitch man. And it still is for Priceline. Know the real genius behind Priceline was this guy. Jay Walker. Jay studied economics as an undergraduate at Cornell. And he actually listened and thought two steps beyond what his lecturers told him at Cornell and came up with the idea of a conditional price offer, which led to Priceline and revolutionized the entire travel industry in the United States.

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I have another example. So one that you’re also very familiar with. The search page at Google. It could be at any other search engine, and what I want you to pay attention to is that right hand side, the ads over there. Google collects about $50 billion a year, from advertisers, large and small, seeking placement on that right hand side. They auction off the site. But that’s not how the system started, because when Google was launched, online advertising was in its infancy, and Google, believe it or not, went door to door, advertiser to advertiser, trying to get them to place for an ad next to a search term. Highly laborious, you quickly can see that this is not going to scale, as the number of searches explodes on Google.

And so the founder of Google asked two young engineers, Eric Veach and Salar Kamangar, to come up with an automatic system, that would solve this problem. Well, they were instinctively attracted to auctions. But they were thinking about another problem. That is if they auction off the sites, they fear that the advertisers would bid a very low price, and then incrementally raise their prices just a little bit, and keep the auctions going on forever. And if this happened, and a lot of searches were also going on at the same time, the whole site would crash.

So, as an engineering solution, they came up with this idea. That the winning auction, or the winning placement will be the price, the second highest price that was bid plus one penny. This will cut off the auctions, greatly simplify the process, and in the process also solve another problem called “the winner’s curse“. I’m sure that many of you that have participated in auctions may have regretted winning because you felt like you’ve paid too much. Pretty obvious point.