First Degree of Freedom

"If you choose not to decide, you still have made a choice." - N. Peart

A.E. 1.29.2012

The Ambidextrous Economist was born free.  He can be reached at AmbidextrousEconomist@gmail.com.

Field Goals

The second in a series of self-reflective pieces on the impact of economics on everyday life. 

To read the first installment, click here: Part I: Safety First

Whether we are influenced either by nature or through nurture is a persisting philosophical argument. It’s also a logical fallacy in the form of a false choice. We are influenced by genetic predisposition to some degree, as we are formed by our environment. It’s not one or the other - It’s both.

For the longest time, elite collegiate athletic programs tend to skew their successes either toward football or basketball. The two are widely characterized as revenue-generating sports, meaning that Universities make more money from football and basketball tickets, concessions, and broadcast proceeds than it costs to run the individual programs. In terms of organizational archetecture, basketball and football are considered profit centers.

Conventional wisdom suggested that since University’s faced a choice. They could allocate favoring their investment in either their football program, or push more chips at basketball. Then the University of Florida Gators won both the BCS Football National Championship and the NCAA Basketball Championship in the same year. My alma mater, The Ohio State University, was Florida's opponent in both sports. While it appeared that the paradigm shifted, it appears that conventional wisdom was relying once again on a false choice. 

Theory

We operate under theory. We may not be able to articulate that theory. We may not recognize that we have a theory. That doesn’t mean we’re not using one. 

A theory is a proposition in the form: If X-> Then Y. 

We live in a world of causality, not one of suspended animation. For every action taken their are costs, and there are benefits. These outcomes will be used to objectify whether our theory worked, whether it can be improved, or whether it has been disproved and should be discarded. 

There are several theories we operate under nearly every day that are known to be logical fallacies. Here are just a few:

The first is the fundamental attribution error. This suggests that X precedes Y, therefore X caused Y. Just because something (X) happened before something else (Y), it doesn’t mean the first caused the second. EXAMPLE: When it strikes 4 O'clock, it's time for tea.  I'd really like some tea. I'll move the clock ahead so it shows 4:00 and everyone will show up for a tea party now.

Another familiar pitfall is correlation does not imply causality. X and Y may appear to happen sequentially time and again. We might theorize that X causes Y. EXAMPLE: Every time I wear my lucky shirt, my team wins.

The argument of the hot hand is a persisting statistical debate. It concerns a jump shooter in basketball who is on a streak. Statisticians will argue that each shot is an independent event. The outcome of a prior basket is sunk. As such, it has no bearing on the shooter’s next shot. The Ambidextrous Economist isn’t so sure.  It should be noted in all fairness that no one ever starts counting a streak with a miss.

Practice

If we were flipping coins to see if they were heads or tails, I’d side with the statisticians and their most staunch-held beliefs that things like ‘luck’ don’t exist. But we’re shooting hoops, yo. When you’re flipping coins, the odds never change. It’s almost more in line with believing in pre-destination will give 50% heads if the experiment is run enough times. 

Shooting baskets is more about the individual’s ability to use his free will to improve his odds. By improving ball handling and movement without the ball, he can improve his odds by finding shots within his range. Every practice, every game, every hour in the gym: All these lead to the total ballplayer. Turns out, the last shot a baller takes impacts his belief about his next shot. He remembers it.  The hot hand becomes a self-fulfilling prophesy when it's attached to a pure shooter.

To illustrate the difference, bet someone whether a coin toss will land heads or tails. Put a five dollar bill on it.  Suddenly someone else needs to flip to keep it ‘fair’. So is there skill to flipping a coin? Enough chance that skill is involved that the conflict of interest needed to be quashed. A baller is aiming to make the basket, and has something at stake. Until something is at stake, you’re just flipping coins. Incentives matter.

Real Choices / Real Costs

To choose a particular path is to forsake all others. Opportunity cost is the convention used by economists to evaluate decision making ex post. It’s calculation shows opportunity cost is a real cost. Strategy is as much about as what you don’t do as it is about what you do do.

‘If you follow every dream, you might get lost.' - Neil Young

Naïvely hiding money under your mattress is forsaking all the interest that money could be earning in a risk-free savings account. We must make choices, and those choices impact whatever kind of return we expect on our investment.

The Division of Labor is one of the most salient lessons in Adam Smith’s Wealth of Nations, and it plays itself out in every type of organization all across the world. As the world moved from an agrarian society, past simple barter trading and mercantilism into the Industrial Age, the principles of Smith’s magnum opus has pervaded economic theory. 

Smith used a pin making factory for his example, illustrating how pins are rolled, flattened, hammered... *yawn*... but the implications of Smith’s point [sic] are staggering. A combined workforce specializing in the individual production units can produce thousands more per worker than any one individual worker could make on his own.  The ability to leverage the division of labor multiple times in the production process of a good is referred to as Economies of Scale. The question of scale economies is one that asks the correct degree of specialization versus generalization in the production process.

The classic example is Henry Ford. Using an assembly line production of automobiles in Detroit, Ford was able to pay his line workers five dollars a day, an amount unheard of in that day and age.

Two-Platoon

Just months before I started playing for Marysville as a sophomore, I asked my mom how she thought things might work out. I don’t know what I said to get her going, but I must have been nervous. She said something like, “You’ve always been good at almost anything. But you never really just picked one thing and went with it.” That was all I needed to hear. From then on, for better or worse, everything else took a back seat to football.

In Marysville, you play offense OR you play defense. It’s referred to in football as the Two-Platoon system. The tradeoff is between one of specialization versus generalization. When players spend all their time on one side of the ball, they begin to know that part of the game intimately. 

Two-Platoon football is also a lot less demanding physically during the games, as opponents’ key players typically are taking ~50% more snaps. Most of Marysville’s opponents were worn out by the time the fourth quarter came around. Two-Platoon was not a new advent at the time, as professional and collegiate teams had long implemented two platoons long before. But at the high school level it was an achievement in terms of turnout.

The division of labor in Two-Platoon football enables the individual offensive or defensive player to become more efficient at their job. A football team using that system has to forgo the impact some players could have if they were able to play both sides of the ball. This is mitigated somewhat by the fact that special teams were created by a hybrid of offensive and defensive players, but strict adherence to the Two-Platoon system still constitutes an opportunity cost in in the end analysis insomuch as it means star players can’t play both offense and defense.  

As always, the decision is one of tradeoffs. The consensus going into our sophomore year was that our class was “stacked”. There were enough quality players at all twenty-two positions that the varsity squad took up four sophomores and the JV team won all but one game. What I was unable to articulate at the time, and which I now know, is that the system employed by Walt Braun at Marysville had achieved economies of scope through the systemic implementation of Two-Platoon. It became Marysville's systemic competitive advantage.

Walt Braun recognized Marysville was not turning out a single product (i.e. a football team). They were turning out at least twenty-two products:  One for each starting spot. And within the competition for those spots, there was an intense, weekly battle for playing time. Over the summer, the competition multiplied many times over. Synergies is a word that is often misused in merger talks to justify a bad deal. Notwithstanding the fact that business speak turned it into a joke, synergies are supposed to mean that the whole is greater than the sum of the parts.

The greatest benefit of the Two-Platoon approach is that it fosters competition in scrimmages. If you started on defense, the one time a week you got a shot to play your own first team offense meant bragging rights.  Every week the best offense got to see the best defense in the state, and vice-versa. It was a virtuous loop: Each part of the machine was making the other parts sharper and more focused. The biggest hits anyone ever gave or got were in the inter-squad scrimmage on picture day.

It was during a practice late sophomore year that Coach Braun visited the JV practice. I remember every single syllable. He could project his voice across the entire field that now bears his name.

“I’ve heard some of you talking about winning a state championship...

That’s an attainable goal! That’s an attainable goal!” yelled Braun.

When I repeated those ambitions of playing in the Silverdome at the end of my junior varsity season at the awards ceremony, I took a great deal of heat. To be perfectly honest, lots of people laughed. The running joke became, “You and me, Baby: All the way to the ‘Dome.” 

At that point, I’d burned the ships behind me. 'Burning the ships' is a colloquialism, possibly apocryphal, where the leader of an invading army set his ships afire to show his troops that retreat was not an option. One thing that I learned is there is no shame in going ‘All in’ if you’re betting on yourself.  - A.E. 2.6.2012

The Ambidextrous Economist is free to do what he wants any old time.  He can be reached at AmbidextrousEconomist@gmail.com.

Going For Three: Options in Theory & Practice

The third in a series of self-reflective pieces on the impact of economics on everyday life. To read the from the beginning, click here: First Degree of Freedom

The language of football is unique. The secrecy involved in the art of deception is about keeping your intentions hidden from your opponent. Plays barked out pre-snap can change the play, but if it’s done right, everything said should sound like a foreign language to the opponent.

There are two stories that I think are important when discussing the intensity of rivalry between adversaries in football. The first concerns a scoreless tie between Navy and Duke, where Navy Head Coach Eddie Erdelatz in 1953. Erdelatz likened the tie ending with, ‘..Kissing your sister.’ 

The second story concerns Coach Woody Hayes of The Ohio State University. Leading the rival Michigan Wolverines by a score of 44-14, the Buckeyes scored again late in the game. Hayes elected to go for the two point conversion, which was a total dick move. When Hayes was asked why he was running up the score by going for two, Hayes explained, “Because I couldn’t go for three.”

Unfortunately, both Hayes and Walt Braun’s careers would both end suddenly with violent outbursts. Hayes punched an opposing player during a game. Braun hit his best friend, an assistant coach, with his cane.

Options

Options have a place in our conventional everyday language. They resemble the opportunity set of available choices we face at any particular decision point. 

Financial Options have a place in the financial services industry as well. Options are derivative instruments. That is, they derive their value from the underlying value of another asset. A financial option gives the holder the option to either buy or sell a particular number of shares at a specific time in the future. 

There are essentially two main option types (I’m ignoring the difference between European and American options for now), but the way that financial engineers have cleverly combined different options makes the territory that much more nebulous. 

The first type is a call option, which gives you the opportunity to buy a particular equity (stock) at a particular date in the future, for a specified price (the exercise price, or 'strike' price). 

The put option is the call option’s natural opposite number. A put option allows the holder to sell a particular number of shares at a specified date in the future at the agreed strike price. Put/Call Parity is the mechanism by which the two option prices converge toward the exercise date.

In theory, options are meant to hedge an investor’s exposure. Since the equity share itself makes a return equitable with the risk of that stock, the option is meant to provide downside protection, and can be thought of as insurance against large losses. In practice, options are one of speculator’s favorite toys. The idea of using leverage to purchase large lots of options is extremely risky and no downside protection. The position of an options trader in a speculative market can become extremely precarious in a short amount of time.

The Black-Scholes formula is the academically accepted way to value financial options.  It is based on the notion of put/call parity and borrows the math from a heat transfer formula in thermodynamics.  In as close to layman’s terms a I can muster, there are five essential pieces of the Black-Scholes formula:

1. Time to Maturity - The difference between now and the date where the options are either exercised or expire. 

2. Current Price of the Underlying Asset - The market price, the ‘spot’ price

3. Strike price -  The agreed price to pay to exercise each option

4. Risk-free rate - Depending on the length of the investment, otherwise usually the return on 10-year T-Bill

5. Volatility of the Underlying Asset - a determination of risk using the historical co-variance of the stock with the average return of the market

The lesson here is simple and apart from the specifics just described. Just possessing an option, financial or otherwise, has value.

Option Football

The Option Play is a facet of football that parallels the triple threat position in basketball. The quarterback takes the snap. The fullback dives, and the QB’s first option is to handoff to the fullback. Alternately, the QB simply fakes the handoff to the first back diving. 

The defensive line must be disruptive enough to thwart the quick hitter. The tradeoff here for the defense is that there is less pressure on the QB if he chooses to pass, which to this point in the play is an option he has retained. 

The next option is for the QB to run himself. The combination of his ability to fake pass and effectively run the ball himself can be a backbreaking combination to defenses. The final option is to pitch to the tailback five yards to his outside. This is by far the most risky of the options. Marysville as a rule did not allow the QB to pitch to the tailback. As always, the calculation is an assessment of costs versus benefits. Walt Braun believed the risk of a turnover from a bad pitch was not worth the potential benefits of the potential yardage gain from a pitch. Which sucks, because I would've been the pitch man. Marysville had a centralized decision making-process. If the pitch option was deferred to the QB, it would be de-centralized in that sense.

The idea of an option football offense is that you retain options, read the defense, and choose the most appropriate course of action. Done effectively, it forces the defense to react to all threats, spreading themselves thin for the ultimate option exercised successfully.

Real Options is a cross-discipline practice that combines financial valuation with strategy. It uses the same five numbers from the Black-Scholes formula for calculating the value of an financial option, but Real Options methodology allows practitioners to use proxies. Real Options valuations are especially instructive when evaluating the notion of a staged investment. Rather than using a single discount rate for the life of a project, as a Net Present Value or Internal Rate of Return valuation methods require, the Real Options framework allows for the breakdown of the different stages an investment, with multiple risk components in a multi-phased project.