Hal Varian Answers Your Questions

Last week, we solicited your questions for Google chief economist Hal Varian. Here are his answers. Thanks to Hal for his generosity and to all of you for the good questions.

Q: Google’s recent announcement that it will be investing in energy research suggests that management now thinks it can earn better returns from investing in fields other than its core search business. Is Google turning a corner and planning to diversify beyond its Internet roots?

A: Google’s work in the energy area is primarily under the auspices of Google.org, which is our non-profit side. (See this page for details). But we also see a business opportunity here: Google’s data centers use a lot of energy — if we can figure out how to economize on that energy use, we can save a significant amount of money.

Q: In the classic supply/demand scenario, price equalizes quantity demanded by consumers with quantity supplied by producers. How do you see this economic model evolving as we move toward consumption of virtual, yet tangible products, such as iTunes movies and music?

A: Instead of the “perfect competition” that one sees with commodity products, highly differentiated products such as movies and music exhibit “monopolistic competition.” Each movie appeals to a different audience, and, in principle, they each have a little bit of price-setting power. On the other hand, when there is free entry, pure economic profits are eroded. One common outcome in such markets is differential pricing, where the product is sold in a variety of forms for a variety of prices. Indeed, if you look at a Hollywood film, it is sold in theaters, hotels, airplanes, DVDs, pay TV, and free TV at several different prices. This “versioning” is a typical outcome in such markets.

Q: How can we explain the fairly entrenched position of Google, even though the differences in search algorithms are now only recognizable at the margins? Is there some hidden network effect that makes it better for all of us to use the same search engine?

A: The traditional forces that support market entrenchment, such as network effects, scale economies, and switching costs, don’t really apply to Google. To explain Google’s success, you have to go back to a much older economics concept: learning by doing. Google has been doing Web search for nearly 10 years, so it’s not surprising that we do it better than our competitors. And we’re working very hard to keep it that way!

Q: Does the current search market share anything with the early volatile market, which saw engines like WebCrawler and Lycos rise to the top and then become overtaken every year or so?

A: As we put it, the competition is only a click away. That’s why our corporate goal is to invest 70 percent of our time and effort into improving our search and ad performance.

Q: It seems that many consumers react to things being “free” in ways that are different from how we might predict. As an example, faced with a choice between two software products, one costing $5 and the other being free but “costing” 2 hours per month of lost efficiency, many people would choose the free version. However, if you were to offer them the same $5 (one-time payment) in return for 2 hours of their time each month for, say, the next year, many of them would turn you down. This inconsistent behavior seems highly relevant in today’s ad-supported world. What ways do you have of studying and predicting consumers’ decisions to use pay or ad-supported services?

A: This is a very interesting question. Most content is sold via ads — think of radio, TV, magazines, and newspapers — but some content (books, movies, DVDs) is sold via a purchase model. Interestingly, we are seeing a trend on TV away from ad-supported content, and toward subscriptions and pay-per-view, in part because TV ads have become so annoying. My guess is that the pendulum will swing back towards pay-per-view, at least to some extent.

Q: Which of Google’s current projects has the most profitable growth potential? Also, does Google view the audio/TV/print expansion within AdWords as replacing ad agencies, or opening up the broadcast medium to smaller advertisers?

A: We definitely don’t want to displace ad agencies. They own the customer relationship, and they are very good at providing high-touch services that Google can’t duplicate. However, we are interested in providing agencies with better technologies to manage their advertising campaigns across different media, and we have several initiatives in this area right now.

Q: How does Google measure the market value and determine pricing for its ad placements on search results?

A: We determine a market value by making a market. No kidding. Google auctions off placement for ads on results pages. The high bidder gets the most prominent position, the second highest bidder gets the second most prominent position, and so on. See my paper on “Position Auctions” for more details.

Q: I’m interested in an economic perspective on the impact of information technology on the healthcare system. I’ve heard that Google is exploring this area. Several companies (e.g., WebMD, Revolution Health) are providing an impressive amount of information directly to consumers. How will the current gatekeepers react?

A: I don’t think that there is a conscious effort to hide healthcare information from consumers. The problem is simply that there is a lot of it, and it can be difficult or expensive to find high quality, useful information. Google is in the business of helping people find information, so if we can help out in this area, we are happy to do so.

Q: What do you see as the root causes of high healthcare costs in the U.S.? Which of these are amenable to correction? Which are not?

A: There’s a fundamental problem with healthcare: when you are very sick, you are willing to pay almost anything to get better. And it’s even better if someone else, like your insurance company, pays. Somehow, healthcare has to be rationed, either by a price system or by third-party decisions. That is always going to be difficult, no matter what institutional arrangements we use.

Q: In recent decades, do you believe that America’s demand curve for non-essential goods and luxury items, especially those in the tech sector, has undergone a shift? It seems as if people who traditionally would not have the money to spend on such items are lining up for high-end laptops, HDTVs, and Blu-Ray players. If there has been a demand shift in this market, what has been the impact on Google?

A: I think that the demand for entertainment has always been there. What has changed is the supply. As we’ve moved to digital signal processing, we’ve had a huge productivity boost from Moore’s Law, and it has become a lot cheaper to manipulate bits — whether they are in your iPod or your HDTV.

Q: What grade would you give mainstream media on its “education” of the American public on economics?

A: I think that the Times has done a good job. This blog, the Economic Scene columns, and the other Times columns all show a strong commitment to economic reporting. There are other good examples as well, such as the Wall Street Journal, Business Week, and the Economist.

Q: To what extent are “classical” economic models capable of accommodating the anti-competitive power of large corporations in terms of their ability to control consumer preferences and wield political power? Does the presence of a large corporate aspect to the current free market make it not quite an idealized free market anymore? If so, how do you account for this in economic models? Does the current “conventional wisdom” among economists account for the answer to these questions?

A: I think that the power of large corporations to control consumer preferences is vastly exaggerated. Look at all the new products from large corporations that fail. This isn’t to say that large corporations don’t pose a problem; but, in my opinion, the most problematic way they exploit their power is through direct manipulation of the political process rather than manipulation of consumer preferences.

Q: How would you rate the future of experimental economics?

A: I’m a big fan of experimental economics. In fact, we’re using it at Google to study various sorts of market designs. The goal in economic experiments, as in all experiments, is to make the results reproducible.

Q: Aside from auctions, what have been some of the applications of game theory to the Internet or Internet-related businesses? What role, if any, has game theory played in the area of computer/Internet security?

A: This is a good place for me to plug Ross Anderson‘s page on “The Economics of Information Security.” I think that there are a lot of opportunities to apply game theoretic reasoning here. It is certainly an area where thinking strategically is important.

Q: Do you think more Ph.D.s in I/O and marketing will migrate to jobs in the private sector in the same way that those in finance have been moving for some time now?

A: Yes, I think so. One problem is that academic programs tend to be oriented toward producing more academics, and they don’t pay as much attention to non-academic jobs as they should. Business schools are somewhat better than economics departments in this regard.

Q: Your job sounds extremely interesting. What jobs would you recommend to a young person with an interest, and maybe a bachelors degree, in economics?

A: If you are looking for a career where your services will be in high demand, you should find something where you provide a scarce, complementary service to something that is getting ubiquitous and cheap. So what’s getting ubiquitous and cheap? Data. And what is complementary to data? Analysis. So my recommendation is to take lots of courses about how to manipulate and analyze data: databases, machine learning, econometrics, statistics, visualization, and so on.

Q: What books, theories, and thinkers would you recommend to an undergraduate studying economics, with a strong bend towards the philosophical and political underpinnings of the discipline?

A: There are lots of good books in this area. I’m sure you have already read Freakonomics. I think you would enjoy Paul Seabright‘s book The Company of Strangers. It it a very enjoyable read, and you may see a number of connections with Intermediate Microeconomics.

Q: Many observers anticipate severe oil shortages over the next decade. However, oil futures predict as far ahead as 2016, and show oil prices as being lower than today. How would you explain this discrepancy? Is this a market failure, allowing high profits at low risk? More generally, is there a better way of estimating future prices than by looking at commodities trading?

A: I think that commodity futures are about as good as one can get. There are a lot of highly motivated people trying to forecast prices, and the price that emerges should be a pretty good consensus estimate. But even so, it is important to keep in mind that roughly half of the participants think that the futures market price is either too low or too high.

Q: In 2001, you wrote, “The reason for the California electricity crisis can be summed up in four words: demand grew, supply didn’t.” Given the evidence of market manipulation by Enron and others, do you still think the reasons were benign market forces, or something more sinister?

A: I think that the failure to invest in generation and transmission facilities led to a system that operated very close to capacity. This allowed for unscrupulous traders to push the system over the edge on some occasions. As such, I would still argue that it was lack of capacity expansion that created the environment that enabled manipulation.

Q: You once said that “marketing is the new finance,” because of the data and tools that are now available. In your opinion, what are the three most useful quantitative techniques for analyzing this kind of data? To what extent does Google use this type of analysis?

A: The three most important techniques, in my opinion, are: 1) experimental design and analysis; 2) regression; and 3) Bayesian methods. We use the first two extensively, and are beginning to use Bayesian techniques more.

Q: Is the pricing of keyword bidding at the same stage now as pricing options were in the late 1970s? If not, where would you place it?

A: Keyword bidding models are based on game theoretic models of auctions, which is a very advanced and successful area in economics. I think that the bidding models we have now work even better than the early options pricing models.

Q: Often, the value forgone of pirated music and software is calculated by multiplying the number of illegal downloads by the value of those downloads if sold at full price, ignore elasticities and the like. To what extent can these be measured in a environment where data travels almost without restriction, and how would it assist those industries that are affected?

A: I agree that this calculation dramatically overestimates the losses from pirated software. On the other hand, we all have to recognize that content producers have to be able to profit from their products in order to continue producing. I think that we will eventually end up with much cheaper content (i.e., music downloads for under 50 cents) and with enough copy protection to make purchase the natural choice.

Q: What are the chances of the modern day QWERTY keyboard ever being changed to a more efficient layout? Are the switching costs simply too high for consumers to re-learn their typing skills, or could it save us time in the long run?

A: The evidence on QWERTY’s inefficiency is not very compelling. There are better layouts, but I don’t think that they are better enough to warrant switching in most cases.

Q: Do you feel that more traditional economic models do an adequate job of representing what economists would like them to? Do you think that emerging fields of study, like behavioral economics, will become increasingly important and/or potentially integrated into the core of economic focus? Given the assumptions we make in economics with respect to human rationality, optimal decision making, and large-scale generalizations, how can anyone in the field feel confident that a theoretical conclusion/result/finding is truly significant?

A: I think that the “traditional model” is a good starting point for economic analysis, but I don’t think that it is necessarily the ending point. You have to explore different alternatives to see which model seems to explain the data best. However, I will say that I think that formulating a model mathematically is quite important, as it serves as a check for internal consistency. Furthermore, a mathematical model allows you to draw out the consequences of an assumption that often allows for better understanding.

Q: PC or Mac?

A: Linux.

Q: How close to “perfect information” can you get in your position at Google?

A: I sit one office away from our CEO, so I would say “about 12 feet.”