Wednesday, 31 October 2012

Various teaching links: How to know more than the next guy.

There’s an old joke about two men in a forest trying to get away from a tiger.  One puts on an old pair of running shoes.  “You can’t go very fast in those” says the other.  “I only have to go faster than you” says the first. 

Regrettably,  much of life is being faster than the next guy.  So here’s a lesson in how to get ahead, drawn from the report into the West Coast Mainline bidding fiasco, which I just saw here.

As you remember, the bidding process collapsed in ignominy and will have to be rerun following the admission of errors in the process by the Department for Transport (DfT) who conducted the bids.  The inquiry into the fiasco has a preliminary report out.  I read the following lessons.

1.      The bidding works like this.  The winner of the bid gets all the revenues from the line they operate.  But, they have to pay a per year fee to the DfT to operate the line.  The DfT recognizes, correctly, that revenues might rise or fall depending on general economic activity which cannot be foreseen.  Thus there is an adjustment formula that adjusts the fee in line with GDP, in particular reducing it if GDP falls.  So you can win the bid by offering a large fee, knowing that the fee will fall if unexpected bad times come along.
2.      At the same time, the DfT does not want the franchiesees to go bust.  So you can also win the bid by offering to hold a lump sum of money, which payable to the DfT in bad times.
3.      What’s key for the bidders is to know whether they can win by offering:
a.       to hold a large lump sum, but bid a low fee
b.      bid a large fee, but hold a small lump sum
4.      The DfT have an economic model, which tells them the answer i.e. if  a bidder decides to adjust the lump sum, how much they can vary the fee..   Here’s what went wrong.

a.       they were unwilling to show the model to the bidders who were just given a number telling them the trade off between lump sum and fee.   As it turned out, that number was not based on the model at all, but on some other procedure kept secret from the bidders.
b.      The model worked out payments in real terms, in 2010 prices.  But the DfT thought the model results were in nominal terms.  So bidders were given a figure for what they were told was an adjustment in nominal terms (see paras 5.14.3).  This gave them the wrong price.  This matters since the bids last for five years.   So if you are told to make an adjustment of £X in 2015 and that mistakenly in real terms, it can drastically understate the correct nominal figure (by the compounded price change over 5 years).  As the report says 5.15. “Had they been converted into the nominal terms, which they should have been, significantly increased [adjustments] would have been required”

So here’s how to get ahead by knowing more than the next guy.

  1. A nominal number is in pounds, e.g. my salary was £400 per week last year and £420 this year, a rise of 20/400=5%
  2. A price index tells you how much the average basket of goods costs from year to year e.g. the basket costs £200 last year and £210 this year, a rise of 10/200=5%.  
  3. Since wage and prices have risen by the same, the “real” wage is unchanged.  Since a numbers in real terms is the nominal number divided by the price index and index of the real wage is £400 last year and £400 this year.