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April 27, 2007

Your World In Quotes: Economics Edition

Jamie Galbraith, in the forward to the new edition of John Kenneth Galbraith's "The New Industrial State":

Large business firms often even replace the market altogether. This they do by integration: Replacing activity previously mediated by open purchase and sale with activity either internal to the corporation, or between a large, stable enterprise and its small, specialized suppliers, to whom risk is transferred. People reduce uncertainty neither through clairvoyance ("perfect foresight"), nor by confident exploitation of probabilities ("portfolio diversification"). They do it by forming up into structured groups large enough to forge the future for themselves. In politics these are countries and parties; in economics, corporations.

Once control passes to the organization, Galbraith wrote, it passes completely; the economics developed to describe the small firm and its owner-entrepreneur become obsolete. That form of economics celebrates the rational act of maximization, which consists of finding the shortest path to a given destination. But organizations do not have destinations. They have members, participants, stakeholders, all with a diversity of interests, talents, and purposes. Decisions are made by committees; the leadership of those on top is circumscribed by the need to get the underlings to go along. Individuals, the very focal point of traditional economics, no longer matter very much. Power in the firm belongs to what Galbraith called the "technostructure."

It's always worth saying that "economics," as a discipline, has thought about many of these issues in great depth, and developed cunning and complex models to express some, if not all, of these developments. But economics as it's deployed in common discourse -- often by self-interested interlocutors -- tends towards simplistic neoclassical arguments, which are in fact quite poor at describing the behavior of an economy as complex as ours.

Update: On a slightly less dry note, you gotta love the Galbraith style. He argues that profits aren't maximized merely for shareholder gain, as the shareholders are abstractions rather than voices around the table, and the natural inclination of individuals is to wrest gains for themselves. To think otherwise, Galbraith writes, "one must imagine a man of vigorous, lusty, and reassuringly heterosexual inclination eschews the lovely and available women by whom he is intimately surrounded in order to maximize the opportunities of other men whose existence he only knows through hearsay." This, incidentally, is exactly what's going on with the skyrocketing CEO pay approved by comfy, nepotistic boards of directors. They're advantaging those at the table, not the nameless masses known as "shareholders."

April 27, 2007 in Economics, Quotes -- Nonfiction | Permalink

Comments

Errrr, economics has got even much more massive problems than that with firms.

As time has gone on, inside the firm transactions have massively increased. I.E., non-markets (firms) have apparently proven superior to markets in numerous situations. Intrafirm transactions now stand at something north of 40% of trade in physical goods, and at a massive percentage of salary (or worker payment) transactions. Did you know that the practice before 1880/1890 or so was that each team or workgroup in a factory were not employees in our current sense, but a seperate "firm" of contractors, who accepted bids from the factory (i.e., what was a market transaction, is now not a market transaction)?

Something like half of transactions in goods is outside the market. If that's the case, how well does "market" even begin to describe the economy as a whole?

Posted by: burritoboy | Apr 27, 2007 2:35:52 PM

"He argues that profits aren't maximized merely for shareholder gain, as the shareholders are abstractions rather than voices around the table"

Joel Podolny proved that firms don't maximize for profit (as necessary for neoclassical theory to work). Instead, firms maximize for utility.

Posted by: burritoboy | Apr 27, 2007 2:38:10 PM

Where would I find that paper?

Posted by: Ezra | Apr 27, 2007 2:40:42 PM

burritoboy has some real smarts.

Economics really hasn't offered a good set of ideas and models that reflect the reality of current corporate behavior in the marketplace. Unless one has worked in a major corporation with some opportunity to observe the reaches of higher management (I've been fortunate enough to have done this in two mega-firms), understanding or describing their actions is probably beyond grasp. Economic historians have the same problems as actual economists: they are both blind people describing parts of the elephant by touch alone.

It didn't HAVE to be this way. Comcast or AT&T are not the natural products of market ocmpetition. They were allowed to create themselves by mistaken ideas that government shouldn't be hindering the marketplace (instead of the more rational approach of limiting some kinds of market activity that work against the common good).

Posted by: JimPortlandOR | Apr 27, 2007 2:47:47 PM

> That form of economics celebrates the
> rational act of maximization, which
> consists of finding the shortest path
> to a given destination. But organizations
> do not have destinations. They have members,
> participants, stakeholders, all with a
> diversity of interests, talents, and purposes.

I would say the first criticism is even more basic than that. When you take an Operations Research class and reach the optimization (linear programming) section, your first homework assignment is to do a one matrix problem, which is expressed as a one factory firm. Then you are assigned 3 one factory problems. When you come in with the three one factory problems clutched in your hand, the professor combines them into 1 three factory corporate optimization.

The examples of course are cleverly chosen so that the sum optimized outputs of the 3 one factory problems is less than the total output of the 1 three factory firm problem. Usually one of the factories produces a wildly different product mix, and has a much lower sub-profit - but the overall organization has a total higher profit.

This is always a contrived example, but it is not hard to find similar situations in real life: the sum of the subproblems is not the outcome of the summed problem. This is a major flaw in simple microeconomic analysis. In the business schools it has led to the "theory of the firm" line of thought, but unfortunately business schools really don't bring enough intellectual firepower (and perhaps honesty) to the topic to do it justice. The econ depts generally ignore the question until the 2nd year of graduate school - and very few people (and fewer policy-makers) ever get that far.

Cranky

Posted by: Cranky Observer | Apr 27, 2007 2:51:31 PM

Google has lots on Joel Podolny

Posted by: JimPortlandOR | Apr 27, 2007 2:51:47 PM

Wouldn't this same phenonemon be a reason to distrust unions as a means of benefiting workers, rather then a means of benefiting union bosses?

Posted by: Dave Justus | Apr 27, 2007 2:53:00 PM

> Unless one has worked in a major corporation
> with some opportunity to observe the reaches
> of higher management (I've been fortunate
> enough to have done this in two mega-firms),
> understanding or describing their actions is
> probably beyond grasp.

It is worse than that. There is a famous business sociologist who published some well-known and oft-cited papers based on his 10 year study of a large corporation where I worked. Every person at that company who was in-the-know (basically lower-middle-class white dudes with finance degrees from certain schools who were at the manager level or above and had "passed the test") knew that every senior person the sociologist had talked to for 10 years had lied to him - straightforwardly and consistently. And that the company had helpfully provided him all the documentation he needed - all of which confirmed the lies he had been told. It was something of a men's washroom joke among those who knew.

Cranky

Posted by: Cranky Observer | Apr 27, 2007 2:56:03 PM

"He argues that profits aren't maximized merely for shareholder gain, as the shareholders are abstractions rather than voices around the table"

Those abstractions take form as the threat of corporate raiders on the horizon. That's what the M&A "pirates" of the '80s were all about, targeting companies that had been allocating their resources to maintaining the comfort of the corporate culture - board members, managers, workers, vendors - and either forcibly redistributing value to the shareholders, or forcing them to preemptively do so in defense.

Posted by: Senescent | Apr 27, 2007 3:00:26 PM

The obvious truth that seems to escape market theocrats is that, as personal gain is the engine of their economic model, the logical end of such acquisitiveness is the domination and manipulation of that model. Absent sufficient countervailing forces, there is no reason to expect that market developement would follow another course. Incantory mantras to "free competition" are'nt an effective substitute.

Posted by: W.B. Reeves | Apr 27, 2007 3:05:55 PM

> Those abstractions take form as the threat
> of corporate raiders on the horizon. That's
> what the M&A "pirates" of the '80s were all
> about, targeting companies that had been
> allocating their resources to maintaining
> the comfort of the corporate culture

The flip side being that the corporate raiders destroyed a lot of companies that had provided good value to their _customers_ for many years, transforming them into purveyors of junk and in essence scam artists (Coleman comes to mind, as does the HP Instrument and Calculator divisions, but there are many others). So perhaps there was another aspect to the around-the-table culture.

To me the interesting question is why a system that had worked reasonably well from 1900 - 1970, without too much excessive greed by those in control, suddenly exploded. What happened in 1970 such that Presidents making $250k/year suddenly decided in mass that they needed to be "CEOs" making $2 million (and later $200 million)/year?

Cranky

Posted by: Cranky Observer | Apr 27, 2007 3:08:42 PM

Yes, except that Unions, by definition, exist only in synergy with a countervailing force: the employer. A union has no existence independent of the workforce and the workplace, over which it has no proprietary authority. A Union exists only by virtue of its ability to win benefits from Management. In the context of a market economy, each acts as a brake on the excesses of the other. The exceptions to this being when the "union" is fused with management, as in the case of the company union, or with the state as in the old Soviet model.

This leaves aside the fact that Union "Bosses" are very likely subject to the electoral veto of their memberships.

Posted by: W.B. Reeves | Apr 27, 2007 3:26:49 PM

Oops! Neglected to insert the relevant quote:

Wouldn't this same phenonemon be a reason to distrust unions as a means of benefiting workers, rather then a means of benefiting union bosses?

Yes, except that Unions, by definition, exist only in synergy with a countervailing force: the employer. A union has no existence independent of the workforce and the workplace, over which it has no proprietary authority. A Union exists only by virtue of its ability to win benefits from Management. In the context of a market economy, each acts as a brake on the excesses of the other. The exceptions to this being when the "union" is fused with management, as in the case of the company union, or with the state as in the old Soviet model.

This leaves aside the fact that Union "Bosses" are very likely subject to the electoral veto of their memberships.

Posted by: W.B. Reeves | Apr 27, 2007 3:31:19 PM

Wouldn't this same phenonemon be a reason to distrust unions as a means of benefiting workers, rather then a means of benefiting union bosses? Posted by: Dave Justus | Apr 27, 2007 11:53:00 AM
What happened in 1970 such that Presidents making $250k/year suddenly decided in mass that they needed to be "CEOs" making $2 million (and later $200 million)/year? Posted by: Cranky Observer | Apr 27, 2007 12:08:42 PM

I think these two have an echo-and-bounce, cause-and-effect sort of relationship.

Posted by: DataShade | Apr 27, 2007 3:41:01 PM

To me the interesting question is why a system that had worked reasonably well from 1900 - 1970, without too much excessive greed by those in control, suddenly exploded.

Well, if you overlook the twenties-thirties.

Posted by: W.B. Reeves | Apr 27, 2007 3:45:47 PM

"That's what the M&A "pirates" of the '80s were all about, targeting companies that had been allocating their resources to maintaining the comfort of the corporate culture - board members, managers, workers, vendors - and either forcibly redistributing value to the shareholders, or forcing them to preemptively do so in defense."

That's true but we should also remind ourselves that the M&A (hostile takeover) investment strategy, beyond having all sort of more obvious faults that people have been discussing for twenty odd years, also haven't fundamentally changed the corporate governance problem. These problems are not temporary and passing phenomenon, but are embedded in the very structure of the American corporation. See Mark Roe's discussion in his Strong Managers, Weak Owners.

Also problematic was:

a. since the raiders were financial players, mostly staffed with former investment bankers, they tended to see problems and solutions through the lens of financial theory. What that translates to is that the more obvious value situations (say, the company has an asset the raider could easily peddle off) were preferred and financial solutions (say, restructuring the balance sheet) were preferred over managerial or operational solutions.

b. the hostile raid solution was and is only really available when a firm has some pretty clear financial fixes. I.E. it can far more easily be utilized when the firm is already clearly exhibiting decline or some readily apparent financial value. So it's not really something that can really improve a firm much earlier when it's decline starts and that is ideally what we want - not someone who mops up a much worse mess later.

c. the hostile raiders severely damaged American corporate culture as a whole. We always must remember that Wall Street is not really a corporate place - most front-office high-flyers on Wall Street work in very small, largely egalitarian, non-bureaucratized teams (this was particularly true of the M&A guys who formed the bulk of early raiders). So when investment bankers capture a large amount of firms, they tended to change corporate cultures to resemble those of Wall Street - high pressure environments, long work hours, extreme differences in compensation, massive pay for the top tiers of a firm (remember, until comparatively recently, most Wall Street firms were private partnerships), emphasis on superficial smarts and education, often quite superficial external analysis of industries and companies (usually using highly inappropriate metaphors from academic economic theory), disregard of takeover targets' internal capabilities and workforce expertise, etc.

Posted by: burritoboy | Apr 27, 2007 4:00:43 PM

"Where would I find that paper?"

"Love or Money?: The Effects of Owner Motivation in the California Wine Industry" (with F. Scott Morton), Journal of Industrial Economics, Vol. 50, No. 4, 431-456, December 2002

Posted by: burritoboy | Apr 27, 2007 4:03:59 PM

"What happened in 1970 such that Presidents making $250k/year suddenly decided in mass that they needed to be "CEOs" making $2 million (and later $200 million)/year?"

See Rakesh Khurana's book Searching for the Corporate Savior.

Posted by: burritoboy | Apr 27, 2007 4:05:42 PM

Burritoboy is covering so much of this, but there's a simple principle at work to answer your question about what happened, Cranky Observer: basically, learning from experience. Lots of things hadn't been done because boards feared the likely consequences from their peers, rivals, regulators, money sources, and so on. But eventually, if enough people see that something might be done, someone will try it. If they get away with it, others start imitating them. The nihilistic spirit that spread through American (and other countries') business world in the last few decades had been the subject of often-wistful conversation in the decades before.

Posted by: Bruce Baugh | Apr 27, 2007 4:43:48 PM

For those too lazy to use Google Scholar the link to the paper in .pdf format is here: http://tinyurl.com/yq48zj

Posted by: eriks | Apr 27, 2007 5:08:09 PM

I'm not through the paper yet, but isn't it possible that those in the wine industry exhibit different characteristics than folks making widgets?

Posted by: Ezra | Apr 27, 2007 6:02:34 PM

"Joel Podolny proved that firms don't maximize for profit (as necessary for neoclassical theory to work). Instead, firms maximize for utility."

You're basing a far-reaching assertion like that on a paper limited to the California Wine Industry? An industry that's pretty rife with retirees and ex-Silly-con Valley types who cash out and found a wee Napa or Carmel vineyard as a hobby? This is like theorizing about Wall Street based on observations made at a Renaissance fair craft stalls.

As you've previously lectured me on the overreaching of scientists on claims of truth, it strikes me you need to be removing a big ol' log from your eye.

Posted by: Sock Puppet of the Great Satan | Apr 27, 2007 6:03:40 PM

"the hostile raid solution was and is only really available when a firm has some pretty clear financial fixes. I.E. it can far more easily be utilized when the firm is already clearly exhibiting decline or some readily apparent financial value. So it's not really something that can really improve a firm much earlier when it's decline starts and that is ideally what we want - not someone who mops up a much worse mess later."

I like your analysis of the M&A raiders in the 1980s as far as it goes, but it strikes me that it's 20 years out of date, given the different (and larger) role of private equity, which tend to be more activist shareholders in what public companies they hold, and whose general partners often come from operational backgrounds, as well as i-banking, and the fixes can be operational (in getting a management team in with a suitable operational background) as well as just increasing leverage. Similarly, an operational background is preferred in VC to i-banking or being from a top-tier consultant.

[Granted, that fact that the private equiry firms are taking a 20% carry, there's still problems with agency and hold-up costs.]

BTW, Dow Chemical canned two of its high-level execs this week for discussing a takeover with a private equity firm.

Thanks for the ref. to the Khurana book. Anything with a blurb from Dave Vogel of UCB has to be good.

Posted by: Sock Puppet of the Great Satan | Apr 27, 2007 6:19:52 PM


"I'm not through the paper yet, but isn't it possible that those in the wine industry exhibit different characteristics than folks making widgets?"

No, actually. Oh, each firm's utility will vary - the wine grower gets a lot of intangible utility, the waste manager gets less. But overall: you have to use a utility function, and not a profit function.

Here's the sticky point: people will propose assuming, for the overall economy, that non-money utility is zero. Is that a good assumption, or not?

Well, that zero assumption would mean that producers effectively never enjoy any aspect of their product or the process that makes their product. But we know that's not the case - even in the case of waste management, people have pride that their firms are efficient, or well-known, or have a good reputation. And clearly Podolny's work applies directly to very large segments of the economy: publishing, many financial sectors, healthcare, entertainment, restaurants, fashion, retailing, even automaking (a lot of people do join automakers because they love cars), news media and many others. Even real estate - my own firm will not do any projects, no matter how profitable, if they do not believe the project to be top-drawer in all major aspects.

So, we're talking about at minimum, a majority of our economy (healthcare + real estate + financial services alone is over 50%). That means a utility worldview is more useful than a profit-maximization worldview.

Posted by: burritoboy | Apr 27, 2007 6:49:34 PM

"I like your analysis of the M&A raiders in the 1980s as far as it goes, but it strikes me that it's 20 years out of date"

Certainly, the private equity business has changed. However, I think the core problems still remain.

a. Private equity in it's role as a primarily financial investor, usually fairly short-term in nature (yes, some funds are ten-year funds, but you're in trouble if you don't start showing investors good returns by year 4 at the latest).

b. A private equity firm's structure as a small, very highly motivated, very credentialed elite group of partners.

c. like any "external analyst" business, quite susceptible to groupthink, fads, overconfident framing.

Posted by: burritoboy | Apr 27, 2007 7:17:19 PM

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