Your World

What is Human Nature?

noreply@blogger.com ([Admin]) — Thu, 13 Jan 2011 17:15:00 +0000

Human nature is made up the characteristic patterns of thoughts, feelings and behaviors which make a person unique; Personality arises from within the individual and remains fairly consistent throughout life. Human nature varies person to person in both male and female, personality plays a vital role in human nature the triads like emotion thoughts feelings etc all play an imperative role.

These characteristics may vary person to person or in other words we can put it in a way that the person lacks the element of happiness, smile etc. to understand his/her nature. Human nature is such a thing that can change within a second to understand it in a better and detailed way we can look at the example below.

Suppose there is a meeting going on within the office and there the clients are being briefed about a certain topic as different people present their part of the presentation the client’s attitude changes by their questions in between to the presenter making the presenter and the team confused, more like creating a barrier in between effective communication. This might be against your nature in such a way that you might not like or accept this attitude by the client’s pin pointing while the presentation is being presented. This act might arise ager within you and you might point out to one of the client sitting either to wait for the presentation to end or either raises his hand if he/she has some query on which immediate action is needed. Or to cut it in a very rude manner while surely depict that the personality or the nature of the person lacks courtesy or etiquettes on how to handle situations ethically.

It is basically a lot of things which reflect human nature, it can be the way a person meets talk, share ideas, handle or tackles situations or even leading a team with objectives and goals so a person should show that he/she has to have all triads present in his/her nature to avoid the unseen.

In this world people deceive us by their human nature by showing false personality and not being their own self but following others footsteps which they think are right and try to impose their way of things as they perceive which causes the other person to suffer and thus his thoughts ideas go in his subconscious this way motivation is needed and personality comes to a halt. Life seems to treat us in many different ways in which we are tested upon our personality in which our distinctive nature is made to tackle them effectively.

Let’s take the example of the James Lange Theory this theory can be applied anywhere as it caters to human nature, to understand this theory let’s suppose a person is walking in the street and suddenly a dog appears in front of him since every person knows his/her fight mechanism he stops and focuses to the dog watching his next move, when the dog barks it is assured that it will or is going to attack sooner or later thus the autonomic arousal is in result fear and he then runs away to save his life.

It is clear that human nature plays a vital role in taking spontaneous decisions in different situations there is this flight and fight mechanism that is always working in the brain.

Let’s take another example of a school going child who has to do homework but since he is not allowed to play outside with his friends according to Freud this desire of playing outside will go into the subconscious of the child and in result his nature to finish his work would change into something different, which would bring up aggression, anger in his personality.

There is nothing in this world which does not possess nature it is basically GOD gifted and thus we find nature in every aspect of life. There is an old controversy of nature and nurture according to Plato Nature is something that is God gifted (Brain, Biology, Heritatery) there is the element of innateness present in it. On the other hand Nurture is something which is basically based on observation and experience it’s the social learning from others in other words to understand nurture we can say that its distinguished by society, learning and culture. The nature versus nurture debate is one of the oldest issues in psychology. The debate centers on the relative contributions of genetic inheritance and environmental factors to human development. Some philosophers such as Plato and Descartes suggested that certain things are inborn, or that they simply occur naturally regardless of environmental influences.

Human nature has a lot of influence from socialization, since we meet interact and share experiences one learns a lot from his/her social circle. It is in the nick of time we decide either to accept or reject a person from our personal understanding, since it’s the judgment of human nature that depicts the relation to take further or reject it to avoid personal issues in life. A very similar example is of our decision to make friends our enemies within different arguments, this decision is not done on the basis of human nature but it’s the ego which makes the person to act this way

In the end I’d like to conclude with my opinion that human nature is derived from personality and the better upbringing of the personality with a good moral and social value will make the his/her human nature stand out and thus will have a good social status and value among the peers and society

Guidelines for producing a short documentary

noreply@blogger.com ([Admin]) — Fri, 08 Jan 2010 13:07:00 +0000

Before shooting the film

The starting point is, of course, to think of an interesting topic that all the members of the group are enthusiastic about.

Watch documentary movies.

Choose a subject that you find fascinating and is accessible to you. Choosing a subject that is compelling & timely will result in a strong and relevant film. It is often better to focus on a local personality or local event so that you will have access to loads of resources for your film. Besides, it's much simpler & cheaper to shoot at home than abroad.

Become an expert on your chosen subject through research. Research your subject as thoroughly as possible. Gain knowledge through the internet, books, and word of mouth. Attend events pertaining to your chosen subject.

It is important to formulate the basic idea of the film as precisely and clearly as possible. If you do not know why you want to make this film, what it is about and where the story is going, then it might not be a very good idea for a film.

Find a selection of different documentaries, discuss the qualities of each film and note the good elements. This will probably give you an idea of how you want to structure your own film. During these screenings, however, keep in mind that most documentaries are not made on the same basis as the short fiction film – this limits the degree to which you should be inspired.

The preparation phase is very time consuming in the documentary genre. It requires thorough research on your topic or source of inspiration. In order to get a fairly good understanding of your person and his or her story you need to visit him or her and make some test interviews. This will give you an impression of the person's limits and boundaries, and what s/he is willing to talk about.

If possible, bring a video camera (to the first meetings) to find out how the person reacts to the camera, and to let him/her get used to its presence before the actual shoot. It also gives you a chance to map the different locations and thus plan more precisely what you want to be in the film (a test film is the basis for working out a fairly accurate storyboard/preliminary script.)

As regards the screenplay, there are different ways of structuring the material in a documentary.

1) The Linear Narrative Form, also known as classic Hollywood storytelling;

2) The Discursive Narrative Form, which gives priority to information, facts and logic;

3) The Episodic Narrative Form, which juxtaposes situations that have no narrative or causal relations.

4) The Poetic Narrative Form, which is built up around visual poetic associations.

The Camera plays a role: it acts on the sender's (i.e. your) behalf. Remember that the camera angles and movements are significant for the degree to which you express respect for, solidarity with, antipathy against, etc., the people in the film. (In some respects you always make films about yourself – even though you are working in groups). Before the shoot starts make sure you have agreed on certain principles for operating the camera (of course this is of special importance if the camera is operated by more than one member of the group).

It is a good idea to draw up a set of rules, some aesthetic narrative guidelines for what you can and cannot do. This will save you many discussions during the shoot and will ensure you a fairly coherent style (it easily becomes rather mixed with more than one director).

For instance, you can make rules about the interviews and the rooms where they should take place; whether or not the interviewer should be visible in the picture; whether the camera movements should be calm or swift; in which rooms or situations the camera should be on a tripod or handheld; whether the persons should be filmed from below, at eye-level, from above; if the interviewer's questions should be cut out (in which case a certain interview technique is required); whether you want to use voice-over commentary, and so on and so forth.

Note that one of the dangers of operating with a set of aesthetic rules (like using the storyboard method) is that the interviewee may become too "stiff" and tense. The rules are only meant to be guidelines – not dogmas – and you should be willing to change them as you go along.

It is important that you reflect on what sort of "voice" you want in your film already in the preparation phase (before working out a storyboard):

1) The Expository Mode: The viewer is addressed directly "with titles or voices that advance an argument about the historical world," and often images merely become illustrations of what the authoritative commentary (voice of God) maintains. A logical connection between sequences is predominant.

2) The Observational Mode: The camera acts as 'a fly on the wall,' style and mise-en-scène become invisible and in its purest form inter-titles, interview and voice-over commentary are excluded; the filmmaker is unobtrusive and the viewer is left to interpret reality for himself.

3) The Interactive Mode: Different kinds of dialogue and monologue are dominant. Most often these films are based on interviews.

4) The Reflexive Mode: This renders visible the epistemological and aesthetic reflections that are the basis for the production, thus drawing attention to the process of filmmaking. The poetic representation focuses on experiencing the world, not on the objective representation of it; it attempts to perceive the world aesthetically, and is often emotional in a poetic way. Remember that a documentary can speak with many 'voices.'

If your film contains an interview session it is important that you experiment with different interview techniques before you start shooting. It can be difficult to find the right technique; at any rate it should always be developed in accordance with the people in the film. Find out whether the person is dependent on the interviewer's response or if s/he is a natural storyteller. This is important when you decide whether the interview in the film should have a visible interviewer (dialogue) or a hidden interviewer (pseudo monologue). The choice of an inaudible interviewer challenges your interviewee to a larger extent: S/he must be able to handle a 3-4 second pause between your question and his or her answer while remaining natural and engaged. The interviewee should always make clear who and what s/he is talking about (without depending on the information incorporated in your questions). Not everyone can handle an interview situation like that. Many people are – to a large extent – dependent on the interview being more like a conversation.

As you develop your method for the interview, try out different ways of asking questions. Your questions should be phrased in such a way that the answers are delivered within a limited time and do not omit any important information.

Furthermore, you should test different interview set–ups (i.e. different positions of the camera, the microphone, the interviewer, the interviewee, lighting, and so on) for aesthetic reasons as well as out of consideration for the interviewee.

An interview is always an artificial situation, and it is important to make the interviewee feel as comfortable as possible – some people find it difficult to avoid looking into the camera if it is placed right in front of them.

Deciding what style of music (if any) you want in the film can be very time consuming. Your choice of music plays an important part in the overall impression of the film, and these discussions should not be postponed until the editing phase. Music is an important factor when it comes to creating a 'mood' in the film, and the wrong choice of music can ruin the production. Discuss whether the music should be supportive, controlling, disturbing, or contrapuntal in relation to what is visually expressed. If you make a test film on location, try out different types of music with the filmed material.

A storyboard might be useful even though you are making a documentary. By making a storyboard (instead of improvising your way through) you get a high degree of control. This ensures that the project is realistic within the given time.

By using a storyboard you reduce the risk of lacking important shots in the editing room. It is clear, however, that the storyboard of a documentary cannot be as accurate as that of a fiction film (which does not mean that it shouldn't be as detailed as possible): You cannot plan the exact length of the different shots, at least not those involving 'real-life' people. Try not to be too ambitious when it comes to the number of stories that you want people to tell. Telling a story often takes longer than you expect.

One of the fascinating aspects about filming reality is that it cannot be controlled. Invariably, new possibilities will turn up along the way. Thus, the storyboard should always be regarded as a preliminary script that can be adjusted on location. Just remember that the danger of improvising a lot is that you might end up with a story lacking some of the essential elements.

Consider whether you can give information 'the cinematic way' and show rather than have people tell the story (through talking-head monologue, explanatory voice-over, and so on).

The Shooting Phase:

Shoot the 'soft' things first (the daily chores). Don't shoot the interview until the person has become used to the presence of the camera as well as his/her role as an 'actor.'

As regards the interviews, compared to the interviewee the members of the film group are 'high status' (because you control the technical equipment and know what is to be filmed). In order to make the best of the interview and make the interviewee feel more comfortable, try to place yourselves in a low status position. You can tone down your high status position by pretending that you are not in complete control of the technical equipment. It may also have a relaxing effect if the interviewer improvises his other questions instead of reading off a script.

If a scene doesn't turn out as you planned (and it has to be re-shot), don't indicate that the interviewee didn't do well (even if that is the case). Instead, find some other excuses for re-shooting the scene; for instance, that the sound wasn't good enough, the picture was out of focus and so on.

When you need to check your filmed material, it is a good idea to leave one or two members of the group to chat with the interviewee (while the others check the pictures). Let the interviewee finish his or her story, even though you have already gotten what you wanted (to show respect for what s/he is saying).

In order to balance the unequal relationship between interviewer and interviewee and to make the interview situation less artificial, it might be a good idea for the interviewer to share some stories and contribute to the conversation.

Be careful about the technical side of the production. Making a documentary – filming 'reality' – is not an excuse for poor technical quality.

In order to make your persons appear as natural and spontaneous as possible, it is important to shoot the different scenes at psychologically the right times and places.

If the person is occupied with something, s/he is more likely to forget the camera.

If you use such camera movements as panning and tilting, make sure you have several takes of each shot in which the camera is moved at different speeds. This will give you more possibilities in the editing room.

If the camera is handheld it is important to keep it fairly steady. Make sure the picture pauses for 4-5 seconds every now and again, as this gives you a natural place to cut.

Avoid zooming unless you have deliberately chosen the aesthetics of television. It is difficult to edit a shot that contains a zoom. If you need to get closer to an object it is better to move the camera.

In general it is good to make the shots a little longer than first intended – you never know what you might need in the editing room.

Be ready to switch on the camera (or leave it on) if something unexpected happens that takes the full attention of your character to sort out. It might turn out to be a magical moment that you should consider using instead of one of the scenes from the script. In general, you need to be spontaneous and open to chance.

Shoot the general pictures in different formats (e.g. full shot as well as close shot). Often people find themselves lacking a particular format in the editing room. In general, extra pictures might come in handy.

Using the potential of cinematic techniques without drowning reality is a fine balancing act. On the other hand – don't rely so much on reality that you forget that you are actually making a film.

Be ready to make changes – maybe even to give up the original concept of the film (i.e. throw away the storyboard) if you find out that what you had planned doesn't really work. This goes for the shooting phase as well as the editing phase.

The Editing phase:

Basically, the editing principles of fiction and documentary are the same. However, there are more possibilities when editing a documentary, as you are not bound by causality in the same way and thus do not need to tell your story in a certain way, which gives you a high degree of freedom; you should therefore consider alternative ways of piecing the material together. Try to maintain certain sensitivity towards the raw material in order to avoid forcing it in the wrong direction because you are too focused on the story you had planned to tell.

Rather than throwing the good story or the good feeling overboard, it might be better to give up on style, aesthetics or beautiful pictures.

It can be difficult to identify the unnecessary 'darlings' or 'bad bits,' especially if you have become hypnotized by the material and are no longer able to see what works and what doesn't. It is always a good idea to get somebody to view your production with a fresh eye.

BASIC STEPS TO FOLLOW In CLASS:

Step 1:

Write a good documentary script, and do your research thoroughly.

Step 2:

Create a shot-by-shot outline of the script and use this as your guide. A timeline is also beneficial.

Step 3:

Lease or purchase a camera, tripod, microphones and video editing equipment. Without these basic tools, you will not have the means to make a documentary.

Step 4:

Contact all of the people you want to interview and set up times to meet with them.

Step 5:

Stick to your outline and relay the story. Film everything on the script.

Step 6:

Film two or three times more footage than you expect to use. It can always be edited later.

Step 7:

Edit the footage into a concise 90-minute film. Enlist the help of experienced documentary makers or editors to help you with this process.

Step 8:

Write a documentary treatment, which includes a synopsis and other details about the film. Submit it to film distribution companies for consideration.

Customer Choice and Demands

noreply@blogger.com ([Admin]) — Fri, 08 Jan 2010 13:05:00 +0000

It is not the province of economics to determine the value of life in “hedonic units” or any other units, but to work out, on the basis of the general principles of conduct and the fundamental facts of social situation, the laws which determine prices of commodities and the direction of the social economic process. It is therefore not quantities, not even intensities, of satisfaction with which we are concerned. . . .or any other absolute magnitude whatever, but the purely relative judgment of comparative significance of alternatives open to choice.
Frank Knight
eople adjust to changes in some economic conditions with a reasonable degree of predictability. When department stores announce lower prices, customers will pour through the doors. The lower the prices go, the larger the crowd will be. When the price of gasoline goes up, drivers will make fewer and shorter trips. If the price stays up, drivers will buy smaller, more economical cars. Even the Defense Department will reduce its planned purchases when prices rise.
Behavior that is not measured in dollars and cents is also predictable in some respects. Students who stray from the sidewalks to dirt paths on sunny days stick to concrete when the weather is damp. Professors who raise their course requirements and grading standards find their classes are shrinking in size. Small children shy away from doing things for which they have recently been punished. When lines for movie tickets become long, some people go elsewhere for entertainment.
On an intuitive level you find these examples reasonable. Going one step beyond intuition, the economist would say that such responses are the predictable consequences of rational behavior. That is, people who desire to maximize their utility can be expected to respond in these ways. Their responses are governed by the law of demand, a concept we first introduced in Chapter 3 and now take up in greater detail.
Predicting Consumer Demand
The assumptions about rational behavior described early in the book provide a good general basis for explaining behavior. People will do those things whose expected benefits exceed their expected costs. They will avoid doing things for which the opposite is true. By themselves, however, such assumptions do not allow us to predict future

At the old prices, the original combination (two Cokes and two hot dogs) gave you a total utility of only 64 utils (45 from hot dogs and 19 from Coke). If you cut back to one Coke and three hot dogs now, your total utility will rise to 67 utils (57 from hot dogs and 10 from Coke). Your new utility-maximizing combination—the one that best satisfies your preferences—will therefore be one Coke and three hot dogs. No other combination of Coke and hot dogs will give you greater satisfaction. (Try to find one.)

To sum up, if the price of hot dogs goes down relative to the price of Coke, the rational person will buy more hot dogs. If the price of Coke rises relative to the price of hot dogs, the rational person will buy less Coke. This principle will hold true for any good or service and is commonly known as the law of demand. The law of demand states the assumed inverse relationship between product price and quantity demanded, everything else held constant. If the relative price of a good falls, the individual will buy more of the good. If the relative price rises, the individual will buy

Thus far we have discussed demand solely in terms of the individual’s behavior. The concept is most useful, however, when applied to whole markets or segments of the population. Market demand is the summation of the quantities demanded by all consumers of a good or service at each and every price during some specified time period. To obtain the market demand for a product, we need to find some way of adding up the wants of the individuals who collectively make up the market.

This is, of course, an extremely simple example, since only two individuals are involved. The market demand curves for much larger groups of people, however, are derived in essentially the same way. The demands of Fred, Marsha, Roberta, and others would be added to those of Anna and Betty. As more people demand more Coke, the market demand curve flattens out and extends further to the right.

Elasticity: Consumers’ Responsiveness to Price Changes

In the media and in general conversation, we often hear claims that a price change will have no effect on purchases. Someone may predict that an increase in the price of prescription drugs will not affect people’s use of them. The same remark is heard in connection with many other goods and services, from gasoline and public parks to medical services and salt. What people usually mean by such statements is that a price

The Advantage

noreply@blogger.com ([Admin]) — Fri, 08 Jan 2010 13:01:00 +0000

The advantage of letting people know that you have been, and are planning to be, in business a long time is that it informs them that you have something to lose –potential future business -- if you engage in dishonest dealing. In effect, you are providing potential customers with a hostage, something of value that one party to a contract (the customer) can destroy if the other party (seller) does not keep its promises. There are numerous other ways that businesses create arrangements to provide hostages in ways that make their commitments to honest dealing credible. Before examining some of these arrangements, however, it is important to consider an important feature that hostages should have.

The use of hostages has a long history, and is traditionally thought of as a way to reduce the likelihood of hostilities between two countries or kingdoms. For example, if King A intended to wage war on Kingdom C and wanted to keep Kingdom B neutral, he could assure King B of his good faith by yielding up his beloved daughter to King B as a hostage. Assuming King A really did love his daughter, he would then be very reluctant to break his promise and invade Kingdom B after conquering Kingdom C. But even if King A does have a compelling incentive not to wage war against King B as long as his daughter is King B’s hostage, a potential problem remains. King B may find the daughter so attractive that he values her more than her father’s promise not to invade. Therefore, King B may decide to join with Kingdom C against King A and keep the daughter for himself. This suggests that an ugly daughter (one only a father could love!) makes a better hostage than a beautiful daughter.

A firm’s reputation can be thought of as a hostage that the firm puts in the hands of its customers as assurance that it is committed to honest dealing. A firm’s reputation is an ideal hostage because it is valuable to the firm, but has no value to customers apart from its ability to ensure honesty. A firm has a motivation to remain honest in order to prevent its reputation from being destroyed by customer dissatisfaction, but customers cannot capture the value of the reputation for themselves. The more a firm can show that it values its reputation, the better hostage it makes.

Consider the value of a logo to a firm. Companies commonly spend what seems an enormous amount of money for logos to identify them to the public. Well-known artists are paid handsomely to produce designs that do not seem any more attractive than those that could be rendered by lesser-known artists (many of whose artistic efforts have never gone beyond bathroom walls). Furthermore, companies are seldom shy about publicizing the high costs of their logos.

It may seem wasteful for a company to spend so much for a logo, and silly to let consumers know about the waste (the cost of which ends up in the price of its products). But expensive logos make sense when we recognize that much of the value of a company’s logo depends on its cost. The more expensive a company’s logo, the more that company has to lose if it engages in business practices that harm its reputation with consumers, a reputation embodied in the company logo. The company that spends a lot on its logo is effectively giving consumers a hostage that is very valuable to the company. Consumers have no interest in the logo except as an indication of the company’s commitment to honest dealing, but will not hesitate to destroy the value of the logo (hostage) if the company fails to live up to that commitment.

Expensive logos are an example of how businesses make non-salvageable investments to penalize themselves if they engage in dishonest dealing. Such investments are particularly common when the quality of the product is difficult for consumers to determine. The products sold in jewelry stores, for example, can vary tremendously and few consumers can judge that value themselves. Those jewelry stores that carry the more expensive products want to be convincing when they tell customers that those products are worth the prices being charged. One way of doing this is by selling jewelry in stores with expensive fixtures that would be difficult to use in other locations: ornate chandeliers, unusually shaped display cases, expensive counter tops, and generous floor space. What could the store do with this stuff if it went out of business? Not much, and this tells the customers that the store has a lot to lose by misrepresenting. The idea of firms intentionally making their profits vulnerable to the actions of others may seem inconsistent with our discussion on “make-or-buy” decisions. In that early chapter we argued that firms often forgo the advantages of buying inputs in the marketplace by making them in-house to protect their profits on their investment against exploitation by others. The difference in the two cases is important. When firms put their profits at risk as a hostage to consumers, those consumers cannot capture the profits for themselves. They can only destroy them, and their only motivation for doing so would be that the firm is no longer satisfying their demands. In the case where a firm incurs the disadvantage of producing in-house to protect its profits, the problem is that suppliers can actually capture those profits for themselves by acting opportunistically, or dishonestly. So in some cases protecting profits promotes honest dealing, and in other cases putting those profits at risk promotes honest dealing.
The importance business people attach to committing themselves to honesty sometimes leads them to put their profits in a position to be competed away by other firms that will benefit from doing so. Consider a situation where a firm has a patent on a high quality product that consumers would like to purchase at the advertised price, but a product that would be difficult to stop using because its use requires costly commitments. The fear of the potential buyers is that the seller will exploit the long-term patent

It may seem wasteful for a company to spend so much for a logo, and silly to let consumers know about the waste (the cost of which ends up in the price of its products). But expensive logos make sense when we recognize that much of the value of a com¬pany’s logo depends on its cost. The more expensive a company’s logo, the more that company has to lose if it engages in business practices that harm its reputation with consumers, a reputation embodied in the company logo. The company that spends a lot on its logo is effectively giving consumers a hostage that is very valuable to the company. Consumers have no interest in the logo except as an indication of the company’s commit¬ment to honest dealing, but will not hesitate to destroy the value of the logo (hostage) if the company fails to live up to that commitment.

Another possibility is for the seller to give up his or her monopoly position by licensing another firm to sell the product. By doing so the seller makes his or her promise to charge a reasonable price in the future credible, since if the seller breaks the promise the buyer can turn to an alternative seller. Giving up a monopoly position is a costly move of course, but it is exactly what semiconductor firms that have developed patented chips have done. To make credible their promise of a reliable and competitively priced supply of a new proprietary chip (the use of which requires costly commitments by the user), semiconductor firms have licensed such chips to competitive firms. Such a licensing arrangement is another example of making profits by way of a hostage intended to encourage honesty.7

The more difficult it is for consumers to determine the quality of a product or service, the more advantage there is in committing to honesty with hostage arrangements. Consider the case of repair work. When someone purchases repair work on their car, for example, they can generally tell if the work eliminates the problem. The car is running again, the rattle is gone, the front wheels now turn in the same direction as the steering wheel, etc. But few people know if the repair shop charged them for only the repairs necessary, or if it charged them for lots of parts and hours of labor when tightening a screw was all that was done. One way repair shops can reduce the payoff to dishonest repair charges is through joint ownership with the dealership selling the cars being repaired. In this way the owner of the dealership makes future car sales a hostage to honest repair work. Dealerships depend on repeat sales from satisfied customers, and an important factor in how satisfied people are with their cars is the cost of upkeep and re¬pairs. The gains a dealership could realize from overcharging for repair work would be quickly offset by reductions in both repair business and car sales.

Automobiles are not the only products in which it is common to find repairs and sales tied together in ways that provide incentives for honest dealing. Many products come with guarantees entitling the buyer to repairs and replacement of defective parts for a specified period of time. These guarantees also serve as hostages against poor quality and high repair costs. Of course, guarantees not only provide assurance of quality, they provide protection against the failure of that assurance. Sellers often offer extra assur¬ance, and the opportunity to reduce their risk, by selling a warranty with their product that extends the time, and often the coverage, of the standard guarantee.

Knowing that a product is under guarantee or warranty can tempt buyers to use the product improperly and carelessly, and then blame the seller for the consequences. With this moral hazard in mind, sellers put restrictions on guarantees and warranties that leave buyers responsible for problems they are in the best position to prevent. For exam¬ple, refrigerator manufacturers ensure against defects in the motor but not against damage to the shelves or finish. Similarly, automobile manufacturers ensure against problems in the engine and drive train (if the car has been properly serviced) but not against damage to the body and the seat covers. While such restrictions obviously serve the interests of sellers, they also serve the interests of buyers. When a buyer takes advantage of a guarantee by misrepresenting the cause of a difficulty with a product, all consumers pay because of higher costs to the seller. Buyers are in a prisoners’ dilemma in which they are better off collectively using the product with care and not exploiting a guarantee for problems they could have avoided. But without restrictions on the guarantee each indi¬vidual is tempted to shift the cost of their careless behavior to others.

Adverse selection is a problem associated with distortions arising from the fact that buyers and sellers often have different information that is relevant to a transaction. Most of this chapter has been concerned with the ways sellers commit themselves to honestly revealing the quality of products when they have more information about that quality than do buyers. But in the case of warranties it is the buyer who has crucial information that is difficult for the seller to obtain. Some buyers are harder on the prod¬uct than average and others are easier on the product than average. The use of automo¬biles is the most obvious example. Some people drive in ways that greatly increase the probability that their cars will need expensive repair work, while others drive in ways that reduce that probability. If a car manufacturer offers a warranty at a price equal to the average cost of repairs, only those who know that their driving causes greater than average repair costs will purchase the warranty, which is therefore being sold at a loss. If the car manufacturer attempts to increase the price of the warranty to cover the higher than expected repair costs, then more people will drop out of the market leaving only the worst drivers buying the warranty.8

Even though people would like to be able to reduce their risks by purchasing war-ranties at prices that accurately reflect their expected repair bills, the market for these

How Honesty Pays in Business

noreply@blogger.com ([Admin]) — Fri, 30 Oct 2009 07:42:00 +0000

There exist the popular perception that markets fail because business is full of dishonest scoundrels – especially high ranking executives -- who cheat, lie, steal, and worse to increase their profits. This perception is reflected in and reinforced by the way business people are depicted in the media. According to one study, during the 1980s almost 90 percent of all business characters on television were portrayed as corrupt

The case to be made for honesty in business is not based on any claim that business people are particularly virtuous, or ethical to the core of their beings. We can make no claim to keen insights into the virtue of business people or anyone else. We might even be persuaded that business people have less virtue on average than do those who choose more caring occupations, such as teachers, social workers, missionaries, and nurses. But we do claim to know one simple fact about human behavior, and that is people respond to incentives in fairly predictable ways. In particular, the lower the personal cost of dishonesty, the greater the extent of dishonestly within most identified groups of people. If business people act honestly to an unusual degree (or different from what other people in other situations do), it must be in part because they expect to pay a high price for behaving dishonestly. This is, in fact, the case because business people have found, somewhat paradoxically, that they can increase profits by accepting institutional and contractual arrangements that impose large losses on them if they are dishonest.

Though seldom mentioned, most business activity requires a high degree of honest behavior. If business is going to be conducted at any but the simplest level, products must be represented honestly, promises must be kept, costly commitments must be made, and business people must cooperate with each other to take the interests of others, particularly consumers, into consideration. Indeed, if the proverbial man from Mars came down and observed business activity, he might very well conclude that business people are extraordinarily honest, trusting, and cooperative. They sell precious gems that really are precious to customers who cannot tell the difference between a diamond and cut glass. They promise not to raise the price of a product once customers make investments that make switching to another product costly, and they typically keep the promise. They make good faith pledges that the businesses they own, but are about to sell, will continue to give their customers good service. They commit themselves to costly investments to serve customers knowing the investments will become worthless if customers shift their business elsewhere.

The way business people behave in the marketplace suggests a level of morality that is at variance with the self-interest that economists assume, in their theoretical models, motivates business activity. Some argue that the economist’s assumption of self interest is extreme, and we recognize that many people, including many business people, behave honestly simply because they feel it is the right thing to do. But few would recommend that we blindly trust in the honesty of others when engaged in business activity. The person who is foolish enough to assume that all business people are honest

It is easy to imagine a situation in which business people can profit at the expense of their customers, workers, and others with whom they deal if they behave deceitfully. For example, the quality of many products (say used cars or diamonds) is difficult for consumers to easily determine. The seller who takes advantage of this by charging a high quality price for a low quality product would capture extra profits from the sale. A business owner who is about to retire can profit by making promises not to be fulfilled until after his retirement, and which he does not plan to keep. The monopoly producer of a superior product (but one which requires the consumer to make costly investments in order to use it) can offer the product at a low price and then, once the consumer becomes dependent on it, increase the price significantly. Other examples of the potential profit from dishonest behavior are easily imagined. In fact, such examples are about the only type of behavior some people ever associate with business.

A businessperson who attempts to profit from dishonest dealing faces the fact that few people are naively trusting. It may be possible to profit from dishonesty in the short run, but those who do so find it increasingly difficult to get people to deal with them in the long run. And in some businesses it is extremely difficult to profit from dishonesty even in the short run. How many people, for example, would pay full price for a “genuine” Rolex watch, or diamond necklace, from someone selling them out of a Volkswagen van at the curb of a busy street? Without being able to provide some assurance of honesty, the opportunities to profit in business are very limited.

So business people have a strong motivation to put themselves in situations in which dishonest behavior is penalized. Only by doing so can they provide potential customers, workers, and investors with the assurance of honest dealing required if they are to become actual customers, workers, and investors.

The advantage of honesty in business can be illustrated by considering the problem facing Mary who has a well-maintained 1990 Honda Accord that she is willing to sell for as little as $4,000. If interested buyers know how well maintained the car is,

So the mix of 1990 Accords for sale will tilt more in the direction of poorly maintained cars, their expected value will decline, and even fewer well-maintained 1990 Accords will be sold. This situation is often described as a market for “lemons,” and illustrates the value of sellers being able to commit themselves to honesty.

Choosing the Most Efficient Remedy for Externalities

noreply@blogger.com ([Admin]) — Fri, 30 Oct 2009 07:40:00 +0000

selecting the most efficient method of minimizing externalities can be a complicated process. To illustrate, we will compare the costs of two approaches to controlling pollution, government standards versus property rights

Suppose five firms are emitting sulfur dioxide, a pollutant that causes acid rain. The reduction of the unwanted emissions can be thought of as an economic good whose production involves a cost. We can assume that the marginal cost of reducing sulfur dioxide emissions will rise as more and more units are eliminated. We can also assume that such costs will differ from firm to firm. Table 7.1 incorporates these assumptions. Firm A, for example, must pay $100 to eliminate the first unit of sulfur dioxide and $200 to eliminate the second. Firm B must pay $200 for the first unit and $600 for the second. Although the information in the table is hypothetical, it reflects the structure of real-world pollution clean-up costs. The technological fact of increasing marginal costs faces firms when they clean up the air as well as when they produce goods and services.

Suppose the Environmental Protection Agency (EPA) decides that the maximum acceptable level of sulfur dioxide is ten units. To achieve that level, the EPA prohibits firms from emitting more than two units of sulfur dioxide each.

Remember that the EPA can control the number of tickets it sells. To limit pollution to the maximum acceptable level of ten units, all it needs to do is sell no more than ten tickets. Either way, whether by pollution standards or rights, the level of pollution is kept down to ten units, but the pollution rights method allows firms that want to avoid the cost of a cleanup to bid for tickets.

The potential market for such rights can be illustrated by conventional supply and demand curves. The supply curve is determined by EPA policymakers, who limit the number of tickets to ten. Because in this example the supply is fixed, the supply curve must be vertical (perfectly inelastic). Whatever the price, the number of pollution rights remains the same. The demand curve is derived from the costs firms must bear to clean up their emissions. The higher the cost of the cleanup, the more

At a price of $1,500 per ticket, firm A will buy one and only one ticket. At that price, it is cheaper for the firm to clean up its first four units (the cost of the cleanup is $100 + $200 + $400 + $800). Only the fifth unit, which would cost $1,600 to clean up, makes the purchase of a $1,500 ticket worthwhile. Similarly, firm B will buy three tickets, firm C none, firm D two, and firm E four.

The cost of any cleanup must be measured by the value of the resources that go into it. The value of the resources is approximated by the firm’s expenditures on the cleanup—not by their expenditures on pollution tickets. (The tickets do not represent real resources, but a transfer of purchasing power from the firms to the government.) Accordingly, the economic cost of reducing pollution to ten units is $9,300; $1,500 for firm A. $800 for B, $3,000 each for C and D, and $1,000 for E

The idea of selling rights to pollute may not sound attractive, but it makes sense economically. When the government sets standards, it is giving away rights to pollute. In our example, telling each firm that it must reduce its sulfur dioxide emissions by three units is effectively giving them each permission to dump two units into the atmosphere. One might ask whether the government should be giving away rights to the atmosphere, which has many other uses besides the absorption of pollution. Though some pollution may be necessary to continued production, that is no argument for giving away pollution rights. Land is needed in may production processes, but the Forest Service does not give away the rights to public lands. When pollution rights are sold, on the other hand, potential users can express the relative values they place on the right to pollute.² In that way, rights can be assigned to their most valuable and productive uses.

Market Failures External Costs and Benefits

noreply@blogger.com ([Admin]) — Fri, 30 Oct 2009 07:37:00 +0000

In its broadest definitional sense, collective action is the enactment and enforcement of law. The justification for all collective action, for government, lies in its ability to make men better off. This is where any discussion of the bases for collective action must begin.

James Buchanan

Howmuch should government involve itself in the marketplace? How much does business want government involvement.” These questions touch on one of the most important economic issues of our time: the division of responsibility between the public and private sectors. In general, economic principles would suggest that government undertake only functions that it can perform more efficiently than the market. As we will see, businesses are not always opposed to government involvement in the economy. Indeed, many businesses have incentives to try to make sure that government is more involved in the economy than is “efficient.”

Economics provides a method for evaluating the relative efficiency of government and the marketplace. It enables the United States to identify which goods and services the market will fail to produce altogether, and which it will produce inefficiently. We saw in an earlier chapter that such market failures have three sources: monopoly power, external costs, and external benefits. Now, using the principles and graphic analyses developed in earlier chapters, we will take a closer look at external costs and benefits and at government attempts to capture them and correct market failures.

In a competitive market, producers must minimize their production costs in order to lower their prices, increase their production levels, and improve the quality of their products. Consumers must demonstrate how much they will pay for a product, and in what amount they will buy it. In a competitive market, production will move toward the intersection of the market supply and demand

These results cannot be achieved unless competition is intense, buyers receive all the product’s benefits, and producers pay all the costs of production. If such optimum conditions are not achieved, the market fails. Part of the excess benefits shown by the shaded area in the figure will not be realized by either buyers or sellers.

When exchanges between buyers and sellers affect people who are not directly involved in the trades, they are said to have external effects, or to generate externalities. Externalities are the positive or negative effects that exchanges may have on people who are not in the market. They are third-party effects. When such effects are pleasurable they are called external benefits. When they are unpleasant, or impose a cost on people other than the buyers or sellers, they are called external costs. The effects of external costs and benefits on production and market efficiency can be seen with the aid of supply and demand curves.

Producers may not bear all the costs associated with production, however. A by-product of the production process may be solid or gaseous waste dumped into rivers or emitted into the atmosphere. The stench of production may pervde the surrounding community. Towns located downstream may have to clean up the water. People may have to paint their houses more frequently or seek medical attention for eye irritation. Homeowners may have to accept lower prices than usual for their property. All these costs are imposed on people not directly involved in the production, consumption, or exchange of the paper product. Nonetheless, these external costs are part of the total cost of production to society.

In a perfectly competitive market, in which all participants act independently, survival may require that a producer impose external costs on others. An individual producer who voluntarily installs equipment to clean up pollution will incur costs higher than those of its competitors. It will not be able to match price cuts, and so in the long run may be out of business -- and some producers may not care whether they cause harm to others by polluting the environment. Even socially concerned producers cannot afford to care too much about the environment.

Government dictates in educational institutions have sometimes imposed onerous costs on students. For instance, until the late 1960s, the University of Virginia had a dress code that required male students to wear coats and ties. Colleges routinely set the hours by which students should return to their dormitories and expelled those who rebelled. At the University of California, students were once forbidden to engage in on-campus political activity. Costs are imposed on those who must obey such rules. The more centralized the government that is setting the standards, the less opportunity people will have to escape the rules by moving elsewhere.

In certain markets, government action may not be necessary. Over the long run, some of the external costs and benefits that cause market distortions may be internalized. That is, they may become private costs and benefits. Suppose the development of a park would generate external benefits for all businesses in a shopping district. More customers would be attracted to the district, and more sales would be made. An alert entrepreneur could internalize those benefits by building a shopping mall with a park.

Persuasion

External costs arise partly because we do not consider the welfare of others in our decisions. Indeed, if we fully recognized the adverse effects of our actions on others, external cost would not exist. Our production decisions would be based as much as possible on the total costs of production to society.

Thus government can alleviate market distortions by persuading citizens to consider how their behavior affects others. Forest Service advertisements urge people not to litter or to risk forest fires when camping. Other government campaigns encourage people not to drive if they drink, to cultivate their land so as to minimize erosion, and to conserve water and gas. Although such efforts are limited in their effect, they may be more acceptable than other approaches, given political constraints.

Persuasion can take the form of publicity. The government can publish studies demonstrating that particular products or activities have external costs or benefits. The resultant publicity may in turn encourage those activities with external benefits and discourage those activities with external costs. The government has, for example, used this method in the case of cigarettes, publishing studies showing the external costs of smoking.

Government production can be a mixed blessing. When other producers remain in the market, government participation may increase competition. Sometimes it means the elimination of competition. Consider the U.S. Postal Service, which has exclusive rights to the delivery of first-class mail. As a government agency, the Post Office is not permitted to make a profit that can be turnover to shareholders. Because of its market position with little competition for home delivery of mail, however, it may tolerate higher costs and lower work standards than competitive firms.

Some government production, such as the provision of public goods like national defense, is unavoidable. In most cases, however, direct ownership and production may not be necessary. Instead of producing goods with which externalities are associated, government could simply contract with private firms for the business. That is precisely how most states handle road construction, how several states handle the penal system, and how a few city governments provide ambulance, police, and firefighting services.

Cartoons teaching children?

noreply@blogger.com ([Admin]) — Sun, 27 Sep 2009 07:13:00 +0000

As we are all aware that cartoons are seen by children all over the world but are our parents aware of what is being shown in those cartoons ?

My point of writing an article on this topic is to create awareness among parents that simply allow their children to watch any cartoon channel and seem to be content of what is being shown on it. It was a coincidence that I was at a birthday party of my youngest cousin he is 5 years old, there were a lot of children at his party they played games like they usually did but after the party ended all the adults were on the table talking on different topics and the children were told to go in the TV lounge and watch cartoons.

Since being a lover of cartoons I went to watch it to pass time, as soon as I sat down I saw all the children sitting in a group and watching it like it was some kind of a teaching session going on in that cartoon. To tell u the truth about the channel and the cartoon it was totally something I did not expect at all.

POGO is India's cartoon channel which comes in our country also, but has anyone seen what is being showed on it? sometimes when we are switching channels we come across this channel showing Just For Laugh Gags or Mr. Bean it gives us the feel that this channel is totally safe for children to watch, what's going on when the children are watching it alone with no parental guidance. Being it from India they have developed a strategy to promote and educate the Hindu children on their religion from their cartoons some cartoons like "Chota Beem" are a pure example of this strategy.

How could a child say that I want to become Chota Beem when I grow older or how can he say that I want to be like that four hand guy in the cartoon ? It's all about the awareness that is being transmitted to the child with the help of cartoons so that in India by the time he/she goes to school they should be fully aware or should have the knowledge about their religion so that they could be thought at a higher level at school.

The point to write this article is not to blame it to the channel for showing such cartoons like this or the cable operators to ban this channel but to create awareness among young children and parents that they should at least see what is being shown on TV. I hope that parents and young children read this article so that they should know the difference between right and wrong, the code of ethics plays a vital role in the personality of the child thus the parents should tell the reason so that the child stays away from it.

Anonymous .

Firm Incentives

noreply@blogger.com ([Admin]) — Sat, 26 Sep 2009 06:51:00 +0000

The manager will have to be closely monitored. The franchisee, on the other hand, becomes the residual claimant on the new restaurant business and, accordingly, has a stronger incentive to reduce shirking and other forms of opportunistic behavior by the employees.
We note above that monitoring costs (or the costs associated with keeping track of manager and worker performance) are not eliminated through franchising. This is the case because the franchisees have some reason to shirk (albeit that the incentive to shirk is impaired by the franchise agreement that leaves the franchisee an important residual claimant). Customers often go to franchised outlets because they have high confidence in the nature and quality of the goods and services offered. McDonalds customers know that they may not get the best burger in town when they go to a McDonalds, but they do have strong expectations on the size and taste of the burgers and the cleanliness of the restaurant. McDonalds has a strong incentive to build and maintain a desired reputation for its stores, and therein lies the monitoring catch. Each franchisee, especially those that have limited repeat business, can “cheat” (or free ride on McDonalds overall reputation) by cutting the size of the burgers or letting their restaurants deteriorate. The cost savings for the individual cheating store can translate into a reduced demand for other McDonalds restaurants. This is a prisoner’s dilemma in which all stores can be worse off if noncooperative behavior becomes a widespread problem. So, McDonalds must set (and has strong incentives to do so) production and cleanliness standards and then back up the standards with inspections and fines, if not outright termination of the franchise contract.
McDonalds (and any other franchiser) also controls quality by requiring the individual restaurants to buy their ingredients -- for example, burger patties and buns -- from McDonalds itself or from approved suppliers. McDonalds has good reason to want its franchisees to buy the ingredients from McDonalds, not because (contrary to legal opinion) it gives McDonalds some sort of monopoly control, but because McDonalds has a problem in monitoring outside suppliers.48 Outside suppliers have an incentive to shirk on the quality standards with the consent of the franchisees that, individually, have an interest in cutting their individual costs. Moreover, by selling key ingredients, the franchiser has an indirect way of determining if its royalties are being accurately computed. So-called “tie-in sales” are simply a means of reducing monitoring costs. Of course, the franchises also have an interest in their franchiser having the lowest possible monitoring cost: it minimizes the chances of free riding by the franchisees and maintains the value of the franchise. Similarly, a franchiser like McDonalds (as do the franchisees) has an interest in holding all franchisees to uniform prices that are higher than individual McDonalds might want to choose. By maintaining uniform retail prices, McDonalds encourages its franchisees to incur the costs that must be incurred to maintain desired quality standards.
These points help explain up-front payment and royalty provisions in franchise contracts. The value of the franchise to the franchisee – and what the franchisee will pay, at a maximum, for the franchise – is equal to the present value of the difference between two income streams, the income that could be earned with and without the franchise. The greater the difference, the greater the up-front payment the franchisee is willing to make. However, the franchisee is not likely to want to pay the full difference up-front. This is because the franchiser would then have little incentive to live up to the contract (to maintain the flow of business and to police all franchisees). The franchiser could run off with all the gains and no costs. As a consequence, both the franchiser and franchisee will likely agree to an up-front payment that is less than the difference in the two income streams identified above and to add a royalty payment. The royalty payment is something the franchisee, not just the franchiser, will want to include in the contract simply because the franchiser will then have a stake in maintaining the franchisee’s business. A combination of some up-front payment and royalty is likely to maximize the gains to both franchisee and franchiser.
Franchising also has risk problems no matter how carefully the contract may be drawn. Typically, franchisees invest heavily in their franchise, which means the franchisee has a risky investment portfolio because it is not highly diversified. This can mean that the franchisee will be reluctant to engage in additional capital investment that could be viewed as risky only because of the lack of spread of the investment. As a consequence, franchisers will tend to favor franchisees that own multiple outlets. A franchisee with multiple outlets can spread the risk of its investments and can more likely internalize the benefits of its investments in maintaining store quality (customers are more likely to patronize, or fail to do so, at another of the owner’s outlets).
Obviously, both ownership and franchise methods of expansion have costs and benefits for investors. We can’t here settle the issue of how a firm like McDonalds should expand, by ownership of additional outlets or by franchising them. All we can do is point out that franchising should not be as important when markets are “local.” It should not, therefore, be a surprise that franchising grew rapidly in the 1950s with the spread of television that greatly expanded the market potential for many goods and services and when transportation costs. The chances for opportunistic behavior can be lowered through franchising, but hardly eliminated.49 If the franchisee buys the rights to the franchise and then invests in the store that has limited resale value, the franchiser can appropriate the rents simply by demanding higher franchise payments or failing to enforce production and quality standards with the franchisees, increasing the take of the franchiser but curbing the resale value of the franchise. On the other hand, if the franchisee pays for the building that has a limited resale value, the franchisee can, after the fact, demand lower franchise fees and special treatment (to the extent the franchiser must incur a cost in locating another franchisee).

Began declining rapidly, which allowed people to move among local markets.50 Franchising will tend to be favored when there is a low investment risk for the franchisee and when there are few incentives for free riding by both franchisee and franchisers. We should expect that franchises should be favored the greater the monitoring costs (implying the farther the store location is from the franchiser, the more likely the expansion will be through franchising, a conclusion that has been supported by empirical studies51). Also, we would expect stores at locations with relatively few repeat customers to be company owned. A better way of putting that point is the fewer the repeat customers in a given location, the greater the store will be company owned. When a store has few repeat customers, the incentive to cheat is strong, which means that the franchiser will have to maintain close monitoring to suppress the incentive for the franchisee to cheat or free ride – which implies there may be fewer cost advantages to franchising the location.52 If monitoring costs go down, we should expect firms to increase their ownership of their outlets.
Much of what we have written in this chapter is based on the presumption that people will behave opportunistically. We see the presumption as well grounded, given the extent to which people do behave that way in their daily dealings (and most managers have no trouble identifying instances of opportunistic behavior in workers, suppliers, and investors). We may, however, have given the impression that we believe that all people are always willing to behave opportunistically, which is simply contradicted by everyday experience. The business world is full of saints and sinners, and most people are some combination of both. We simply base our discussion here and in later chapters on a presumption that people will behave opportunistically not because such an assumption is fully descriptive of everyone in business, but because that is the threat managers want to protect themselves against. Business people don’t have to worry about the Mother Teresa’s of the world. They do have to worry about less-than-perfect people. (And they do have to worry about people who pretend to be like Mother Teresa before any deal is consummated.) They need to understand the consequences of opportunistic behavior in order that they can appropriately structure contracts and embedded incentives.

This suggests that the size and specialization of firms will change over time in response to technological advances that alter the relative costs of market transactions and the costs (as well as the efficiency) of managerial control. In other chapters we discuss the effects that improvements in communication, transportation, and management information systems are having on the size and focus of firms. The trend for firms to downsize and to refocus on their “core competencies” can be explained, at least in part, by the reduced cost of smaller, more specialized firms dealing with each other through market exchange in collaborative productive efforts. But no matter how specialized firms become, resources will continue to be allocated differently within firms than they are across markets. The reason firms will continue to exist is that over some range of productive activity, it is more efficient for resources to be directed by managerial control than by market exchange.53
MANAGER’S CORNER: Fringes, Incentives, and Profits
Varying the form of pay is one important way firms seek to motivate workers – and overcome the prisoners’ dilemma/principal-agency problems that have been at the heart of this chapter. And worker pay can take many forms, from cold cash to an assortment of fringe benefits. However, it needs to be noted that workers tend to think and talk about their fringe benefits in remarkably different terms than they do about their wages. Workers who profess that they “earn” their wages will describe their fringes with reference to what their employers “give” them. “Gee, our bosses give us three weeks of vacation, thirty minutes of coffee breaks a day, the right to flexible schedules, and discounts on purchases of company goods. They also provide us with medical and dental insurance and cover 80 percent of the cost. Would you believe we only have to pay 20 percent”.

Here, we have shown how opportunistic behavior can arise in the most basic of management decisions, whether to “make or buy.” An important task of a good manager is being constantly attentive to the trade-off between the advantages of buying and those of making, and one of the major worries is the extent of opportunistic behavior in that decision. In assessing this trade-off managers need to be aware that the decision is dependent upon the nature of what is to be bought or produced and that bureaucratic tendencies within a firm can distort decisions in favor of producing in-house even though buying would be more efficient. The firm that loses sight of this tendency may soon be out-competed by smaller firms that rely less on internal allocation and more on specialization and market transactions to produce at lower cost.
53 It should be pointed out.

If either the workers or the employers who make such comments are in fact telling the truth, then the company should be a prime candidate for a hostile takeover. Someone -- a more pragmatic and resourceful businessperson -- should buy the owners out, and the workers should want that someone to buy the company because they could then share in the gains to be had from the improved efficiency of the company.
Our arguments here will be a challenge to many readers since it will develop a radically different way of thinking about fringe benefits. It will require readers to set aside any preconceived view that fringes are a gift or that fringes are either provided or they are not. The approached used here employs what we call marginal analysis, or the evaluation of fringes in terms of their marginal cost and marginal value. It is grounded in the principle that profits can be increased so long as the marginal value of doing anything in business is greater than the marginal cost.
This principle implies that a firm should extend its output for as long as the marginal value of doing so (in terms of additional revenue) exceeds the marginal cost of each successive extension. It should do the same with a fringe: provide it so long as it “pays,” meaning so long as the marginal cost of the fringe is less than its marginal value (in terms of wages workers are willing to forgo and greater production) for the firm. This way of looking at firm decision-making means that changes in the cost of fringes can have predictable consequences. An increase in the cost of any fringe can give rise to a cut in the amount of the fringe that is provided. An increase in the value of the fringe to workers can lead to more of the fringe being provided.
Workers As Profit Centers
We don’t want to be overly crass in our view of business (although that may appear to be our intention from the words we have to use within the limited space we have to develop our arguments). We only want to be realistic when we surmise that from our economic perspective (the one that is likely to dominate in competitive business environments), the overwhelming Employers use some of the same language, and their answers to any question of why fringes are provided are typically equally misleading, though probably more gratuitous. The main difference is that employers inevitably talk in terms of the cost of their fringes. “Would you believe that the cost of health insurance to our firm is $4,486 per employee? That means that we spend millions, if not tens of millions, each year on all of our employees’ health insurance.

When making decisions on fringe benefits employers face two unavoidable economic catches: First, fringes are costly, and some fringes, like health and dental insurance, are extraordinarily costly. Second, there are limits to the value workers place on fringes. The reason is simply that workers value a lot of things, and what they buy, directly from vendors or indirectly via their employers, is largely dependent on who is the lowest cost provider.
Yes, workers buy fringe benefits from employers. They do so when the value the workers place on the fringes exceeds the cost of the fringes to the firms. When that condition holds, firms can make money by, effectively, “selling” fringes -- for example, health insurance -¬to their workers. How? Most firms don’t send sales people around the office and plant selling health insurance or weeks of vacation to their employees like they sell fruit in the company cafeteria, but they nevertheless make the sales. They do it somewhat on the sly, indirectly, by offering the fringes and letting their particular labor market conditions adjust. If workers truly value a particular fringe, then the firms that provide the fringe will see an increase in the supply of labor available to them. They will be able to hire more workers at a lower wage and/or be able to increase the “quality” (productivity) of the workers that they do hire.
Firms are paid for the cost of providing fringe benefits primarily in two ways: One, their real wage bill goes down with the increased competition for the available jobs that results from the greater number of job seekers (who are attracted by the fringe). This reflects the willingness of workers to pay employers for the fringe benefits. Two, employers gain by being more discriminatory in whom they hire, employing more productive workers for the wages paid and increasing sales.
No matter what happens in particular markets, we know several things about the pattern that will emerge in the fringe-benefit market:
•Many firms (but not all) can make money by “selling” fringes to their workers.
•Firms won’t provide the fringes if the combined gains from lower wages and better workers are not greater than the cost of the fringes.
We expect employers and workers to treat fringes like they do everything else, seeking some optimum combination of fringes and money wages. Again, this means that employers and workers should be expected to weigh off their additional (or marginal) value against their additional (or marginal) cost. An employer will add to a fringe like health insurance as long at the marginal value (measured in money wage concessions or increased production from workers) is greater than the marginal cost of the added fringe. Similarly, workers will “buy” more of any fringe from their employer so long as its marginal value (in terms of improved health or reduction in the cost of private purchase) is greater than its marginal cost (wage concessions).
While we can’t give specifics, we do know that managers are well advised to search earnestly for the “optimum” combination (which means some experimentation would likely be in order) even though the process of finding the optimum is beset with imprecisions. The firms that come closest to the optimum will be the ones that can make the most money from their employees. They will also be the ones that provide their employees the most valuable compensation for the money spent -- and so will have the lowest cost structure and be the most competitive. By trying to make as much money as possible from their employees, firms not only stay more competitive, they also benefit their workers as well.
So far, we have considered only fringes in which the added cost of the fringe to the firm is less than the value of the fringe to the workers. What if that were not the case? Returning attention to Figure 6.2, suppose that the cost of the fringe to firms were greater than the value of the fringe to workers (in the graph, the distance bc is greater than the distance ac), what would happen? The straight answer: Nothing. The fringe would not be provided. The reason is obvious: Both sides, workers and owners, would lose. The resulting drop in the wage would be less than the cost of the fringe to the employers, and the resulting drop in the wage would be greater than the value of the fringe to the workers. (To see this point, just try drawing a graph with the vertical drop in the demand greater than the outward shift of the supply.) Such a fringe would not -- and should not -- be provided simply because it is a loser to both sides.

What Firms Should Do

noreply@blogger.com ([Admin]) — Tue, 25 Aug 2009 09:00:00 +0000

An important message of this chapter is that because people can’t have everything they want, they will do what they can to get as much as they can. “Firms” are a means by which people can get “more” of what they want than otherwise. Firms are expensive operations, by their nature. Accordingly, people would not bother organizing themselves into “firms” if there were not gains to be had by doing so. But therein lies a fundamental dilemma for managers, how can managers ensure that the gains that could be had are actually realized and are shared in some mutually agreed upon way by all of the “stakeholders” in the firm? The problem is especially difficult when everyone associated with the firm – owners, managers, line workers, buyers, and suppliers -- probably want to take a greater share of the gains than they are getting and which he pointed out that no one person could make something even as simple as a lead pencil.31 It takes literally thousands of people specializing in such things as the production of paint, graphite, wood products, metal, machine tools, and transportation to manufacture a pencil and make it conveniently available to consumers. No one knows enough – or can know enough – to do everything required in pencil production. Prosperity depends on our ability to become very efficient in a specialized activity and then to exchange in the market place the value we produce for a wide range of products that have been efficiently produced by other specialists. Our ability to exchange in the market place not only allows us to produce more value through specialization, it also allows us to obtain the greatest return for our specialized effort by imposing the discipline of competition on those from whom we buy.
In this chapter, we extend our discussion of how transaction costs in markets can cause firms to extend the scope and scale of their operations. We are concerned with a special form of “opportunistic behavior” relating to the use of specialized plant and equipment that can cause firms to make things themselves even though outside suppliers could produce those things more efficiently.
Make or Buy Decisions
Much the same advantage from specialization and exchange applies to firms as well as individuals. But that comment begs an important question: Exactly what should firms make inside their organizations and what should they buy from some outside vendor? Business commentators have a habit of coming up with rules that don’t add very much to the answer. For example, one CEO deduced, “You should only do, in-house, what gives you a competitive advantage.”32 Okay, but why would anyone get a competitive advantage by doing anything inside, given that such a move reduces, to one degree or another contribute less in the way of work and investment than they are contributing. Managers have to find ways of overcoming the stakeholders’ inclination to “give little but take a lot.” One of the rolls of incentives is to overcome that inclination by tying how much people receive with what they give to the firm.
One of the more important lessons business people learn is that efficiencies can be realized from specialization and exchange. Anyone who attempted to produce even a small fraction of what he or she consumed would be a very poor person indeed.
specialization, and as a manager it is useful to understand the cause of these limits and what it implies about the advantages of producing in-house rather than buying in the market.
The problem with total reliance on the market should now be familiar: there are significant costs -- transaction costs -- associated with making market exchanges. You have to identify those who are able and willing to enter into a transaction, negotiate the specific terms of the transaction and how those terms might change under changing circumstances, draw up a contract that reflects as accurately as possible the agreed upon terms, arrange to monitor the performance of the other party to make sure the terms of the agreement are kept, and be prepared to resolve conflicts that arise between the agreement and the performance. Because of these transaction costs, it is often better for some individual or some group of individuals to directly manage the use of a variety of resources in a productive enterprise that we call a firm.
Transaction costs are lower, for example, when owners of labor become employees of the firm by entering into long-run agreements to perform tasks, that are not always spelled out clearly in advance, under the direction of managers in return for a fixed wage or salary. A market transaction is not needed every time it is desirable to alter what a worker does. Employment contracts typically allow managers wide discretionary authority to re-deploy workers as circumstances change without having to incur further transaction costs. Furthermore, with a uniform employment contract with a large number of workers, a manager can direct productive interactions between these workers that might otherwise require negotiated agreements between each pair of workers. As an example, ten workers could be hired with ten transactions, each negotiated through a relatively simple and uniform employment agreement. If those ten workers were independent contractors who had to interact with each other in ways that employees of a firm often do, they might well have to negotiate the terms of that interaction in 45 separate agreements.35
In general, the higher the cost of transacting through markets, the more a firm will make for itself with its own employees rather than buy from other firms. The reason restaurants don’t make their own toothpicks is that the cost of transactions is extremely low in the case of toothpicks. It is hard to imagine the transaction costs of acquiring toothpicks ever getting so high that restaurants would make their own. But one might have thought the same about beef until McDonalds opened an outlet in Moscow. Because of the primitive nature of markets in Russia when McDonalds opened its first Moscow outlet (before the collapse of the Soviet Union), relying on outside suppliers for beef of a specified quality was highly risky. Because of the high transaction costs, McDonalds raised it own cattle to supply much of its beef requirements for its Moscow restaurant. Negotiating an agreement between two parties can be costly, but the most costly part of a transaction often involves attempts to avoid opportunistic behavior by the parties after the agreement has been reached. Agreements commonly call for one or both parties to make investments in expensive plant and equipment that are highly specific to a particular productive activity. Once the investment is made, it has little, if any value in alternative activities. Investments in highly specific capital are often very risky, and therefore unattractive, even though the cost of the capital is less than it is worth. The problem is that once someone commits to an investment in specific capital to provide a service to another party, it is very tempting for that other party to take advantage of the investor’s inflexibility by paying less than the original agreement called for.36 There are so-called “quasi rents” that are appropriable, or that can be taken by another party through unscrupulous, opportunistic dealing.37 The desire to avoid this risk of opportunistic behavior can be a major factor in a firm’s decision to make rather than buy what it needs.
Any price between $125 and $150 million a year would be attractive to both investors in the pipeline and the electric generating plant that would use it. If, for example, the generating plant agrees to pay investors $137.5 million each year to build and operate the pipeline, both parties would realize annual profits of $12.5 million from the project. But the investors would be taking a serious risk because of the lack of flexibility after the pipeline is built. The main problem is that a pipeline is a dedicated investment, meaning there is a big difference in the return needed to make the pipeline worth building and the return needed to make it worth operating after it is built. While it takes at least $125 million per year to motivate building the pipeline, once it has been built it will pay to maintain and operate it for anything more than $25 million. Why? Because that is all it takes to operate the line. The pipeline investment itself is a sunk cost, literally and figuratively, not to be recaptured once it has been made. So after investors have made the commitment to construct the pipeline, the generating plant would be in a position to capture almost the entire value of initial pipeline investment by repudiating the original agreement and offering to pay only slightly more than $25 million per year.40
Of course, our example is much too extreme. The generating plant is not likely to risk its reputation by blatantly repudiating a contract. And even if it did, the pipeline investors would have legal recourse with a good chance of recovering much, if not all, of their loss. Furthermore, as the example is constructed, the generating plant has more to lose from opportunistic behavior by the pipeline owners than vice versa. If the pipeline refuses service to the plant, the cost of producing electricity increases by $150 million per year. So the pipeline owners could act opportunistically by threatening to cut off the supply of natural gas unless they receive an annual payment of almost $150 million per year.
But our main point dare not be overlooked and should be taken seriously by cost minimizing and profit maximizing business people: Anytime a transaction requires a large investment in dedicated capital, there is the potential for costly problems in negotiating and enforcing agreements. True, opportunistic behavior (actions taken as a consequence of an investment that has been made and cannot be recaptured) will seldom be as blatant as in the above example where it is clear that a lower price is a violation of the contract. But in actual contracts involving long-term capital commitments, unforeseen changes in circumstances (higher costs, interrupted supplies, stricter government regulations, etc.) can justify changes in prices, or other terms of the contract. Typically contracts will attempt to anticipate some of these changes and incorporate them into the agreed upon terms, but it is impossible to anticipate and specify The early history of the automobile industry provides an example of a merger between two companies that can be explained by the advantages of producing rather than buying when dedicated capital investment is involved.41 In 1919, General Motors entered into a long-term contract with Fisher Body for the purchase of closed metal car bodies. This contract required that Fisher Body invest in expensive stamping machines and dies specifically designed to produce the bodies demanded by GM. This put Fisher Body in a vulnerable position, given that once the investment was made GM could have threatened to buy from someone else unless Fisher Body reduced prices substantially. This problem was anticipated, which explains why the contract required that GM buy all of the closed metal bodies from Fisher and specified the price as equal to Fisher’s variable cost plus 17.6 percent.
However, while these contractual terms protected Fisher against opportunistic behavior on the part of GM, they created an unanticipated opportunity for Fisher to take advantage of GM. The demand for closed metal bodies increased rapidly during the early 1920s (in part because of increased auto sales, but also from a dramatic shift from open wooden bodies to closed metal bodies). The increased production lowered Fisher’s production costs, and indeed made it possible for Fisher to lower its costs significantly more than it did. Evidence suggests that Fisher took advantage of the 17.6 percent “price add-on” by keeping its variable costs (particularly labor costs), and therefore the price charged GM, higher than necessary.
General Motors was aware of this “over charge” and requested that Fisher build a new auto body plant next to GM’s assembly plant. This would have eliminated the costs of transporting the auto bodies (a variable cost that came with the 17.6 percent add-on) and reduced GM’s price. Fisher refused to make the move, however, possibly because of concerns that such a dedicated investment to GM requirements would be exploited by GM. As a result of the potential haggling, threats and counter-threats, GM bought Fisher Body in 1926 and the two companies merged. GM could buy Fisher simply because their tenuous dealings, with accompanying transaction costs, were depressing both companies’ market value. GM could pay a premium for Fisher simply because of the anticipated transaction cost savings.

The construction of electric generating plants next to coalmines provides another example of the potential benefits to a firm for producing an input rather than buying it when highly specific capital is involved. There is an obvious advantage in “mine-mouth” arrangements from reducing the cost of transporting coal to the generating plant. But if the mine and the generating plant are separately owned, the potential for opportunistic behavior exists after the costly investments are made. The mine owner, for example, could take advantage of the fact that the generating plant is far removed from a rail line connecting it to other coal supplies by increasing the price of coal. To avoid such risks, common ownership of both the mine and the generating plant is much more likely in the case of “mine-mouth” generating plants than in the case of generating plants that can rely on alternative sources of coal. And, when ownership is separate in a “mine-mouth” arrangement, the terms of exchange between the generating plant and mine are typically spelled out in very detailed and long-term contracts that cover a wide range of future contingencies.42
There are other ways a firm can benefit from the advantages of buying an input rather than producing it while reducing the risks of being “held-up” by a supplier who uses specialized equipment to produce a crucial input. It can make sense for the firm to buy the specialized equipment and then rent it to the supplier. If the supplier attempts to take advantage of the crucial nature of the input, the firm can move the specialized equipment to another supplier rather than be forced to pay a higher than expected price for the input. This is exactly the arrangement that automobile companies have with some of their suppliers. Ford, for example, buys components from many small and specialized companies, but commonly owns the specialized equipment needed and rents it to the contracting firms.43
Firms are also aware that those who supply them with services are reluctant to commit themselves to costly capital investments that, once made, leave them vulnerable to hold-up (demands that the terms and conditions of the relationship be changed after an investment that cannot be recaptured has been made). In such case the firm that provides the capital equipment An arrangement that reduced the threat of opportunistic behavior on the part of firms against workers was the much-criticized “company town.” In the past it was common for companies (typically mining companies) to set up operations in, what were at the time, very remote locations. In the company towns, the company owned the stores where employees shopped and the houses where they lived. The popular view of these company stores and houses is that they allowed the companies to exploit their workers with outrageous prices and rents, often charging them more for basic necessities than they earned from backbreaking work in the mines. The late Tennessee Ernie Ford captured this popular view in his famous song “Sixteen Tons.”44
Without denying that the lives of nineteenth-century miners were tough, company stores and houses can be seen as a way for the companies to reduce (but not totally eliminate) their ability to exploit their workers by behaving opportunistically. Certainly workers would be reluctant to purchase a house in a remote location with only one employer. The worker who committed to such an investment would be far more vulnerable to opportunistic wage reductions by the employer than would the worker who rented company housing. Similarly, few merchants would be willing to establish a store in such a location, knowing that once the investment was made they would be vulnerable to opportunistic demands for price reductions that just covered their variable costs, leaving no return on their capital cost. Again, in an ideal world without transaction costs – and without opportunistic behavior -- mining companies would have specialized in extracting ore and would have let suppliers of labor buy their housing and other provisions through other specialists. But in the real world of transaction costs, it was better for mining companies to also provide basic services for their employees. This is not to say that there was no exploitation. But the exploitation was surely less under the company town arrangement than if, for example, workers had bought their own houses.45
The threat to one party of a transaction from opportunistic behavior on the part of the other party explains other business and social practices. Consider the fact that despite valiant efforts, the vast majority of farm workers have never been able to effectively unionize in the United States. No doubt many reasons explain this failure, but one reason is that a union of farm workers would be in a position to harm farmers through opportunistic behavior. A crop is a highly specialized and, before harvested, immobile investment, and one whose value is easy to The threat of opportunistic behavior is surely an important consideration in another important exchange relationship, that of marriage. Although there clearly are exceptions, rich people seldom marry poor people. The story of the wealthy prince marrying poor, but beautiful, Cinderella, is, after all, a fairy tale. Rich people generally marry other rich people. As with all activities, there are many explanations for marital sorting, including the obvious fact that the rich tend to hang around others who are rich. But an important explanation is that marriage is effectively a specialized investment that, once made, commits and creates value not easily shifted to another enterprise, or object of affection. The rich person who marries a poor person is making an investment that is subject to hold-up. This is a hold-up possibility that is not ignored, as evidenced by the fact that pre-nuptial agreements are common in the case of large wealth differences between the two parties to a marriage. But because of the difficulty of anticipating all possible contingencies relevant to distributing wealth upon the termination of a marriage, such agreements still leave lots of room for opportunistic behavior. Marriage between people of roughly equal wealth reduces, though hardly eliminates, the ability of one party to capture most of the value committed by the other party.
A good general rule for a manager is to buy the productive inputs the firm needs rather than make them. When inputs are produced in-house, some of the efficiency advantages of specialization provided through market exchange are lost. But as with most general rules, there are lots of exceptions to that of buying rather than making. In many cases the loss from making rather than buying will be more than offset by the savings in transaction costs. Typically, firms should favor making those things that require capital that will be used for specific purposes and, therefore, will not have a ready resale market.
The Decision to Franchise
The decision a firm faces over whether to expand through additional outlets that are owned by the firm or that are franchised to outside investors has many of the features of decisions to make or buy inputs. Franchising is simply a type of firm expansion – with special contractual features and with all the attendant problems.

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Reasons for Firm Incentives

noreply@blogger.com ([Admin]) — Sun, 09 Aug 2009 10:32:00 +0000

Amazing things happen when people take responsibility for everything themselves. The results are quite different, and at times people are unrecognizable. Work changes and attitudes to it, too.
Mikhail Gorbachev
n conventional economic discussions of how firms are managed, incentives are nowhere
considered. This is the case because the “firm” is little more than a theoretical “black box”
in which things happen somewhat mysteriously. Economists typically acknowledge that the “firm” is the basic production unit, but little or nothing is said of why the firm ever came into existence or, for that matter, what the firm is. As a consequence, we are told little about why firms do what they do (and don’t do). There is nothing in conventional discussions that tells us about the role of real people in a firm.
How are firms to be distinguished from the markets they inhabit, especially in terms of the incentives people in firms and markets face? That question is seldom addressed (other than, perhaps, specifying that firms can be one of several legal forms, for example, proprietorships, partnerships, professional associations, or corporations). In conventional discussions of the “theory of the firm,” firms maximize their profits, which is their only noted raison d’être. But students of conventional theory are never told how firms do what they are supposed to do, or why they do what they do. The owners, presumably, devise ways to ensure that everyone in the organization follows instructions, all of which are intent on squeezing every ounce of profit from every opportunity. Students are never told what the instructions are or what is done to ensure that workers follow them. The structure of incentives inside the firm never comes up because their purpose is effectively assumed away: people do what they are supposed to do, naturally or by some unspecified mysterious process. For people in business, the economist’s approach to the “firm” must appear strange indeed, given that business people spend much of their working day trying to coax people to do what they are supposed to do. Nothing is less automatic in business than getting people to pay attention to their firms’ profits (as distinguished from the workers’ more personal concerns).
In this chapter, before we delve into the structure of firm costs in following chapters, we address the issue of why firms exist not because it is an interesting philosophical question. Rather, we are concerned with that question because its answer can help us understand why the existence of firms and incentives go hand in hand. There is more than an ounce of truth to the refrain, “You cannot have one without the other.” In this chapter, we lay out the limited
Chapter 6. Reasons for Firm Incentives
economic propositions that will undergird the analysis of much of the book. These propositions are powerful as they are simple, are relatively easily to understand.
How Firms Make Markets More Efficient
Why is it that firms add to the efficiency of the markets? That’s an intriguing question, especially given how standard theories trumpet the superior efficiency of markets. Students of conventional theory might rightfully wonder: If markets are so efficient, why do entrepreneurs ever go to the trouble of organizing firms? Why not just have everything done by way of markets, with little or nothing actually done (in the sense that things are “made”) inside firms? All of the firm’s inputs could be bought by individuals, with each individual adding value to the inputs he or she purchases and then selling this result to another individual who adds more value, etc. until a final product is produced and a final market is reached at which point the completed product is sold to consumers. The various independent suppliers may be at the same general location, even in the same building, but everyone, at all times, could be up for contracting with all other suppliers or some centralized buyer of the inputs. By keeping everything on a market basis, the benefits of competition could be constantly reaped. Entrepreneurs could always look for competitive bids from alternative suppliers for everything used -- whether in the form of parts to be assembled, accounting and computer services to be used, or, for that matter, executive talent to be employed.
Individuals, as producers relying exclusively on markets, could always take the least costly bid. They could also keep their options open, including retaining the option to switch to new suppliers that propose better deals. No one would be tied down to internal sources of supply for their production needs. They would not have to incur the considerable costs of organizing themselves into production teams and departments and various levels of management. They would not have to incur the costs of internal management. They could, so to speak, maintain a great deal of freedom!
Then why do firms exist? What is the incentive – driving force – behind firms? For that matter, what is a firm in the first place? University of Chicago Law and Economics Professor Ronald Coase, on whose classic work “The Nature of the Firm” much of this chapter is based and many of the particular arguments drawn, proposed a substantially new but deceptively simple explanation.1 He reasoned that the firm is any organization that supercedes the pricing system, in which hierarchy, and methods of command and control are substituted for exchanges. To use his exact words: “A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.”
While efficiency improvements can certainly be had from specialization of any resource, especially labor, Smith was wrong to conclude that firms were necessary to coordinate the workers’ separate tasks. This is because, as economists have long recognized, their separate tasks could be coordinated by the pricing system within markets.
Markets could, conceivably, exist even within the stages of production that are held together by, say, assembly lines. Workers at the various stages could simply buy what is produced before them. The person who produces soles in a shoe factory could buy the leather and then sell the completed soles to the shoe assemblers. For example, the bookkeeping services provided a shoe factory by its accounting department could easily be bought on the market. Similarly, all of the intermediate goods involved in Smith’s pin production could be bought and sold until the completed pins are sold to those who want them.
Why, then, do we observe firms as such, which organize activities by hierarchies and directions that are not based on changing prices (which distinguishes them from markets)? In terms of our examples, why are there shoe and pin companies? Admittedly, over the years economists have tendered various answers.4
3 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), pp. 4-12. 4 The late University of Chicago economist Frank Knight speculated that firms arise because of uncertainty (Risk, Uncertainty, and Profit [Chicago: University of Chicago Press, 1971]). If business were conducted in a totally certain world, there would be no need for firms, according to Knight. Workers would know their pattern of rewards, and there would be no need for anyone to specialize in the acceptance of the costs of dealing with risks and uncertainties that abound in the real world of business.
As it is, according to Knight, some workers are willing to work for firms because of the type of deal that is struck: The workers accept a reduction in their expected pay in order to reduce the variability and outright uncertainty of that pay. Entrepreneurs are willing to make such a bargain with their workers because they are effectively paid to do so by their workers (who accept a reduction in pay) and because the employers can reduce their exposure to risk and uncertainties faced by individual workers by making similar bargains with a host of workers. As Knight put it (see the bottom of the next page),
This fact [the intelligence of one person can be used to direct others] is responsible for the most fundamental change of all in the form of organization, the system under which the confident and adventuresome assume the risk or insure the doubtful and timid by
Chapter 6. Reasons for Firm Incentives
Again, how can the existence of firms, as constructs distinctly different from markets, be explained? There are probably many reasons people might think firms exist, several of which Coase dismisses for being wrongheaded or for not being important.5 What Coase was interested in, however, was not a catalogue of “small” explanations for this or that firm, but an explanation for the existence of firms that, to one degree or another, is applicable to virtually all firms. He was seeking a unifying theme, a common basis. In his 1937 article, he struck upon an unbelievably simple answer to his puzzle, but it was also an explanation that earned him the Nobel Prize in Economics -- more than a half-century later!
What did he say? How did he justify the firm’s existence? Simply put, he observed that there are costs of dealing in markets. He dubbed these costs marketing costs, but most economists now call them transaction costs. Whatever they are called, these costs include the time and resources that must be devoted to organizing economic activity through markets. Transaction costs include the particular real economic costs (whether measured in money or not) of discovering the best deals as evaluated in terms of prices and attributes of products, negotiating contracts, and ensuring that the resulting terms of the contract are followed. When we were going through our explanation of how work on an assembly line could be viewed as passing through various markets, most readers probably imagined that the whole process could be terribly time consuming, especially if the suppliers and producers at the various stages were constantly subject to replacement by competitors.
Reasons Firms Exist
Once the costs of market activity are recognized, the reason for the emergence of the firm is transparent: Firms, which substitute internal direction for markets, arise because they reduce the need for making market transactions. Firms lower the costs that go with market transactions. If internal direction were not, at times and up to some point, more cost-
guaranteeing to the latter a specified income in return for the assignment of the actual results . . . With human nature as we know it, it would be impracticable or very unusual for one man to guarantee to another a definite result of the latter’s actions without being given power to direct his work. And on the other hand the second party would not place himself under the direction of the first without such a guarantee . . . The result of this manifold specialization of function is the enterprise and wage system of industry. Its existence in the world is the direct result of the fact of uncertainty (Ibid., pp. 269-270).
5 Ibid, pp. 41-42. For example, Coase concedes that some people might prefer to be directed in their work. As a consequence, they might accept lower pay just to be told what to do. However, Coase dismisses this explanation as unlikely to be important because “it would rather seem that the opposite tendency is operating if one judges from the stress normally laid on the advantage of ‘being one’s own master’” (Ibid.,
p. 38). Of course, it might be that some people like to control others, meaning they would give up a portion of their pay to have other people follow their direction. However, again Coase finds such an explanation lacking, mainly because it could not possibly be true “in the majority of the cases.” (Ibid.). People who direct the work of others are frequently paid a premium for their efforts.
Chapter 6. Reasons for Firm Incentives
effective than markets, then firms would never exist – would have no reason for being, meaning that no one would have the required incentive to go to the trouble of creating them. However, while firms may never eliminate the need for markets and contracts, with all of their attendant costs, they must surely reduce them.
Entrepreneurs and their hired workers essentially substitute one long-term contract for a series of short-term contracts: The workers agree to accept directions from the entrepreneurs (or their agents, or managers) within certain broad limits (with the exact limits subject to variation) in exchange for security and a level of welfare (including pay) that is higher than the workers would be able to receive in the market without firms. Similarly, the entrepreneurs (or their agents) agree to share with the workers some of the efficiency gains obtained from reducing transaction costs.6
The firm is a viable economic institution because both sides to the contract – owners and workers -- gain. Firms can be expected to proliferate in markets simply because of the mutually beneficial deals that can be made. Those entrepreneurs who refuse to operate within firms and stick solely to market-based contracts, when in fact a firm’s hierarchical organization is more cost-effective than market-based organizations, will simply be out-competed for resources by the firms that do form and achieve the efficiency-improving deals with workers (and owners of other resources).
If firms reduce transaction costs, does it follow that one giant firm should span the entire economy, as, say, Lenin and his followers thought possible for the Soviet Union? Our intuition says, “No!” But there are also good reasons for expecting firms to be limited in size.
Cost Limits to Firm Size
Clearly, by organizing activities under the umbrella of firms, entrepreneurs give up some of the benefits of markets, which provide competitively delivered goods and services. Managers suffer from their own limited organizational skills, and skilled managers are scarce, as evident by the relatively high salaries many of them command. Communication problems within firms expand as firms grow, encompassing more activities, more levels of production, and more diverse products. Because many people may not like to take directions, as the firm expands to include more people, the firm may have to pay progressively higher prices to workers and other resource owners in order to draw them into the firm and then direct them.
6Coase recognizes that entrepreneurs could overcome some of the costs of repeatedly negotiating and enforcing short-term contracts by devising one long-term contract. However, as the time period over which a contract is in force is extended, more and more unknowns are covered, which implies that the contract must allow for progressively greater flexibility for the parties to the contract. The firm is, in essence, a substitute for such a long-term contract in that it covers an indefinite future and provides for flexibility. That is to say, the firm as a legal institution permits workers to exit more or less at will and it gives managers the authority, within bounds, to change the directives given to workers.
Chapter 6. Reasons for Firm Incentives
There are, in short, limits to what can be done through organizations. These limits can’t always be overcome, except at greater costs, even with the application of the best organizational techniques, whether through the establishment of teams, through the empowerment of employees, or through the creation of new business and departmental structures (for example, relying on top-down, bottom-up, or participatory decision making). Even the best industrial psychology theories and practices have their limits when applied to human relationships.
The Agency Problem
Firms might be restricted in their size because they are also likely to suffer from a major problem -- the so-called agency problem (or, alternately, the principal/agent problem) that will be considered and reconsidered often in this book. This problem is easily understood as a conflict of interests between identifiable groups within firms. The entrepreneurs or owners of firms (the principals) organize firms to pursue their own interests, which are often (but, admittedly, not always) greater profits. To pursue profits, however, the entrepreneurs must hire managers who then hire workers (all of whom are agents). However, the goals of the worker/agents are not always compatible with the goals of the owner/principals. Indeed, they are often in direct conflict. Both groups want to get as much as they can from the resources assembled in the firms.
The problem the principals face is getting the agents to work diligently at their behest and with their (the principals’) interests in mind, a core problem facing business organizations that even the venerable Adam Smith recognized more than two centuries ago.7 Needless to say, agents often resist doing the principals’ bidding, a fact that makes it difficult -- i.e., costly -¬for the principals to achieve their goals.
It might be thought that most, if not all, of these conflicts can be resolved through contracts, which many can. However, like all business arrangements, contracts have serious limitations, not the least of which is that they can’t be all-inclusive, covering all aspects of even “simple” business relationships (which all are more or less complex). Contracts simply cannot anticipate and cover all possible ways the parties to the contract, if they are so inclined, can get around specific provisions. The cost of enforcing the contracts can also be a problem, and an added cost, even when both parties know that provisions have been violated. Each party will recognize the costs and may be tempted to exploit them, and will figure that the other may be
7 In his classic The Wealth of Nations, Adam Smith wrote, “The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot be well expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company” [The Wealth of Nations (New York, Modern Library, 1937), p. 700].
Chapter 6. Reasons for Firm Incentives
equally tempted. Each will seek some means by which the contract will be self-enforcing, or will encourage each party to live up to the letter and spirit of the contract because it is in the interest of each party to do so. This is where incentives will come in, to help make contracts self-enforcing. Incentives can encourage the parties to more closely follow the intent and letter of contracts.
Competition will be a powerful force toward minimizing agency costs. Firms in competitive markets that are not able to control agency costs are firms that are not likely to survive for long, mainly because of what has been dubbed the “market for corporate control.”8 Firms that allow agency costs to get out of hand will risk either failure or takeover (by way of proxy fights, tender offers, or mergers). In later chapters, we will discuss at length how managers can solve their own agency problems including controlling their own behavior as agents for shareholders. At the same time, we would be remiss if we didn’t repeatedly point out the market pressures on managers to solve such problems, even if they are not naturally inclined to do so. If corporations are not able to adequately solve their agency problems, we can imagine that the corporate form of doing business will be (according to one esteemed financial analyst9) “eclipsed” as new forms of business emerge. Of course, this means that obstruction in the market for corporate control (for example, legal impediments to takeovers) can translate into greater agency costs, and less efficient corporate governance.
Why are firms the sizes they are? When economists in or out of business usually address that question, the answer most often given relates in one way or another to economies of scale. By economies of scale, we mean something very specific, the cost savings that emerge when all resource inputs -- labor, land, and capital -- are increased together. In some industries, it is indeed true that as more and more of all resources are added to production within a given firm, output expands by more than the use of resources. That is to say, if resource use expands by 10 percent and output expands by 15 percent, then the firm experiences economies of scale. Its (long-run) average cost of production declines. Why does that happen? The answer is almost always “technology,” which is another way of saying that it “just happens,” given what is known about combining inputs and getting output. This is not the most satisfying explanation, but it is nonetheless true that economies of scale are available in some industries (automobile) but not in others (crafts).
We agree that the standard approach toward explaining firm size is instructive. We have spent long hours at our classroom boards with chalk in hand developing and describing scale economies in the typical fashion of professors, using (long-run) average cost curves and pointing out when firms in the expansion process contemplate starting a new plant. We think the
8 One of the more important contemporary articles on the “market for corporate control” is by Henry G. Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy , vol. 73 (April 1963), pp. 110-120. 9 See Michael C. Jensen, “Eclipse of the Public Corporation,” Harvard Business Review (September-October 1989), pp. 64-65.
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standard approach is useful, but we also believe it leaves out a lot of interesting forces at work on managers within firms. This is understandable, given that standard economic theory totally assumes away the roles of managers, which we intend to discuss at length.
Coase and his followers have taken a dramatically different tack in explaining why firms are the sizes they are in terms of scale of operations and scope of products delivered to market. The new breed of theorists pays special attention to the difficulties managers face as they seek to expand the scale and scope of the firm. They posit that as a firm expands, agency costs mount. This is primarily because workers have more and more opportunities to engage in what can only be tagged opportunistic behavior – or taking advantage of their position by misusing and abusing firm resources. Shirking, or not working with due diligence, is one form of opportunistic behavior that is known to all employees. Theft of firm resources is another form. As the firm grows, the contributions of the individual worker become less detectable, which means workers have progressively fewer incentives to work diligently on behalf of firm objectives, or to do what they are told by their superiors. They can more easily hide.
The tendency for larger size to undercut the incentives of participants in any group is not just theoretical speculation. It has been observed in closely monitored experiments. In an experiment conducted more than a half century ago, a German scientist asked workers to pull on a rope connected to a meter that would measure the effort expended. Total effort for all workers combined increased as workers were added to the group doing the pulling at the same time that the individual efforts of the workers declined. When three workers pulled on the rope, the individual effort averaged 84 percent of the effort expended by one worker. With eight workers pulling, the average individual effort was one-half the effort of the one worker.10 Hence, group size and individual effort were inversely related – as they are in most group circumstances -- inversely related.
The problem evident in the experiment is not that the workers become any more corrupt or inclined to take advantage of their situation as their number increases. The problem is that their incentive to expend effort deteriorates as the group expands. Each person’s effort counts for less in the context of the larger group, a point which University of Maryland economist Mancur Olson elaborated upon decades ago (and we considered in detail in the last chapter).11 The “common objectives” of the group become less and less compelling in directing individual
10 As reported by A. Furnham, “Wasting Time in the Board Room,” Financial Times, March 10, 1993, p. xx. 11 See Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1965). Olson argues that common goals have less force in “large” groups than “small” groups, which explains why cartels don’t form in open competitive markets. All competitors might understand that it is in their group interest to cut production and increase their market price, if all curb production. However, each competitor can reason that its individual curb in output will have no effect on total output and thus cannot be detected. Hence, the “logic of collective action” is for everyone to “cheat” on the cartel, or not curb production, which means that nothing will happen to the market price.
Chapter 6. Reasons for Firm Incentives
efforts. Such a finding means that if each worker added to the group must be paid the same as all others, the cost of additional production obviously rises with the size of the working group. The finding also implies that to get a constant increase in effort with the additional workers, all workers must be given greater incentive to hold to their previous level of effort.12
Optimum Size Firms
How large should a firm be? Contrary to what might be thought, the answer depends on more than “economies of scale” technically specified. Technology determines what might be possible, but it doesn’t determine what will happen. And what happens depends on policies that minimize shirking and maximize the use of the technology by workers. This means that scale economies depend as much or more on what happens within any given firm as they do on what is technologically possible. The size of the firm obviously depends on the extent to which owners must incur greater monitoring costs as they lose control with increases in the size of the firm and additional layers of hierarchy (a point well developed by Oliver Williamson in his classic article written more than thirty years ago13). However, the size of the firm also depends on the cost of using the market.
Management information Professors Vijay Gurbaxani and Seungjin Whang have devised a graphical means of illustrating the “optimal firm size” as the consequence of two forces: “internal coordinating costs” and “external coordinating costs.”14 As a firm expands, its internal coordinating costs are likely to increase. This is because the firm’s hierarchical pyramid will likely become larger with more and more decisions made at the top by managers who are further and further removed from the local information available to workers at the bottom of the pyramid. There is a need to process information up and down the pyramid. When the information goes up, there are unavoidable problems and costs: costs of communication, costs of miscommunication, and opportunity costs associated with delays in communication, all of which can lead to suboptimal decisions. These “decision information costs” become progressively greater as the decision rights are moved up the pyramid.
Attempts to rectify the decision costs by delegating decision making to the lower ranks may help, but this can – and will -- also introduce another form of costs -- which, you will recall, we previously have called agency costs. These include the cost of monitoring (managers
12 Workers can also reason that if the residual from their added effort goes to the firm owners, they can possibly garner some of the residual by collusively (by explicit or tacit means) restricting their effort and hiking their rate of pay, which means that the incentive system must seek to undermine such collusive agreement. For a discussion of these points see, Felix R. FitzRoy and Kornelius Kraft, “Cooperation, Productivity, and Profit Sharing,” Quarterly Journal of Economics (February 1987), pp. 23-35. 13 Oliver E. Williamson, “Hierarchical Control and Optimum Size Firms,” Journal of Political Economy , vol. 75 (no. 2, 1967), pp. 123-138. 14Vijay Gurbaxani and Seungjin Whang, “The Impact of Information Systems on Organizations and Markets,” Communication of the ACM, January 1991, pp. 59-73.
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actually watching employees as they work or checking their production) and bonding (workers providing assurance that the tasks or services will be done as the agreement requires), and the loss of the residual gains (or profits) through worker shirking, which we covered earlier.
The basic problem managers face is one of balancing the decision information costs with agency costs and finding that location for decision rights that minimizes the two forms of costs. From this perspective, where the decision rights are located will depend heavily on the amount of information flow per unit of time. When upward flow of information is high, the decision rights will tend to be located toward the floor of the firm, mainly because the costs of suboptimal decisions by having the decision making done high up the hierarchy will be high. The firm, in other words, can afford to tolerate agency costs because the costs of avoiding the them, via centralized decisions, can be higher.
Nevertheless, as the firm expands, we should expect that the internal coordinating costs along with the cost of operations will increase. The upward sloping line in Figure 6.1 depicts this relationship.
But internal costs are not all that matter to a firm contemplating an expansion. It must also consider the cost of the market, or what Gurbaxani and Whang call “external coordination costs.” If the firm remains “small” and buys many of its parts, supplies, and services (such as accounting, legal, and advertising services) from outside venders, then it must cover a number of what we have called “transaction costs.” These include the costs of transportation, inventory holding, communication, contract writing, and contract enforcing. However, as the firm expands in size, then these transaction costs should be expected to diminish. After all, a larger firm seeks to supplant market transactions. The downward sloping line in Figure 6.1A depicts this inverse relationship between firm size and transaction costs.
Again, how large should a firm be? If a firm vertically integrates, it will engage in fewer market transactions, lowering its transaction costs. It can also benefit from economies of scale, the technical kind mentioned earlier. However, in the process of expanding, it will confront growing internal coordination costs, or all of the problems of trying to move information up the decision making chain, getting the “right” decisions, and then preventing people from exploiting their decision making authority to their own advantage.
The firm should stop expanding in scale and scope when the total of the two types of costs -- external and internal coordinating costs -- are minimized. This minimum can be shown graphically by summing the two curves in Figure 6.1A to obtain the U-shaped curve in Figure 6.1B. The optimal (or most efficient/cost-effective) firm size is at the bottom of the U.
This way of thinking about firm size would have only limited interest if it did not lend itself to a couple of additional observations, which permit thinking about the location, shape, and changes in the curve. First, the exact location of the bottom will, of course, vary for different firms in different industries. Different firms have different capacities to coordinate activities
Chapter 6. Reasons for Firm Incentives
through markets and hierarchies. Second, firm size will also vary according to the changing abilities of firms to coordinate activities internally and externally.
Figure 6.1A and 6.1B External and Internal Coordinating Costs As the firm expands, the internal coordinating costs increase as the external coordinating costs fall.
Clearly, Adam Smith and many of his followers were correct when they observed that when tasks are divided among a number of workers, the workers become more proficient at what they do. Smith began his economic classic The Wealth of Nations by writing about how specialization of labor increased “pin” (really nail) production.3 By specializing, workers can become more proficient at what they do, which means they can produce more in their time at work. They also don’t have to waste time changing tasks, which means more time can be spent directly on production.
A firm that is efficient at processing information will be larger, everything else equal, than one that isn’t so able. If a firm is able to improve the efficiency of its upward information flow and reduce the number of wrong decisions, then the upward sloping curve in Figure 6.1A will move down and to the right, causing the sum of the two curves in the bottom panel of the figure to move to the right, for a greater optimal size firm. If the costs of using markets go down, the firm size can be expected to decline, not because the firm has become less efficient internally (it may have become more efficient), but because markets are now relatively more cost effective. Again, from this perspective, the size of the firm changes for reasons other than those related to the technology of actual production. It depends on the ability of managers to squeeze out the scale economies that are possible from their workers.
Of course, knowing that the owners will always worry that their manager-agents will exploit their positions for their own benefit at the expense of the owners, managers will want to “bond” themselves against exploitation of their positions. (And we don’t use the term “bond” in the modern pop-psychology sense of developing warm and fuzzy relationships; rather, we use it in the same sense that is common when accused criminals post a bond, or give some assurance that they will appear in court if released from jail.) That is to say, managers have an interest in letting the owners know that they, the managers, will suffer some loss when exploitation occurs.
Chapter 6. Reasons for Firm Incentives
Devices such as audits of the company are clearly in the interest of stockholders. But they are also in the interest of managers by reducing the scope for managerial misdeeds, thus increasing the market value of the company – and the value of its managers. By buying their companies’ stock, manager-agents can also bond themselves, assuring stockholders that they will incur at least some losses from agency costs. To the extent manager-agents can bond themselves convincingly, the firm can grow from expanded sources of external investment funds. By bonding themselves, manager-agents can demand higher compensation. Firms can be expected to expand and contract with reductions and increases in the costs of developing effective managerial bonds.15
Changes in Organizational Costs
Finally, we can observe that the size of the firm can be expected to change with changes in the relative costs of organizing a given set of activities by way of markets and hierarchies. For example, suppose that the costs of engaging in market transactions are lowered, meaning markets become relatively more economical vis a vis firms. Entrepreneurs should be expected to organize more of their activities through markets, fewer through firms. Then, those firms that more fully exploit markets, and rely less on internal directions, should be able to increase the payments provided workers and other resources that they buy through markets, collectively leaving fewer resources to expand their market share relative to those firms that make less use of markets. Accordingly, firms should be expected to downsize, to use a popular expression.
An old, well-worn, and widely appreciated explanation for downsizing is that modern technology has enabled firms to produce more with less. Personal computers, with their ever-escalating power, have enabled firms to lay off workers (or hire fewer workers). Banks no longer need as many tellers, given the advent of the ATMs.
One not-so-widely-appreciated explanation is that markets have become cheaper, which means that firms have less incentive to use hierarchical structures and more incentive to use markets. And one good reason firms have found markets relatively more attractive is the rapidly developing computer and communication technology, which has reduced the costs of entrepreneurs operating in markets. The new technology has lowered the costs of locating suitable trading partners and suppliers, as well as negotiating, consummating, and monitoring market-based deals (and the contracts that go with them). In terms of Figure 6.1, the downward sloping transaction costs curve has dropped down and to the left, causing the bottom of the U to move leftward.
“Outsourcing” became a management buzzword in the 1980s because the growing efficiency of markets, through technology, made it economical. Outsourcing continued apace in the 1990s. Of 26 major companies surveyed, 86 percent said they outsourced some activity industry generating $100 billion in annual revenues by 1996.16 For all practical purposes, airlines now outsource the acquisition of their reservations through independent contractors called travel agents, given that more than 70 percent of all airline reservations are now taken by such agents, working through computerized markets, not through the hierarchical structures within the airlines.
Frito-Lay has issued its sales people hand scanners in part to increase the reliability of the flow of information back to company distribution centers, but also to track the work of the sales people. The company can obtain reports on when each employee starts and stops work, the time spent on trips between stores, and the number of returns. The sales people can be asked to account for more of their time and activities while they are on the job.
Obviously, we have not covered the full spectrum of explanations for the rich variety of sizes of firms that exists in the “real world” of business. We have also left the net impact of technology somewhat up in the air, given that it is pressing some firms to expand and others to downsize. The reason is simple: technology is having a multitude of impacts that can be exploited in different ways by firms in different situations.
Prisoners’ Dilemma Problems, Again
The discussion to this point reduces to a relatively simple message: Firms exist to bring about cost savings, and they generate the cost savings through cooperation. However, cooperation is not always and everywhere “natural”; people have an incentive to “cheat,” or not do what they are supposed to do or have agreed to do. This may be the case because of powerful incentives to toward noncooperation built-in to many business environments.
16 As reported by John A. Byrne, “Has Outsourcing Gone Too Far?” Business Week, April 1, 1996, p. 27.
Chapter 6. Reasons for Firm Incentives
An illustration of the tendency toward noncooperative behavior, despite the general advantage from cooperation, is a classic so-called “conditional-sum game” known as the prisoners’ dilemma (which we have already introduced without formally calling them by their proper name).17 This is a dilemma, commonly found in business, that takes its name from a particular situation involving the decision two prisoners have to make on whether or not to confess to a crime they committed. But the dilemma can also be applied whenever two or more people find themselves in a situation where the best decision from the perspective of each leads to the worst outcome from the perspective of all.
Consider a situation in which the police have two people in custody who are known to be guilty of a serious crime, but who, in the absence of a confession by one of them, can be convicted only of a relatively minor crime. How can the police (humanely) encourage the needed confession? One effective approach is to separate the two prisoners and present each with the same set of choices and consequences. Each is told that if one confesses to the serious crime and the other does not, then the one who confesses receives a light sentence of one year, while the one who does not confess receives the maximum sentence of fifteen years. If they both confess, then both receive the standard sentence of ten years. And if both refuse to confess, then each is sentenced to two years for the minor crime.
Overcoming a large-number prisoners’ dilemma by motivating cooperative behavior is obviously difficult, but not impossible. The best hope for those who are in a prisoners’ dilemma situation is to agree ahead of time to certain rules, restrictions, or arrangements that will punish those who choose the noncooperative option. For example, those who are jointly engaging in criminal activity will see advantages in forming gangs whose members are committed to punishing noncooperative behavior. The gang members who are confronted with the above prisoners’ dilemma will seriously consider the possibility that the shorter sentence received for confessing will hasten the time when a far more harsh punishment for “squealing” on a fellow gang member is imposed by the gang.
The problem illustrated by the prisoners’ dilemma is a very general one that is encountered in many different guises, most of which have nothing to do with prisoners. Excessive pollution, for example, can be described as a prisoners’ dilemma in which citizens – meaning, typically, a very large number of people -- would be better off collectively if everyone polluted less, yet, from the perspective of each individual the greatest payoff comes from continuing to engage in polluting activities no matter what others are expected to do. As another example, while there may be wide agreement that we would be better off with less government spending, each interest group is better off lobbying for more government spending on its favorite program. People are tempted by the noncooperative solution in polluting and lobbying because they benefit individually and only have limited and costly ways of ensuring that others resist the noncooperative solution.
Chapter 6. Reasons for Firm Incentives
Many areas of business are fertile grounds for the conditional-sum game situations represented by the prisoners’ dilemma. A number of examples of business-related prisoners’ dilemmas will be discussed in some detail in subsequent chapters, and an important task of managers is to identify and resolve these dilemmas as they arise both within the firm and with suppliers and customers of the firm. Indeed, we see “management” as concerned with finding resolutions of prisoners’ dilemmas. Good managers constantly seek to remind members of the firm of the benefits of cooperation and of the costs that can be imposed on people who insist on taking the noncooperative course.
Consider, for example, the issue of corporate travel, which is a major business expense -- estimated at over $130 billion in 1994 (the latest available data at this writing).18 If a business were able to economize on travel costs, it would realize significant gains. And much of this gain would be captured by the firms’ traveling employees who, if they were able to travel at less cost, would earn higher incomes as their net value to the firm increased. So all the traveling employees in a firm could be better off if they all cut back on unnecessary travel expenses. But the employees are in a prisoners’ dilemma with respect to reducing travel costs because each recognizes that he or she is personally better off by flying first class, staying at hotels with multiple stars, and dining at elegant restaurants (behaving noncooperatively), than making the least expensive travel plans (behaving cooperatively) regardless of what the other employees do. Each individual employee would be best off if all other employees economized, which would allow her salary to be higher as she continued to take luxury trips. But if the others also make the more expensive travel arrangements, she would be foolish not to do so herself since her sacrifice would not noticeably increase her salary.
Airlines have recognized the “games” people play with their bosses and other workers, and have played along by making the travel game more rewarding to business travelers, more costly to the travelers’ firms, and more profitable to the airlines – all through their “frequent-flier” programs. Of course, you can bet managers are more than incidentally concerned about the use of frequent-flier programs by employees. When American Airlines initiated its AAdvantage frequent-flier program in 1981, the company was intent on staving off the fierce price competition that had broken out among established and new airlines after fares and routes were deregulated in 1978. As other writers have noted, American was seeking to enhance “customer loyalty” by offering their best, most regular customers free or reduced-price flights after they built up their mileage accounts. Greater customer loyalty can mean that customers are less responsive to price increases, which could translate into actual higher prices. 19
At the same time, there is more to the issue than “customer loyalty.” American figured that it could benefit from the obvious prisoners’ dilemma their customers, especially business
18 As reported in Jonathan Dahl, “Many Bypass the New Rules of the Road,” The Wall Street Journal, September 29, 1994, p. B1. 19For a discussion of frequent-flier programs as a means of enhancing customer loyalty, see Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Currency/Doubleday, 1996), pp. 132-158.
Chapter 6. Reasons for Firm Incentives
travelers, are in. By setting up the frequent-flier program, American (and all other airlines that followed suit) increased the individual payoff to business travelers for noncooperative behavior. American did this under its frequent-flier program by allowing travelers to benefit from more free flights and first-class upgrades by choosing more expensive, and often less direct, flights. They encouraged business people to act opportunistically, to use their discretion for their own benefit at the expense of everyone else in their firms.
For example, a business traveler who is on the verge of having enough miles in his American account to qualify for elite status (additional upgrades of travel perks) might choose a more expensive American flight over a comparable Southwest Airline flight just to get additional AAdvantage miles. The company would in effect, pick up the cost of the traveler’s vacation flight. Business travelers are also encouraged to book their flights later than they could, which requires paying full fare, so they can use their frequent-flier upgrades to first class (these upgrades are typically not allowed with discount tickets). Or business people will take circuitous routes to their destinations to qualify for more frequent-flier miles than could be gotten from a direct trip. The prisoners’ dilemma problem for workers and their companies has, of course, prompted as a host of other non-airline firms -- rental car companies, hotels, and restaurants – to begin granting frequent-flier miles with selected airlines for travel services people buy with them, encouraging once again higher-than-necessary travel costs. The company incurs the cost of the added miles plus the lost time.
Now, use of frequent-flier miles might actually lower worker wages (because of the added cost to their firms, which can reduce the demand for workers, and the benefit of the miles to workers, which can increase worker supply and lower wages, topics to be covered later), but, still, workers have an incentive to exploit the program. Again, they are in prisoners’ dilemma under which the cooperative strategy might be best for all, but the noncooperative strategy dominates the choice each individual faces.
These problems created by frequent-flier programs are not trivial for many businesses, and we would expect the bigger the firm, the greater the problem (given the greater opportunity for opportunistic behavior in large firms). Thirty percent of business travelers working for Mitsubishi Electronics America wait until the last few days before booking their flights, according to corporate travel manager John Fazio. Fazio adds, “We have people who need to travel at the last minute, but it’s not 30 percent.”20 Corporate travel managers complain that the frequent-flier programs have resulted in excessive air fares (a problem for 87 percent of the firms surveyed), wasted employee time (a problem for 68 percent of the surveyed firms), use of more expensive hotels (a problems for 67 percent of the surveyed firms), and unnecessary travel (a problem for 59 percent of the surveyed firms).21 The corporate travel managers
20 See Dahl, Ibid., p. B1. 21 As reported by Frederick J. Stephenson and Richard J. Fox, “Corporate Strategies for Frequent-Flier Programs,” Transportation Journal, vol. 32, no. 1, (Fall 1992), pp. 38-50. The 1991 survey included 506 corporate members of the National Business Travel Association who did not work for airlines.
Chapter 6. Reasons for Firm Incentives
interviewed felt that the frequent-flier programs resulted in an average “waste” of about 8 percent of all of their travel expenditures.22
Frequent-flier programs put business travelers in a game situation that benefits the airlines at the expense of business travelers and their firms by encouraging noncooperative behavior. Recognizing this game, and the noncooperative incentives built into it, is important for managers who are trying to cut travel costs. And in the effort to cut these costs, managers are also in a game with the airlines, which respond to cost cutting measures with new wrinkles designed to intensify the prisoners’ dilemma faced by business travelers. For example, USAir announced plans to provide a Business Select class (featuring roomier seats and better meals) for those business travelers who pay full fare for their coach tickets.23 Of course, when all airlines have frequent-flier programs, the problems for firms may be compounded by the fact that all airlines have more “loyal” customer bases and all are less likely to cut prices (another topic to be addressed later in greater detail).
The Moral Sense
Much our analysis in the “Manager’s Corner” sections of the chapters to this book will be grounded, as it has already, in the principal/agent problem, or the tendency of underlings to pursue their own private goals at the expense of the goals of the firm and its owners. We do that for a simple reason: We want to understand how employees might behave in order that managers can draw up policies and incentives that can protect the firm and its owners from agency costs.
We do not by any means wish to suggest that people are not, in the slightest degree, driven by an innate sense of duty or obligation to do that which they are supposed to do as a employee in a team or firm. On the contrary, people do seem to have a built-in tendency to cooperate -- to a degree. UCLA business professor James Q. Wilson has shown, with reference to casual observation and to a host of psychological experiments, that most people do have a “moral sense,” which can show up in their willingness to forgo individual advantage (or opportunities to shirk) for the good of the group, which can be a firm.24
Moreover a variety of factors -- including considerations of equity and fairness -¬influence people’s willingness to cooperate. As organizational behaviorists have shown, “culture” has an impact on the extent of cooperation. People from “collectivistic” societies, like China, may be more inclined to cooperate than people from “individualistic” societies, like the United States.25 Training in “group values” can affect the extent of cooperation. What do people do? What should they do? Better yet, what do we expect them to do -- eventually? We suspect that different twosomes caught in the woods by sabretooth tigers over the millenniums have tried a number of strategies. However, running is, over the long run, a strategy for possible extinction, given that the tiger can pick off the runners one by one. We should not be surprised that human society has come to be dominated by people who have a “natural” tendency to cooperate or who have found ways to inculcate cooperation in their members. Moreover, parents spend a lot of family resources trying to ensure that children see the benefits of cooperation, and school teachers and coaches reinforce those values with an emphasis on the benefits of sharing and doing what one is supposed to do or has agreed to do vis a vis people beyond the reach of the family. Managers do much the same.
Those societies that have found ways of cooperating have prospered and survived. Those that haven’t have languished or retrogressed into economic oblivion, leaving the current generation with a disproportionate representation from groups that have been cooperative. Those who didn’t cooperate long ago when confronted with attacks by sabretooth tigers were eaten; those who did cooperate with greater frequency lived to propagate future generations.
What we are saying here is that human society is complex, driven by a variety of forces -- based in both psychology and economics -- that vary in intensity with respect to one another and that are at times conflicting. However, there are evolutionary reasons, if nothing else, to expect that people who cooperate will be disproportionately represented in societies that survive. Organizations can exploit -- and, given the forces of competition, must exploit --people’s limited but inherent desire or tendency to work together, to be a part of something that
Chapter 6. Reasons for Firm Incentives
is bigger and better than they are. Organizations should be expected to try to reap the synergetic consequences of their individual and collective efforts.
However, if that were the whole story -- if all that mattered were people’s tendencies to cooperate -- then management would hardly be a discipline worthy of much professional reflection. There would be little or no need or role for managers, other than that of cheerleader. The problem is that firms are also beset with the very incentive problems that we have stressed. The evolutionary process is far from perfect. Moreover, as evolutionary biologist Richard Hawkins has argued, we are all beset with “selfish genes” intent on using “survival machines” (living organisms such as human beings) to increase our chances (the genes’ individual chances, not so much the species’ chances) of survival.26 “Selfish genes” are willing to cooperate, if that’s what is needed (or, rather, is what works); but the fundamental goal is survival. To the extent that Hawkins is right, what he might be saying is, in essence, that we have to work very hard to override basic, self-centered drives at the core of our being.
It may well be that two people can work together “naturally,” fully capturing their synergetic potential. The same may be said of groups of three and four people, maybe ten or even thirty. The point that emerges from the “logic of collective action” is that as the group size -- team or firm -- gets progressively larger, the consequences of impaired incentives mount, giving rise to the growing prospects that people will shirk or in other ways take advantage of the fact that they and others cannot properly assess what they contribute to firm output.
As we have already studied, economists concerned with the economics of politics have long recognized how the “logic of choice” within groups applies to politics. The infamous “special interest” groups, which are relatively small and have long been the whipping boys of commentators, tend to have political clout that is disproportionate to their numbers. Indeed, special interest groups often get benefits from governments, with the high costs of their programs diffused over a much larger number of a more politically latent group, the general population of voters. Mancur Olson cites farmers for being the classic case of an interest group that constitutes a minor fraction (less than three percent) of the population but that has persuaded Congress to pass a variety of programs over the years that benefit farmers and their families and impose higher prices on consumers and higher taxes on taxpayers.27
Political economist James Buchanan points out that honor codes, which, when they work, can be valuable to all students, tend to break down as universities grow in size. For that matter, crime, which is a violation of the cooperative tendency of a community, if not a nation, tends to rise disproportionately to the population. Buchanan’s explanation is that the probability reports that when people think that their contribution to group goals, for example, pulling on a rope, cannot be measured, then individuals will reduce their effort.30 When members of a team pulling on a rope were blind folded and then told that others were pulling with them, the individual members exerted 90 percent of their best individual effort when one other person was supposed to be pulling. The effort fell to 85 percent when two to six other players were pulling. The shirking that occurs in large groups is now so well documented that it has a name -- “social loafing.”
A central point of this discussion is not that managers can never expect workers to cooperate. We have conceded that they will – but only to a degree, given normal circumstances. However, there are countervailing incentive forces, which, unless attention is given to the details of firm organization, can undercut the power of people’s natural tendencies to cooperate and achieve their synergetic potential.

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The Value Of Tough Bosses

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What does the “logic of group behavior” have to do with the direct interest of MBA students who seek to run businesses and direct the work of others? In a word, “plenty,” as we will see throughout the rest of the book. We will show how the “logic” is central to
19 These points have been made in a much more complete and technical manner by Armenia A. Alton and Harold Demotes, “Production, Information Costs, and Economic Organization,” American Economic Review, vol. 62, pp. 777-795, December 1972 20 Some managers in the Soviet Union are paid less than industrial workers in the United States; however, the ratio of a manager’s salary to a worker’s salary is typically greater in the Soviet Union.
how competitive markets (and cartels) work and will discuss a multitude of ways to apply the “logic” directly to management problems.
For now, we can stress a maxim that emerges from the economic view of group behavior: Being (or having) a tough boss is tough, but a boss who isn’t tough isn’t worth much. And because tough bosses are valuable, and lenient bosses are not, there is a reason for believing that existing organizational arrangements serve to impose the discipline on bosses necessary to ensure that they do a good job imposing discipline on the workforce. Competition will press firms to hire tough bosses, and, as we will show in this chapter, the owners of the firm, or their manager-agents, not workers, will tend to the bosses. That is to say, owners or their agents will tend to boss workers, not the other way around, for the simple reason that worker-bosses will not likely survive in competitive markets. Workers may not like tough bosses, but we will explain that, if given the option, workers would choose to hire tough bosses.21
Everyone recognizes that firms compete with each other by providing better products at lower prices in a constant effort to capture the consumer dollar. This competition takes place on a number of fronts, including innovative new products, cost cutting production techniques, clever and informative advertising, and the right pricing policy. But a continuing theme of this and other management books is that none of these competitive efforts can be successful unless a firm backs them up with an organizational structure that is competitive -- one that motivates its employees to work diligently and cooperatively. Before addressing the issue of organization, however, let’s first examine why workers value tough bosses. Those firms that do the best job in this organizational competition are the most likely to survive and thrive.
The organizational arrangements used by the most successful firms are most likely to be adopted by other firms, because of the force of profit maximization and market competition. So we should expect business firms to be organized in ways that motivate bosses to work diligently at motivating workers to work diligently and at the least cost. We should expect that the choice between workers and owners of capital as to which group will market the better bosses will depend on which group can be expected to press the other to work the most diligently or at the least cost. We have already given away the answer: Owners (or their manager-agents) will tend to boss the workers, a perfectly acceptable outcome for the owners, of course, but also for the workers, which might not be expected. To understand that point, we must first appreciate why workers would want tough bosses.
Take this Job and . . .
Though probably overstated, common wisdom has it that workers do not like their bosses, much less tough bosses. The sentiment expressed in the well-known country song “Take This Job and Shove It” could only be directed at a boss. Bosses are also the butts of much humor. There is the old quip that boss spelled backward is “Double SOB.”
21 As we will see, even when workers own the firm and could be their own bosses, they invariably hire a boss, typically a tough one at that.
And there is the story about the fellow who went to the president of a major university and offered his services as a full professor. Noticing that the fellow had no advanced degree, the president informed him that he was unqualified. The fellow then offered his services as an associate professor and received the same response. After offering his services as an assistant professor and hearing that he was still unqualified, the fellow muttered. “I’ll be a Son-of-a-Bitch,” at which point the president said, “Why didn’t you tell me earlier? I’m looking for someone to be dean of the business school.”
If it were not for an element of truth contained in them, such jokes would be hopelessly unfunny. Bosses are often unpopular with those they boss. But tough bosses are much like foul tasting medicines are for the sick; you don’t like them, but you want them anyway because they are good for you. Workers may not like tough bosses, but they willingly put up with them because tough bosses mean higher productivity, more job security, and better wages.
The productivity of workers is an important factor in determining their wages.22 More productive workers receive higher wages than less productive workers. Firms would soon go bankrupt if they paid workers more than their productivity indicated they should be paid, but firms would soon lose their workers if they paid them less than their productivity.
Many things, of course, determine how productive workers are. The amount of physical capital they work with, and the amount of experience and education (human capital) the workers bring to their jobs are two extremely important, and commonly discussed, factors in worker productivity. But how well the workers in a firm work together as a team is also important (a point that will become more apparent in the “Manager’s Corner” on “The Value of Teams” later in this chapter). An individual worker can have all the training, capital and diligence needed to be highly productive, but productivity will suffer unless other workers pull their weight by properly performing their duties. The productivity of each worker is crucially dependent upon the efforts of all workers in the vast majority of firms.
So all workers are better off if they all work conscientiously on their individual tasks and as part of a team. In other words, it is collectively rational for everyone to work responsibly. But there is little individual motivation to work hard to promote the collective interest of the group, or firm.23
While each worker wants other workers to work hard to maintain the general productivity of the firm, each worker recognizes that her contribution to the general productivity is small. By shirking some responsibilities, she receives all of the benefits from the extra leisure but suffers from only a very small portion of the resulting productivity loss, which is spread over everyone in the firm. She suffers, of course, from some of the productivity loss when other workers choose to loaf on the job, but she
22 It is also true, as we will see in a later chapter, that how wages are paid can be an important factor in determining how productive workers are.23 This line of analysis has been developed at length by Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1965).
knows that the decisions others make are independent of whether she shirks or not. And if everyone else shirks, little good will result for her, or for the firm, from diligent effort on her part. So no matter what she believes other workers will do, the rational thing for her to do is to capture the private benefits from shirking at practically every opportunity. With all other workers facing the same incentives, the strong tendency is for shirking on the job to reduce the productivity, and the wages, of all workers in the firm, and quite possibly to threaten their jobs by threatening the firm’s viability.
The situation just described is another example of the general problem of the logic of group behavior, or more precisely a form of the prisoners’ dilemma that is endemic to that logic. This involves a classic police interrogation technique in which officers separate two suspects, indicating to each that if she confesses, then she will get off with light charges and penalties. Collectively, they might both be better off if neither confesses (which implies that the two suspects work together for their common objective, a lighter sentence), but each can be even better off if she confesses while her cohort doesn’t. More formally, a prisoners’ dilemma is a situation in which each individual is better off by acting independently of other parties in the group, no matter what the other parties do, but all parties in the group are better off by working together.
Consider a slightly different form of the prisoner’s dilemma that is described in the matrix in Table 5.1, which shows the payoff to Jane for different combinations of shirking on her part and shirking on the part of her fellow workers.24 No matter what Jane believes others will do, the biggest payoff to her (in terms of the value of her expected financial compensation and leisure time) comes from shirking. Clearly, she hopes everyone else works responsibly so that general labor productivity and the firm’s profits are high despite her lack of effort, in which case she receives the highest possible payoff that any one individual can receive of 125.25 Unfortunately for Jane, all workers face payoff possibilities similar to the ones she faces (and to simplify the discussion, we assume everyone faces the same payoffs). So everyone will shirk which means that everyone will end up with a payoff of 50, which is the lowest possible collective payoff for workers.26
Workers are faced with self-destructive incentives when their work environment is described by the shirking version of the prisoners’ dilemma (which we have discussed now in several other contexts). It is clearly desirable for workers to extricate themselves from this prisoners’ dilemma. They can double their gain. But how?
24 The payoff can be in dollars, utility, or any other unit of measure. The only important consideration is that higher numbers represent higher payoffs. This is in contrast to the original prisoners’ dilemma example in which the number in the payoff matrix represented the length of prison sentences, so the higher number represented lower payoffs. 25 Of course, not everyone can receive this payoff.26 Jane would receive a lower payoff of 25 if she were the only one who did not shirk, but because of her effort the collective payoff would be higher than if she did shirk, as her effort would raise the payoff to the shirkers to something slightly higher than 50.
Table 5.1 The Inclination to shirk on the Job
Other Workers None shirk Some shirk All shirk
Don’t shirk 100 75 25 Jane
Shirk 125 100 50
In an abstract sense, the only way to escape this prisoners’ dilemma is to somehow alter the payoffs for shirking. More concretely, this requires workers to agree to collectively subject themselves to tough penalties that no one individual would unilaterally be willing to accept. While no one will like being subjected to tough penalties, everyone will be willing to accept the discipline those penalties impose in return for having that discipline applied to everyone else.
The situation here is analogous to many other situations we find ourselves in. For example, consider the problem of controlling pollution that was briefly mentioned in an earlier chapter. While each person would find it convenient to be able to freely pollute the environment, when everyone is free to do so we each lose more from the pollution of others than we gain from our own freedom to pollute. So we accept restrictions on our own polluting behavior in return for having restrictions imposed on the polluting behavior of others. Littering and shirking may not often be thought of as analogous, but they are. One pollutes the outside environment and the other pollutes the work environment.
An even better analogy is that between workers and college students. The “productivity” of a college from the student’s perspective depends on its reputation for turning out well-educated graduates with high grade a reliable indication that a student has worked hard and learned a lot. But students are tempted to take courses from professors who let them spend more time at parties than in the library and still give high grades. But if all professors curried favor with their students with lax grading policies, all students would be harmed as the value of their degrees decreased. While students may not like the discipline imposed on them by tough professors, they want tough professors to help them maintain the reputation of their college and the value of their diplomas. (The ideal situation for each student is for the professor to go easy on him or her alone and to be demanding of all other students.27)
Similarly, workers may not like bosses who carefully monitor their behavior, spot the shirkers and ruthlessly penalize them, but they want such bosses. We mean penalties sufficiently harsh to change the payoffs in Table5.1 and eliminate the prisoners’ dilemma. As shown in Table 5.1, the representative worker Jane captures 25 units of benefits from shirking no matter what other workers do. If she had a boss tough enough to impose more than 25 units of suffering, say 35 units, on Jane if she engaged in shirking, her relevant payoff matrix would be transformed into the one shown in Table 5.2. Jane may not like her new boss, but she would cease to find advantages in shirking. And with a
27 See Dwight Lee, “Why It Pays to Have Tough Profs,” The Margin (September/October 1990): 28-29.
tough boss monitoring all workers, and unmercifully penalizing those who dare shirk, Jane will find that she is more than compensated because her fellow workers have also quit shirking. Instead of being in an unproductive firm, surrounded by a bunch of other unproductive workers, each receiving a payoff of 50, she will find herself as part of a hard-working, cooperative team of workers, each receiving a payoff of 100.
The common perception is that bosses hire workers, and in most situations this is what appears to happen. Bosses see benefits that can be realized only by having workers, and so they hire them. But since it is also true that workers see benefits that can be realized only from having a boss, it is reasonable to think of workers hiring a boss, and preferably a tough one.
Table 5.2 Shirking in Large Worker Groups
Other Workers
None shirk Some shirk All shirk
Don’t shirk 100 75 25 Jane
Shirk 90 65 15
Actual Tough Bosses
The idea of workers hiring a tough boss is illustrated by an interesting, though probably apocryphal, story of a missionary in 19th century China. Soon after arriving in China, the missionary, who was then full of enthusiasm for doing good, came upon a group of men pulling a heavily loaded barge up a river. Each man was holding on to a rope attached to the barge as he struggled forward against the river’s current, while on the barge was a large Chinaman with a long whip with which he lashed the back of anyone who let his rope go slack. Upon seeing this, the missionary experienced a surge of indignation and rushed up to the group of Chinamen to inform them that he would put an end to such outrageous abuse. Instead of being appreciative of the missionary’s concern, however, the Chinamen told him to butt out, that they owned the barge, they earned more money the faster they got the cargo up the river, and they had hired the brute with the whip to eliminate the temptation each would otherwise have to slack off.
The missionary story may be doubted, but the point shouldn’t be. Even highly skilled and disciplined workers can benefit from having a “boss” help them overcome the shirking that can be motivated by the prisoners’ dilemma. Consider the experience related by Gordon E. Moore, a highly regarded scientist and one of the founders of Intel, Inc. Before Intel, Moore and seven other scientists entered a business venture that failed because of what Moore described as “chaos.” Because of the inability of the group of scientists to act as an effective team in this initial venture, before embarking on their
next, according to Moore, “the first thing we had to do was to hire our own boss -¬essentially hire someone to run the company.”28
Pointing to stories and actual cases where the workers hire their boss is instructive in emphasizing the importance of tough bosses to workers. But the typical situation finds the boss hiring the workers, not the other way around. We will explain later why this is the case, but we can lay the groundwork for such an explanation by recognizing that our discussion of the advantages of having tough bosses has left an important question unanswered. An important job of bosses is to monitor workers and impose penalties on those who shirk, but how do we make sure that the bosses don’t shirk themselves? How can you organize a firm to make sure that bosses are tough?
The work of a boss is not easy or pleasant. It requires serious effort to keep close tabs on a group of workers. It is not always easy to know when a worker is really shirking or just taking a justifiable break. A certain amount of what appears to be shirking at the moment has to be allowed for workers to be fully productive over the long run. There is always some tension between reasonable flexibility and credible predictability in enforcing the rules, and it is difficult to strike the best balance. Too much flexibility can lead to an undisciplined workforce, and too much rigidity can destroy worker morale. Also, quite apart from the difficulty of knowing when to impose tough penalties on a worker is the unpleasantness of doing so. Few people enjoy disciplining those they work with by giving them unsatisfactory progress reports, reducing their pay, or dismissing them. The easiest thing for a boss to do is not to be tough on shirkers. But the boss who is not tough on shirkers is also a shirker.
A boss can also be tempted to form an alliance with a group of workers who provide favors in return for letting them shirk more than other workers. Such a group improves its well being at the expense of the firm’s productivity, but most of this cost can be shifted to those outside the alliance.
Of course, you could always have someone whose job it is to monitor the boss and penalize him when he shirks on his responsibility to penalize workers who are shirking. But two problems with this solution immediately come to mind. One, the second boss will be even more removed from workers than the first boss, and so will have an even more difficult time knowing whether the workers are being properly disciplined. Second, and even more important, who is going to monitor the second boss and penalize him or her for shirking? Who is going to monitor the monitor? This approach leads to an infinite regression, which means it leads nowhere. The solution to the problem is the one workers should want by making sure that the boss has some incentive to be tough. The workers should want their bosses to be “incentivized” to remain tough in spite of all the temptations to concede in particular circumstances for particular workers.
28 See Gordon E. Moore, “The Accidental Entrepreneur,” Engineering & Science, vol. 62, no. 4 (Summer 1994): 23-30.
The Role of the Residual Claimant
Every good boss understands that he or she has to be more than just “tough.” A boss needs to be a good “leader,” a good “coach,” and a good “nurse maid,” as well as many other things. The good boss inspires allegiance to the firm and the commonly shared, corporate goals. Every good boss wants workers to seek the cooperative solutions in the various prisoners’ dilemmas that invariably arise in the workplace. Having said that, however, a good boss will invariably be called upon to make some pretty tough decisions, mainly because the boss usually stands astride the interests of the owners above and the workers below. The lesson of this “Manager’s Corner” to this point should not be forgotten, “Woe be to the boss who simply seeks to be a nice guy to all claims.” But firms must structure themselves so that bosses will want to be tough. How can that be done?
In many firms the boss is also the owner. The owner/boss is someone who owns the physical capital (such as the building, the land, the machinery, and the office furniture), provides the raw materials and other supplies used in the business, and hires and supervises the workers necessary to convert those factors of production into goods and services. In return for assuming the responsibility of paying for all of the productive inputs, including labor, the owner earns the right to all of the revenue generated by those inputs.
Economists refer to the owners as residual claimants (a concept first introduced in our discussion of property rights), since they are the ones who claim any residual (commonly referred to as profits) that remains from the sales revenue after all the expenses have been paid. As the boss, the owner is responsible for monitoring the workers to see if each one of them is properly performing his or her job, and for applying the appropriate penalties (or encouragement) if they aren’t. By combining the roles of ownership and boss in the same individual, a boss is created who, as a residual claimant, has a powerful incentive to work hard at being a tough boss.
The employees who have the toughest bosses are likely to be those who work for residual claimants. But the residual claimants probably have the toughest boss of all -¬themselves. There is a lot of truth to the old saying that when you run your own business, you are the toughest boss you will ever have. Small business owners commonly work long and hard since there is a very direct and immediate connection between their efforts and their income.29 When they are able to obtain more output from their workers, they increase the residual they are able to claim for themselves. A residual-claimant boss may be uncomfortable disciplining those who work for her, or dismissing someone who is not doing the job, and indeed may choose to ignore some shirking. But in this case the cost of the shirking is concentrated on the boss who allows it, rather than diffused over a large number of people who individually have little control over the shirking and little motivation to do anything about it even if they did. So with a boss who is also a residual
29 For example, in 1992 wage and salary agricultural workers averaged a 40.6-hour week, while self-employed agricultural workers averaged a 47.1-hour week. See United States Bureau of the Census, Statistical Abstract of the United States: 1993 (113th edition), Washington, DC, 1993: p. 401, table 636.
claimant, there is little danger that shirking on the part of workers will be allowed to get out of hand.
When productive activity is organized by a residual claimant, all resources -- not just labor -- tend to be employed more productively than when those who make the management decisions are not residual claimants. The contrast between government agencies and private firms managed by owner/bosses, or proprietors, is instructive. Examples abound of the panic that seizes the managers of public agencies at the end of the budget year if their agencies have not spent all of the year’s appropriations. The managers of public agencies are not claimants to the difference between the value their agency creates and the cost of creating the value. This does not mean that public agencies have no incentive to economize on resources, only that their incentives to do so are impaired by the absence of direct, close-at-hand residual claimants.30
If, for example, a public agency managed to perform the same service for a hundred thousand dollars a year less than in previous years, the agency administrator would not benefit by being able to put the savings in her pocket. In fact, she would find herself worse off as she would be in charge of an agency with a smaller budget and therefore one less prestigious in the political pecking order. She would also realize that the money she saved by her diligence would be captured by an over-budgeted agency, enhancing the prestige of its less efficient administrator.
The clever public administrator is one who makes sure every last cent, and more, of the budget is spent by the end of the budget year, regardless of whether it is spent on anything that actually improves productivity. Can you imagine a proprietor of a private firm responding to the news that production costs are less than expected by urging his employees to buy more computers and office furniture, and attend more conferences before the end of the year?31
To make the point differently, assume that as a result of your management training you become an expert on maximizing the efficiency of trash pick-up services. In one nearby town the trash is picked up by the municipal sanitation department, financed out of tax revenue, and headed by a public spirited, bureaucratic sanitation professional. In another nearby town the trash is picked up by a private firm, financed by direct consumer charges, and owned by a local businessperson who is proud of her loyal workers and impressive fleet of trash trucks. By applying linear programming techniques
30 Granted, taxpayers could be viewed as the residual claimants to any efficiency improvement resulting from tough managerial decisions in public enterprises, given that efficiency improvement can result in lower tax bills. However, taxpayers have little incentive to closely monitor the activities of public agencies, and, as a matter of fact, do little of it. The reason is simple: Each taxpayer can reason that there is little direct payoff to anyone incurring the costs of monitoring and enforcing greater efficiency in public agencies. [See Gordon Tullock, The Mathematics of Politics (Ann Arbor, Mich.: University of Michigan Press, 1972), especially chap. 7.] 31 You might expect a manager down in the bowels of a large corporation urging his workers to “waste” money at the end of the year, but not someone who has a substantial stake in his or her own decisions. The single proprietor/residual claimant is someone who has total claim to the net income stream, which implies maximum incentive to minimize waste.
to the routing pattern, you discover that each trash service can continue to provide the same pickup with half the number of trucks and personnel currently being used.
Who is going to be most receptive to your consulting proposal to streamline their trash pickup operation, the bureaucratic manager who never misses an opportunity to tell of his devotion to the taxpaying public, or the proprietor who is devoted to her workers and treasures her trash trucks? Bet on this, the bureaucrat will show you the door as soon as he becomes convinced that your idea really would save a lot of taxpayer dollars by reducing his budget by 50 percent.
On the other hand, the proprietor will hire you as a consultant as soon as she becomes convinced that your ideas will allow her to lay off half of her workers and sell half of her trucks. The manager who is also a residual claimant can be depended on to economize on resources despite his or her other concerns. The manager who is not a residual claimant can be depended on to waste resources despite his or her statements to the contrary.32
No matter how cheaply a service is produced, resources have to be employed that could have otherwise been used to produce other things of value. The value of the sacrificed alternative has to be known and taken into account to make sure that the right amount of the service is produced. As a residual claimant, a proprietor not only has a strong motivation to produce a service as cheaply as possible, she also has the information and motivation to increase the output of the service only as long as the additional value generated is greater than the value foregone elsewhere in the economy.
The prices of labor and other productive inputs are the best indicators of the value of those resources in their best alternative uses. So the total wage and input expense of a firm reflects quite well the value sacrificed elsewhere in the economy to manufacture that firm’s product. Similarly, the revenue obtained from selling the product is a reasonable reflection of the product’s value. So proprietors of businesses receive a constant flow of information on the net value their firm is contributing to the economy, and self-interest motivates a constant effort to produce any given level of output, and produce it in the way that maximizes firms’ contributions.
When the one controlling the firm can claim a firm’s profits, those profits serve a very useful function in guiding resources into their most valuable uses. If, for example, consumers increase the value they place on musical earrings (if such were ever made) relative to the value they place on other products, the price of musical earrings will increase in response to increased demand, as will the profits of the firms producing them. The increased profit will give the proprietors of these firms the financial ability, and the motivation, to obtain additional inputs to expand output of this dual-purpose fashion accessory of which consumers now want more. Also, some proprietors of firms making other products will now experience declining profits and find advantages in shifting into
32 Much of the motivation for privatizing municipal services comes from the cost reductions that take place when residual claimants are in charge of supplying these services. There is plenty of evidence that privatization does significantly lower the cost, often by 50 percent or more, of basic municipal services such as trash pick-up, fire protection, and school buses. See James T. Bennett and Manual H. Johnson, Better Government at Half the Price (Ottawa, Ill.: Carolina House, 1983).
production of musical earrings. This redirection of labor and other productive resources continues, driving down prices and profits in musical earring production, until the return in this productive activity is no greater than the return in other productive activities. At this point there is no way to further redirect resources to increase the net value they generate.33
The incentives created by residual-claimant business arrangements do a reasonable job of lining up the interests of bosses with the interests of their workers, their customers, and the general goal of economic efficiency -- using scarce resources to create as much wealth as possible. This alignment of interests is a crucial factor in getting large numbers of people with diverse objectives and limited concern for the objectives of others to cooperate with one another in ways that promote their general well being. Having the residual claimant direct resources is, understandably, an organizational arrangement that workers should applaud. The residual claimant can be expected to press all workers to work diligently, so that wages, fringes, and job security can be enhanced. Indeed, the workers would be willing to pay the residual claimants to force all workers to apply themselves diligently (which is what they effectively do); both workers and residual claimants can share in the added productivity from added diligence.
Certainly this ability to productively harmonize a diversity of interests is a major reason for the emergence and sustainability of residual-claimant business arrangements. But there is another reason why firms are commonly owned and managed by the same person, a reason that helps explain why the typical situation finds the boss hiring the workers instead of the workers hiring the boss.
People differ in a host of ways, and many of their differences have important implications for the type of productive efforts for which they are best suited. For example, both of the authors would have liked to have been successful movie stars, but because we have slightly less charisma than baking soda, we became economists instead. Had we been endowed with even less charm, we would have become accountants. More relevant to the current discussion, however, is the fact that people differ in their willingness to accept risk. Most people are what economists call risk averse; they shy away from activities whose outcomes are not known with reasonable certitude. Such people might, for example, prefer a sure $500 than a 50 percent chance of receiving $1,500 with a 50 percent chance of losing $500 (which has an expected value of $500).34
33 The profits received by firms that are too large to be managed by single proprietors also serve to direct resources into their highest valued uses. But this is true because these firms are organized in ways that allow the owners (the residual claimants) to exert some control over those who manage the firm (the hired bosses). The problem that owners of large corporations face in controlling managers is discussed in subsequent chapters.34 The prevalence of insurance reflects the risk averseness of most people. Insurance allows people to experience a relatively small loss with 100 percent probability (their insurance premiums) in order to avoid a small chance of a much larger loss, but a loss with an expected value that is less than the insurance premiums. It is interesting to note, however, that the same people who buy fire insurance on their house will also buy lottery tickets. Buying a lottery ticket reflects risk-loving behavior since you are taking a small loss with 100 percent probability (the price of the lottery ticket) in order to take a chance on a payoff that is smaller in expected value than the loss. Explanations exist for why rational individuals would buy insurance and gamble. Probably the best known of these explanations was given by M. Friedman and L. J.
But some people are more risk averse than others, as measured by how much less than $500 a sure payoff would have to be before they would no longer prefer it to a gamble with a $500 expected value. And people who are highly risk averse will make very different career choices than those who are not.
Consider the choice between becoming a residual claimant by starting your own business and taking a job offered by a residual claimant. The choice to become a residual claimant is a risky one, requiring the purchase of productive capital and the hiring of workers (thereby obligating yourself to fixed payments) with no guarantee that the revenue generated will cover those costs. The person who starts a firm can lose a tremendous amount of money. Of course, in return for accepting this risk a residual claimant who combines keen foresight, hard work, and a certain amount of luck may end up claiming a lot of residual and becoming quite wealthy. Clearly, those willing to accept risks will tend to be attracted to a career of owning and managing businesses as residual claimants.
Those people who are more risk averse will tend to avoid the financial perils of entrepreneurship. They will find it more attractive to accept a job with a fixed and relatively secure wage, even though the return from such a job is less than the expected return from riskier entrepreneurial activity.
So business arrangements that put management control in the hands of residual claimants not only create strong incentives for efficient decisions, they also allow people to occupationally sort themselves out in accordance with an important difference in their productive attributes and their attitude toward risk. Not only will people who are not very risk averse be more comfortable as residual claimants than most people, they will generally be more competent at dealing with the risks that are inherent in organizing production in order to best respond to the constantly changing preferences of consumers. At the same time, those who are not averse to taking risks are likely less reliable at the relatively routine and predictable activity typically associated with earning a fixed wage than are those who are highly averse to risk.
By having people sort themselves into jobs according to their willingness to assume risk, the risk cost of doing business is minimized. And remember that when firms face competition in either their resource or product markets, they must look to lower all costs as much as possible. Otherwise, the firms’ very existence can be threatened by those firms who pay attention to costs, including costs that are as hard to define as risk costs. If the firms that don’t pay attention to costs avoid outright closure from being underpriced by competitors, they will be taken over by investors who detect an unexploited opportunity -- who buy the firms (or their stock) at a low price and sell them at a higher price after restructuring the firms to lower their costs.
Consider the prospect that more risk-averse workers own their firms and hire the less risk-averse owners of capital (as well as other resources) who would be paid a fixed
Savage [“The Utility Analysis of Choices Involving Risk,” Journal of Political Economy , vol. 56 (August 1948), pp. 279-304]. But the fact remains than in situations that would put a significant amount of their wealth or income at risk, most people are risk averse.
return on their investments (with the fixed return having all the guarantees that are usually accorded worker wages).35 Workers would then, in effect, be the residual claimants, and worker wages would then tend to vary (as do profits in the usual capitalist-owned firm) in less than predictable ways with the shifts in market forces and general economic conditions. Such a firm would not likely be a durable arrangement for even moderately large firms in which fixed investments are important. It’s not hard to see why.36
The workers might be spurred to work harder and smarter because of the sense of ownership, which the proponents of worker ownership argue would be the case. But then, maybe not. Workers might be more inclined to shirk, given they are no longer pushed to work harder and smarter by owner-capitalists. And each worker can reason that his or her contribution to profits is very little (especially in large firms), so little that the power of residual claimacy is lost in the dispersion of ownership among workers. For this reason alone, we would expect most worker-owned firms to be relatively small.
Risk-averse worker-owners would require a “risk premium” built into their expected incomes, and their risk premium would be greater than the risk premium that the less averse owners of capital would require. Hence, the cost of doing business for the worker-owned firm would be higher than for the capitalist-owned firm, which means the worker-owned firms would tend to fail in competition with capitalist-owned firms. Instead of outright failure, we might expect many worker-owned firms to be converted to capitalist-owned firms simply because the workers would want to sell their ownership rights to the less risk-averse capitalists who, because of their lower risk aversion, can pay a higher price for ownership rights than other workers. The net income stream would be higher under the capitalist-owned firm, which means that the capital owners could pay more for the firm than it is worth to the workers. (The worker-owned firms would continue only if the workers were not allowed to sell their supposed ownership rights, which was true in the former Soviet Union and Yugoslavia.)
However, the worker-owned firm would be fraught with other competitive difficulties. Because of their risk aversion, workers would demand higher rates of return on their investments, a fact that would likely restrict their investments and lower their competitiveness and viability over the long run. Moreover, with workers are in control of the flow of payments to the capitalists after they, the capitalists, have made the fixed investment, the capitalists would have a serious worry. The capitalists must fear that the workers would tend to use their controlling position to appropriate the capital through non-competitive wages and fringe benefit payments to themselves, a fear that is not so prominent among workers when capitalists own the fixed assets and pay the workers a fixed wage.37 Therefore, even the capitalists would require a risk premium before they invested in worker-owned firms.
35 In effect, the owners of capital would hold financial assets that would have the look and feel of bonds. 36 For an extended discussion of points in this section, see Michael C. Jensen and William H. Meckling, “Rights and Production Functions: An Application to Labor-Managed Firms and Codetermination,” Journal of Business, vol. 52, no. 4 (1979), pp. 469-506. 37 See the discussion of why workers do not own firms by Benjamin Klein, Robert G. Crawford, and Armen A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,”
Of course, the workers could make the requisite investment, but we must wonder where they will obtain the investment funds. Out of their own pockets? Would they not want to put their own funds in secure investments? We must also wonder if workers would be interested in investing in their own worker-run firms. Like capitalists, workers can understand the threat to their investments from other workers, given the limited competitiveness of their worker-owned firms and the tendency of workers to restrict investment and drain the capital stock through over-payments in wages and fringes. Workers, however, have an additional problem: if they invest their financial resources in their own firms, then they will have a very narrow range of personal investments. By their work for their firms, they already plan to invest a great deal of their resources in their jobs just by spending time at work. Adding a financial investment means they will restrict the scope of assets in their personal portfolio of investments. That fact alone will increase their aversion to risky investments by their firm, and the longer the term of the investment, the greater the risk. Accordingly, we would expect the investments of worker-owned firms to be for shorter periods than would be the case in capitalist-owned firms, which implies that worker-owned firms would tend to lag in the development and application of new technologies. Such a tendency would once again make worker-owned firms less competitive, especially over the long run.
We are not suggesting that no firms will be worker-owned and managed. After all, some are. Instead, the analysis explains why there are relatively few such firms, and why they are typically small firms, relying primarily on human capital of the owner/workers rather than physical capital. When large firms, such as Weirton Steel and United Airlines, are worker-owned, they are not worker-managed. The worker-owners of such firms immediately hire bosses to make the tough decisions that have to be made to keep a firm viable, but then there are the inevitable tensions that come with worker ownership.
Worker-Owned Firms
Weirton Steel Company was taken over by employees in 1983. For a while it was a big success as workers put in long hours, helped each other outside their narrow work rule responsibilities, and did what it took so they could say “We kept the job moving,” as maintenance worker Frank Slanchik said. But soon distrust built between workers and
Journal of Law and Economics, vol. 21 (1978), pp. 297-326. The problem of appropriation by workers is especially acute if the fixed assets are firm specific because they have no alternative use, which implies a limited resale value. As we have seen in other instances, owners of fixed assets with limited resale values open themselves to opportunistic behavior on the part of the buyer, in this case, the workers, who, once the specific investment is made, can appropriate the difference between the purchase and resale price. Workers hired by their capitalist-owners do not generally have the same worry about their work-related investments with their capitalist-owners. The workers’ investments in their job-related skills are typically not firm specific. If workers need firm-specific skills, the workers can protect themselves from appropriation by having their firm pay for the investment they might make in firm-specific skills. Put another way, when human capital is relatively important on the job, we would expect the workers to also be the owners, which tends to be the case in accounting and law firms in which the ratio of human to physical capital investments tend to be high.
their managers (they still hire managers). The two big issues were money and management control. Slanchik notes, “These two issues are especially likely to crop up in capital-intensive industries such as steel and airlines, which constantly require huge capital expenditures that can be viewed as draining money away from potential wage increases.”38
In July 1994, United Airline workers took an average pay cut of 15 percent for 55 percent interest in the company and 3 of its 12 seats on the airlines board of directors. According to Business Week, worker ownership of United Airlines has worked surprisingly well.39 But even in the case of United, some problems that should have been expected are now evident. The 20,000 United flight attendants never joined the buyout and are still unhappy with the management. And, according to Business Week, “Many other employees still resent the pay cuts they took and suspect the ESOP [Employee Stock Ownership Plan] was foisted on them by greedy corporate executives and investment bankers who walked off with millions.”40 Moreover, the company offended many employees when it announced bonuses for 600 managers under a longstanding incentive-compensation plan. Investors have been reluctant to infuse additional capital into the airline, fearing that the employees would “revolt against cost-cutting decisions.”41
This fear is so far unfounded, but the worker-ownership arrangement took place at the beginning of a very profitable period for airlines, United included. Part of the carrier’s post-buyout success stems from a surge in air travel that has generated a record $2 billion in profits for the industry in 1996. Investors have to worry that when times get tougher in the future, United’s newfound cooperative spirit might be seriously challenged, given that strains are already evident among the different worker groups. The 21,000 United Airlines flight attendants, who have been working without a contract for over a year, are thinking about an attack against United with a tactic known as “Create Havoc Around Our System” – or “Chaos.”42 The tactic consists of unannounced strike of individual flights, which can disrupt the entire schedule of an airline. Although the flight attendant union, the Association of Flight Attendants, says it does not want to invoke Chaos, but given United’s “record profits,” United attendants are “angry” and ready to strike, or so claims Kevin Lum, president of United’s flight attendant association.43
Understandably, investors can’t be sure just how tough United’s workers will be on each other. They also have to fear that the workers would not add their share to the company’s capital stock, by depleting retained earnings with wage increases, and would be tempted to drain the firm of any capital added by outside investors by way of wage
38 Susan, Carey, “ESOP Fables: UAL Worker-Owners May Face Bumpy Ride If the Past Is a Guide,” Wall Street Journal, December 23, 1993, p. 1. 39 See Susan Chandler, “United We Own.” Business Week March 18, 1996, pp. 96-100. 40 Ibid., p. 98. 41 Ibid., p. 99.42 In the WSJ on 24 June 1997 was an article by Susan Carey “United Flight Attendants Warn of ‘Chaos’,” Wall Street Journal, pp. B-1 and B-2. 43 Ibid.
increases. The workers have to worry about the inclination of each worker group to garner firm profits at the expense of other groups and the investors. The workers also have to worry that they have taken over the role of the investors, which is accepting the risk that comes from being residual claimants. The workers’ insecurities can be heightened by the fact that the company’s future will be jeopardized by the absence of the capital that it will need to remain competitive with investor-owned airlines that don’t have the problems and fears that United might have.
We should not be surprised if, at some later date, the workers effectively try to “buy back” some security by selling their stake in their company, giving the investors that right to be tough bosses in exchange for more investment funds and a more certain income stream for workers (with more of their income coming from wages, salaries, and fringe benefits and less of it coming from dividends).
Management Snooping
Technology has given workers a chance to loaf on the job while they appear busy at their desk. All workers have to do is surf the web for entertainment, shopping, and sex sites on their office computers while giving passersby (including their bosses) the impression that they, the workers, couldn’t be more focused on company business. And workers are often good at acting busy and engaged.
At the same time, technology is coming to the rescue of manager/monitors – or bosses who want to be really tough, if not oppressive. Programs such NetNanny, SurfWatch, and CyberPatrol enable managers to block worker access to web sites with certain words on the site, for example, “sex.” However, with the aid of a program called com.Policy from SilverStone Software, managers now can, from their own desktop computers, go much further and check out what worker’s have on their computer screens. The software can take a snapshot of the worker’s computer screen and sends it, via the local area network, to the boss’ screen. If a worker visits an XXX-rated web site or writes a love note to a coworker or someone across the country, managers can know it, and, depending on how tough they want to be, the managers can penalize or dismiss the workers for using company equipment for personal use. Presumably, the managers can, with the aid of the software, increase worker productivity, given that the penalties or threat of penalties, can eliminate worker shirking.
The real question is Should managers use technology that allows them to “snoop” (to use the characterization of the technology’s critics)? Would workers want them to use it? Clearly, there are good reasons managers and workers alike would not want to use the software, it represents an invasion of worker privacy. Many managers and, we suppose, almost all workers, find “snooping” distasteful. But, as in all other business matters, the worker problems must be weighed off against the benefits to the firm and workers.
Workers might not want their privacy invaded at the whim of their bosses, but the workers can understand the now familiar prisoner’s dilemma they are in -- one in which many of the workers might be inclined to misuse their office computers for private gain (entertainment, maintenance of love affairs, and sexual stimulation). In large offices, the
workers can reason that everyone else is misusing (at least to some extent) their computers, that their individual misuse will have an inconsequential impact on the firm’s profitability or survivability, and that they each worker should do what everyone else is doing, take advantage of the opportunity to misuse their computers – even though long-run firm profits and worker wages will suffer as a result of what the workers do (or, rather, don’t do).
Accordingly, workers could welcome the invasion of their privacy, primarily because the gain in income and long-term job security is of greater value than the loss of privacy. Managers can use the software simply because they are doing what their stockholders and workers want them to do, make mutually beneficial trades with their workers, which is, in this case, ask them to give up some privacy in exchange for the prospects of higher wages and security.
At the same time, we should not expect that the above deduction will apply in every worker group. Some worker groups will value their privacy very highly, so highly in fact that in some instances the managers would have to add more to worker wages than the firm could gain in greater productivity from use of the monitoring software. In such cases, use of the software would be nonsensical: it would hurt both the workers and the firm’s bottom line. Put another way, some bosses aren’t as tough as they might want to be simply because, beyond some point, toughness – added “snooping” -- doesn’t pay; it can be a net drain on the company.
Critics of the snooping software are prone to characterize it as “intrusive,” if not “Orwellian.” One such critic was reported to have reacted to the software’s introduction with the comment, “It worries me that with the assistance of a variety of tools that every moment of a person’s workday can be monitored. Workers are not robots that work 24 hours a day without ceasing.”44 We simply don’t see the matter in such black and white terms. The old quip “different strokes for different folks” contains much wisdom, especially in business. We see nothing wrong with employers warning their employees, “The computers are the firm’s, and we reserve the right to snoop on what you are doing with the firm’s equipment as we see fit.” To the extent that the (potential) snooping is seen as a threat to workers, the firm would have to pay in higher wages for the snooping bosses might do. If they did not pay a higher wage for the announcement, workers could be expected to go elsewhere, where the firm explicitly rules out snooping. What is understandably objectionable to employees is the snooping when it is not announced or, worse yet, when managers profess, or just intimate, that they will not use the available technology, but then snoop at will. Such managers not only violate the privacy and trust of their workers, they engage in a form of fraud. They effectively ask their workers to take a lower rate of pay than they would otherwise demand, and then don’t give their workers what they pay for, privacy. Moreover, such after-the-fact snooping doesn’t do what the firm wants, increase beforehand the incentive workers have to apply themselves.
44 As quoted in Lisa Wirthman, “Superior Snooping: New Software Can Catch Workers Goofing Off, But Some Say Such Surveillance Goes Too Far,” Orange County (Calif.) Register, July 20, 1997, p. 1 and 10 (connect section).
Unannounced snooping is just poor management policy on virtually all scores. With announced snooping policies, workers can sort themselves among firms. Those workers who value their privacy or on-the-job entertainment highly can work for firms that don’t snoop. Those workers who value their privacy very little can work for firms that announce that they might snoop. “Different strokes for different folks” can be a means of elevating on-the-job satisfaction.
What firms would be most likely to use the monitoring software (or any other technology that permits close scrutiny of worker behavior)? We can’t give a totally satisfactory answer. Workplace conditions and worker preferences are bound to vary across industries. But we can say with conviction that there is no “one-size/fits-all” monitoring policy. We can only imagine that different firms will announce different levels of snooping -- with some firms ruling it out, other firms adopting close snooping, and still others announcing occasional snooping. And many firms with the same level of snooping can be expected to impose penalties with different levels of severity.
Although we can’t say much in theory about what firms should do, we can note that the snooping software, and similar technologies, would more likely be used in “large” firms where the output of individual workers is hard to detect, measure, and monitor than in “small” firms where output is relatively easy to detect, measure, and monitor precisely because each worker’s contribution to firm output is such a large share of the total. The snooping technology would not likely be used among workers whose incomes are tied strongly to measures of their performance, for example, sales people who are on commission and far removed from the company headquarters. Such workers will suffer a personal cost if they spend their work time surfing the web or writing love notes. Managers should be little more concerned with such workers’ misuse of their company computers than they are concerned about how their workers use their paychecks at the mall. If such workers are not performing (because they are “spending” too much of their pay on net surfing), then the firm should consider the prospect that they need to increase the cost of wasted time by more strongly tying pay to performance (a subject to which we return in a later chapter).
By implication, managers will not likely use the software to monitor employees who are highly creative. “Creativity” does not always happen when workers diligently apply themselves, and often occurs precisely because workers are relaxed, with the ability to do as they pleased without fear of being penalized for goofing off. Firms would probably be more inclined to use the software with employees who are paid by the hour and have little or no personal payoff from working hard and smart. It should go without saying that the more workers value their privacy, the less likely monitoring software will be used. This is because the more workers value their privacy, the more managers would have to pay in higher wages to invade the privacy.
The Reason for Corporations
Competition determines which business arrangements will survive and which will not. The prevalence of single proprietorships is explained by the advantage of this business
form in producing those products the consumers want as inexpensively as possible. But changing circumstances can reduce the competitive advantage of a business arrangement as new arrangements are found to do a better job of organizing productive activity. Technological advances that took place during the latter part of the nineteenth century made it possible to realize huge economies from large scale production in many manufacturing industries. These technological advances shifted the advantage to business organizations that were far too large to be owned and managed by one proprietor, or even by a few. But the advantage of large business firms is reduced by the fact that they make it impossible to concentrate the motivation created by ownership entirely in the hands of those making management decisions.
Those manufacturing firms that developed organizational arrangements that did the best job of reducing the disconnection between the owners’ incentives and the managers’ control were best able to take advantage of economies from large-scale production. The result was a competition that resulted in the development of the modem corporation, the business form that today accounts for most of the value produced in the United States economy, even though small owner-managed firms still make up, by far, the largest number of firms in the economy.
However, it must be remembered (contrary to what is often taught in business books) that the corporation (an organization under which investors have limited liability) was not a creation of the state.45 The corporation emerged before states got into the incorporating business. Groups of private investors formed corporations because they believed that there were economies to be had if they all agreed to create a business in which outside parties could not hold the individual investors liable for more than their investment in the corporation (that is, the investors’ personal fortunes would not be at risk from the operation of the firm, as was and remains true of proprietorships and partnerships). Clearly, such a public announcement of limited liability (made evident with “Inc.” on the end of corporate names) might make lenders weary and cause them to demand higher interest rates on loans. However, the firm would have the offsetting advantage of being able to attract more funds from more investors, increasing firm equity, a force that could not only increase the firm’s ability to achieve scale economies grounded in technology, but would lower risk costs to lenders. Of course, the outside investors could be hard taskmasters, given that they could shift their investment away from firms not maximizing profitably. But that doesn’t mean the workers would find the corporate form unattractive. On the contrary, given the potential scale economies and risk reductions, corporations may provide more secure employment than small proprietorships.
Jack Welch, the chief executive officer of General Electric, has played out the central point of this “Manager’s Corner” because he surely qualifies as a tough boss.
45 Robert Hessen, In Defense of the Corporation (Stanford, Calif.: Hoover Institution Press, 1979) develops this view of the corporation.
Indeed, Fortune once named Welch “America's Toughest Boss.”46 Welch earned his reputation by cutting payrolls, closing plants and demanding more from those that remained open. Needless to say, these decisions were not always popular with workers at GE. But today, GE is one of America's most profitable companies, creating far more wealth to the economy and opportunities for its workers than it would have if the tough and unpopular decisions had not been made. In Welch's words, “Now people come to work with a different agenda: They want to win against the competition, because they know that . . . . customers are their only source of job security. They don't like weak managers, because they know that the weak managers of the 1970s and 1980s cost millions of people their jobs.”47
MANAGER’S CORNER II: The Value of Teams
The central reason firms exist is that people are often more productive when they work together -- in “teams” -- than when they work in isolation from one another but are tied together by markets. “Teams” are no passing and empty management fad. Firms have always utilized them. What seems to be new is the emphasis within management circles on the economies that can be garnered from assigning complex sets of tasks to relatively small teams of workers, those within departments and, for larger projects, across departments. However, “teams” also present problems in the form of opportunities for shirking (which should be self–evident to many MBA students who form their own study and project groups to complete class assignments). A central problem managers face is constructing teams so that they minimize the amount of shirking.
At its defense avionics plant, Honeywell reports that its on-time delivery went from 40 percent in the late 1980s to 99 percent at the start of 1996, when it substituted teams, in which workers’ contributions are regulated by the members, for assembly-line production, in which workers’ contributions are regulated extensively by the speed of the motors that drive the conveyor belts. Dell Computer is convinced that its team-based production has improved quality in its made-to-order mail-order sales. Within twelve months of switching to teams in its battery production, a different company, Electrosource, found its output per worker doubled (with its workforce dropping from 300 to 80 workers).48
If people could not increase their joint productivity by cooperating, we would observe individual proprietorships (with no employees other than the owners) being the most common form of business organization and also the form that contributed most to national production. As it is, while proprietorships outnumber other business forms (for example, partnerships and corporations) by a wide margin, they account for only a minor fraction of the nation’s output. Even then, many proprietorships can’t get along without a few employees. Single-worker firms tend to be associated with the arts. Few artists have
46 Noel M. Tichy and Stratford Sherman, "Jack Welch's Lessons for Success," Fortune (25 January 1993) pp. 86-93.47 Ibid. p. 92.
48 As reported in Paulette Thomas, “Work Week: Teams Rule,” Wall Street Journal, May 28, 1996, p. A1.
employees. Even we are writing this book as a partnership in the expectation that our joint efforts will pay off in a better book than either of us could write alone. We are a “team” of a sort. But notice there are only two of us, and we aren’t about to write a book with a number of others, for reasons explained below. As important as teams can be in business, managers must recognize inherent incentive problems that limit the size of productive teams.
Team Production
To be exact, what do we mean by “team production”? If Mary and Jim could each produce 100 widgets independent of one another and could together produce only 200 widgets, there would be no basis for team production, and no basis for the two to form a firm with all of the trappings of a hierarchy. The added cost of their organization would, no doubt, make them uncompetitive vis a vis other producers like themselves who worked independently of one another. However, if Mary and Jim could produce 250 widgets when working together, then team production might be profitable (depending on the exact costs associated with operating their two-person organization).
Hence, we would define team production as those forms of work in which results are highly interactive: The output of any one member of the group is dependent on what the other group members do. The simplest and clearest form of “team work” is that which occurs when Mary and Jim (and any number of other people) move objects that neither can handle alone from one place to another. The work of people on an assembly line or on a television-advertising project is a more complicated form of teamwork.
Granted, finding business endeavors that have the potential of expanding output by more than the growth in the number of employees is a major problem businesses face, but it is not the only problem and may not be the more pressing day-to-day problem when groups of people are required to do the work. The truly pressing problem facing managers on a daily basis is making sure that the synergetic potential of the workers who are brought together into a team is actually realized, that is, production is carried out in a cost-effective manner, so that the cost of organization does not dissipate the expanded output of, in our simple Mary/Jim example, 50 widgets.49
We often think of firms failing for purely financial reasons. They don’t make a profit, or they incur losses. Firms are said to be illiquid and insolvent when they fail. That view of failure is instructive, but the matter can also be seen in a different light, as an organizational problem and a failure in organizational incentives. A poorly run organization can mean that all of the 50 “extra” widgets that Mary and Jim can produce together are lost in unnecessary expenditures and impaired productivity. If the organizational costs exceed the equivalent of 50 widgets, then we can say that Mary and Jim have incurred a loss, which would force them to adjust their practices as a firm or to part ways.
49We remind the reader that “cost” is the value of that which is foregone when something is done. Cost can be measured in money, but the real cost is the value of that which is actually given up.
Many firms do fail and break apart, not because the potential for expanded output does not exist, but because the potential is not realized when it could be. The people who are organized in the firm can do better apart, or in other organizations, than they can together. That’s what we really mean by reoccurring business “losses.”
Why can’t people always realize their collective potential? There is a multitude of answers that question. Firms may not have the requisite product design or a well-thought-out business strategy to promote the products. Some people just can’t get along; they rub each other wrong when they try to cooperate. Nasty conflicts, which deflect people’s energies at work to interpersonal defensive and predatory actions, can be so frequent that the production potentials are missed.
While recognizing many non-economic explanations for organizational problems, we, however, would like to stay with our recurring theme, that incentives always matter a great deal and they can become problematic within firms. Our general answer to our question, why firms’ potential can go unrealized, is that frequently the firm does not find ways to properly align the interests of the workers with the interests of other workers and the owners. They don’t cooperate like they should.
In our simple firm example, involving only two people, Mary and Jim, each party has a strong personal incentive (quite apart from an altruistic motivation) to work with the other. After all, Mary’s contribution to firm output is easily detected by her and by Jim. The same is true for Jim. Moreover, each can readily tell when the other person is not contributing what is expected (or agreed upon). Each might like to sit on his or her hands and let the other person carry the full workload. However, the potential is not then likely to be realized, given that the active participation of both Mary and Jim is what generates the added production and their reason for wanting to become a firm (or team) in the first place.
Furthermore, Jim can tell when Mary is shirking her duties, and vice versa, just by looking at the output figures and knowing that there is only one other person to blame. Accordingly, when Mary shirks, Jim can “punish” Mary by shirking also, and vice versa, ensuring that they both will be worse off than they would have been had they never sought to cooperate. The agreement Mary and Jim might have to work together can be, in this way and to this extent, self-enforcing, with each checking the other -- and each effectively threatening the other with reprisal in kind. The threat of added cost is especially powerful when Mary and Jim are also the owners of the firm. The cost of the shirking and any “tit for tat” consequences are fully borne by the two of them. There is no prospect for cost shifting.
Two-person firms are, conceptually, the easiest business ventures to organize and manage because the incentives are so obvious and strong and properly aligned. Organizational and management problems can begin to mount, however, as the number of people in the firm or “team” begins to mount.
Everyone who joins a firm may have the same objective as Mary and Jim -- they all may want to make as much money as possible, or reap the full synergetic potential of their cooperative efforts. At the same time, a number of things can happen as the size of
the firm or “team” grows in terms of more employees. Clearly, communication becomes more and more problematic. What the boss says can become muffled and less clear and forceful as the message is spread through more and more people within the firm.
Also, and probably more importantly, as explained in the “logic of group behavior,” incentives begin to change with the growth in the size of groups. Foremost, each individual’s contribution to the totality of firm output becomes less and less obvious as the number of people grows. This is especially true when the firm is organized to take advantage of people’s specialties. Employees often don’t know what their colleagues do and, therefore, are not able to assess their work.
When Mary is one of two people in a firm, then she is responsible for half of the output (assuming equal contributions, of course), but when she is one of a thousand people, her contribution is down to one-tenth of one percent of firm output. If she is a clerk in the advertising department assigned to mailing checks for ads, she might not even be able to tell that she is responsible for one-tenth of a percent of output, income, and profits.
If Mary works for a firm with several hundred thousand workers, you can bet that she has a hard time identifying just how much she contributes to the firm. She can’t tell that she is contributing anything at all, and neither can anyone else. She can literally get lost in the company. If she doesn’t contribute, she and others will have an equally difficult time figuring out what exactly was lost to the firm. Her firm’s survival is not likely to be materially affected by what she does or does not do. She is the proverbial “drop in the bucket,” and the bigger the bucket, the less consequential each drop is. Of course, the same could be said of Jim and everyone else in the firm.
Now, it might be said that all of the “drops” add up to a “bucket.” The problem is that each person must look at what he or she can do, given what all the others do. And drops, taken individually, don’t really matter, so long as there are a lot of other drops around.
Admittedly, if no one else contributes anything to production (there are no other drops in the bucket), the contribution of any one person is material -- in fact, everything. The point is that in large groups and as output expands, each worker has an impaired incentive to do that which is in all of their interests to do -- that is, to make their small contribution to the sum total of what the firm does. All workers may want the bucket to get filled, but to do so takes more than wishful thinking, which often comes in the form of assuming that people will dutifully do that which they were hired to do. The point here is that large-number prisoners’ dilemmas are more troublesome than small-number prisoners’ dilemmas.
A central lesson of this discussion is, as stressed before, not that managers can never expect workers to cooperate. We concede that most people do have – very likely because of genetics and the way they were reared -- a “moral sense,” or capacity to do what they have committed to doing -- that they will cooperate, but only to a degree, given normal circumstances. However, there are countervailing incentive forces embedded in the way groups – or teams – of people work that, unless attention is given to the details of
firm organization, can undercut the power of people’s natural tendencies to cooperate and achieve their synergetic potential. If people were total angels, always inclined to do as they are told or as they said they would do, then the role of managers would be seriously contracted. Even if almost everyone were inclined to do as they were told or committed to doing, still managers would want to have in place policies and an organizational structure that would prevent the few “bad” people from doing real damage to the firm, which, if left unchecked, they certainly could do. The arguments presented also help us answer several questions.
Why are there so many small firms? Many commentators give answers based on technology: Economies of scale (relating strictly to production techniques and equipment) are highly limited in many industries. One very good organizational reason is that many firms have not been able to overcome the disincentives of size, making expansion too costly and uncompetitive.
Why are large firms broken into departments? While it might be thought that the administrative overhead of department structures, which requires that each department have a manager and an office with all the trappings of departmental power, is “unnecessary,” departments are a means firms use to reduce the size of the relevant group within the firm. The purpose is not only to make sure that the actions of individuals can be monitored more closely by bosses, but also that the individuals in any given department can more easily recognize their own and others’ contributions to “output.”
Why do workers have departmental bosses? One reason is that the owners want their instructions to be carried out. Another explanation, one favored by UCLA economists Armen Alchian and Harold Demsetz, is that the workers themselves want someone who is capable of monitoring the output of their co-workers, to prevent than from shirking and to increase the incomes and job security of all workers.50 Workers want someone who is given the authority to fire members who shirk. As discussed under “Manager’s Corner I,” if owners didn’t create bosses, then the workers probably would want them created in many situations for many of the same reasons and from much the same mold as do owners.
Why is there so much current interest in “teams”? As acknowledged, we suspect that the concept of teams in industry has always been around and used for a long time. After all, we have worked as members of “teams” (mainly, departments of business and economics professors) for all of our careers. However, it is also likely that over recent decades, managers probably became far too enamored with the dictates of “scientific management,” which focused on the means of controlling workers with punishments and rewards that come from bosses who are outside (and above) the workers’ immediate working group. Managers tried with some success to reduce shirking with the introduction of the assembly lines, under which the speed of the assembly-line belt determined how fast workers worked (with the presumption that workers would not have much leeway to adjust behavior, which might have been true for the pace of the work

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Group Behavior in Business

noreply@blogger.com ([Admin]) — Mon, 15 Jun 2009 09:57:00 +0000

The Logic of Group Behavior In Business and Elsewhere
Men journey together with a view to particular advantage and by way of providing some particular thing needed for the purpose of life, and similarly the political association seems to have come together originally. . . for the sake of the general advantage it brings.
Aristotle1
Unless the number of individuals in a group is quite small, or unless there is coercion, . . .rational, self-interested individuals will not act to achieve their common or group interest. In other words, even if all. . . would gain if, as a group, they acted to achieve their common interest or objective, they will still not voluntarily act to achieve that common or group interest.
Mancur Olson2
n earlier chapters, we introduced the usefulness of markets. However, as is evident
inside firms, not all human interactions are through “markets.” People often act
cooperatively in groups or, as the case may be, in “firms.” In this chapter our central purpose is to explore how and under what conditions people can organize their behavior into voluntary cooperative associations (groups and firms) in which all work together for the attainment of some common objective, say, greater environmental cleanliness, the development of a “club atmosphere,” or the maximization of firm profits. The focus of our attention is on the viability of groups like families, cliques, communes, clubs, unions, and professional associations and societies, as well as firms, in which individual participation is voluntary to cohere and pursue the common interests of the members.
We consider two dominant and conflicting theories of group behavior. They are “the common interest theory” and “the economic theory” of group behavior. The former is based on the proposition that a group is an organic whole” identified by the “common interest” shared by its individual members. Its basic thesis is that all groups, even very large ones, are organized to pursue the common interest of the group members. Taking this theory one step further, it implies that if people share a common interest, they will organize themselves into a group and voluntarily pursue their shared interest.
According to the economic theory of group behavior, the group is a collection of independently motivated individuals who organize voluntarily to pursue their common interest only in small groups, like families or clubs. In large groups the common interest
1 Aristotle, Ethics, vol. 8, no. 9, p. 1160a. 2 Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1971), p. 2
is very often ineffective in motivating group behavior. The logic of this theory seems perverse; but, as we will see in later chapters, it is the basis for almost all economic discussion of markets and explains why many policy proponents argue governments must be delegated coercive powers to collect taxes and to pursue the “public interest.” It also helps explain why firms are organized the way they are and why managers manage the way they do. This is, therefore, one of the pivotal chapters in this book.
However, keep in mind that groups are not the only means by which people’s interpersonal or social behavior is organized in society. Economics is basically a study of comparative social systems, an examination of how the different ways of organizing interpersonal behavior can be fitted together in different combinations. We call these means of organizing people’s behavior “social organizers” and mention four of them here: markets which involve exchanges of goods and services, government coercion, violence, and voluntary groups. On the surface, violence may not appear to be a bona fide alternative, but we are forced to mention it because of the use made of it throughout the world. The behavior of street-gang members, for example, with respect to people totally unassociated with them, is largely based upon either the existence or the threat of violence. The Cold War was a tenuous truce founded to a sizable degree on the threat of a nuclear holocaust. The persistent violence in the streets of Northern Ireland during the 1960s and 1970s will for many years have a profound influence on what the people of that country can hope to accomplish. Many examples can be cited which illustrate the spread of terrorist activities and the threat they represent to the fabric of social order which has been built on the basis of other social organizers. Aside from what we have already said with regard to anarchy, we will have little to say about violence as a social organizer. This does not lessen the importance, which we attribute to violence; it simply reflects the fact that economists have only recently turned their attention to the subject and much remains to be done in the way of theory construction.3
The question of how you appraise the roles the various social organizers should play in social order appears to be wrapped in one’s personal ideology or value system—that is, there appears to be no room for positive analysis. Indeed, what we as individuals want the system to accomplish is surely a factor in how each of us evaluates potential social organizers. Personal values will affect our attitude as to whether or not a given social organizer should be used and, if used, how extensively. The avowed Marxist has very harsh opinions of the market system. But perhaps just as important in our appraisal is what we know about the relative effectiveness—the advantages and limitations—of the potential means for ordering behavior. If, for example, we have only a rudimentary understanding of how the market works and fail to appreciate with sufficient clarity the limitations of cooperative efforts, we may naturally place greater reliance on voluntary
3 For example of economists’ initial probes into the area of malevolence and violence, see Kenneth E. Boulding, The Economy of Love and Fear (Belmont, Calif.: Wadsworth Publishing Company, Inc., 1973), and Gordon Tullock, The Social Dilemma: The Economics of War and Revolution (Blacksburg, Va.: University Publications, 1974). Only those who wish to be challenged will find these books useful.
cooperation than we would otherwise. We, therefore, in this chapter highlight the limitations of voluntary groups as a social organizer in order that we may appreciate why markets are not only beneficial but also necessary in organizing a society of heterogeneous individuals.
Common Interest Theory of Group Behavior
There are almost as many theories of group behavior as there are group theorists. However, categorizing theories according to dominant themes or characteristics is sensible in light of our limited space.
All theories of group behavior begin by recognizing the multiplicity of forces, which affect group members and, therefore, groups. This is especially true of what we term the common interest theory. Many present-day sociologists, political scientists, and psychologists generally share this point of view, which has been prominent at least since Aristotle. The determinants of group behavior most often singled out are the “leadership quality” of specific group members and the need felt among group members for “affiliation,” “security,” “recognition,” “social status,” or money. Groups like clubs or unions form so that members can achieve or satisfy a want that they could not satisfy as efficiently through individual action. All these considerations are instrumental in affecting “group cohesion,” which, in turn, affects the “strength” of the group and its ability to compete with other groups for the same objectives. From the perspective of this theory, when people join firms, they accept the firm’s objective and pursue it because everyone else wants the same thing, leading to self-enforcing group cohesion.
The common interest theory views the “group” as an organic whole, much like an individual, as opposed to a collection of individuals whose separate actions appear to be “group action.” According to the theory, the group has a life of its own which is to a degree independent of the individuals who comprise it. Herbert Spencer, a nineteenth-century sociologist, often described the group as a “social organism” or as a “superorganic” entity.4 Karl Marx wrote of the “class struggle” which will bring down “bourgeois capitalism” and of the proletariat” which will, in its place, erect the communist society. And it was probably the social-organism view of groups that Aristotle had in mind when he wrote, “Man is by nature a political animal.”5
Two major reasons are given for viewing groups as a social organism. First, a group consists of a mass of interdependencies, which connect the individuals in the group. Without the interdependencies, there would be only isolated individuals, and the term group would have no meaning. Individuals are like the nodes of a spider web. The
4 Spencer was actually somewhat ambivalent on the subject; at times he also wrote of groups as a composite of individuals. This aspect of his writing reflected the influence David Hume and Adam Smith had on his thinking. See Herbert Spencer, Principles of Sociology (London: Williams and Norgate, Ltd., 1896). 5 Aristotle, Politics, Book II.
spider web is constructed on these nodes, and the movements in one part of the web can be transmitted to all other parts. Much like the process of synergism in biology,6 the actions of individuals within a group combine to form a force that is greater than the sum of the forces generated by individuals isolated from one another. The group must, so the argument goes, be thought of as more than the sum total of individuals. This argument is often used to arouse support for a labor union. Union leaders argue that the union can get higher wage increases for all workers can obtain acting independently of one another. The reason is that union leaders efficiently coordinate the efforts of all. Environmental groups make essentially the same argument: With well-placed lobbyists, the environmental group can have a greater political impact than can all the individuals they represent writing independent letters to their representatives at different times.
Second, groups tend to emerge because they satisfy some interest shared by all the group’s members. Because all share this “common interest,” individuals have an incentive to work with others to pursue that interest, sharing the costs as they work together. Aristotle wrote, “Men journey together with a view to particular advantage,”7 and Arthur Bentley said, “There is no group without its interest.. . .The group and the interest are not separate. . . . If we try to take the group without the interest, we simply have nothing at all.”8
Having observed that a common interest can be shared by all of a group’s member, the adherents of this theory of group behavior argue that a group can with slight modification, be treated as an individual. The primary modification is the relative tightness or looseness of the ties that bind the group members together. This usually makes group action and reaction less decisive and precise than that of individuals, but the difference between a group and an individual is still a matter of degree, not kind. For instance, the difficulty of passing information about group goals from person to person can make the group’s response to new information somewhat sluggish. Nevertheless, a group can be assumed to maximize the attainment of its common objective. Furthermore, the implicit assumption is made that this will be true of large as well as small groups. It is on this deduction that Mancur Olson and many economists take issue with this analysis of group behavior.
The Economic Theory of Group Behavior
Mancur Olson, on whose work this section rests, agrees that the “common interest” can be influential and is very important in motivating the behavior of members of small groups. However, he, like so many other economists, insists that a group must be looked upon as a composite of individuals as opposed to an anthropomorphic whole, that the common interest, which can be so effective in motivating members of small groups, can be impotent in motivating members of large groups: “Unless there is coercion in large
6 This is the process whereby two or more substances (gases or pollutants) come together, and combined can have a greater effect than the sum of the effects of each individual taken separately.7 Aristotle, Ethics, vol. 8, no. 1, p. 1160a. 8 Bentley, in Peter Odegard (ed.) Process of Government (Cambridge: The Belknap Press, Harvard University Press, 1967), pp. 211-213.
groups. . . ., rational self-interested individuals will not act to achieve their common or group interest.” Furthermore, he contends, “These points hold true when there is unanimous agreement in a group about the common goal and the methods of achieving it.”9 To understand this theory, we will first examine the propositions upon which it is founded and then analyze some qualifications.
Basic Propositions
Using economic analysis, people are assumed to be as rational in their decision to join a group as they are toward doing anything else; they will join a group if the benefits of doing so are greater than the costs they must bear. As explained earlier, these costs and benefits, like all others relevant to any other act, must be discounted by the probability that the costs and benefits will be realized.10 There are several direct, private benefits to belonging to groups, such as companionship, security, recognition, and social status. A person may also belong to a group for no other reason than to receive mail from it and, in that small way, to feel important. A group may serve as an outlet for our altruistic or charitable feelings. If by “common interest” we mean a collection of these types of private benefits, it is easy to see how they can motivate group behavior. Entrepreneurs can emerge to “sell” these types of private benefits as they do in the case of private golf clubs or Weight-watchers. The group action will be then, essentially, a market phenomenon—that is, a problem in simple exchange.
However, the central concern of this theory is a “common interest” which is separate and detached from these types of private benefits. The concern is with public benefits that transcend the entire group, which cannot be provided by the market, and which may be obtained only by some form of collective action. That is, a group of people must band together to change things from what they otherwise would be. Examples include the common interest of consumers in general to obtain better, safer products than the market would provide without collective action; the interest of labor unions is to secure higher wages and better fringe benefits than could be obtained by the independent actions of laborers; the interest of students is to have better instruction; the interest of faculties is to educate quality graduates. These are examples of the common interest being a public good. (As you will recall, a public good was defined as a good— or service—the benefits of which are shared by all members of the relevant group if the good is provided or consumed by anyone.)
9 Olson, Logic of Collective Action, p. 2. A number of economists were moving toward the development of Olson’s line of analysis, but the force and clarity of Olson’s presentation of his view of group behavior make his book an important reference work.10 This type of cost and benefit analysis has been explicit, if not implicit, in much of the writing of those in support of the “common interest theory of groups” explained above. There would be little reason for talking about a “common interest” if it did not have something to do with benefits of group participation. See, for example, Dorwin Cartwright, “The Nature of Group Cohesiveness,” in Dorwin Cartwright and Alvin Zander, eds., Group Dynamics: Research and Theory, 3d ed. (New York: Harper & Row, Publishers, 1968), pp. 91-109.
Small Groups
Small groups are not without their problems in pursuing the “common interest” of their members. They have a problem of becoming organized, holding together, and ensuring that everyone contributes his part to the group’s common interest. This point was illustrated earlier in terms of Fred and Harry’s problems of setting up a social contract, and it can be understood in terms of all those little things which we can do with friends and neighbors but which will go undone because of the problems associated with having two or three people come together for the “common good.” For example, it may be in the common interest of three neighbors for all to rid their yards of dandelions. If one person does it, and the other two do not, the person who removes the dandelions may find his yard full of them the next year because of seeds doing from the other two yards. Why do we so often find such a small number of neighbors failing to join together to do something like eradicating dandelions?
We can address this question with the use of the public goods demand curve developed earlier. The common interest is dandelion eradication; and two neighbors, Fred and Harry, again, have a demand for this public good.11 There is no particular reason for us to assume that Fred and Harry have identical demands for this particular public good; consequently, we have drawn Harry’s demand for eliminating dandelions in Figure
5.1 greater than Fred’s demand.
Figure 5.1 The Problem of Getting Collective Action
If the marginal cost curve is MC2, the marginal cost of eliminating even the first dandelion will be too high to take any action at dandelion eradication. However, if the cost were lower, MC1 instead of MC2, Harry would be willing to eliminate as many as Q1 dandelions. Fred would still do nothing.

11 We realize the imperfections of this example of a public good; much of the benefit of each person’s action is private. Only a portion of one neighbor’s dandelions may actually affect other people’s yards. The example, however, is a reasonably good one for our purpose.
If we assume, for simplicity only, that the marginal cost of eliminating dandelions is constant, the marginal cost curve will be horizontal. Whether or not either Fred or Harry will individually do anything about his dandelions depends, given their demands, upon the position of the marginal cost curve. If, for example, it is positioned as MC2 in Figure 5.1, neither Fred nor Harry will be motivated individually to do any thing about the problem. The marginal cost of eliminating the first dandelion is greater than the benefits that even Harry, who has the greater demand, received from it. Notice that the marginal cost curve (MC2) does not intersect either of the demand curves in the graph, meaning that the optimum level of activity for both, on an individual basis, is zero. On the other hand, if the marginal cost curve is at MC1, Fred will still be unwilling to do anything, but Harry will be willing to eliminate, on his own, up to Q1 dandelions. Fred, however, will benefit from Harry’s actions; he will have fewer dandelions in his own yard; he can “free-ride” because of Harry’s high demand for dandelion eradication.
Still, the quantity of dandelions eradicated may not be what is socially optimal. Consider Figure 5.2. In that figure we have constructed Fred and Harry’s joint, or public good, demand curve. Their collective demand curve is obtained by vertically summing the demands of the individuals. Under individual action, Q1 dandelions are eradicated by Harry. However, the value which Fred and Harry collectively place on the elimination of additional dandelions is greater than the marginal cost. For example, the marginal value of the Q1th unit to both Fred and Harry combined is MB1; the marginal cost, MC1. They can gain by eliminating that dandelion and all others up to Q3. This is the point where the marginal cost curve and the public good demand curve intersect. By sharing the cost of eliminating the weeds, they can move to Q3. Harry will not move to that point if he has to pay the full cost for each unit, MC1, but he will move beyond Q1 if he can get Fred to take over part of the cost. How they share the cost must, because of the complications involved, be reserved for a later discussion; we need only point out here that there is no reason to believe that an equal sharing of the cost will be the outcome.
Figure 5.2 Efficient Provision of Collective Goods
The public goods demand curve, which is the darker curve in the figure, is derived by vertically adding the demands of Fred and Harry. Given a marginal cost represented by MC1, the optimum quantity of dandelions removed is Q3.

Even though Fred and Harry may not ever agree to work out their common problem (or interest) cooperatively, there are several conditions that may lead them to do so. In a small group there is personal contact. Everyone knows everyone else. What benefits or costs there may be from an individual’s action are spread over just a few people and, therefore, the effect felt by any one person can be significant. (Fred knows there is a reasonably high probability that what he does to eliminate dandelions from the border of his property affects Harry’s welfare.) If the individual providing the public good is concerned about the welfare of those within his group and receives personal satisfaction from knowing that he has in some way helped them, he has an incentive to contribute to the common good; and we emphasize that before the common good can be realized, individuals must have some motivation for contributing toward it. Furthermore, “free-riders” are easily detected in a small group. (Harry can tell with relative ease when Fred is not working on, or has not worked on, the dandelions in his yard.) If one person tries to let the others shoulder his share, the absence of his contribution will probably be detected. Others can then bring social pressure to bear to force him to live up to his end of the bargain. The enforcement costs are low because the group is small. There are many ways to let a neighbor know you are displeased with some aspect of his behavior.
Finally, in small groups an individual shirking responsibilities can be excluded from the group if he does not contribute to the common interest and joins the group merely to free ride on the efforts of others. In larger groups, like nations, exclusion is more difficult and, therefore, more unlikely.
The problem of organizing “group behavior” to serve the common interest has been a problem for almost all groups, even the utopian communities that sprang up during the nineteenth century and in the 1960s. Rosebeth Kanter, in her study of successful nineteenth-century utopian communities concluded:
The primary issue with which a utopian community must cope in order to have the strength and solidarity to endure is its human organization: how people arrange to do the work that the community needs to survive as a group, and how the group in turn manages to satisfy and involve its members over a long period of time. The idealized version of communal life must be meshed with the reality of the work to be done in the community, involving difficult problems of social organization. In utopia, for instance, who takes out the garbage?12
Kanter found that the most successful communities minimized the free-rider problems by restricting entry into the community. They restricted entry by requiring potential members to make commitments to the group. A six “commitment mechanism” distinguished the successful from the unsuccessful utopias: (1) sacrifice of habits common to the outside world, such as abstinence from alcohol and tobacco or, in some cases, celibacy; (2) assignment of all worldly goods to the community; (3) adoption of rules which would minimize the disruptive effects of relationships between members and
12 Rosebeth M. Kanter, Commitment and Community: Communes and Utopias in Sociological Perspective (Cambridge, Mass.: Harvard University Press, 1973), p. 64.
nonmembers and which would (through, for example, the wearing of uniforms) distinguish members from nonmembers; (4) collective sharing of all property and all communal work; (5) submission to public confession and criticism; and (6) expressed commitment to an identifiable power structure and tradition. Needless to say, the cost implied in these “commitment mechanisms” would tend to discourage many free riders from joining the society. By identifying the boundaries to societies, these mechanisms made exclusion possible. As Kanter points out, the importance of these commitment mechanisms is illustrated by the fact that their breakdown foreshadowed the end of the community.
Other means of bringing about collective behavior on the part of group members are suggested by the cattlemen’s associations formed during the nineteenth century. During the nineteenth century, cattle were allowed to run free over the ranges of the West. The cattlemen had a common interest in ensuring that the ranges were not overstocked and overgrazed and in securing cooperation in rounding up the cattle. To provide for these common interests, cattlemen formed associations which sent out patrols to keep out intruders and which were responsible for the roundups. Any cattleman who failed to contribute his share toward these ends could be excluded from the association, which generally meant that his cattle were excluded from the roundup or were confiscated by the association if they were rounded up.13
The family is a small group, which by its very nature is designed to promote the common interest of its members. That common interest may be something called “a happy family life,” which is, admittedly, difficult to define. The family does not escape difficulties. At present its validity as a viable institution is being challenged by many sources; however, it does have several redeeming features that we think will cause it to endure, imperfect though it may be, as a basic component of social fabric. Because of the smallness of the group, contributions made toward the common interest of the family can be shared and appreciated directly. Parents usually know when their children are failing to take the interest of the family into account, and children can easily ascertain similar behavior in their parents. Family members are able, at least in most cases, to know personally what others in the group like and dislike; they can set up an interpersonal cost-and-benefit structure among themselves that can guide all members toward the common interest. Most collective decisions are also made with relative ease.14 However, even with all the advantages of close personal contact, the family as a small group often fails to achieve the common interest. Although all family members may be encouraged to “go their own way” up to a point, some individuals may take this too far. They may fail to contribute their share to the common goal and may cause bitterness and, perhaps, the demise of the family. Given the frequent failure of the family as a viable organization
13 For a very interesting historical investigation of the cattle business during the late nineteenth century, see Rodgers Taylor Dennen, “From Common to Private Property: The Enclosure of the Open Range,” Ph.D. dissertation, University of Washington, 1975.14 See, for more discussion on the economics of the family, Richard B. McKenzie and Gordon Tullock, “Marriage, Divorce, and the Family,” in The New World of Economics (Homewood, Ill.: Richard D. Irwin, Inc. 1978), chap. 8
with a common interest,15 the failure of much larger groups to achieve their expressed common objectives is not difficult to understand.
Large Groups
In a large-group setting, the problems of having individual members contribute toward the development of the common interest are potentially much greater. The direct, personal interface which is present in small groups is usually lacking in larger groups; and, by the nature of large groups and the public good they produce, the benefits generated by any one person are generally spread over a large number of people, so much so that their actions have a significant effect on anyone, even themselves. As a result, they may perceive neither direct benefits in terms of what their behavior does for themselves, personally, nor indirect benefits in terms of what their behavior contributes to the welfare of others.
On the other hand, an individual may be able to detect benefits from his actions, but he must weigh these benefits against the costs he may have to incur to achieve them. For a large group the costs of providing detectable benefits can be substantial—or they can escalate with the size of the group. This is not only because there are more people to be served by the public good,16 but also because large groups are normally organized to provide public goods that are rather expensive to begin with. Police protection, national defense, and schools are examples of very costly public goods provided by large groups. If all people contribute to the public good, the cost to any one person can be slight; but the question confronting the individual is how much he will have to contribute to make his actions detectable, given what all the others do.
In the context of a very large group, suppose there are certain common national objectives to which we can all subscribe, such as a specific charitable program. It is, in other words, in our “common interest” to promote this program. Will people be willing to voluntarily contribute to the federal treasury for the purpose of achieving this goal? Certainly some people will (as Harry does in Figure 5.1 with a marginal cost of MC2), but many people may not. As they do each April 15 (the deadline for filing tax returns), most will contribute as little income tax as possible. Under a system of voluntary contributions, some people will contribute nothing. A person may reason that although he agrees with the national objective, or common interest, his contribution—that which he can justify—will do little to achieve it. He can also reason that withholding his contribution will have no detectable effect on the scope and effectiveness of the program. (If you or your parents did not pay taxes, would the level of public goods that benefit you
15 Approximately one-third of all families based on the institution of marriage end in divorce. Many others fail, in terms of the presence of intense hostility, even though there is no legal recognition of that fact.16 For a pure public good, the costs, by definition, do not rise with a few additional members. However, most groups provide services that are less than a pure public good. Education is an example of an impure public good; all education does not benefit all members of society simultaneously and to the same degree. Under these circumstances, the costs can rise, as we have suggested, with the membership, although by a lower percentage.
be materially affected?) It is for this reason that compulsory taxes are necessary. Olson writes:
Almost any government is economically beneficial to its citizens, in that the law and order it provides is a prerequisite to all civilized economic activity. But despite the force of patriotism, the appeal of the national ideology, the bond of a common culture, and the indispensability of the system of law and order no major state in modern history has been able to support itself through voluntary dues or contributions. Philanthropic contributions are not even a significant source of revenues for most countries. Taxes, compulsory payments by definition, are needed. Indeed, as the old saying indicates, their necessity is as certain as death itself.17
The general tenor of the argument also applies to contributions that go to CARE, a voluntary charitable organization interested mainly in improving the diets of impoverished people around the world. Many of the students reading these pages have been disturbed by scenes of undernourished and malnourished children shown in television commercials for CARE. All those who are disturbed would probably like to see something done for these children. They have had an opportunity to make a contribution, but how many people ever actually contribute so much has a dollar? Needless to say, many do give. They are like Harry in Figure 5.2, who is willing to dig, voluntarily, some of the weeds from his yard. On the other hand, we emphasize the point that a large number of people who have been concerned never make a contribution. (It would be an interesting classroom experiment to see how many students are disturbed by the CARE commercials and how many have ever given to the organization.) There are many reasons for people not giving, and we do not mean to understate the importance of these reasons; we mean only to emphasize that the large-group problem is one significant reason.
True, if all members of a large group make a small contribution toward the common interest, whatever it is, there may be sizable benefits to all within the group. But, again, the problem that must be overcome is the potential lack of individual incentives form which he collective behavior must emerge. Through appropriate organization of group members, the common interest may be achieved, even if the membership is large. This, however, merely shifts our attention to the problem of developing that organization. The organization of a large group can be construed as a public good, and there are likely to be costs to making the organization workable. This is likely for two reasons: first, there are a large number of people to organize, which means that even if there is no resistance on the part of the people to be organized, there will be costs associated with getting them together or having them work at the same time for the same objectives. Second, some individuals may try to “free-ride” on the efforts of others, which means it will cost more to get people to become members of the group. Further, each free rider implies a greater burden on the active members of the group. If everyone waits for “the other guy to take the initiative,” the group may never be organized. It is because of the organization costs
17 Olson, Logic of Collective Action, p. 13
that students complain so often about the instructional quality of the faculty or some other aspect of university life without doing anything about it. This is also why most people who are disgruntled with the two major political parties do not form a party with those who share their views. The probability of getting sufficient support is frequently very low, which is another way of saying the expected costs are high.
Because an organization may appear to be an obvious way to promote the public good, individuals who try to organize people for that purpose may go through a learning experience before they conclude that it is too costly a venture for them. Even if the organization is successful, the success may be temporary. Eventually, the free-rider problem emerges and the group may fall apart. During the winter of 1973-74, the United States was in the midst of an “energy crisis.” Prices of gasoline and other fuels were being held down in spite of the limited imports of fuel coming into the country from the Middle Eeast. Truckers were having a difficult item obtaining adequate supplies of diesel fuel and of passing their higher operating costs through to the buyers of truck services. Independent truckers sensed that it was in their common interest (not the public’s, of course,) to halt their deliveries of goods and services and, in that way, put pressure on the authorities to increase rates and to allocate more fuel supplies for the use of truckers. The call for cooperation met with some success; some truckers did terminate operations and some caught headlines by blocking traffic on major highways. However, there were many unwilling to go along with the work stoppage—something that was in their common interest. Consequently, the supporters of the work stoppage resorted to violence, and it was the threat of violence, and not the common interest, which kept many truckers off the road. If it had not been for the violence and the initial willingness of state police departments to allow truckers to flaunt the law by stopping traffic, including other truckers, it is very doubtful that the truckers would have had as much success as they did.
Qualifications to the Economic Theory
Obviously, there are many cases in which people acting in what may appear to be rather large groups try to accomplish things that are in the common interest of the membership. The League of Women Voters during the mid-1970s pushed hard for passage of the Equal Rights Amendment. To the Constitution; labor unions work for wage increases; and the American Medial Association does lobby for legislation that is in the common interest of a large number of doctors. Churches, the Blood Mobile, and other charitable groups are able to work fairly effectively for the “public interest,” and several of the possible explanations for this observed behavior force us to step outside the scope of the public goods theory.
Why may people work for the “public interest”? First, as Immanuel Kant, an eighteenth century philosopher, said they should, people can place value on the act itself as distinguished from the results or consequences of the act. The act of making a charitable contribution, which can be broadly defined to include picking up trash in public areas or holding the door for someone with an armful of packages, may have a value in and of itself. This is true whether the effects of the act are detectable to the individual making he charitable contribution or not. The personal satisfaction (or value)
that comes form the act itself is probably the dominant reason why some people do give to CARE. To the extent people behave in this way, the public good theory loses force. Notice, however, that Olson, in formulating his argument, focused on rational economic man as opposed to moral man, envisioned by Kant. We expect that as the group becomes larger, greater effort will be made to instill people with the belief that the act itself is important.
Second, the contribution that a person has to make in group settings is often so slight that even though the private benefits are small, the contribution to the common interest is also small and can be a rational policy course. This may explain, for example, student membership in groups like the National Association of Student Teachers. All one has to do in many situations like this one is show up at an occasional meeting and make a small dues payment. Further, the private benefits of being with others at the meetings and finding out what the plans are for the association can be sufficient incentive to motivate limited action that is in the common interest.
Third, all may not equally share the benefits received by group members from promotion of the common interest. One or more persons may receive a sizable portion of the total benefits and, accordingly, be willing to provide the public good, at least up to some limit. Many businessmen are willing to participate in local politics or to support advertising campaigns to promote their community as a recreational area. Although a restaurant owner may believe the entire community will benefit economically from an influx of tourists, he is surely aware that a share of these benefits will accrue to himself. Businessmen may also support such community efforts because of implied threats of being socially ostracized.
Fourth, large organizations can be broken down into smaller groups. Because of the personal contact with the smaller units, the common interest of the unit can be realized. In promoting the interest of the small unit to which they belong, people can promote the common interest of the large group. The League of Women Voters is broken down into small community clubs that promote interests common to other League clubs around the country. The Lions Club collectively promotes programs to prevent blindness and to help the blind; they do this through a highly decentralized organizational structure. Political parties are structured in such a way that the local precinct units “get out the votes.” The surest way for a presidential contender to lose an election is to fail to have a “grass-roots” (meaning small-group) organization. Churches are organized into congregations, and each congregation is decentralized further into circles and fellowship groups. Most of the work in the Congress is done in committees and subcommittees. Quiet often a multiplicity of small groups is actually responsible for what may appear to be the activity of a large groups. The decentralization that is so prevalent among voluntary groups tends to support the economic view of groups18
18 Admittedly, other explanations for decentralization can be made, one of which relates to diseconomies of scale. That is, the organization just becomes technically less efficient as its size is expanded. The economic theory of groups rests on the motivational aspect of large organizations, rather than on the technical capabilities of the organization.
Fifth, large groups may be viable because the group organizers sell their members a service and use the profits from sales to promote projects that are in the common interest of the group. The Sierra Club, which is in the forefront of the environmental movement, is a rather large group that has members in every part of North America. The group receives voluntary contributions from members and nonmembers alike to research and lobby for environmental issues. However, it also sells a number of publications and offers a variety of environmentally related tours for its members. From these activities, it secures substantial resources to promote the common interest of its membership. The American Economics Association has several thousand members. However, most economists do not belong to the AEA for what they can do for it. They join primarily to receive its journal and to be able to tell others that they belong—both, private benefits. (The AEA also provides economists with information on employment opportunities.)
Sixth, the basic argument for any group is that people can accomplish more through groups than they can through independent action. This means that there are potential benefits to be reaped (or, some may say, “skimmed off”) by anyone who is willing to bear the cost of developing and maintaining the organization. A business firm is fundamentally a group of workers and stockholders interested in producing a good (a public good, to them). They have a common interest in seeing a good produced which will sell. The entrepreneur is essentially a person who organizes a group of people into a production unit; he overcomes all the problems associated with trying to get a large number of people to work in their common interest by providing workers with private benefits -- that is, he pays them for their contribution to the production of the good. The entrepreneur-manager can be viewed as a person who is responsible for reducing any tendency of workers to avoid their responsibilities to the large-group firm. Because it is in their interest to eliminate shirking, the workers may be just as interested as stockholders in having and paying someone to perform this task.19 An individual worker may be delighted if he is allowed to remain idle while no one else is, but he will want to avoid the risks of all workers shirking. If all shirk, nothing will be sold, the firm will collapse, and workers will lose their wages. We may, therefore, expect that even in communist societies, managers will be paid handsomely (relatively speaking) for the tasks they perform. It is interesting to note that the wage differential between workers and managers is greater in the Soviet Union than it is in the United States.

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Water rights and markets

noreply@blogger.com ([Admin]) — Mon, 15 Jun 2009 09:56:00 +0000

Why have the percentage estimates of job losses been so low? The simple answer is the labor markets for low-skilled workers are highly competitive, which explains the low wages paid workers with limited skills in the first place. Many employers of low-skilled workers would love to be able to pay their workers more, but they have to face a market reality: if they paid more, then their competitors would have a cost advantage in pricing their products.
When Congress forces employers to pay more in money wages, it also forces them to pay less in other forms, most notably in fringe benefits. If there are few fringes to take away, the employers can always increase work demands.
Why would employers curb benefits and increase work demands? There are three reasons:
15 For reviews of the minimum-wage literature, see Charles Brown, Curtis Gilroy, and Andrew Kohen, “The Effect of the Minimum Wage on Employment and Unemployment,” Journal of Economic Literature, vol. 20 (1982), pp. 487-528; and Charles Brown, “Minimum Wage Laws: Are They Overrated?” Journal of Economic Perspectives, vol. 2 (1988), pp. 133-147. In more recent studies in the 1990s, the reported employment effects among teenagers continue to be relatively small [Richard V. Burkhauser and David Whittenberg, “A Reassessment of the New Economics of the Minimum Wage Literature Using Monthly Data from the SIPP and CPS” (Syracuse, N.Y.: Center for Policy Research, Syracuse University, 1998).
16 These estimates of the responsiveness of labor markets to minimum wage hikes are independent of the tightness of labor markets. If the country’s labor markets remain relatively tight over the next year or so, the number of low-skill workers covered by the minimum wage can be expected to fall as market-determined wage rates for low-skill workers rise past the proposed new levels for the minimum wage. (Currently, only about 4 million Americans work at the federal minimum wage.) Hence, while the percentage reduction in the number of minimum wage jobs may remain more or less in line with past studies, it stands to reason that the actual number of minimum wage jobs will fall as the count of covered workers shrinks.
17 Victor R. Fuchs, Alan B. Krueger, and James M. Poterba, “Economists’ Views about Parameters, Values, and Policies: Survey Results in Labor and Public Economics,” Journal of Economic Literature, vol. 36 (September 1998), pp. 1387-1425.
First, they can do it, given that the minimum-wage hike will attract a greater number of workers (and workers who are more productive) and cause some employers to conclude that they cannot hire as many workers --unless adjustments are made. Hence, given the tightness of the labor market, the forced wage hike necessarily strengthens the bargaining position of employers, given that the employers can tell prospective workers, “If you don’t like it, I can hire someone else. Your replacements are lined up at my personnel office door.”18 Employers will make the adjustments for an offensive reason, to improve their profits (or curb losses).
Second, and perhaps more importantly, employers of covered workers must (to decrease costs) cut fringes and/or increase work demands or face the threat of losing their market positions as their competitors cut fringes and increase work demands. Employers will, in other words, make adjustments for defensive reasons, to prevent their market rivals from taking a portion of their markets and causing their profits to fall (or losses to mount).
Third, if employers don’t cut fringes and/or increase work demands, the value of the company’s stock will suffer on the market, leaving open profitable opportunities for investors to buy the firm, change the firm’s benefit/work demand policies, improve the firms profitability, and then sell the firm at a higher market value. Employers -- either the original or new owners -- will make the adjustments for financial reasons, to maximize share values.19
The net effect of the adjustments in fringes and work demands is that the cost impact of the minimum-wage hike will be largely neutralized. For example, when the minimum wage is raised by $1, the cost of labor may, on balance, rise by only 5 cents. Such an adjustment explains why the Card and Krueger studies and more than a hundred other statistical studies on the minimum wage have found that minimum-wage hikes have caused a small (if not negligible) percentage drop in jobs even among that group of workers – teenagers working at fast food restaurants – whose jobs are most likely to be cut.20
18 Tight labor markets, like the ones in the United States in 1999, can cause wages and fringe benefits to rise, even for low-skill workers, and can cause the number of workers affected by any minimum wage hike to fall. However, the point that minimum wage hikes increase the relative bargaining power of employers still holds for those workers remaining at the minimum wage. Moreover, if employers have responded to their tight labor markets by increasing their workers’ fringe benefits, then there will be more benefits for employers to take away when faced with a hike in the mandated money wage rate.
19 Indeed, it may be interesting to note that, at least conceptually, minimum-wage workers might contemplate the prospects of buying their firms, if their firms did not make compensation and work adjustments and if they, the minimum-wage workers, could make the purchase. The point here is that even worker groups can see the financial benefits of adjusting fringe benefits and work demands in light of a minimum-wage increase.
20 Even the Employment Policies Institute study cited above (Macpherson, “The Effects of the 1999-2000 Washington Minimum-Wage Increase”), which is likely to contain estimates of the employment losses that are on the high side of the expected range, shows a reduction in Washington’s total employment (2.7 million workers) of less than three tenths of one percent for a proposed 26 percent increase in the state’s minimum wage. However, it can be noted that if Washington has the average percentage of minimum
This line of argument can also help us understand why workers who retain their jobs are unlikely to be any better off. They get more money, but they also get fewer fringes and have to work harder for their pay. We know the covered workers who retain their jobs will be worse off, at least marginally so, because the only reason an employer intent on making as much profit as possible would offer the fringes and reduced work in the first place is that the workers valued the fringes and lax work demands more highly than they valued the money wages that they had to give up in order to get the fringes or lax work demands. Further, profit-maximizing employers aren’t about to offer workers anything that’s costly unless they get something in return, like greater output per hour or a lower wage bill.
If a firm offers costly benefits that do not lower wages or fail to offer benefits that could lower wages, then that firm should be subject to takeover. Some savvy investor can be expected to buy the firm, change its benefit policies, lower wages by more than the rise in other costs rise, improving the firm’s profitability in the process, and then sell the firm for a higher price.
Make no mistake about it, profit-maximizing firms do not “give” fringes to their workers; they require their workers to pay for the fringes through wage-rate reductions. The wage rate reductions can be expected because, if workers value the fringes, the supply of workers will go up, forcing the money wage rate down.
It follows that competitive market pressures will force firms to do what is right by their bottom lines and their workers. This means that when the minimum wage is raised, the value of the resulting lost fringes and reduced work demands to the workers will be greater than the value of the additional money income.
Put another way, the workers who retain their jobs are made worse off (perhaps, marginally so) in spite of the money-wage increase. Employment in low-skill jobs may go down (albeit ever so slightly) in the face of minimum-wage increases not so much because the employers don’t want to offer the jobs (as traditionally argued), but because not as many workers want the minimum-wage jobs that are offered.21
Available Empirical Evidence
Have the expected effects been seen in empirical studies? The most compelling evidence is captured in the many studies already cited that indicate that job losses from a minimum-wage increase tend to be small, even within the worker groups are most likely to be adversely affected. However, there have been other studies over the past two
wage workers, 8.8 percent, then the EPI study suggests that each 10 percent increase in the minimum wage lowers the employment of covered workers by, at most, 1.2 percent.
21 Granted, not all low skill workers have many fringe benefits that can be taken away, and some minimum wage workers may be working very hard. The argument that is being developed suggests that the negative employment effects of a minimum wage increase will be concentrated among this group of particularly disadvantaged workers.
decades that have attempted to assess directly the impact of minimum-wage increases on fringes and work demands, as well as the overall value of jobs.
• Writing in the American Economic Review, Masanori Hashimoto found that under the 1967 minimum-wage hike, workers gained 32 cents in money income but lost 41 cents per hour in training -- a net loss of 9 cents an hour in full-income compensation.22
• Linda Leighton and Jacob Mincer concluded that increases in the minimum wage reduce on-the-job training -- and, as a result, dampen growth in the real long-run income of covered workers. 23
• Walter Wessels found that the minimum wage caused retail establishments in New York to increase work demands. In response to a minimum-wage increase, only 714 of the surveyed stores cut back store hours, but 4827 stores reduced the number of workers and/or their employees’ hours worked. Thus, in most stores, fewer workers were given fewer hours to do the same work as before.24
• The research of Belton Fleisher, 25 William Alpert,26 and L.F. Dunn27 shows that minimum-wage increases lead to large reductions in fringe benefits and to worsening of working conditions.

If the minimum wage does not cause employers to make substantial reductions in nonmoney benefits, then increases in the minimum wage should cause (1) an increase in the labor-force participation rates of covered workers (because workers would be moving up their supply-of-labor curves), (2) a reduction in the rate at which covered workers quit their jobs (because their jobs would then be more attractive), and (3) a significant increase in prices of production processes heavily dependent on covered minimum-wage workers. However, Wessels found little empirical support for such conclusions drawn from conventional theory. Indeed, in general, he found that minimum-wage increases had the exact opposite effect: (1) participation rates went down, (2) quit rates went up, and (3) prices did not rise appreciably -- findings consistent only with the view that
22Masanori Hashimoto, “Minimum Wage Effect on Training to the Job,” American Economic Review, vol. 70 (December 1982), pp. 1070-87.23Linda Leighton and Jacob Mincer, “Effects of Minimum Wage on Human Capital Formation,” in The Economics of Legal Minimum Wages,” ed. Simon Rothenberg (Washington, D.C.: American Enterprise Institute, 1981).24Walter J. Wessels, “Minimum Wages: Are Workers Really Better Off?” (Paper prepared for presentation at a conference on minimum wages, Washington, D.C., National Chamber Foundation, July 29, 1987). For more details, see Walter J. Wessels, Minimum Wages, Fringe Benefits, and Working Conditions (Washington, D.C.: American Enterprise Institute, 1980). 25Belton M. Fleisher, Minimum Wage Regulation in Retail Trade (Washington, D.C.: American Enterprise Institute, 1981).26 William T. Alpert, The Minimum Wage in the Restaurant Industry (New York: Praeger, 1986).
27 L.F. Dunn, “Nonpecuniary Job Preferences and Welfare Losses among Migrant Agriculture Workers,” American Journal of Agriculture Economics 67 (May 1985), pp. 257-65.
minimum-wage increases make workers worse off.28 With regard to quit rates, Wessels writes,
I could find no industry which had a significant decrease in their quit rates. Two industries had a significant increase in their quit rates.... These results are only consistent with a lower full compensation. I also found that quit rates went up more in those industries with the average lowest wages, the more full compensation is reduced. I also found that in the long run, several industries experienced a significantly large increase in the quit rate: a result only possible if minimum wages reduce full compensation.29
Seen from this perspective, Herbert’s cited figures on the added income received by 10 million workers are grossly misleading because the figures suggest that the affected workers are “better off,” which is not likely to be the case, given their loss of fringe benefits and increased work demands. The fact that the Card and Krueger studies also found, supposedly, no loss of jobs suggests that the market may have forced non-wage adjustments on the fast food restaurants studied.
Granted, economists might speculate, as they have, that the job reductions have been small because the low-skill labor market exhibits a “low elasticity of demand” (or low responsiveness among employers to a wage hike), but such an explanation is hardly compelling. The demand elasticity for anything, including labor, is related to the number of substitutes the good (or labor) has: the greater the number of substitutes, the greater the ability of buyers (employers) to move away from the good (labor) when the price (wage rate) is raised, and hence, the greater the responsiveness of buyers (employers), or elasticity of demand. The problem with the explanation is that there is no labor group that has more substitutes than low-skill (minimum-wage) workers, especially now that firms have so much flexibility to automate jobs out of existence or to replace domestic workers with foreign workers by way of imports. The elasticity of demand for low-skill labor must be relatively high. Hence, the relatively small decline in the number of low-skill workers in response to a minimum-wage hike points to a conclusion central to this: the mandated wage hike is likely offset in large measure by other adjustments in the affected workers’ compensation package.
Minimum-Wage Consequences over Time
This line of argument does not lead to the conclusion that minimum-wage increases of given amounts should always have the exact employment effect no matter when they are legislated. Looking back at Figure 4.7, we might reason that as the real minimum wage rose between 1938 and 1968, employers did what they were pressed to do to moderate their labor cost increases: take away progressively more fringe benefits and add progressively more work demands (compared to what they would have done). Hence, as time went by, we might expect the employment effects of a given minimum wage
28Wessels, “Minimum Wages: Are Workers Really Better Off?” 29Ibid., p. 13.
increase to go up as 1968 was approached. As time passed, there simply were fewer ways for employers to adjust to the wage hike.
However, as the minimum wage has fallen irregularly since 1968, we might expect employers to respond by gradually adding back more fringe benefits and relaxing their work demands (a trend that has likely been accelerated with growing tightness in labor markets in the late 1990s). The result should be that in the 1990s, employers should have had more ways to adjust to a minimum-wage hike than they had in, say, the late 1960s. As a consequence, we should not be surprised that Card and Krueger found little or no employment effect in the early 1990s, whereas other studies in the 1960s found larger effects.30 We should not be surprised if future studies of the impact of any 1999 increase in the minimum wage show similarly negligible negative employment effects.
* * * * *
Members of Congress and the president need to recognize a simple fact of modern economics: You can’t fool the market as much as imagined, at least not all the time. Politicians simply do not have as much power to manipulate markets as they may think they have. Markets can be expected to outsmart the smartest of politicians in the next round of minimum-wage hikes. We can anticipate that, once again, the chosen increase in the minimum wage will have minimum employment consequences for two reasons: First, members of Congress will choose a fairly small increase in the minimum wage because of political groups working against the proposed minimum-wage bill. Second, market forces will largely neutralize the potential negative employment effects of whatever wage increase is legislated.
Concluding Comments
The market system can perform the very valuable service of rationing scarce resources among those who want them. It alleviates the congestion that develops when resources, goods, and services are rationed by other means. Markets, however, are not always permitted to operate unobstructed. Government has objectives of its own, objectives that are determined collectively rather than individually. We have seen how government can use its power to tax, to raise government revenues, or reallocate market demand.
30 The implication of the theory that a minimum-wage hike will have a greater impact on employment when the minimum wage is high, compared to when it is low, has not been rigorously tested to date. However, it is interesting to note that through the 1950s 1960s, and early 1970s, the editors at the New York Times were staunchly for increases in the minimum wage, mainly because the evidence on the negative employment effect was not strong, to say the least. However, as the evidence in the 1960s mounted that minimum-wage hikes had a negative employment effect, especially among minority teenagers, the editors began to shift their editorial stance. By the mid-1980s, they came out in favor of a minimum wage of “$0.00.” They have since shifted their editorial stance back to support for minimum-wage hikes, mainly because the negative employment effects have been shown to be nil in recent studies. See Richard B, Mckenzie, Times Change: The Minimum Wage and the New York Times (San Francisco: Pacific Research Institute, 1994).
Government power can also be used to eliminate externalities or reduce monopoly power. Whether the use of such controls is considered good or bad depends to a significant extent on one’s personal values and circumstances. In a free market system, price controls and consumer protection will always be controversial.
In the case of minimum wage hikes, it appears that policy makers and economists alike have failed to grasp an important lesson: The hikes do not destroy competition, only redirect its force. They also give managers an incentives to find ways of reducing their impact on employment – and the net benefits of the hikes to the workers.
Review Questions
1 Is a tax on margarine efficient in the economic sense of the term? Why would margarine producers prefer to have an excise tax imposed on both butter and margarine? Would such a tax be more or less efficient than a tax on margarine alone?
2 If punishment for crime is a kind of tax on those who engage in illegal activity, what effect would the legalization of marijuana have on its supply and demand? What would happen to the market price? The quantity sold? Illustrate with supply and demand curves.
3 If in a competitive market, prices are held below market equilibrium by government controls, what will be the effect on output? How might managers be expected to react to the laws?
4 Why might some managers want price controls? Why don’t they get together and control prices themselves (if it were legal)?
5 How would price controls affect a firm’s incentive to innovate? Explain.
6 “If prices are controlled in only one competitive industry, the resulting shortage will be greater than if prices were controlled in all industries.” Do you agree? Explain.
7 “Price controls can be more effective in the short run than in the long run.” Explain.
8 Why would some firms want the minimum wage to be increased? Why would some managers who believe that workers “deserve” higher wages cut fringe benefits or increase worker demands in response to a hike in the minimum wage?

READING: Water Rights and Water Markets
Terry L. Anderson, Montana State University
Mark Twain wrote, “Whiskey is for drinkin’—water is for fightin’.” In the American West, water has always been a matter of survival. It was the cause of many frontier skirmishes, and it may provoke conflict again. Newsweek warned recently that “drought, waste, and pollution threaten a water shortage whose impact may rival the energy crisis.” And former Secretary of the Interior James Watt said, “The energy crisis will seem like a Sunday picnic when compared to the water crisis.”
Unless Americans change their ways, a water crisis is inevitable. In economic terms, the quantity of water demanded is greater than the quantity available, and there is little time to adjust either amount. The
reason for the imbalance is that the government has been keeping prices below market-clearing levels. In most places in the United States, water is cheaper than dirt. Nowhere in the nation do water prices reflect the true scarcity of the resource.
In Southern California, for example, water is in short supply. Yet Los Angeles residents pay only
0.60 per thousand gallons—a quantity that costs the residents of Frankfurt, Germany, $2.80. It is not surprising, therefore, that each person in the United States consumers an average of 180 gallons a day, compared with 37 gallons in Germany. Water prices are actually lowest in the arid Southwest, where residents of El Paso and Albuquerque pay $0.53 and $0.59, respectively, per thousand gallons, compared with $1.78 in Philadelphia. In many U.S. cities the real price of water has fallen in recent decades, despite the threat of shortages.
Agricultural users, who consume over 80 percent of the water in western states, enjoy extremely low prices. Throughout the nation the price of irrigation water ranges from about $0.009 to $0.09 per thousand gallons. In 1981, the average price of covering one acre of land in California’s Central Valley with one foot of water was $5.00, or less than $0.02 per thousand gallons. Supplying that amount of water cost the government as much as $325. According to a 1980 study by the Department of the Interior, government subsidies covered between 57 and 97 percent of the cost of water projects.
Pricing water at market rates could help to solve the water crisis. Water consumption—whether for industrial, municipal, or agricultural use—is highly responsive to price changes. For example, the quantity of water used in industrial processes varies considerably around the world, depending on prices. Where water is expensive, electric power is produced using as little 1.32 gallons per kilowatt-hour. Where water is cheap, production requires as many as 170 gallons per kilowatt-hour. One study of urban water consumption showed that a 10 percent increase in the price of water decreased the quantity of water demanded about 4 to 13 percent.
Pricing water more realistically will require changes in the laws governing water use, as well as the creation of an effective water market. Like any market, a water market will depend on well-defined, well-enforced property rights. If water rights are secure and people can trace them, prices will quickly come to reflect the true scarcity of the resource. During the late nineteenth century, such a system evolved in the American West. Rights were defined on a first-come, first served basis, and institutions arose through which owners of rights could seek out the highest and best use of the resource. The system offered incentives that encouraged some people to deliver water wherever it was demanded. Thousands of miles of ditches were constructed, and millions of acres blossomed, as a result of entrepreneurial efforts to deliver water. Over time, however, legislators, bureaucrats, and judges have tinkered with the system. Legal restrictions now limit the transfer of water, and its use is determined by politicians, not by the market.
One place where a water market might encourage more efficient water use is the Imperial Irrigation District (IID) in Southern California. The IID receives its water from the U.S. Bureau of Reclamation, at subsidized rates. Its water could be conserved if ditches were lined, wastewater recovered, and the timing of irrigation changed. All those measures would be costly to farmers, however. And at present low prices, farmers have little incentive to invest in conservation. Recently, the Municipal Water District (MWD) of Southern California, thwarted in its effort to obtain water from Northern California, has begun negotiating for water from the IID. The MWD is willing to fund improvements in farmers’ irrigation systems in return for the water those improvements would save. If such a trade could be accomplished, everyone would be better off.

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Tax for Customer Protection

noreply@blogger.com ([Admin]) — Mon, 15 Jun 2009 09:51:00 +0000

Government Controls: How Management Incentives Are Affected
Without bandying jargon or exhibiting formulae, without being superficial or condescending, the scientist should be able to communicate to the public the nature and variety of consequences that can reasonable be expected to flow from a given action or sequence of actions. In the case of the economist, he can often reveal in an informal way, if not the detailed chain of reasoning by which he reaches his conclusions, at least the broad contours of the argument.
E. J. Mishan
arlier chapters showed how the models of competitive and monopolistic markets
illuminate the economic effects of market changes, such as an increase in the price
of oil. This chapter will examine the use of government controls to soften the
impact of such changes. We will consider four types of government control: excise taxes, price controls, consumer protection laws, and minimum-wage laws. As we will see, government controls can inspire management reactions that negate some of the expected effects of the controls.
Who Pays the Tax?
Most people are convinced that consumers bear the burden of excise (or sales) taxes. They believe producers simply pass the tax on to consumers at higher prices. Yet every time a new (or increased) excise tax is proposed producers lobby against it. If excise taxes could be passed on to consumers, firms would have little reason to spend hundreds of thousands of dollars opposing them. In fact, excise taxes do hurt producers.
Figure 4.1 shows the margarine industry’s supply and demand curves, S1 and D. In a competitive market, the price will end toward P2 and the quantity sold toward Q3. If the state imposes a $0.25 tax on each pound of margarine sold and collects the tax from producers, it effectively raises the cost of production. The producer must now pay a price not just for the right to use resources, such as equipment and raw materials, but for the right to continue production legally. The supply curve, reflecting this cost increase, shifts to S2. The vertical difference between the two curves, P2 and P1, represents the extra $0.25 cost added by the tax.
Figure 4.1 The Economic Effect of an Excise Tax
An excise tax of $0.25 will shift the supply curve for margarine to the left, from S1 to S2. The quantity produced will fall from Q3 to Q2; the price will rise from P2 to P3. The increase, $0.20, however, will not cover the added cost to the producer, $0.25.

Given the shift in supply, the quantity of margarine produced falls to Q2 and the price rises to P3. Note, however, that the price increase (P1 to P2) is less than the vertical distance between the two supply curves (P2 to P1). That is, the price increases by less than the amount of the tax that caused the shift in supply. Clearly, the producer’s net has fallen. If the tax is $0.25, but the price paid by consumers rises only $0.20 ($1.20 ¬$1.00), the producer loses $0.50. It now nets only $0.95 on a product that used to bring $1.00. In other words, the tax not only reduces the quantity of margarine producers can sell, but makes each sale less profitable.
Incidentally, butter producers have a clear incentive to support a tax on margarine. When the price of margarine increases, consumers will seek substitutes. The demand for butter will rise, and producers will be able to sell more butter and charge more for each pound.
The $0.25 tax in our example is divided between consumers and producers, although most of it ($0.20) is paid by consumers. Why do consumers pay most of the tax? Consumers bear most of the tax burden because consumers are relatively unresponsive to the price change. The result, as depicted in Figure 4.1, is that consumers bear most of the tax burden while producers pay only a small part (20 percent) of the tax. If consumers were more responsive to the price change, then a greater share of the tax burden would fall on producers who would then have more incentive to oppose the tax politically. Indeed, we should that the amount of money producers would be willing to spend to oppose taxes on their product (through campaign contributions or lobbying) will depend critically on the responsiveness of consumers to a price change. The more responsive consumers are, the more producers should be willing to spend to oppose the tax.
Price Controls
Price controls are by no means a modern invention. The first recorded legal code, the four-thousand-year-old Code of Hammurabi, included regulations governing the maximum wage, housing prices, and rents on property such as boats, animals, and tools. And in A.D. 301, the Roman Emperor Diocletian issued an edict specifying maximum prices for everything from poultry to gold, and maximum wages for everyone from lawyers to the cleaners of sewer systems. The penalty for violating the edict was death. More recently, wage and price controls have been used both in wartime (during the Second World War and the Korean War) and in peacetime. President Richard Nixon imposed an across-the-board wage-price freeze in 1971. Prime Minister Pierre Trudeau imposed controls on the Canadian economy in 1975. President Jimmy Carter controlled energy prices in 1977 and later proposed the decontrol of natural gas.
Wage and price controls are almost always controversial. Like attempts to control expenditures, they often create more problems than they solve. We will examine both sides of the issue, starting with the argument in favor of controls.
Figure 4.2 The Effect of an Excise Tax When Demand is More Elastic Than Supply
If demand is much more elastic than supply, the quantity purchased will decline significantly when supply decreases from S1 to S2 in response to the added cost of the excise tax. Producers will lose $0.20; consumers will pay only $0.05 more.

The Case for Price Controls
The case for price ceilings on particular products is complex. On the most basic level, many people believe that prices should be controlled to protect citizens from the harmful effects of inflation. When prices start to rise, redistributing personal income and disrupting the status quo, it seems unfair. Price controls may seem especially legitimate to people, like the elderly, who must live on fixed incomes, and have little means of compensating for the effects of price increases on goods like oil and gas.
Unearned Profits
Many proponents of price controls view the supply curve for a controlled good as essentially vertical. They believe that a price rise will not affect the quantity produced. Consumers will get nothing more in the way of goods, but producers will reap a windfall profit. Instead of an incentive to produce more, profit is seen as an economic rent—an exploitative surplus received by companies fortunate enough to be in the market at the right time.
Administered Prices
A technical argument for price controls is most often advanced by economists and public officials. Many economists maintain that a significant segment of the business and industrial community—the larger firms that control a sizable portion of industry sales— no longer responds to the forces of supply and demand. Firms in highly concentrated industries like steel, automobiles, computers, and tobacco can override market forces by manipulating their output so as to set price levels. Furthermore, they can manage the demand for their products through advertising campaigns. With market forces ineffective, control must come from the government. Price controls are the only way to avoid the production inefficiencies and inequitable distribution of income that result from concentration of industry. As John Kenneth Galbraith, a leading advocate of price controls, has put it, “Controls are made necessary because planning has replaced the market system. That is to say that the firm and the union have assumed the decisive power in setting prices and wages. This means that the decision no longer lies with the market and thus with the public.”1
Monopoly Power
Later in the course, we will see how a monopolist can be expected to restrict output in order to push up its price in order to earn greater profits. The case for price controls under monopoly conditions is, for many advocates of controls, a matter of “fairness.” The controls give back to consumers what they “deserve” in terms of lower prices. However, as we will see, under monopoly conditions, if the producer is forced to charge a (somewhat) lower price, the producer will rationally choose to increase the output level. Hence, price controls benefit consumers in two ways, first through lower prices and then through greater output.
The Case Against Price Controls
Just as the case for price controls is tied closely to the existence of monopoly power, the case against controls rests heavily on the competitive market model. Economists who
1 John Kenneth Galbraith, Economics and the Public Purpose (Boston: Houghton Mifflin, 1973), p. 315.
oppose controls feel that competition is sufficient to govern business behavior, including pricing decisions. Opponents of controls also stress the individual’s right to act without government interference—a right they see as crucial to a society’s ability to adjust to social and environmental change.
When we say that the prices of certain products should be controlled by government, what do we mean by “government”? Can government as we know it consistently reflect the public interest? Is government immune to human failings? Opponents of price controls emphasize that the pricing decisions made by any government agency will reflect the will of its staff. Personal preference will loom large in their decisions on what constitutes a just price and a just allocation of goods and services. Political considerations may also play a role. Firms with a talent for political maneuvering will have an advantage under a price control system. In other words, competitive behavior is not necessarily reduced by price controls, though its form of expression may be changed.
If price controls are complemented by a system of government allocation of supplies, then strikes, demonstrations, and violence may also influence government decisions. During the energy crisis of 1973—1974, and again in 1978, the federal government regulated the allocation of crude oil between gasoline and diesel fuel producers. When truckers received less fuel than they claimed they needed, independent drivers stuck, threatening to paralyze the nation’s commerce unless they got more fuel at lower prices. To ensure cooperation among drivers, the strikers blocked roads, vandalized the equipment of nonstrikers, and shot at drivers who ventured out on the road. One trucker was killed, and others were seriously injured. At least for a short time, such tactics were productive. The government agreed to earmark more crude oil for diesel fuel production and to lower the federal excise tax on diesel fuel. (Courts later declared those decisions illegal.)
Shortages and the Effective Price of a Product
In a competitive market, any restriction on the upward movement of prices will lead to shortages. Consider Figure 4.3, which shows supply and demand curves for gasoline. Initially, the supply and demand curves are S1 and D, and the equilibrium price is P1. Now suppose that the supply of gasoline shifts to S2, and government officials, believing that the new equilibrium price is unjust, freeze the price at P1. What will happen to the market for gasoline?
At price P1, which is now below equilibrium, the number of gallons demanded by consumers is Q2, but the number of gallons supplied is much lower, Q1. A shortage of Q2 --Q1 gallons has developed. As a result, some consumers will not get all the gasoline they want. Some may be unable to get any.
Because of the shortage, consumers will have to wait in line to get whatever gasoline they can. To avoid a long line, they may try to get to the service station early— but others may do the same. To assure themselves a prime position, consumers may have to sit at the pumps before the station opens. In winter, waiting in line may mean wasting gas to keep warm. The moral of the story: although the pump price of gasoline may be
held constant at P1, the effective price -- the sum of the pump price and the values of time lost waiting in line -- will rise.
Shortages can raise the effective price of a product in other ways. With a long line of customers waiting to buy, a service station owner can afford to lower the quality of his service. He can neglect to clean windshields or check oil levels, and in general treat customers more abruptly than usual. As a result, the effective price of gasoline rises still higher. Again, during he energy crises of 1973-1974 and 1978, some service station owners started closing on weekends and at night. A few required customers to sign long-term contracts and pay in advance for their gasoline. The added interest cost of advance payment raised the price of gasoline even higher.
Figure 4.3 The Effect of Price Controls on Supply
If the supply of gasoline is reduced from S1 to S2, but the price is controlled at P1, a shortage equal to the difference between Q1 and Q2 will emerge.

Black Markets and the Need for Rationing
Besides such legal maneuvers to evade price controls, some businesses may engage in fraud or black marketeering. During the winter of 1973—1974, a good many gasoline station owners filled their premium tanks with regular gasoline and sold it at premium prices. At the same time, a greater-than-expected shortage of heating oil developed. Truckers, unable to get all the diesel fuel they wanted at the controlled price, had found they could use home heating oil in their trucks. They paid home heating oil dealers a black market price for fuel oil, thus reducing the supply available to homeowners. As always, government controls bring enforcement problems.
To assure fair and equitable distribution of goods in short supply, some means of rationing is needed. If no formal system is adopted, supplies will be distributed on a first-come, first-served basis—in effect, rationing by congestion. A more efficient method is to issue coupons that entitle people to buy specific quantities of the rationed good at the prevailing price. By limiting the number of coupons, government reduces the demand for the product to match the available supply, thereby eliminating the shortage and relieving the congestion in the marketplace. In Figure 4.4, for example, demand is reduced from D1 to D2.
The coupon system may appear to be fair and simple, but how are the coupons to be distributed? Clearly the government will not want to auction off the coupons, for that would amount to letting consumers bid up the price. Should coupons be distributed equally among all consumers? Not everyone lives the same distance from work or school. Some, like salespeople, must travel much more than others. Should a commuter receive more gas than a retired person? If so, how much more? Should the distribution of coupons be based on the distance traveled? (And if such a system is adopted, will people lie about their needs?) These are formidable questions that must be answered if a coupon system is to be truly equitable. By comparison, the pricing system inherently allows people to reflect the intensity of their needs in their purchases.
Once the coupons are distributed, should the recipients be allowed to sell them to others? That is, should legal markets for coupons be permitted to spring up? If the deals made in such a market are voluntary, both parties to the exchange will benefit. The person who buys coupons values gasoline more than her money. The person who sells his coupons may have to cut back on driving, but he will have more money to buy other things. The seller must value those other things more than lost trips, or he would not agree to make the exchange. The positive (and often high) market value of coupons shows that price controls have not really eliminated the shortage.
Figure 4.4 The Effect on Rationing on Demand
Price controls can create a shortage. For instance, at the controlled price P1, a shortage of Q2 --Q1 gallons will develop. By issuing a limited number of coupons that must be used to purchase a product, government can reduce demand and eliminate the shortage. Here rationing reduces demand from D1 to D2, where demand intersects the supply curve at the controlled price.

Furthermore, if the coupons have a value, the price of a gallon of gasoline has not really been held constant. If the price of an extra coupon for one gallon of gasoline is $0.50 and the pump price of that gallon is $1.25, the total price to the consumer is $1.75 ($0.50 + $1.25). The existence of a coupon market means that the price of gasoline has risen. In fact, the price to the consumer will be greater under a rationing system than under a pricing system. This is because the quantity supplied by refineries will be reduced.
Perhaps the most damaging aspect of a rationing system is that the benefits of such a price increase are not received by producers—oil companies, refineries, and service stations—but by those fortunate enough to get coupons. Thus the price increase does not provide producers with an incentive to supply more gasoline. (If the increase went to producers, their higher profits would encourage them to search for new sources of oil and step up their production plans.)
Consumer Protection
Less than one hundred years ago the general rule of the marketplace was caveat emptor— “let the buyer beware.” The individual consumer was held responsible for the safety, quality, and effectiveness of his purchases. The seller could assume liability for the safety and effectiveness of goods and services, but only through a contract endorsed by both parties. The same rule applied to contracts: the buyer was responsible for what he signed. Although consumers could sue sellers for breach of contract or for fraud, no government agency would initiate the suit. Nor did government protect citizens in other ways from the products they bought.
During this century, however, product liability has gradually shifted from the consumer to the producer and the seller. Both court decisions and changes in the law have contributed to this shift. Many now see consumer protection as a government function.
The Case for Consumer Protection
The argument for relieving consumers of product liability resembles the argument for regulation of utilities in many respects. Both cases hinge on the costs of gaining information and the problems created by external benefits and costs and monopoly power.
External Benefits
When two cars collide, both cars will sustain less damage and both drivers less injury if just one of the cars is equipped with protective bumpers. Thus people who do not buy protective bumpers can benefit from others’ investments. If many car buyers ignore the benefits others may receive from their purchases, the quantity of shock-absorbing bumpers sold will be less than the socially desirable or economically efficient amount.
This analysis of external benefits can be extended to include the concept of consumer protection. Suppose the supply curve in Figure 4.5 is the industry’s willingness to offer protective bumpers. The demand curve D1 represents consumer demand based on the private benefits to consumers, while D2 represents private plus public (external) benefits. Under competitive conditions, the quantity produced and sold in the marketplace will be Q1—even though up to Q2, the total benefits of bumpers exceed their cost. The private benefits of the bumpers are small enough that many people cannot justify purchasing them.
Graphically, the vertical distance between the two demand curves, ab, represents the external benefits per bumper sold that are not being captured by the market. Government can close this gap by setting product standards. By requiring new cars to have shock-absorbing bumpers, government effectively increases demand from D1 to D 2. It forces people to expand their purchases from Q1 to Q2, thus capturing the external benefits shown by the shaded area abc.
Figure 4.5 The External Benefits of Consumer Protection
Private demand for shock-absorbing bumpers is shown by the demand curve D1: total demand (private plus public, or external, benefits), by D 2. The vertical distance between the two curves represents the social benefits from each bumper. In a free market, Q1 bumpers will be sold. If all benefits are considered, however, the efficient output level will be Q2. By requiring people to purchase Q2 bumpers, government can capture the external benefits shown by the shaded area abc. If the government requires consumers to buy more than Q2 bumpers, however, excess costs will be incurred. If Q4 bumpers are purchased, their excess social cost, shown by the shaded area cde, will offset their social benefits (abc). The net social gain will be zero.

This approach can be extended to a wide range of goods and services that offer significant external benefits, from safety caps for drugs to protective devices for explosives. This argument does not justify unlimited government intervention, however. We cannot conclude, for example, that all automobiles must have shock-absorbing bumpers. Such a requirement might result in the purchase of far more than Q2 bumpers. Beyond Q2, the marginal cost of safety bumpers is greater than their marginal benefit. An excess burden, or net social cost, is incurred when the public must purchase more than Q2.
If the public is required to purchase Q4 bumpers, for instance, the excess burden will be equal to the shaded area cde. The social cost of extending purchases to Q4 just equals the social benefits of extending purchases to Q2 (shown by the area abc). Consequently, there is no real net social benefit in moving to Q4. If the required number of bumpers is greater than Q2 but less than Q4, some net social benefit will be realized. At Q3, the excess social cost cfg is smaller than the social benefit abc. Some net benefit will be realized.
Up to a point, then, consumer protection can be socially beneficial. Society, however, can end up purchasing too much of a good thing. It is possible to make the world so safe that few resources are available for any other purpose.
Nevertheless, governments tend to require safety devices for all products in a category. Determining the optimum quantity is so difficult and costly that a blanket rule is preferable. Yet as opponents of consumer protection point out, the blanket rule itself may be extremely costly if it requires more than the socially beneficial quantity to be produced. Ultimately, the question comes down to the actual costs and benefits of particular product standards.
External Costs
The argument for consumer protection based on external costs is closely related to the argument for pollution control (a point to be taken up later in the book). If the consumers who use a product do not bear all the costs associated with its use, they will tend to consume more of the good than is socially desirable. In the process they will impose a cost on others. For example, a person who buys a spray deodorant incurs a private cost equal to its money price. If the release of the chemicals used in aerosol sprays has a harmful effect on the earth’s ozone layer, as many scientists believe, however, the use of such products imposes an external cost on nonusers. At the very least, the public incurs a risk cost from the use of aerosol sprays.
Curve D in Figure 4.6 shows the market demand for spray deodorant. The supply curve S1 shows the marginal cost of producing the good, not counting the ozone effect. In a competitive market, the quantity of spray deodorant purchased will be Q2. If producers have to compensate those who bear the external costs of their product, however, their supply curve will shift to S2, and the quantity purchased will drop to Q1. The vertical distance between the two supply curves represents the external, or ozone, cost of each can sold. By including this cost in the price of the product, the government reduces social costs by the shaded area.
Figure 4.6 The External Costs of Consumer Protection
Curve S1 represents the supply curve for spray deodorant, not including external costs. Curve S2 represents the total cost, including harm to the earth’s ozone layer. Thus the vertical distance between S1 and S2 shows the external cost of producing each can of spray deodorant. In a free market, Q2 cans will be produced—more than the efficient level, Q1. Government can eliminate over¬production by internalizing the external costs of production, shown by the shaded area.

The argument does not necessarily demonstrate that spray cans should be banned. The amount of government regulation should depend on the degree of external cost. If
the use of spray cans will ultimately cause the destruction of life on earth, then the external costs are quite high and a complete ban is in order. If costs are lower, a less stringent policy might be appropriate.
Monopoly Power
Consumer advocates suspect that some firms use their market power to restrict the variety of products available to consumers and to reduce their quality, safety and effectiveness. The monopolist, in other words, can choose not only what price and quantity of a given product to offer, but what features it will have. Left to itself, the monopolistic firm will maximize profits by finding that one combination of price, quantity, and product features that minimizes costs and maximizes revenues.
Consumer advocates argue that most consumers want safer, more effective products than they can now obtain and are willing to pay competitive prices for them. They see consumer protection laws as a means of forcing monopolistic producers to provide what the public wants.
Information Costs
The complexities of modern technology can be overwhelming. Proponents of consumer protection argue that consumers cannot hope to comprehend the ins and outs of the dozens of products they must consider, from color televisions to prescription drugs. For instance, the production of cereals and meats is so far removed from common experience that consumers have little idea what chemicals may be added during processing. Without adequate information and the technical ability to comprehend it, consumers cannot make rational choices based on true costs and benefits. Therefore product safety experts must protect them.
This line of reasoning resembles the argument for a standard requiring shock-absorbing bumpers. Like the bumpers, consumer information benefits far more people than those who pay for it. That is, there are external benefits associated with its provision. The market demand for information, like the market demand for protective bumpers, will not fully reflect its social benefits. Because of external benefits, the quantity of information produced and purchased will fall short of the efficient level. By intervening in the market to supplement the information flow, government can increase social welfare.
The Case Against Consumer Protection
Some of the arguments against consumer protection have already been mentioned. In this section we will reemphasize them and highlight some additional points. As these arguments and counter arguments suggest, consumer protection is a complex issue, and it is difficult to find an efficient solution to the problem.
Competition as a Form of Consumer Protection
No one can reasonably expect to be protected against all the whims and exploitative efforts of businesses. The cost of complete protection would be prohibitive, and the benefits often too small to justify the cost. Thus we should not expect the market system to protect consumers completely against unsafe products and services. The relevant question is whether the market or government is more efficient in accomplishing the task of consumer protection.
In answering that question it is important to remember that few consumers are as powerless as consumer protection advocates maintain. Although one person can do little to coerce producers into providing safer, more effective goods and services, collectively consumers have considerable power of persuasion. They can offer to pay more for a safer product—and there is some price that profit-maximizing entrepreneurs will accept for such a product—or they can turn to different producers to obtain what they want. If producers do not offer what consumers want, and if they repeatedly produce shoddy merchandise, more and more consumers will move to other producers or purchase substitute goods. For example, if the Coca-Cola Company persisted in selling drinks that had lost their carbonation, consumers could move to Pepsi, 7-Up, or other substitute drinks. The fear of losing customers helps keep producers in line, pressuring them to offer the goods customers want.
Differences in Risk Taking
Some people are more willing than others to assume the risk that goods and services may be defective, ineffective, or unsafe. They differ in the personal value they place on avoiding risk. Thus some will participate in dangerous sports like hang gliding, while others would not dare. Some people will take a chance on buying a used car or toaster, while others would always insist on (and pay more for) new merchandise. If surveys are correct, most drivers are willing to accept the risk of driving without seat belts—although a few would not go around the block without them. Everything else held equal, people with a strong aversion to risk will demand safer products than those who prefer to take their chances.
Such differences in the willingness to assume risk may reflect differences in economic circumstances. Some believe that the demand for safer products is positively related to income. The rich are far more likely to buckle their seat belts than the poor. Even the choice of restaurants by the rich and poor may reflect different attitudes toward risk. People with low incomes patronize greasy-spoon restaurants, accepting the risk of food poisoning. They may reason that they are better off by eating cheaply than by spending more to protect their health.
If all consumers were willing to accept the same degree of risk, it would be relatively easy to protect them through product standards. Government regulators would simply determine the level of risk acceptable to all, and set their standards accordingly. Of course, consumer choice would be restricted. Some ineffective or less safe products would no longer be offered for sale. In the real world, as we have observed, consumers differ in their risk aversion. Uniform standards would force those who are comparatively
efficient in coping with risk, or who have no real aversion to risk, to buy safer products. Assuming that safety is not a free good, the cost to consumers would increase—and in economic terms, that amounts to a misallocation of resources. People who do not have children, for example, must still pay for childproof caps on drug bottles.
If full liability for product safety and effectiveness were shifted to the producer, the same type of problem could develop. Again, consumers would be unable to choose their preferred level of risk. When producers assume the risk, they might decide to discontinue certain product lines to avoid lawsuits and damage claims, or they might buy insurance to cover their newly acquired risk cost, raising the price to the consumer. In effect, consumers would be forced to buy insurance against unsafe or defective products. They would no longer have the option of insuring themselves, perhaps at a lower price.
The Needs of the Poor
Many people support consumer protection because of their concern for the poor, who may be unable to afford the information necessary to make an informed choice. The poor may also be the least capable of understanding technical product information, and the least able to endure the losses associated with defective goods and services. Opponents of consumer protection point out that the poor often prefer to buy low-quality goods and services because they are less expensive. They pay less so they can have more of other goods and services. If less safe (but cheaper) products are removed from the shelves, then, the burden of consumer protection falls disproportionately on the poor.
MANAGER’S CORNER: The Importance of Manager Incentives in the Minimum-Wage Debate
Political support in Congress for another hike in the federal minimum wage is growing. Following the lead of President Clinton, who called for an increase in the minimum wage in his 1999 State of the Union message, Senator Edward Kennedy (D-Mass.) and Representative David Bonior (D-Mich.) have proposed that the minimum hourly wage be raised by $1, or from $5.15 currently to $6.15 in two steps over the next year and a half.2
Indeed, even Republican members of Congress appear ready to press for their own increase in the minimum wage this year. Representative Jack Quinn (R-NY) has argued, “I believe it is a forgone conclusion that some type of minimum wage increase bill will be approved in this session of Congress. Rather than fight the thing and have Republicans being dragged kicking and screaming to a vote on the minimum wage, I say to my party, ‘Why not take the lead?’”3 Other political interest groups will draw on the support of many members of Congress in their effort to defeat any proposed increase.
2 The Kennedy and Bonior companion bills would, if passed, raise the minimum wage from $5.15 to $5.65 on September 1, 1999 and to $6.15 an hour on September 1, 2000 [House, U.S. Congress, 106th Cong., 1st Sess., “Fair Minimum Wage Act of 1999,” H.R.325 (January 19, 1999); Senate, U.S. Congress, 106th Cong., 1st Sess., “Fair Minimum Wage Act of 1999,” S. 192 (January 19, 1999)].
3 As quoted by Janet Hook, “GOP Relaxes Opposition to Minimum Wage Increase Politics: Republican Leaders Hope to Head Off Campaign. Hike May Be Tied to Tax Cuts,” Los Angeles Times, April 12,
Both sides to the heated debate that is also unavoidable will once again restate old and tired arguments, and they both will be off course in their arguments. In considering a new round of minimum wage increases, both minimum wage proponents and opponents need to reconsider how a minimum-wage hikes will affect labor market incentives and manager reactions to what Congress legislates. By the same token, managers in markets affected by any new minimum-wage increase need to be mindful of the competitive forces afoot that will cause them to react to an increase in ways that they might not always like.
The History of the Minimum Wage in Current and Constant Dollars
In emerging debate, much will likely be made of how the current federal minimum wage of $5.15 an hour has no more purchasing power than the minimum wage of the early 1950s, a fact that can be seen in Figure 4.7. The chart shows that the minimum wage in current dollars has risen in a series of nineteen steps from 25 cents an hour when the first federal minimum wage took effect in October 1938 to $5.15 currently. However, in constant, (February) 1999 dollars the minimum wage rose irregularly from $2.92 an hour in October 1938 to $7.70 an hour in 1968, only to fall irregularly from the 1968 peak to its current level of $5.15, which is a third less than the 1968 peak. As can also be seen, the real value of the 1999 minimum wage was slightly below the real minimum wage when it was raised at the start of 1950 (at which time it was $5.25 in 1999 dollars). In recent years, the real minimum wage has fallen only slightly in real terms from $5.25 in October 1997, at which time the minimum wage was last raised, to $5.15.4
The Two Sides to an Old Debate
When the next minimum-wage bill reaches the floor of Congress, it is all but certain that many opponents and proponents in and out of Congress will once again lock political horns over the proposal, no matter what the proposed increase is. While the political partisans can be expected to repeat past claims in earnest, they all will once again be off base on the likely employment consequences of the minimum-wage increase.
1999, p. A1. Quinn’s bill would delay the full $1 increase until September 1, 2001, but it would go one step further and raise the minimum wage annually by the consumer price index after September 1, 2002 [House,
U.S. Congress, 106th Cong., 1st Sess. “Long Term Minimum Wage Adjustment Act of 1999,” H.R. 964 (March 3, 1999).
4 Over the past six decades, the percent of nonsupervisory workers covered by the federal minimum wage has risen from 57 percent in 1950 to 87 percent in 1988 (the latest year of available data). This rise in the coverage of the minimum wage should have led to any increase in the minimum wage to have a progressively greater negative employment effect over the years, which is what economist Marvin Kosters has found [Marvin H. Kosters, Jobs and the Minimum Wage: The Effect of Changes in the Level and Pattern (Washington, D.C.: American Enterprise Institute, 1989), p. A-13].
House Majority Leader Dick Armey, a long-time opponent of the minimum wage, has already declared that the proposed $1 increase in the minimum wage is the “wrong thing” to do, mainly because the increase would significantly reduce employment of the country’s low skilled workers.5 No doubt, Armey is thinking in terms of a supply-and¬demand model that he once taught in his economics classes at North Texas State University. Consider Figure 4.8. If the market is competitive and free of government intervention, the wage rate will settle at W1. Suppose, however, that politicians consider that market wage too low to provide a decent living. They pass a law requiring employers to pay no less than W2. The effect of the law will be to reduce employment. Employers will not be able to afford to employ as many people, and the quantity of labor demanded will fall from Q2 to Q1. Those who manage to keep their jobs at the minimum wage will be better off; their take-home pay will increase. Other workers may no longer have a job. The will either become permanently unemployed or settle for work in a different, less desirable labor market. If the minimum wage displaces them from their preferred employment to their next-best alternative, their full wage rate—that is, their money wage plus the nonmonetary benefits of their job—will have been reduced. If they become permanently unemployed, their money wage will have been reduced from a level judged politically unacceptable to zero.
Figure 4.7 The History of the Minimum Wage in Current and Real Dollar Terms
The minimum wage rose in current dollars from $.25 an hour in 1938 to $5.15 until late 1999. However, in real (1999) dollars, the minimum wage rose from $2.92 in 1938 to $7.70 in 1968, only to fall back to $5.15 an hour in 1999.

To make matters worse, the introduction of a minimum wage increases the number of laborers willing to work (see Figure 4.8). Thus the workers who would have had a job at W1, and who have fewer employment opportunities at W2, must now compete
5 “U.S. Republicans Concede GOP Support for Minimum Wage Boost,” Dow Jones News Service, 1999 (as found on the Dow Jones Interactive Publication Library, April 28, 1999).
with a larger number of workers. Indeed, many of these new arrivals to the market will take jobs once held by menial workers at the market-clearing wage, W1.
On the other side of the argument, Bob Herbert, a columnist for the New York Times and a minimum-wage supporter, approvingly quotes a study from the Economic Policy Institute, a Washington, D.C.-based think tank, that found the last approved minimum-wage hike raised the incomes of 10 million Americans.6 Herbert writes, “The benefits of the increase disproportionately help those working households at the bottom of the income scale. Although households in the bottom 20 percent (whose average income was $15,728 in 1996) received only 5 percent of total national income, 35 percent of the benefits from the minimum wage increase went to these workers. In this regard, the increase had the intended effect of raising the earnings and incomes of low-wage workers and their households.’’7 Moreover, in the growing debate proponents like Herbert will continue to cite statistical studies that show that a minimum wage hike will have no (or minimal) impact on the count of low-wage jobs, which is what the Economic Policy Institute study found.8
Figure 4.8 The Standard View of the Minimum Wage
When Congress raises the minimum wage from W1 to W2, the number of workers hired goes from Q1 to Q2, while the number of workers who are willing to work goes from Q1 to Q3. The result is a “surplus” of workers equal to Q3 – Q1. Some workers gain at the expense of others.
_

Herbert is convinced that such findings should give minimum-wage critics reason to eat their words. Herbert reminds his readers of Cato Institute’s chairman William Niskanen (and former acting chairman of President Reagan’s Council of Economic Advisors and opponent of minimum-wage increases) comments made in the middle of the previous debate over increasing the minimum wage, ‘‘It is hard to explain the continued support for increasing the minimum wage by those interested in helping the working poor.’’9 Herbert and other minimum-wage supporters will point once again to
6 Jared Bernstein and John Schmitt, “Making Work Pay” (Washington, D.C.: Economic Policy Institute, 1998, mimeographed).
7 Bob Herbert, “In America; The Sky Didn’t Fall,” New York Times, June 4, 1998, p. A27.
8 Bernstein and Schmitt, “Making Work Pay.”
9 Ibid.
the empirical work of Princeton University economists David Card and Alan Krueger who concluded in 1994 that the minimum-wage increases in the federal minimum wage in the early 1990s had no measurable negative effect on employment in New Jersey fast-food restaurants (and may have actually increased employment slightly).10 They also insisted in 1998 insisted that more recent employment data from the Bureau of Labor Statistics corroborate their earlier findings.11
Nevertheless, opponents will continue to argue, as they have in the past, that if Congress raises the cost of low-skill labor, less than a fifth of the wage gains will go to households with incomes below the poverty level and more than half of the wage gains will go to households with more than twice the poverty income threshold.12 They will also stress that several hundred thousand jobs are bound to be lost. Some employers will not be able to afford as many workers, and other employers can be expected to automate low-skill jobs out of existence. The opponents will back up their claims with their own statistical studies that will show that some low-skilled workers will be made better off (those who keep their jobs) but only because other low-skilled workers will be made worse off (those who are unemployed).13 For example, the Employment Policies Institute, another Washington, D.C. based think tank, commissioned a study of the labor market impact of a $1.35 increase in the minimum-wage in the State of Washington and found that by 2000, the increase can be expected to destroy 7,431 jobs in the state, causing the affected workers to lose $64 million in annual income.14
Both sides to the debate will once again be wrong in their assessments of the minimum-wage increase because they have both failed to recognize that employers are a lot smarter and are pressed far more by the forces of their labor markets than the political combatants seem to think. Neither side seems to realize that Washington simply doesn’t have the requisite power over markets to significantly improve worker welfare by wage decrees, no matter how well intended the legislation may be. This is why so many
10 David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic Review, vol. 84 (1994), pp. 772-793; or David Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton, N.J: Princeton University Press, 1995).
11 David Card and Alan B. Krueger, “Unemployment Chimera,” Washington Post, March 6, 1998, p. A25.
12 As reported by Kenneth A. Couch, “Distribution and Employment Impacts of Raising the Minimum Wage,” FRBSF Economic Letter (San Francisco: Economic Research, Federal Reserve Bank, February 19, 1999, no. 99-06), p. 1. Couch cites Richard V. Burkhauser, Kenneth A. Couch, and Andrew J. Glenn, “Public Policies for the Working Poor: The Earned Income Tax Credit Versus Minimum Wage Legislation,” Research in Labor Economics, edited by Sol Polacheck, pp. 65-110.

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noreply@blogger.com ([Admin]) — Mon, 08 Jun 2009 15:58:00 +0000

TWILIGHT

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ANGLES AND DEMONS

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------------------------------------------------------------------------------------
UP

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noreply@blogger.com ([Admin]) — Sun, 07 Jun 2009 17:14:00 +0000

TERMINATOR SALVATION

Set in post-apocalyptic 2018, John Connor is the man fated to lead the human resistance against Skynet and its army of Terminators. But the future Connor was raised to believe in is altered in part by the appearance of Marcus Wright, a stranger whose last memory is of being on death row...

Genre: Action | Adventure | Sci-Fi | Thriller
IMDB rating: 7.4/10 (14,923 votes)
Directed by: McG
Starring: Christian Bale, Sam Worthington, Moon Bloodgood, Helena Bonham Carter

Release Name: Terminator.Salvation.CAM.XviD-DEViSE
Size: 1.38 GB
Video: XviD , 704×288 1689 kbps
Audio MP3, 128kbs
Runtime: 106 min
Filename: devise-tscamlll

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FRIDAY THE 13th

Friday.The.13th.EXTENDED.DVDRip.XviD.AC3-DEViSE

AR.......: 2.35:1
Runtime..: 104 mins
Premiere.: 11/02/2009
Genre....: Horror
Rating...: 6.1/10 @ 12,320 votes
IMDB.....: http://www.imdb.com/title/tt0758746/

Release.Date...: 04/06/2009
Retail.Date....: 00/00/0000
Source.........: DVD Retail
Video..........: XviD
Audio..........: AC3
Resolution.....: 720x304
Video Bitrate..: 1463 kbps
Audio Bitrate..: 384 kbps /6 channels/
Language.......: English
Subtitles......: Eng, Sp, Fr

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noreply@blogger.com ([Admin]) — Sun, 07 Jun 2009 17:01:00 +0000

AC/DC Black Ice (music) 2009

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Track List
----------
1. Rock N Roll Train 4:21
2. Skies On Fire 3:34
3. Big Jack 3:57
4. Anything Goes 3:22
5. War Machine 3:09
6. Smash N Grab 4:06
7. Spoilin' For A Fight 3:17
8. Wheels 3:28
9. Decibel 3:33
10. Stormy May Day 3:10
11. She Likes Rock N Roll 3:52
12. Money Made 4:15
13. Rock N Roll Dream 4:40
14. Rockin All The Way 3:22
15. Black Ice 3:25
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Metallica Death Magnetic (MUSIC)

ARTIST > METALLICA
TITLE > Death Magnetic
GENRE > Metal
PLAYTIME > 74:47 MiN
SIZE > 131,2 MB
STORE DATE > 09/12/2008

Track List
----------
01. That Way Just You Life 07:08
02. The End Of The Line 07:52
03. The Broken, Beat & Scarred 06:26
04. The Day That Never Comes 07:56
05. All Nightmare Long 07:58
06. Cyande 06:40
07. The Unforgiven III 07:47
08. The Judas Kiss 08:01
09. Suicide & Redemption 09:58
10. My Apocalypse 05:01

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RELAPSE-EMINEM 2009

Artist - Eminem

Album - Relapse

Track Names:
1. "Dr. West" (skit)
2. "3 A.M."
3. "My Mom"
4. "Insane"
5. "Bagpipes From Baghdad"
6. "Hello"
7. "Tonya" (skit)
8. "Same Song & Dance"
9. "We Made You"
10. "Medicine Ball"
11. "Paul" (skit)
12. "Stay Wide Awake"
13. "Old Time's Sake" (featuring Dr. Dre)
14. "Must Be the Ganja"
15. "Mr. Mathers"
16. "Déjà Vu"
17. "Beautiful"
18. "Crack a Bottle" (featuring Dr. Dre and 50 Cent)
19. "Steve Berman" (skit)
20. "Underground/ Ken Kaniff"

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How Management Incentives Are Affected

noreply@blogger.com ([Admin]) — Sun, 07 Jun 2009 16:57:00 +0000

Without bandying jargon or exhibiting formulae, without being superficial or condescending, the scientist should be able to communicate to the public the nature and variety of consequences that can reasonable be expected to flow from a given action or sequence of actions. In the case of the economist, he can often reveal in an informal way, if not the detailed chain of reasoning by which he reaches his conclusions, at least the broad contours of the argument.
E. J. Mishan
arlier chapters showed how the models of competitive and monopolistic markets
illuminate the economic effects of market changes, such as an increase in the price
of oil. This chapter will examine the use of government controls to soften the
impact of such changes. We will consider four types of government control: excise taxes, price controls, consumer protection laws, and minimum-wage laws. As we will see, government controls can inspire management reactions that negate some of the expected effects of the controls.
Who Pays the Tax?
Most people are convinced that consumers bear the burden of excise (or sales) taxes. They believe producers simply pass the tax on to consumers at higher prices. Yet every time a new (or increased) excise tax is proposed producers lobby against it. If excise taxes could be passed on to consumers, firms would have little reason to spend hundreds of thousands of dollars opposing them. In fact, excise taxes do hurt producers.
the margarine industry’s supply and demand curves, S1 and D. In a competitive market, the price will end toward P2 and the quantity sold toward Q3. If the state imposes a $0.25 tax on each pound of margarine sold and collects the tax from producers, it effectively raises the cost of production. The producer must now pay a price not just for the right to use resources, such as equipment and raw materials, but for the right to continue production legally. The supply curve, reflecting this cost increase, shifts to S2. The vertical difference between the two curves, P2 and P1, represents the extra $0.25 cost added by the tax.
Figure 4.1 The Economic Effect of an Excise Tax
An excise tax of $0.25 will shift the supply curve for margarine to the left, from S1 to S2. The quantity produced will fall from Q3 to Q2; the price will rise from P2 to P3. The increase, $0.20, however, will not cover the added cost to the producer, $0.25.

Given the shift in supply, the quantity of margarine produced falls to Q2 and the price rises to P3. Note, however, that the price increase (P1 to P2) is less than the vertical distance between the two supply curves (P2 to P1). That is, the price increases by less than the amount of the tax that caused the shift in supply. Clearly, the producer’s net has fallen. If the tax is $0.25, but the price paid by consumers rises only $0.20 ($1.20 ¬$1.00), the producer loses $0.50. It now nets only $0.95 on a product that used to bring $1.00. In other words, the tax not only reduces the quantity of margarine producers can sell, but makes each sale less profitable.
Incidentally, butter producers have a clear incentive to support a tax on margarine. When the price of margarine increases, consumers will seek substitutes. The demand for butter will rise, and producers will be able to sell more butter and charge more for each pound.
The $0.25 tax in our example is divided between consumers and producers, although most of it ($0.20) is paid by consumers. Why do consumers pay most of the tax? Consumers bear most of the tax burden because consumers are relatively unresponsive to the price change. The result, as depicted in Figure 4.1, is that consumers bear most of the tax burden while producers pay only a small part (20 percent) of the tax. If consumers were more responsive to the price change, then a greater share of the tax burden would fall on producers who would then have more incentive to oppose the tax politically. Indeed, we should that the amount of money producers would be willing to spend to oppose taxes on their product (through campaign contributions or lobbying) will depend critically on the responsiveness of consumers to a price change. The more responsive consumers are, the more producers should be willing to spend to oppose the tax.
Price Controls
Price controls are by no means a modern invention. The first recorded legal code, the four-thousand-year-old Code of Hammurabi, included regulations governing the maximum wage, housing prices, and rents on property such as boats, animals, and tools. And in A.D. 301, the Roman Emperor Diocletian issued an edict specifying maximum prices for everything from poultry to gold, and maximum wages for everyone from lawyers to the cleaners of sewer systems. The penalty for violating the edict was death. More recently, wage and price controls have been used both in wartime (during the Second World War and the Korean War) and in peacetime. President Richard Nixon imposed an across-the-board wage-price freeze in 1971. Prime Minister Pierre Trudeau imposed controls on the Canadian economy in 1975. President Jimmy Carter controlled energy prices in 1977 and later proposed the decontrol of natural gas.
Wage and price controls are almost always controversial. Like attempts to control expenditures, they often create more problems than they solve. We will examine both sides of the issue, starting with the argument in favor of controls.
Figure 4.2 The Effect of an Excise Tax When Demand is More Elastic Than Supply
If demand is much more elastic than supply, the quantity purchased will decline significantly when supply decreases from S1 to S2 in response to the added cost of the excise tax. Producers will lose $0.20; consumers will pay only $0.05 more.

The Case for Price Controls
The case for price ceilings on particular products is complex. On the most basic level, many people believe that prices should be controlled to protect citizens from the harmful effects of inflation. When prices start to rise, redistributing personal income and disrupting the status quo, it seems unfair. Price controls may seem especially legitimate to people, like the elderly, who must live on fixed incomes, and have little means of compensating for the effects of price increases on goods like oil and gas.
Unearned Profits
Many proponents of price controls view the supply curve for a controlled good as essentially vertical. They believe that a price rise will not affect the quantity produced. Consumers will get nothing more in the way of goods, but producers will reap a windfall profit. Instead of an incentive to produce more, profit is seen as an economic rent—an exploitative surplus received by companies fortunate enough to be in the market at the right time.
Administered Prices
A technical argument for price controls is most often advanced by economists and public officials. Many economists maintain that a significant segment of the business and industrial community—the larger firms that control a sizable portion of industry sales— no longer responds to the forces of supply and demand. Firms in highly concentrated industries like steel, automobiles, computers, and tobacco can override market forces by manipulating their output so as to set price levels. Furthermore, they can manage the demand for their products through advertising campaigns. With market forces ineffective, control must come from the government. Price controls are the only way to avoid the production inefficiencies and inequitable distribution of income that result from concentration of industry. As John Kenneth Galbraith, a leading advocate of price controls, has put it, “Controls are made necessary because planning has replaced the market system. That is to say that the firm and the union have assumed the decisive power in setting prices and wages. This means that the decision no longer lies with the market and thus with the public.”1
Monopoly Power
Later in the course, we will see how a monopolist can be expected to restrict output in order to push up its price in order to earn greater profits. The case for price controls under monopoly conditions is, for many advocates of controls, a matter of “fairness.” The controls give back to consumers what they “deserve” in terms of lower prices. However, as we will see, under monopoly conditions, if the producer is forced to charge a (somewhat) lower price, the producer will rationally choose to increase the output level. Hence, price controls benefit consumers in two ways, first through lower prices and then through greater output.

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Economic Firms

noreply@blogger.com ([Admin]) — Fri, 15 May 2009 05:17:00 +0000

But it seems to us altogether reasonable that long -- term contracting must be grounded in factors other than culture and affluence. One economic explanation may start with a recognition of the extent to which firms are integrated in Japan. The fact of the matter is that in some industries Japanese production is far less integrated into identified “firms” than, say, in the United States and other countries. In the United States and Western Europe, for example, 50 to 60 percent of the automobile manufacturing costs are incurred “in -- house.” In Japanese firms, on the other hand, only 25 to 30 percent of the automobile production costs are typically incurred “in -- house,” or inside Japanese firms. 16 Only 20 percent of Honda’s production costs are incurred inside, which means it buys 80 percent, or $6 billion, of its inputs from outside suppliers.17 Because of the lack of integration, Japanese firms may need to develop long -- term buyer -- supplier relationships to a much greater degree than more highly integrated firms do just to overcome the potential last-period problems, if nothing else.
Put another way, Japanese firms are able to engage in what is called strategic outsourcing, and do so competitively, because they are willing and able to develop long ¬
- term working relationships. If they didn’t, they would have to endure the added costs associated with the ever -- present closing of those relationships. It doesn’t surprise us that many buyer -- supplier relationships in Japan give the “look and feel” of integrated firms with buyers and suppliers helping each other and investing in each other (which is what happens, to more or less degree, within unified firms).
When Honda signs a contract with a supplier, it expects the working relationship to continue for 25 to 50 years, which effectively means that the last-period problem is set back considerably.18 Moreover, the permanence of the buyer -- supplier relationship is two -- way, with commitments on the parts of both buyers and suppliers. Buyers agree to stay with the suppliers, and vice versa, through ups and downs (at least up to a point). Hence, Honda can justify incurring the costs associated with helping its suppliers increase productivity, even provide the needed technology and specialized equipment. Moreover, such expenditures, plus investments in the specific assets of the suppliers, by Honda have the added advantage of being a bond, the value of which is forgone if Honda does not abide by its agreement. Managers at Honda are basically saying to suppliers, “Look at what we are doing. We are serious in our commitment. If we renege, our up -¬front investment will be worth very little. We will lose our projected income stream from the investment. Because of those costs, you can count us in for the long run.” Such tie -¬ins aid in making the contracts self -- enforcing and durable; they help to make the long run a viable perspective.

Should production be rigidly integrated as in American firms or more loosely integrated as in Japanese business consortiums? We surely cannot answer that question with the certitude that many readers will want. Japanese firms obviously gain the benefits of keeping their suppliers in a position that is marginally more tenuous and, maybe, more competitive with other potential suppliers, but they have to deal with the marginally more severe last-period problems. Many factors, which are offsetting and subject to change with the costs associated with contracting and with principal/agency problems we have discussed, are involved. We suspect that different organizational forms will suit different situations and eras (as has obviously been the case in Japan where relational contracting has not always been prevalent19).
Answers will come from real -- world experimentation in the marketplace. We suspect that competition will press firms to adjust their organization forms, and the inherent incentive structures, as some variation of organizational form is relatively more successful. Many American firms have had to seriously consider and, to a degree, duplicate the added organizational flexibility of Japanese firms. Why? Their management methods have obviously worked in some industries, most notably the automobile industry. It takes 17 hours to assemble a car in Japan and 25 to 37 hours to assemble a comparable car in the United States and Europe. Japanese firms can develop a new car in 43 months, whereas it takes American and European firms over 60 months, and Japanese cars come off the production lines with 30 percent fewer defects. The worst American -- made air conditioning units have a thousand defects for every defect in the best Japanese -- made units.20
Firm integration and relational contracting are hardly the only means of moderating last-period problems. Joint ventures, which more often than not require up -¬front investments by the firms involved, can also be seen as extensions of firm efforts to reduce last-period problems, with the potential of enhancing the quality of the goods and services produced and lowering production costs. Joint ventures might lower production costs because they give rise to economies of scale and scope through the application of technology, but they also can lower production costs by lowering the potential costs associated with opportunistic behavior and monitoring. They make the future income streams of each party a function of the continuation of the relationship.
* * * * *
The “last-period” problem is nothing more than what we have tagged it, a “problem” that businesses must consider and handle. It implies costs. At the same time, firms can make money by coming up with creative ways of making customers and suppliers believe that the “last period” is some reasonable distance into the future. Failing firms have a tough time doing that, which is one explanation why the pace of The “hollow corporation,” in which everything is “outsourced,” or nothing is produced directly, is sometimes viewed as the organizational ideal, given that the firm owners can rely on competitive forces to keep the prices of what they sell as low as possible. We doubt that the “hollow corporation” will ever dominate the economic landscape of any country for a simple reason that comes out of the analysis of this “Manager’s Corner”: The absence of the continuing association of employees under one roof would mean that the last-period problems would arise in spades. This is because the direct association of people under one roof has an unappreciated benefit: as in the keiretsu in Japan, the firm permits the creation of abiding relationships that reduce the incentive individuals have to behave opportunistically in the short run and enhance their incentives to work with their long -- term goals in mind. “Bonding” is something that firms do.
Concluding Comments
The concept of rational behavior means that the individual has alternatives, can order those alternatives on the basis of preference, and can act consistently on that basis. The rational individual will also chose those alternatives whose expected benefits exceed their expected costs.
Traditionally economics has focused on the activities of business firms, and much of this book is devoted to exploring human behavior in a market setting. The concept of rational behavior can be applied to other activities, however, from politics and government to family life and leisure pursuits. No matter what the activity, we all tend to maximize our well -- being. Any differences in our behavior can be ascribed to differences in our preferences and in the institutional settings, or constraints, within which we operate.
Institutional settings affect people’s range of alternatives and thus the choices they make. It makes sense to examine the constraints of institutional settings. In this part of the book we will investigate the specific characteristics of the market system, the subject of microeconomic theory. Later we will look at the constraints of government. In both cases the range of choices open to individuals affects the ability of the system to produce the results expected of it.
We have also indicated in this chapter how individual rationality can give rise to a nontrivial problem for managers, the last-period problem, which can make deals costly. At the same time, we have indicated how thinking in terms of rational precepts can suggest ways managers can deal with their last-period problems to lower firm costs and raise firm profitability.
Review Questions
What are the costs and benefits of taking this course in microeconomics? Develop a theory of how much a student can be expected to study for this course. How might the student’s current employment status affect his or her studying time?
Some psychologists see people’s behavior as determined largely by family history and external environmental conditions. How would “cost” fit into their explanations?
Why not base a course on an assumption of widespread “irrational” behavior?
Okay, so no one is totally rational. Does that undermine the use of “rational behavior” as a means of thinking about markets and management problems?
How could drug use and suicide be considered “rational”?
If your firm were consistently dealing with “irrational behavior” among the owners and workers, what would happen to correct the problem? More to the point, what might you do to correct the problem?
Analyse these questions and think.............its not too late...!

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Disincentives in Poverty Relief

noreply@blogger.com ([Admin]) — Fri, 01 May 2009 07:07:00 +0000

Our discussion of rational behavior can be used to understand one of the biggest policy issues of our time, welfare reform. We can do this by assuming that welfare recipients are tolerably rational.
So much of the public discussions about welfare programs, especially cuts in them, assumes that since Congress has the authority to change the programs, it can alter the programs any way it wishes without creating problems. However, as we can easily see, Congress is in something of an economic, if not political, bind on welfare relief, given how incentives change when the program is adjusted. The basic problem is that the practice of scaling down welfare benefits as earned income rises creates an implicit marginal tax on additional earned income that discourages the poor from working. Why not lower the implicit marginal tax rate?
Our graphic analysis suggests that there may be economic as well as altruistic limits to the government’s ability to transfer income from the rich to the poor. As more and more income is allocated to the poor, either the guaranteed income or break -- even income level must go up. If only the guaranteed income level is raised, the implicit marginal tax rate facing the poor increases. If that problem is avoided by raising the break -- even income level, poverty relief will cover more people, and the taxes paid by the remaining workers will go up. Increased aid to the poor thus should have three consequences. A higher explicit tax burden will fall on fewer taxpayers. Because of this burden, higher -- income groups will have less incentive to work, and lower -- income groups, because of the higher implicit tax rate, will also be less inclined to work.
MANAGER’S CORNER: The Last-Period Problem
Much of this chapter has been concerned with how people behave rationally. Here, we introduce “opportunistic behavior” as a form of rational behavior that people in business will want to protect themselves from. We suggest ways different parties to business deals can take advantage of other parties and how managers can structure their organizational and pay policies to minimize what we call “opportunistic behavior.” More specifically, this section is concerned with how an announced end to a business relationship can inspire opportunistic behavior. Its goal is, however, constructive, structuring business deals – and the embedded incentives -- in order to maximize the durability and profitability of the deals. To do that, business relationships must be ongoing, or have no fixed end, to the extent possible. Having a fixed termination date can encourage opportunistic behavior, which can reduce firm revenues and profits. That is to say, a reputation for continuing in business has economic value, which explains why managers work hard to create such a reputation.
The basic problem is that during the last period of any business relationship, there is no penalty for cheating, which implies maximum incentive to cheat. As a consequence, cheating on deals in the last period is more likely than at any other time in the relationship.
Consider a simple business deal. Suppose that you want a thousand widgets of a given quality delivered every month, starting with January and continuing through December, and that you have agreed to make a fixed payment to the supplier when the delivery is made. If you discover after you have made payment that your supplier sent fewer than a thousand units or sent the requisite thousand units but of inferior quality, you can simply withhold future checks until the supplier makes good on his or her end of the bargain. Indeed, you can terminate the yearlong contract, which can impose a substantial penalty for any cheating early in the contract. Knowing that, the supplier will tend to have a strong incentive early on in the contract period to do what he or she has agreed to do.
However, the supplier’s incentive to uphold his or her end of the bargain begins to fade as the year unfolds, for the simple reason that there is less of a penalty -- in terms of what is lost from your ending the working relationship -- that you can impose. The supplier might go so far as to reason that during the last period (December), the penalty is very low, if not zero. The supplier can cut the quantity or quality of the widgets delivered during December and then can take the check before you know what has been done. The biggest fear the supplier has is that you might inspect the shipment before handing over the final check. You may be able to get the supplier to increase the quantity or quality somewhat with inspection, but you should expect him or her to be somewhat more difficult to deal with. And you should not expect the same level of performance or quality.
The problem is that you have lost a great deal of your bargaining power during that last month, and that is the source of what we call and mean by the last-period (or end -- period) problem, meaning the costs that can be expected to be incurred from opportunistic behavior when the end of a working relationship approaches. It is a problem, however, that can be mitigated in several ways. The simplest and perhaps most common way is by maintaining continuing relationships. If you constantly jump from one supplier to another, you might save a few bucks in terms of the quoted prices, but
you might also raise your costs in terms of unfulfilled promises by suppliers during the last period of their association with you. “Working relationships,” in other words, have an economic value apart from what the relationship actually involves, for example, the delivery of so many widgets. This is one important reason businesses spend so much time cultivating and maintaining their relationships and why they may stick with suppliers and customers through temporary difficulties.
Solutions to the Last-Period Problem
Nothing works to solve the last-period problem, however, like success. The more successful a firm is -- the greater the rate of growth for the firm and its industry -- the more likely others will recognize that the firm will continue in business for sometime into the future. The opposite is also true -- failure can feed on itself as suppliers, buyers, and workers begin to think that the last period is near. Firms understand these facts of business life. As a consequence, executives tend to stress their successes and downplay their failures. Their intent may not be totally unethical, given how bad business news can cause the news to get worse. Outsiders understand these tendencies. As a consequence, many investors pay special attention to whether executives are buying or selling their stock in their companies. The executives may have access to (accurate) insider information that is not being distributed to the public.
Another simple way of dealing with the last-period problem in new relationships is to leave open the prospect of future business, in which case the potential penalty is elevated (in a probabilistic sense) in the mind of the supplier. When there is no prospect of future business, the expected cost from cheating is what can be lost during the last period. When there is some prospect of future business, the cost is greater, equal to the cost that can be imposed during the last period plus the cost (discounted by the probability that it will be incurred) incorporated in the loss of future business.
When dealing with remodeling or advertising firms, for instance, you can devise a contract for a specified period, but you can suggest, or intimate, in a variety of creative ways, that if the work is done as promised and there are no problems, you might extend the contract or expand the scope of the relationship. In the case of the remodeling firm, you might point out other repairs in the office that you are thinking of having done. In the case of the advertising firm, you might suggest that there are other ad campaigns for other products and services that you are considering.
You should, therefore, be able to secure somewhat better compliance with your supplier during the last period of the contract, and how much the compliance is improved can be related to just how well you can convince your supplier that you mean business (and a lot of it) for some time into the future. However, we are not suggesting that you should outright lie about uncertain future business. The problem with lying is that it can, when discovered, undercut the value of your suggestions of further business and bring back to life the last-period problem. You need, in other words, to be prepared to extend, from time to time (if not always), working relationships when in fact they work the way you want them to work.

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Principles of Rational Behavior at Work in Society and Business

noreply@blogger.com ([Admin]) — Fri, 01 May 2009 07:02:00 +0000

Microeconomics rests on certain assumptions about individual behavior. One is that people are capable of envisioning various ways of improving their position in life. This chapter reviews and extends the discussion begun in Chapter 1 of how people – business people included -- go about choosing among those alternatives. According to microeconomic theory, consumers and producers make choices rationally, so as to maximize their own welfare and their firms’ profits. This seemingly innocuous basic premise about human behavior will allow us to deduce an amazing variety of implications for business and every other area of human endeavor.People’s wants are ever expanding. We can never satisfy all our wants because we will always conceive of new ones. The best we can do is to maximize our satisfaction, or utility, in the face of scarcity. Utility is the satisfaction a person receives from the consumption of a good or service or from participation in an activity. Happiness, joy, contentment, or pleasure might all be substituted for satisfaction in the definition of utility. Economists attempt to capture in one word—utility—the many contributions made to our well being when we wear, drink, eat, or play something
Of course individuals in a group affect one another’s behavior. In fact, the size and structure of a group can have a dramatic effect on individual behavior. When economists speak of a competitive market, they are actually talking about the influence that other competitors have on the individual consumer or firm.
Rational Behavior
When individuals act to satisfy their wants, they behave rationally. Rational behavior is consistent behavior that maximizes an individual’s satisfaction. The notion of rational behavior rests on three assumptions:
• First the individual has a preference and can identify, within limits, what he or she wants.
• Second, the individual is capable of ordering his or her wants consistently, from most preferred to least preferred.
• Third, the individual will choose consistently from these ordered preferences to maximize his or her satisfaction.

Even though the individual cannot fully satisfy all her wants, she will always choose more of what she wants rather than less. Furthermore, she will always choose less rather than more of what she does not want. In short, the rational individual always stands ready to further her own interests.
Some readers will find these assertions obvious and acceptable. To others, they may seem narrow and uninspiring. Later in the chapter we will examine some possible objections to the concept of rational behavior, but first we must examine its logical consequences.
Rational Decisions in a Constrained Environment
Several important conclusions flow from the economist’s presumption of rational behavior. First, the individual makes choices from an array of alternatives. Second, in making each choice, a person must forgo one or more things for something else. All rational behavior involves a cost, which is the value of the most preferred alternative forgone. Third, in striving to maximize his or her welfare, the individual will take those actions whose benefits exceed their costs.
Choice
We assume that the individual can evaluate the available alternatives and select the one that maximizes his utility. Nothing in the economic definition of rational behavior suggests that the individual is completely free to do as he wishes. Whenever we talk about individual choices, we are actually talking about constrained choices—choices that are limited by outside forces. For example, you as a student find yourself in a certain social and physical environment and have certain physical and mental abilities. These environmental and personal factors influence the options open to you. You may have neither the money, the time, nor the stomach to become a surgeon, or your career goal may not allow you the luxury of taking many of the electives listed in your college catalog.
Although your range of choices may not be wide, choices do exist. At this moment you could be doing any number of things instead of reading this book. You could be studying some other subject, or going out on a date, or playing with your son or daughter. You could have chosen to go shopping, to engage in intramural spots, or to jog around the block. You may not be capable of playing varsity sports, but you have other choices. Although your options are limited, or constrained—you are not completely free to do as you please—you can still choose what you want to do. In fact, you must choose.
Suppose that you have an exam tomorrow in economics and that there are exactly two things you can do within the next 12 hours. You can study economics, or you can play your favorite video game. These two options are represented in Figure 3.1. Suppose you spend the entire 12 hours studying economics. In our example, the most you can study is four chapters, or E1. At the other extreme, you could do nothing but play games—but again, there is a limit: eight games or G1.
Neither extreme is likely to be acceptable. Assuming that you aim both to pass your exam and to have fun, what combination of games and study should you choose? The available options are represented by the straight line.
An individual who behaves rationally will choose an option only when its benefits are greater than or equal to its costs. Furthermore, individuals will try to maximize their satisfaction by choosing the most favorable option available. That is, they will produce or consume those goods and services whose benefits exceed the benefits of the most favored opportunity not taken.
Economists see cost-benefit analysis as the basis of much (but certainly not all) of our behavior. Cost-benefit analysis is the careful calculation of all costs and benefits associated with a given course of action. Why do you attend classes, for example? The obvious answer is that at the time you decide to attend class, you expect the benefits to attending the exceed the costs. The principle applies even to classes you dislike. A particular course may have no intrinsic value, but you may fear that by cutting class, you will miss information that would be useful on the examination. Thus the benefits of attending are a higher grade than you would otherwise expect. Besides, other options open to you on Tuesday morning at 10:00 AM may have so little appeal that the cost of going to class is very slight.
Take another example. Americans are known for the amount of waste they pile up. Our gross national garbage is estimated to be more valuable than the gross national output of many other nations. We throw away many things that people in other parts of the world would be glad to have. However morally reprehensible, waste may be seen as the result of economically rational behavior. Wastefulness may be beneficial in a limited personal sense. The food wrappings people throw away are “wasted,” but they do add convenience and freshness to the food. In the individual’s narrow cost-benefit analysis, the benefits of the wrapping can exceed the costs.
Is life priceless? Although we like to think so, many of us are not willing to bear the cost that must be paid to preserve it. Several million animals—dogs, opossums, squirrels, and birds—are killed on the highways each year. Most of us make some effort to avoid animal highway deaths. If saving lives were all -- important, we could drive less -- but that would bring a significant cost. Even when human beings are involved, we sometimes refuse to bear the cost of preserving life. People avoid helping victims of violent crime, and doctors routinely pass by highway accidents although they might save lives by stopping to help. Indeed, revolutions succeed through people’s willingness to sacrifice lives—both others’ and their one -- to achieve political or economic goals.
The behavior of business people is not materially different from that of drivers or consumers. People in business are constantly concerned with cost-benefit calculations, only the comparisons are often (but not always) made in dollar terms: For example, whether the cost of improving the quality of a product is matched by the benefits of the improvement. Will consumers value the added benefits enough to pay for hem? In assessing the safety of their products, business people must consider whether consumers are willing to pay the cost of any improvements.
The Effects of Time and Risk on Costs and Benefits
When an individual acts, costs are not necessarily incurred immediately, and benefits are not necessarily received immediately. The decision to have a child is a good example. At turn of the century prices, a college -- educated couple’s first child can easily cost more than $500,000, from birth through college.2 Fortunately this high cost is incurred over a relatively long period of time (or people would rarely become parents!).
Benefits received in the future must also be compared with present benefits. If you had a choice between receiving $10,000 now and $10,000 one year from now, you would take $10,000 today. You could put the money in a bank, if nothing else, where it would earn interest, or you could avoid the effects of future inflation by spending the money now. In other words, future benefits must be greater than present benefits to be more attractive than present benefits.
To compare future costs and benefits on an equal footing with costs and benefits realized today, we must adjust them to their present value. Present value is the value of future costs and benefits in terms of current dollars. The usual procedure for calculating present value -- a process called discounting -- involves an adjustment for the interest that could be earned (or would have to be paid) if the money were received (or due) today rather than in the future.3
If there is any uncertainty about whether future benefits or costs will actually be received or paid, further adjustments must be made. Without such adjustments, perfectly rational act may appear to be quite irrational. For example, not all business ventures can be expected to succeed. Some will be less profitable than expected or may collapse altogether. The average fast-food franchise may earn a yearly profit of $1 million, but, but only nine out of ten franchises may survive their first year (because the average profits is distorted by the considerable earnings of one franchise). Thus the estimated profits for such a franchise must be discounted, or multiplied by 0.90. If 10 percent of such ventures can be expected to fail, on average each will earn $900,000 ($1 million x .90).
The entrepreneur who starts a single business venture runs the risk that it may be the one out of ten that fails. In that case profit will be zero. To avoid putting all their eggs in one basket, many entrepreneurs prefer to avoid putting all their “eggs” in the To estimate the actual cost faced by the burglar who is caught, sentenced, and sent to jail for a year, we might multiply the cost if caught, $10,000, by 0.10. That calculation indicates that to a burglar who is sent to jail for an average of one out of ten burglaries, the cost of any one burglary is only $1,000 ($10,000 x 0.10). Thus the actual cost of the burglary is less than the benefits received, $1,500. Although it may be morally reprehensible, the criminal act can conceivably be a rational one.
Surveys of criminal activities and their rewards tend to support such a conclusion. A study of burglary and grand larceny cases in Norfolk, Virginia, showed that for the unusual criminal who committed just one crime and was caught in the act, crime did not pay. The typical criminal, however, convicted the average number of times and sentenced to the average number of years in prison, more than tripled the lifetime income he could have earned from a regular salaried job—even allowing for one or more years of unsalaried incarceration.5 When this study was replicated in Minnesota, the results were not quite as dramatic, but the criminal’s lifetime income still doubled.6 For criminals who are never caught, crime pays even more handsomely.
The concept of rational behavior often proves bothersome to the noneconomist. Most of the difficulties surrounding this concept arise from a misunderstanding of what rationality means. Common objections include the following:

1. People do many things that do not work out to their benefit. A driver speeds and ends up in the hospital. A student cheats, gets caught, and is expelled from school. Many other examples can be cited. To say that people behave rationally does not mean that they never make mistakes. We can calculate our options with some probability, but we do not have perfect knowledge, nor can we fully control the future. Chances are that we will make a mistake at some point, but as individuals, we base our choices on what we expect to happen, not on what does happen. We speed because we expect not to crash, and we cheat because we expect not to be caught. Both can be rational behaviors.

2. Rational behavior implies that a person is totally self -- centered, doing only things that are of direct personal benefit. Rational behavior need not be selfish. Altruism can be rational; a person can want to be of service to others, just as he can want to own a new car. Most of us get pleasure from seeing others happy—and particularly when their happiness is the result of our actions. Altruism may not always spring from rational cost-benefit calculations; however, it is not always inconsistent with economic rationality. Self -- interest, moreover, does not necessarily stop at the individual. For many actions, “self” includes members of one’s family or friends. When a father spends a weekend building a tree house for his children, economists say that he has been engaged in self -- interested behavior.

3.People’s behavior is subject to psychological quirks, hang -- ups, habits and impulses. Surely such behavior cannot be considered rational. Human actions are governed by the constraints of our physical and mental makeup. Like our intelligence, our inclination toward aberrant or impulsive behavior is one of those constraints. It makes our decision-making less precise and contributes to our mistakes, but it does not prevent our acting rationally. Moreover, what looks like impulsive or habitual behavior may actually be the product of some prior rational choice. The human mind can handle only so much information and make only so many decisions in one day. Consequently, we may attempt to economize on decision making by reducing some behaviors to habit. Smoking may appear to be totally impulsive, and the physical addition that accompanies it may indeed restrict the smoker’s range of choices. Why might a person pull a cigarette from the pack “without smoke".

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Financial Aids 09

noreply@blogger.com ([Admin]) — Wed, 22 Apr 2009 08:09:00 +0000

But, can both sides gain by a buyout deal? That may not always be so easy to do. The owners would have to be willing to pay workers more than they, the workers, are willing to accept. There are several reasons such a deal may be possible in many, but not necessarily all, cases. First, the workers could have a higher discount rate than the owners, and this may often be the case because the owners are more diversified than their workers in their investments. Workers tend to concentrate their capital, a main component of which is human capital, in their jobs. By agreeing to a buyout and receiving some form of lump-sum payment in cash (or even in a stream of future cash payments), the workers can diversify their portfolios by scattering the cash among a variety of real and financial assets. Hence, workers might accept less than the current (discounted) value of their overpayments just to gain the greater security of a more diversified investment portfolio. Naturally (and we use that word advisedly), the workers cannot be sure how long they will be around to collect the overpayments. By taking the payments in lump-sum form, they reduce the risk of collection and increase the security of their heirs.
Second, sometimes retirement systems are overfunded, that is, they have greater expected income streams from their investments than are needed for meeting the expected future outflow of retirement payments. This is true, for example, of the California State Employee Retirement System. Therefore, if the company can tap the retirement funds, as the State of California did in the mid-1990s, it can pay workers more in the buyout than they would receive in overpayments by continuing to work. In so doing, they can move those salaries “off budget,” which is what California has done in order to match its budgeted expenditures with declining funding levels for higher education.

We should also expect that workers’ fears will vary across firms and will be related to a host of factors, not the least of which will be the size of the firm. Workers who work for large firms may not be as fearful as workers for small firms, mainly because large firms are more likely to be sued for any retaliatory use of their discretionary employment practices (and efforts to adjust the work of older workers in response to any law that abolishes mandatory retirement rules). Large firms simply have more to take as a penalty for what are judged to be illegal acts. Moreover, it appears that juries are far more likely to impose much larger penalties on large firms, with lots of equity, than their smaller counterparts. This unequal treatment before the courts, however, suggests that laws that abolish mandatory retirement rules will give small firms a competitive advantage over their larger market rivals.
However, we hasten to stress that all we have done is to discuss the transitory adjustments firms will make with their older workers, who are near the previous retirement age. We should expect other adjustments for younger workers, not the least of which will be a change in their wage structures. Not being able to overpay their older workers in their later years will probably mean that the owners will have to raise the pay of their younger workers. After all, the only reason the younger workers would accept underpayment for years is the prospect of overpayments later on.
There are three general observations from this line of inquiry that are interesting:
1 The abolition of mandatory retirement will tend to help those who are about to retire.
2 Abolition might help some older workers who are years from retirement, who work for large firms, and who can hang on to their overpayments. It can hurt other older workers who are fired, demoted, not given raises, or have their pay actually cut
The market is a system that provides producers with incentives to deliver goods and services to others. To respond to those incentives, producers must meet the needs of society. They must compete with other producers to deliver their goods and services in the most cost-effective manner.
A market implies that sellers and buyers can freely respond to incentives and that they have options and can choose among them. It does not mean, however, that behavior is totally unconstrained or that producers can choose from unlimited options. What a competitor can do may be severely limited by what rival firms are willing to do.
The market system is not perfect. Producers may have difficulty acquiring enough information to make reliable production decisions. People take time to respond to incentives,

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Product Markets

noreply@blogger.com ([Admin]) — Wed, 22 Apr 2009 08:03:00 +0000

n the heart of New York City, Fred Lieberman’s small grocery is dwarfed by the tall
buildings that surround it. Yet it is remarkable for what it accomplishes. Lieberman’s
carries thousands of items, most of which are not produced locally, and some of which come thousands of miles from other parts of this country or abroad. A man of modest means, with little knowledge of production processes, Fred Lieberman has nevertheless been able to stock his store with many if not most of the foods and toiletries his customers need and want. Occasionally Lieberman’s runs out of certain items, but most of the time the stock is ample. Its supply is so dependable that customers tend to take it for granted, forgetting that Lieberman’s is one small strand in an extremely complex economic network.
How does Fred Lieberman get the goods he sells, and how does he know which ones to sell and at what price? The simplest answer is that the goods he offers and the prices at which they sell are determined through the market process- the interaction of many buyers and sellers trading what they have (their labor or other resources) for what they want. Lieberman stocks his store by appealing to the private interests of suppliers -- by paying them competitive prices. His customers pay him extra for the convenience of purchasing goods in their neighborhood grocery -- in the process appealing to his private interests. To determine what he should buy, Fred Lieberman considers his suppliers prices. To determine what and how much they should buy, his customers consider the prices he charges. The Nobel Prize-winning economist Friedrich Hayek has suggested that the market process is manageable for people like Fred Lieberman precisely because prices condense into usable form a great deal of information, signaling quickly what people want, what goods cost, and what resources are readily available. Prices guide and coordinate the sellers’ production decisions and consumers’ purchases.
How are prices determined? That is an important question for people in business simply because an understanding of how prices are determined can help business people understand
the forces that will cause prices to change in the future and, therefore, the forces that affect their businesses’ bottom lines. There’s money to be made in being able to understand the dynamics of prices. Our most general answer in this chapter to the question is deceptively simple: In competitive markets, the forces of supply and demand establish prices. However, there is much to be learned through the concepts of supply and demand. Indeed, we suspect that most MBA students will find supply and demand the most useful concepts developed in this book. However, to understand supply and demand, you must first understand the market process that is inherently competitive.
The Competitive Market Process
So far, our discussion of markets and their consequences has been rather casual. In this section we will define precisely such terms as market and competition. In later sections we will examine the way markets work and learn why, in a limited sense, markets can be considered efficient systems for determining what and how much to produce.
The Market Setting
Most people tend to think of a market as a geographical location -- a shopping center, an auction bar, a business district. From an economic perspective, however, it is more useful to think of a market as a process. You may recall from Chapter 1 that a market is defined as the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods to be bought and sold.
In this process, individual market participants search for information relevant to their own interests. Buyers ask about the models, sizes, colors, and quantities available and the prices they must pay for them. Sellers inquire about the types of goods and services buyers want and the prices they are willing to pay.
This market process is self-correcting. Buyers and sellers routinely revise their plans on the basis of experience. As Israel Kirzner has written,
The overly ambitious plans of one period will be replaced by more realistic ones; market opportunities overlooked in one period will be exploited in the next. In other words, even without changes in the basic data of the market, the decision made in one period onetime generates systematic alterations in corresponding decisions for the succeeding period.1
The market is made up of people, consumers and entrepreneurs, attempting to buy and sell on the best terms possible. Through the groping process of give and take, they move from relative ignorance about others’ wants and needs to a reasonably accurate understanding of 1 Israel Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), p. 10.
how much can be bought and sold and at what price. The market functions as an ongoing information and exchange system.
Competition Among Buyers and Among Sellers
Part and parcel of the market process is the concept of competition. Competition is the process by which market participants, in pursuing their own interests, attempt to outdo, outprice, outproduce, and outmaneuver each other. By extension, competition is also the process by which market participants attempt to avoid being outdone, outpriced, outproduced, or outmaneuvered by others.
Competition does not occur between buyer and seller, but among buyers or among sellers. Buyers compete with other buyers for the limited number of goods on the market. To compete, they must discover what other buyers are bidding and offer the seller better terms -- a higher price or the same price for a lower-quality product. Sellers compete with other sellers for the consumer’s dollar. They must learn what their rivals are doing and attempt to do it better or differently -- to lower the price or enhance the product’s appeal.
This kind of competition stimulates the exchange of information, forcing competitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before the bidding begins, buyer look over the merchandise and the other buyers, attempting to determine how high others might be willing to bid for a particular piece. During the auction, this specific information is revealed as buyers call out their bids and others try to top them. Information exchange is less apparent in department stores, where competition is often restricted. Even there, however, comparison-shopping will often reveal some sellers who are offering lower prices in an attempt to attract consumers.
In competing with each other, sellers reveal information that is ultimately of use to buyers. Buyers likewise inform sellers. From the consumer’s point of view,
The function of competition is here precisely to teach us who will serve us well: which grocer or travel agent, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face.2
From the seller’s point of view -- say, the auctioneer’s -- competition among buyers brings the highest prices possible.
Competition among sellers takes many forms, including the price, quality, weight, volume, color, texture, poor durability, and smell of products, as well as the credit terms offered to buyers. Sellers also compete for consumers’ attention by appealing to their hunger and sex drives or their fear of death, pain, and loud noises. All these forms of competition can be divided into two basic categories -- price and nonprice competition. Price competition is of particular interest to economists, who see it as an important source of information for market University of Chicago Press, 1948), p. 97.
participants and a coordinating force that brings the quantity produced into line with the quantity consumers are willing and able to buy. In the following sections, we will construct a model of the competitive market and use it to explore the process of price competition. Nonprice competition will be covered in a later section.
Supply and Demand: A Market Model
A fully competitive market is made up of many buyers and sellers searching for opportunities or ready to enter the market when opportunities arise. To be described as competitive, therefore, a market must include a significant number of actual or potential competitors. A fully competitive market offers freedom of entry: there are no legal or economic barriers to producing and selling goods in the market.
Our market model assumes perfect competition-an ideal situation that is seldom, if ever, achieved in real life but that will simplify our calculations. Perfect competition is a market composed of numerous independent sellers and buyers of an identical product, such that no one individual seller or buyer has the ability to affect the market price by changing the production level. Entry into and exit from a perfectly competitive market is unrestricted. Producers can start up or shut down production at will. Anyone can enter the market, duplicate the good, and compete for consumers’ dollars. Since each competitor produces only a small share of the total output, the individual competitor cannot significantly influence the degree of competition or the market price by entering or leaving the market.
This kind of market is well suited to graphic analysis. Our discussion will concentrate on how buyers and sellers interact to determine the price of tomatoes, a product Mr. Lieberman almost always carries. It will employ two curves. The first represents buyers’ behavior, which is called their demand for the product.
The Elements of Demand
To the general public, demand is simply what people want, but to economists, demand has much more technical meaning. Demand is the assumed inverse relationship between the price of a good or service and the quantity consumers are willing and able to buy during a given period, all other things held constant.
Demand as a Relationship
The relationship between price and quantity is normally assumed to be inverse. That is, when the price of a good rises, the quantity sold, ceteris paribus (Latin for “everything else held constant”), will go down. Conversely, when the price of a good falls, the quantity sold goes up. Demand is not a quantity but a relationship. A given quantity sold at a particular price is properly called quantity demanded.price is properly called quantity demanded.
Both tables and graphs can be used to describe the assumed inverse relationship between price and quantity.
Demand as a Table or a Graph
Demand may be thought of as a schedule of the various quantities of a particular good consumers will buy at various prices. As the price goes down, the quantity purchased goes up and vice versa. Table 2.1 contains a hypothetical schedule of the demand for tomatoes in the New York area during a typical week. The middle column shows prices that might be charged. The column on the right shows the number of bushels consumers will buy at those prices. Note that as the price rises from zero to $11 a bushel, the number of bushels purchased drops from 110,000 to zero.
Demand may also be thought of as a curve. If price is scaled on a graph’s vertical axis and quantity on the horizontal axis, the demand curve has a negative slope (downward and to the right), reflecting the assumed inverse relationship between price and quantity. The shape of the market demand curve is shown in Figure 2.1, which is based on the data from Table 2.1. Points a through l on the graph correspond to the price-quantity combinations A through L in the table. Note that as the price falls from P2 ($8) to P1 ($5), consumers move down their demand curve from a quantity of Q1 (30) to the larger quantity Q2 (60).3
The Slope and Determinants of Demand
Price and quantity are assumed to be inversely related for two reasons. First, as the price of a good decreases (and the prices of all other goods stay the same -- remember ceteris paribus), the purchasing power of consumer incomes rises. More consumers are able to buy the good, and many will buy more of most goods. (This response is called the income effect.)
In addition, as the price of a good decreases (and the prices of all other goods remain the same), the good becomes relatively cheaper, and consumers will substitute that good for others. (This response is called the substitution effect.) Supply may be described as a schedule of the quantity producers will offer at various prices during a given period of time. Table 2.2 shows such a supply schedule. As the price of tomatoes goes up from zero to $11 a bushel, the quantity offered rises from zero of 110,000, reflecting the assumed positive relationship between price and quantity.
Supply may also be thought of as a curve. If the quantity producers will offer is scaled on the horizontal axis of a graph and the price of the good is scaled on the vertical axis, the supply curve will slope upward to the right, reflecting the assumed positive relationship between price and quantity. In Figure 2.3, which was plotted from the data in Table 2.2, points a through l represent the price-quantity combinations A through L. Note how a change in the price causes a movement along the supply curve.4
The Slope and Determinants of Supply
The quantity producers will offer on the market depends on their production costs. Obviously the total cost of production will rise when more is produced because more resources will be required to expand output. The additional or marginal cost of each additional bushel produced also tends to rise as total output expands. In other words, it costs more to produce the second bushel of tomatoes than the first, and more to produce the third than the second. Firms will not expand their output unless they can cover their higher unit costs with a higher price. This is the reason the supply curve is thought to slope upward.
Anything that affects production costs will influence supply and the position of the supply curve. Such factors, which are called determinants of supply, include:
Change in productivity due to a change in technology
Market Equilibrium
Supply and demand represent the two sides of the market—sellers and buyers. By plotting the supply and demand curves together, as in Figure 2.5 we can predict how buyers and sellers will be inconsistent, and a market surplus or shortage of tomatoes will result.
Market Surpluses
Suppose that the price of a bushel of tomatoes is $9, or P2 in Figure 2.5. At this price the quantity demanded by consumers is 20,000 bushels, much less than the quantity offered
Our discussion has assumed free entry into the market. If entry is restricted by monopoly of a strategic resource or by government regulation, the variety of products offered will not be as great as in an open, competitive market. If there are only two or three competitors in a market, everything else being equal, we would expect them to cluster in the middle of a bell-shaped distribution. That tendency has been seen in the past in the broadcasting industry, when the number of television stations permitted in a given geographical area was strictly regulated by the Federal Communications Commission. Not surprisingly, stations carried programs that appealed predominantly to a mass audience—that is, to the middle of the distribution of television watchers. The Public Broadcasting System, PBS, was organized by the government partly to provide programs with less than mass appeal to satisfy viewers on the outer sections of the curve. When cable television emerged and programs became more varied, the prior justification for PBS subsidies became more debatable.
Even with free market entry, product variety depends on the cost of production and the prices people will pay for variations. Magazine and newsstand operators would behave very much like past television managers if they could carry only two or three magazines. They would choose Newsweek or some other magazine that appeals to the largest number of people. Most motel operators, for instance, have room for only a very small newsstand, and so they tend to carry the mass-circulation weeklies and monthlies.
For their own reasons, consumers may also prefer such a compromise. Although they may desire a product that perfectly reflects their tastes, they may buy a product that is not perfectly suitable if they can get it at a lower price. Producers can offer such a product at a lower price because of the economies of scale gained from selling to a large market. For example, most students take pre-designed classes in large lecture halls instead of private tutorials. They do so largely because the mass lecture, although perhaps less effective, is substantially cheaper than tutorials. In a market that is open to entry, producers will take advantage of such opportunities.
If producers in one part of a distribution attempt to charge a higher price than necessary, other producers can move into that segment of the market and push the price down; or consumers can switch to other products. In this way, an optimal variety of products will eventually emerge in a free, reasonably competitive market. Thus the argument for a free market is an argument for the optimal product mix. Without freedom of entry, we cannot tell whether it is possible to improve on the existing combination of products. A free, competitive market gives rival firms a chance to better that combination. The case for the free market becomes even stronger when we recognize that market conditions—and therefore the optimal product mix—are constantly changing.

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Economics

noreply@blogger.com ([Admin]) — Tue, 14 Apr 2009 17:11:00 +0000

The discipline of economics is divided into two main parts—microeconomics and macroeconomics. As the term micro (as in microscope) suggests, microeconomics is the study of the individual markets—for corn, records, books, and so forth—that operate within the broad national economy. When economists measure, explain, and predict the demand for specific products such as bicycles and hand calculators, they are dealing with
microeconomics. Much of the work of economists is concerned with microeconomic analysis—that is, with the interpretation of events in the marketplace and of personal choices among products. This book, which has been designed with MBA students in mind, will deal almost exclusively with microeconomic theory, policy implications, and applications inside firms.
Questions of interest to microeconomists include:
What determines the price of particular goods and services?
What determines the output of particular firms and industries?
What determines the wages workers receive? The interest rates lenders receive? The profits businesses receive?
How do government policies—such as minimum wage laws, price controls, tariffs, and excise taxes—affect the price and output levels of individual markets?
Why do incentives matter inside firms and how can economic theory be used to properly structure a firm’s incentives to increase worker productivity and firm profitability?
Economists are also interested in measuring, explaining, and predicting the performance of the economic system itself. To do so, they study broad subdivisions of the economy, such as the total output of all firms that produce goods and services. Macroeconomics is the study of the national economy as a whole or of its major components. It deals with the “big picture,” not the details, of the nation’s economic activity.
Instead of concentrating on how many bicycles or hand calculators are sold, macroeconomists watch how many good and services consumers purchase in total or how much money all producers spend on new plants and equipment. Instead of tracking the price of a particular good in a particular market, macroeconomics monitors the general price level or average of all pric es. Instead of focusing on the wage rate and the number of people employed as plumbers or engineers, macroeconomists study incomes of all employees and the total number of people employed throughout the economy. In short, macroeconomics involves the study of national production, unemployment, and inflation. For that reason it is often referred to as aggregate economics.
Typical macroeconomic questions include:
What determines the general price level? The rate of inflation? What determines national income and production levels? What determines national employment and unemployment levels? What effects do government monetary and budgetary policies have on the general
price, income, production, employment, and unemployment levels?
These and similar questions are of more than academic interest. The theories that have been developed to answer them can be applied to problems and issues of the real world. They clearly have application to business, given that firm sales are often affected by “macro variables” such as national income and the inflation rate. Throughout this
book, as well as in specific chapters on topics such as regulation and deregulation, and price controls and consumer protection, we will examine the practical applications of economic theory.
However, we hasten to add that this book and course are devoted primarily to “microeconomic” theory and applications. We make microeconomics our focus because the issues at stake are more relevant to the interests of MBA students and because the microeconomic theory is generally viewed as being sounder than macroeconomic theory. Besides, we are firmly convinced that an understanding of the “macroeconomy” is necessarily dependent on an understanding of the “microeconomy.”
In microeconomics we start with the proposition that all actions are constrained by the fact of scarcity. That is to say, in some basic way, scarcity—and the economic question of how to deal with it—touches all of us in how we do business and conduct our lives. We now turn to a study of property rights. Private “property rights” are one of the institutional mechanisms people have devised to help alleviate the pressing constraints of scarcity, which is why we take them up at this early stage in the course.
The Meaning and Importance of Property Rights
Property rights pertain to the permissible use of resources, goods, and services; they define the limits of social behavior and, in that way, determine what can be done by individuals in society. They also specify whether resources, goods, and services are to be used privately or collectively by the state or any smaller group.
Property rights are a social phenomenon; they arise out of the necessity for individuals to “get along” within a social space in which all wish to move and interact. Where individuals are isolated from one another by natural barriers or are located where goods and resources are abundant, property rights have no meaning. In the world of Robinson Crusoe, shipwrecked alone on an island, property rights were inconsequential. His behavior was restricted by the resources found on the island, the tools he was able to take from the ship, and his own ingenuity. He had a problem of efficiently allocating his time within these constraints—procuring food, building shelter, and plotting his escape; however, the notion of “property” did not restrict his behavior—it was not a barrier to what he could do. He was able to take from the shipwreck, with immunity, stores that he thought would be most useful to his purposes.5
After the arrival of Friday, the native whom Robinson Crusoe saved from cannibals, a problem of restricting and ordering interpersonal behavior immediately emerged. The problem was particularly acute for Crusoe because Friday, prior to coming to Tibago, was himself a cannibal. (Each had to clearly establish property rights to his body.) The system that they worked out was a simple one, not markedly different from
5 The absence of human beings affected also his idea of what was useful. Crusoe, in going through the ship, came across a coffer of gold and silver coins: “Thou art not worth to me, no, not taking off the ground; one of these knives is worth all this heap [of gold].” At first, he evaluated the cost of taking the coins in terms of what he could take in their place and decided to leave them. But on second thought, perhaps taking into consideration the probability of being rescued, he took the coins with him! See Robinson Crusoe by Daniel Defoe.
that between Crusoe and “Dog.” Crusoe essentially owned everything. Their relationship was that of master and servant, Crusoe dictating to Friday how the property was to be used.
The notion of property rights is broadly conceived by economists. Property rights are most often applied to discussions of real estate and personal property (bicycles, clothes, etc.); they are also applicable to what people can do with their minds, their ability to speak, how they wear their hair, and if and when they must wear their shoes.
In common speech, we frequently speak of someone owning this land, that house, or these bonds. This conventional style undoubtedly is economical from the viewpoint of quick communications, but it masks the variety and complexity of the ownership relationship. What is owned are rights to use resources, including one’s body and mind, and these rights are always circumscribed, often by prohibition of certain actions. To “own land” usually means to have the right to till (or not to till) the soil, to mine the soil, to offer those rights for sale, etc., but not to have the right to throw soil at a passerby, to use it to change the course of a stream, or to force someone to buy it. What are owned are socially recognized rights of action. 6
Property rights are not necessarily distributed equally, meaning that people do not always have the same rights to use the same resources. Students may have the right to use their voices (i.e., a resource) to speak with friends in casual conversation in the hallways of classroom buildings, but they do not, generally speaking, have the right to disrupt an English class with a harangue on their political views. However, the English professor, although his behavior is circumscribed, has the right to “allow” his or her political views to filter into the English lectures. And if the President of the United States walked into the same English class and began speaking extemporaneously on his (or her) political views, it is not likely that anyone would object. A person has the right to go without shoes on a beach, but one does not always have the right to enter a restaurant without shoes. On the other hand, the restaurant owner’s best friend may have that right. By the same token, although undergraduate students generally pay a fraction of their educational expenses at state universities, they have the right to university facilities such as tennis courts and the university bookstore, but nonstudent taxpayers do not have the same rights to these facilities.
In other words, property rights can be recast in terms of the behavioral rules, which effectively limit and restrict our behavior. Behavioral rules determine what rights we have with regard to the use of resources, goods, and services. The rights we have may be the product of the legislative process and may be enforced by a third party: usually the third party is the government or, more properly, the agents of government. In this case property rights emerge from laws.
On the other hand, rules that establish rights may not have third-party enforcement. In this case they carry weight in the decisions of individuals simply because individuals recognize and respect behavioral limits for themselves and others. They may do this because of the value they attach to “living up” to their contractual agreements, which may be implied in their associations with others, and because their
6 Armen A. Alchian and Harold Demsetz, “The Property Rights Paradigm,” Journal of Economic History, vol. 33, p. 17, March 1973.
own rights may be violated if they violate the rights of others. Two neighbors may implicitly agree to certain modes of behavior, such as not mowing their lawns on Sunday mornings or playing their stereo equipment late at night.7 Their behavior may be in recognition of what it means to be a “good neighbor” and of what life can be like if limits to their behavior are not observed. The neighbor who starts his mower early Sunday morning may hear music late at night or may find his rights invaded in other ways. More will be said on this, but for now we mean only to point out that the behavior of each through “offensive and counteroffensive” maneuvers may deteriorate into a state in which both parties are worse off than they would have been if restrictions on their own behavior were commonly observed. From this we see the bases for behavioral rules or, what amounts to the same thing, property rights.
Property rights are important to any inquiry of social order because it is on the basis of such rights that the terms individual and state are given social meaning, that actions are delimited, and that a specific social order will emerge. The existing property rights structure is predicated upon specific social and physical conditions. Changes in those conditions can cause a readjustment in the nature of social order.
Property Rights and the Market
In the private market economy people are permitted to initiate trades with one another. Indeed, when people trade, they are actually trading “rights” to goods and services or to do certain things. For example, when a person buys a house in the market, he is actually buying the right to live in the house under certain conditions, for example, as long as he does not disturb others. This market economy is predicated upon establishing patterns of private property rights; those patterns have legitimacy because of enforcement by government and, perhaps just as important, because of certain precepts regarding the limits of individual behavior that are commonly accepted and observed.8 Without recognized property rights there would be nothing to trade—no market.
How dependent are markets on government enforcement for the protection and legitimacy of private property rights? Our answer must of necessity be somewhat speculative. We know that markets existed in the “Old West” when formally instituted governments were nonexistent. Further, it is highly improbable that any government can be so pervasive in the affairs of people that it can be the arbiter of all private rights. Cases in which disputes over property rights within college dormitories are settled by student councils are relatively rare, and the disputes that end up in the dean’s office or at police headquarters are rarer still. Most conflicts over property rights are resolved at a local level, between two people, and many potential disputes do not even arise because of generally accepted behavioral limits.
Finally, the concept of property rights helps make clear the relationship between the public and private sectors of the economy—that is, between that section of the
7 This is an example used by James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975), p. 20.8 In addition, there is considerable private enforcement of property rights. Almost all people take some measures to secure their own property. They put locks on their doors, leave lights on at night, and alert their neighbors to take their newspapers in when they are out of town.
economy organized by collective action through government and that section which is organized through the actions of independent individuals. When government regulates aspects of the market, it redefines behavioral limits (in the sense that people can no longer do what they once could) and can be thought of as realigning the property rights between the private and public spheres. When the government imposes price ceilings on goods and services, as it did during the summer of 1971, it is redefining the rights that sellers have with regard to the property they sell. One of the purposes of economics is to analyze the effect that a realignment of property rights has on the efficiency of production.
Anarchy: A State of Disorder
Property rights are so much a part of our everyday experience that we are inclined to think of them as being “natural,” a part of our birthright. The Declaration of Independence speaks of “certain unalienable rights.” Indeed, it is hard to imagine a world in which people interact within a defined social space without the existence of property rights. The purpose of this section is to envision such a state in order to gain some insight into the origins of property rights and, therefore, social order.
Thomas Hobbes, a seventeenth-century political scientist philosopher, envisioned a state in which there was a complete absence of property rights, either those rights that have legitimacy because of their social acceptability or those that exist because of legal enforcement. He called this “the state of nature,” and his analysis was not very attractive. Because Hobbes gave very little credence to social acceptance as a basis for property rights, his attention was on the role of the state. He believed that “during the time men live without a common Power to keep them in awe,” every man will be pitted against another in continual struggle for dominance and protection. Life will be “solitary, poore, nasty, brutish, and short.” Where there is no state, he argued, there will be no law and therefore, “no Property ... no Mine and Thine distinct, but only that to be every man’s that he can get, and for so long as he can keep it.”9
One of Hobbes’ purposes in writing Leviathan was to justify the sovereign state as an absolutely necessary political entity. He tried to convince his contemporaries of the potential for conflict among men without the state; that it is necessary to hand over considerable political power to the state in order that internal conflicts may be minimized. He argued that it is in man’s self-interest to swear full allegiance to the state.
In order to make his argument as convincing as possible, it was somewhat natural for Hobbes to describe “the state of nature” in the worst possible terms. One can accept the criticism that Hobbes exaggerated the need for the state without ignoring a cornerstone of his argument: Without legally defined property rights, there is considerable potential for conflict among men. The life of man in the state of nature may not invariably be “solitary, poore, nasty, brutish, and short,” but it may be markedly less comfortable without property rights than with them.
9 Thomas Hobbes, Leviathan, ed. By C.B. Macpherson [Baltimore, Md.: Penguin Books, Inc., 1968 (first published 1651], pp. 185–88.
In an idealized world in which people are fully considerate of each other’s feelings and adjust and readjust their behavior to that of others without recourse to anything resembling a dividing line between “mine” and “thine,” property rights are no more necessary than they were for Robinson Crusoe alone on Tibago. But in the world as it now exists, there is the potential for conflict. Granted, the potential may not be present in all our interpersonal experiences. People have interests that, for all practical purposes, are independent of one another, and many of our interests are perfectly congruent with the interests of those around us. However, people have spheres of interests (described for two people by the circle in Figure 1.1) that extend outward from themselves and that intersect with the interests of others. A basic axiom of behavior (one to be developed in greater detail later) is that most people want more than they have, which means they have an interest in, or can benefit from, that which others have. In other words, they have competing interests—or, in terms of Figure 1.1, areas where their spheres of interests intersect. It is here that the potential for conflict arises, that a dividing line between “mine” and “thine” must be drawn.
Figure 1.1 Individuals have spheres of interest, which are illustrated, by the two circles. The intersection of the two circles represents the arc of potential conflict between two individuals; it is the area within which property rights (or behavioral limits) must be established.

Children at play provide us with a reasonably clear illustration of the absence of and potential for conflict among people in the larger community. Children can often play together for long periods of time without conflict. They each have interests that do not invade the interests of others (whic h may be described by the clear portions of the circles in Figure 1.1); for example, one may want to play with a truck, one with a bucket and shovel, and another with toy cowboys. For periods, their behavior may approximate the idealized society mentioned above. On the other hand, when two children want to play with the same toy or play the same role of mother or father in their game of “house,” or when one child wants to take over the entire sandbox, conflict is revealed, first with harsh words, possibly in fights, leading to a breakdown of their social interaction—play.
Conflict or the potential for conflict can be alleviated by the development of property rights, held either communally, by the state, or by private individuals. These rights can be established in ways that are similar but which can be conceptually distinguished: (1) voluntary acceptance of behavioral norms with no third-party enforcer, such as the police and courts, and (2) the specification of rights in a legally binding “social contract,” meaning that a third-party enforcer is established. Most of what we say for the remainder of this chapter applies to both modes of establishing rights. However, for reasons developed later in the book, the establishment of rights through voluntary
acceptance of behavioral norms, although important in itself, has distinct limitations, especially in relation to size. More specifically, many behavioral norms have a tendency to break down in large-group settings. Because most people hold to the behavioral norm that they should not pollute, and yet at least to some degree they pollute anyway, and because legal codes are filled with specifications of property rights, meaning something has failed, the limitations of behavioral norms may come as no surprise. Be that as it is, holding the discussion of voluntary behavioral rules until later in the book will permit us to narrow our attention and, perhaps, gain a deeper understanding of the basis of legal property rights. For now, let’s step back and consider in more detail the social basis for property rights.
The Emergence of Property Rights
To develop the analysis in the simplest terms possible, consider a model of two people, Fred and Harry, who live alone on an island. They have, at the start, no behavioral rules or anything else that “naturally” divides their spheres of interest. That is, they have nothing that resembles property rights. Further, being rational, they are assumed to want more than they can produce by themselves. Their social order is essentially anarchic. Each has two fundamental options for increasing his welfare: He can use his labor and other resources to produce goods and services or he can steal from his fellow man. With no social or ethical barriers restricting their behavior, they should be expected to allocate their resources between these options in the most productive way. This may mean that each should steal from the other as long as more is gained that way than through the production of goods and services.
If Fred and Harry find stealing a reasonable course to take, each will have to divert resources into protecting that which he has produced (or stolen). Presumably, their attacks and counterattacks will lead them toward a social equilibrium in which each is applying resources to predation and defense and neither finds any further movement of resources into those lines of activity profitable.10 This is not equilibrium in the sense that the state of affairs is a desirable one; in fact, it may be characterized as a “Hobbesean jungle” in which “every man is Enemy to every man.”
In an economic sense, the resources diverted into predatory and defensive behavior are wasted; they are taken away from productive processes. If these resources are applied to production, total production can rise, and both Fred and Harry can be better off—both can have more than if they try to steal from each other. It is only through winding up in a state of anarchy or seeing the potential for ending up there that they must question the rationality of continued plundering and unrestricted behavior; and it is because of the prospects of individual improvement that there exists a potential for a “social contract” that spells out legally defined property rights. Through a social contract they may agree to place restrictions on their own behavior, but they will do away with the restraints that, through predation and required defense, each imposes on the other. The fear of being attacked on the streets at night can be far more confining than laws that
10 For a rather difficult discussion of “equilibrium” under anarchy, see Winston C. Bush, “Individual Welfare in Anarchy,” in Gordon Tullock (ed.), Explorations in the Theory of Anarchy (Blacksburg, Va.: University Publications, Inc., 1972), pp. 5–8.
restrict people from attacking one another. This is what John Locke meant when he wrote, “The end of law is not to abolish or restrain but to preserve and enlarge freedom.”11
Once the benefits from the social contract are recognized, there may still be, as in the case of voluntary behavioral norms, an incentive for Fred or Harry to chisel on the contract. Fred may find that although he is “better off” materially by agreeing to property rights than he is by remaining in a state of anarchy, he may be even “better off” by violating the agreed-upon rights of the other. Through stealing, or in other ways violating Harry’s rights, Fred can redistribute the total wealth of the community toward himself.
To illustrate, consider Figure 1.2, which contains a chart or matrix of Fred and Harry’s utility (or satisfaction) levels if either respects or fails to respect the rights established for each as a part of the contract. (The actual utility levels are hypothetical but serve the purpose of illustrating a basic point.) There are four cells in the matrix, representing the four combinations of actions that Fred and Harry can take. They can both respect the agreed-upon rights of the other (cell 1), or they can both violate each other’s rights (cell 4). Alternatively, Harry can respect Fred’s rights while Fred violates Harry’s rights (cell 3), or vice versa (cell 2).
Clearly, by the utility levels indicated in cells 1 and 4, Fred and Harry are both better off by respecting each other’s rights than by violating them. However, if Harry respects Fred’s rights and Fred fails to reciprocate, Fred has a utility level of 18 utils, which is greater than he will receive in cell 1, that is, by going along with Harry and respecting the other’s rights. Harry is similarly better off if he violates Fred’s rights while Fred respects Harry’s rights: Harry has a utility level of 16, whereas he will have a utility level of 10 utils if he and Fred respect each other’s rights. The lesson to be learned: Inherent in an agreement over property rights is the possibility for each person to gain by violating the rights of the other. If both follow this course, they both will end up in cell 4, that is, back in the state of anarchy.
Seen in this light, the problem of the firm is the same as the problem of the general economy. As did Hayek, economists have argued for years that no group of government planners, no matter how intelligent and dedicated, can acquire all the localized knowledge necessary to allocate resources intelligently. The long and painful experiments with socialism and its extreme variant, communism, have confirmed that this is one argument that economists got right. But the freedom for people to use the knowledge that only they individually have has to be coupled with incentives that motivate people to use that knowledge in socially cooperative ways—meaning that the best way for individuals to pursue their own objectives is by making decisions that improve the opportunities for others to pursue their objectives. In a market economy these incentives are found primarily in the form of prices that emerge out of the rules of private property and voluntary exchange. Market prices provide the incentive people need to productively coordinate their decisions with each other, thus making it not only possible, but desirable, for people to have a large measure of freedom to make use of the localized information and know-how they have.
A perfect incentive system would assure that everyone could be given complete freedom because it would be in the interest of each to advance the interests of all. No such perfect incentive system exists, not within any firm or within any economy. In every economy there is always some appropriate mix of both market incentives and government controls that achieve the best overall results. The argument over just what the right mix is will no doubt continue indefinitely, but few deny that both incentives and controls are needed. Similarly, for any firm made up of more than one person, there is some mix of incentives and direct managerial control that best promotes the objectives of the firm; i.e., the general interests of its members.
Granted, incentives may not seem to matter much at any point in time, but even so, the power of incentives can accumulate with time. For example, suppose that without improved incentives firm profits will grow in real-dollar terms by 2 percent a year. Suppose that with more effective incentives firm profits can grow by 2.5 percent a year. The difference is not “much,” just a half of a percentage point per year. However, the compound impact of the higher growth rate will mean that after 30 years, real profits will
33F. A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960). Another problem in the management of incentives is that no set of incentives is ever perfect, nor could it be. But even if managers knew the best incentive structure and how best to implement it, a serious incentive problem would remain, What incentive should managers have to find the best set of incentives? That’s a tough but interesting question. An understanding of the structure of firms requires that we recognize the need to subject managers, as well as other employees, to the proper incentives. The need to impose the proper set of incentives on managers is also necessary for understanding firms’ financial structure. For example, the question of what combination of debt and equity instruments is best for financing a firm cannot be answered properly without a consideration of managerial incentives.

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