Category Archives: business economics

Corporate Cash Hoards

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James Surowiecki writes,

Together, Google, Apple, and Microsoft have roughly a quarter of the cash reserves in the entire S&P 500. Google, the most active buyer, has averaged one acquisition a month. Acquisitions have become increasingly important as a way to gain new technology and new engineering talent, expand into new markets or new product areas, and in some cases squelch potential competition. And since no competitor has the resources to outbid the Big Five, it’s another way in which simply being big makes it easier to keep getting bigger.

My inclination is to doubt that having a cash hoard and making acquisitions is a durable advantage. If you cannot wring more value out of a company you buy, then you should not buy it.

But the big gorillas do affect the business environment. For a start-up in some particular category, it feels as if you are in a tournament, with the winner bought by Google or Facebook, and the losers going out of business. And you could be in some objective sense the best company in the tournament, but if Google picks someone else, you still lose.

High Fixed Costs and Public Goods

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The June 2017 issue of Cato Unbound looks at how the private sector could provide public goods. It considers the idea of what Alex Tabarrok calls a Dominant Assurance Contract.

Alex writes,

The dominant assurance contract adds a simple twist to the crowdfunding contract. An entrepreneur commits to produce a valuable public good if and only if enough people donate, but if not enough donate, the entrepreneur commits not just to return the donor’s funds but to give each donor a refund bonus. To see how this solves the public good problem consider the simplest case. Suppose that there is a public good worth $100 to each of 10 people. The cost of the public good is $800. If each person paid $80, they all would be better off. Each person, however, may choose not to donate, perhaps because they think others will not donate, or perhaps because they think that they can free ride.

Now consider a dominant assurance contract. An entrepreneur agrees to produce the public good if and only if each of 10 people pay $80. If fewer than 10 people donate, the contract is said to fail and the entrepreneur agrees to give a refund bonus of $5 to each of the donors. Now imagine that potential donor A thinks that potential donor B will not donate. In that case, it makes sense for A to donate, because by doing so he will earn $5 at no cost. Thus any donor who thinks that the contract will fail has an incentive to donate. Doing so earns free money. As a result, it cannot be an equilibrium for more than one person to fail to donate. We have only one more point to consider. What if donor A thinks that every other donor will donate? In this case, A knows that if he donates he won’t get the refund bonus, since the contract will succeed. But he also knows that if he doesn’t donate he won’t get anything, but if does donate he will pay $80 and get a public good which is worth $100 to him, for a net gain of $20. Thus, A always has an incentive to donate. If others do not donate, he earns free money. If others do donate, he gets the value of the public good. Thus donating is a win-win, and the public good problem is solved.

I think of a public good as a special case of a more general problem, which is that it is often the case that average cost exceeds marginal cost. In fact, one of my main complaints about courses in basic microeconomics is that they focus on the opposite situation where marginal cost exceeds average cost, which is is not so often observed in reality.

For example, if you are building a cell phone network, the fixed cost of the infrastructure will be high. However, once you have the infrastructure, the marginal cost of transmitting a gigabyte of data will be low. If you charge this low marginal cost, you will never recover your fixed cost. Instead, you need customers to “donate” to pay for the infrastructure. The “donation” comes in the form of a monthly subscription fee.

In a typical cell phone pricing model, the charge for using data is zero until you reach your limit, and then it is ridiculously high. This model helps facilitate price discrimination. You pay a higher subscription fee to be in a higher data tier, meaning that you face the zero price at higher levels of data usage. Price discrimination of this sort helps the cell phone company recover fixed cost while making sure that most customers are charged low marginal costs most of the time.

The cell phone company has the ability to exclude non-subscribers from getting its service. With a public good, such as national defense, you no longer can exclude particular individuals. Either everybody gets it, or nobody gets it. Call this the non-excludability property.

Note: The textbook definition of a public good is one that is non-excludable and non-rivalrous. What I am suggesting here is any good that has very low marginal cost is “pretty close to” non-rivalrous. These “pretty close to” non-rivalrous situations are very common. {And with the Internet, they become more common. As maps turned into Google Maps, the marginal cost of producing a tryptich plummeted. As travel agents became TripAdvisor, the marginal cost of vacation planning services plummeted. etc.] Those that are also non-excludable, and therefore meet the textbook definition of public goods, are less common.

Governments, like private firms, can and do use price discrimination and bundling to cover fixed costs. People pay different tax amounts. People receive bundles of services–you pay for trash collection and government schools, even if you desire one but not the other.

Non-excludability is a different issue. Governments typically solve the problem of non-excludability by using coercion–you are forced to “donate.” Coercion produces the “everybody gets it” outcome instead of the “nobody gets it” outcome.

Alex’s contract is an alternative to coercion. The idea is that a typical consumer will receive a small benefit in the “nobody gets it” outcome, but only if that consumer is willing to donate. With the “everybody gets it” outcome, the consumer gets a benefit above that consumer’s willingness to pay. That is the sense in which either outcome is a win for a consumer who is willing to donate, so that it is in the consumer’s interest to be willing to donate.

My problem is that I cannot see a way to combine Alex’s contract with price discrimination and bundling. And I think that price discrimination and bundling are very important for funding government in practice.

Google and Bell Labs

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A commenter writes,

What Google et al are doing is a lot like the Bell Labs of old. Just as AT&T’s monopoly profits paid for a lot of research of uncertain short term direct value to Ma Bell, the Internet bigs have poured a lot of money into side projects that may not actually be profitable, but the core business prints so much money that investors aren’t inclined to ask too many questions.

In hindsight, we owe a lot to Bell Labs and Xerox PARC. Maybe in twenty years the effect of research projects at Google and Amazon will be just as significant.

Creative destruction and the shopping mall

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The LA Times reports,

Between 20% and 25% of the nation’s shopping malls will close in the next five years, according to a new report from Credit Suisse that predicts e-commerce will continue to pull shoppers away from bricks-and-mortar retailers.

I have remarked before that when I was young, a shopping mall’s revenue came from its stores, but today, the revenue seems to be in the food court.

The brick-and-mortar grocery industry is still expanding (at least in our area), and restaurants seem to be doing well. I wonder at what point Amazon fill find a way to go after those businesses.

The make-or-buy decision with respect to human capital

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From a National Academy of Sciences report:

As long-term employment becomes less common, new ways of providing for health care and pensions for all workers need to be considered that transcend their relationships with particular employers. For example, one option would be to institute portable pension plans administered by membership organizations dedicated to the well-being of their members.

Pointer from Timothy Taylor, who includes this quote from the report:

Many employers are increasingly viewing their relationship with employees as a short-term commitment rather than a lifelong investment. As Manpower Group CEO Jonas Prising recently put it, `Employers have gone from being builders of talent to consumers of work.’

Note, however, that this supposed decrease in the share of long-term relationships between employers and employees is not so evident in the data.

Still, I think that the trend is toward firms making more and more use of generic software. (I predicted this almost twenty years ago.) In fact, software-development specialists make more and more use of generic software.

Gary Becker developed the distinction between specific human capital, which is tied to a particular firm, and generic human capital, which can be used anywhere. The more that firms outsource non-core functions and make use of generic software the less they need to invest in specific human capital. Thus, they will tend to do less talent-building and act more like “consumers of work.”

Wal-Mart and Banking, Once Again

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Lawrence J. White writes,

it is exactly this demographic group—low- and moderate-income households—that is most in need of reasonably priced financial services. The percentage of U.S. households that are unbanked (i.e., do not have a bank account) or underbanked (i.e., have an account but rely on non-bank providers for some financial services and products) has been a longstanding policy concern. The most recent data (from a FDIC report that covers 2015) in this regard—based on a survey of more than 36,000 households nationwide—show that 7% of all households were unbanked and an additional 20% of all households were underbanked. Unsurprisingly, the percentages are substantially larger for low- and moderate-income households

Pointer from Mark Thoma. I wonder, though, whether Wal-Mart really has an advantage in serving these households as a bank. It is one thing to develop a great logistical system for moving products from far-flung suppliers to stores. It is another thing to deliver financial services to people with relatively low transaction sizes and more difficulty avoiding default.

Interfirm Inequality

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Timothy Taylor writes,

a rise in between-firm inequality suggests that the US and other leading economies are becoming a more economically segregated, in the sense that those with high pay and those with lower pay are becoming less likely to have the same employer. It means that the classic “American dream” success story, of someone being hired in the mailroom or as a secretary or janitor, and then getting promoted up the company ladder, is less likely to occur. Nowadays, those jobs in the mailroom or the secretarial pool or the janitorial work are more likely to involve working for an outside contractor. In that sense, some of the rungs on the bottom of the ladder of success have been sawed off.

My thoughts:

1. Perhaps there has been an increase in specialization and a decline in substitutability in labor. In the 1950s, there were a lot of good jobs around that anyone could be trained to do. Today, most of the good jobs require that you have a strong mix of training and credentials to get started. George Romney (Mitt’s father) rose through the ranks at a large automobile company. Today, his lack of formal training would make that impossible.

Note that if there has not been a decline in substitutability, then one is probably going to have a very difficult time explaining this “segregation” phenomenon using strictly economic analysis.

2. Perhaps the phenomenon can be explained in part by Tyler Cowen’s “matching” story. Even among people with equal levels of formal training, perhaps the strongest firms have gotten better at finding the workers with the greatest intangible strengths. Perhaps the ability to match in that way is what makes the strongest firms strong and what enables workers with great intangible strengths to get rewarded.

3. Perhaps what is needed and rewarded in today’s workplace is the ability to work adaptively in teams. That makes organizational culture a key determinant of success. A firm with a better organizational culture can maintain a large advantage over other firms. Such a firm can hire better workers and also reward them better.

4. Speaking of “culture matters,” I recommend Scott Sumner’s post on two Michigan cities.

Let me Complain

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about this reported study, which

found that the employees who complained about work were pretty bummed out as a result. In diary entries, they reported feeling crummy and dissatisfied with their work.

The study makes it sound as if the causal variable is how much you complain, and that more complaining leads to more misery. I can think of some alternatives.

1. The causal variable could be something about your job. If you have a bad relationship with your boss, you will have reason to complain and you will be unhappy.

2. The causal variable could be something about you. When I used to hire people, I was convinced that the easiest way to know that Joe will be a malcontent if I hire him is if he is a malcontent in the job that he would leave to come to work for me. In my hiring interview, I would always ask the applicants what they liked and did not like about their most recent job. If they put most of the emphasis on what they disliked, then that was a red flag.

My point here is that the methods of the study leave me doubtful about the inferences that were drawn. Particularly because I am a big believer in (2), that some people are intrinsically less happy than others.

Improving Government Operations 2: Re-organization

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One way to improve government operations would be through re-organization. I once wrote,

the total number of executive entities is 157. I cannot think of any corporation in which the CEO has so many direct reports. This number ought to be fewer than ten.

I proposed consolidation. Ideally, this would be done through legislation. However, if Congress balks, the President could informally choose to make some Cabinet officials and agency heads subordinate to others. My ideas for agencies:

1. Defense. With NSA and CIA incorporated into it. In today’s world, intelligence is as important as any branch of the military.

2. State Department.

3. Financial Operations. This would include Treasury and OMB and would administer Social Security, Medicare, and all government financial guarantee programs.

4. Infrastructure. This would include the electric grid and communications spectrum

5. Economic opportunity. Attempt to coordinate and rationalize all of the many means-tested government transfer programs. Maybe someone would figure out that a Basic Income Grant would be less bad than what we have now.

6. Science and Statistics. Some functions of Commerce, Labor, and Agriculture go here. Many of their other functions disappear.

7. Consumer safety. This would include consumer protection in the financial arena.

8. Homeland Security. Smaller than it is now, with more resemblance to the old FBI.

Improving Government Operations 1: Task Forces vs. Agencies

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The WaPo reported,

President Trump plans to unveil a new White House office on Monday with sweeping authority to overhaul the federal bureaucracy and fulfill key campaign promises — such as reforming care for veterans and fighting opioid addiction — by harvesting ideas from the business world and, potentially, privatizing some government functions.

For a government agency, the incentives are perverse. Problems generate rewards, and solutions don’t. I once wrote,

In a government agency, each worker is paid more the longer the problem persists. In contrast, no one gets paid to work on an IETF task force. Instead, businesses and universities lend experts to work with the IETF. This represents a cost to the employers and perhaps also to the employees, who are kept from research or other activities that could advance their careers. Everyone involved in the process has an incentive to get the problem solved as expeditiously as possible.

An IETF is an Internet Engineering Task Force. My recommendation is to create temporary task forces to solve problems. Meanwhile, shrink agencies whose natural interest is in perpetuating problems.