The Coordination Problem and Winner Cities

A commenter writes,

[migration of firms to small cities is inhibited by] Insufficient maturity of the coordination mechanisms – Maybe tomorrow’s equivalent of the free-state project/charter cities could be a proper linked in group where people can quite literally call out for all sorts of talent that they want in a city. This group could take over small towns or build new cities on empty land with finance coordinated with dominant assurance contracts enforced by blockchain like trustless/minimal trust mechanisms. All of these mechanisms are still immature. Maybe someday when the costs of the bay area really go up, the next big tech firm could try this.

Competing with San Francisco or New York for talented people is like trying to compete with Google in search or Facebook in social networking. In fact, it is more difficult, because the coordination problem is more subtle.

For instance, if you wanted to lure me to new city, you would need to insure that there are Israeli folk dance sessions. That requires coordinating enough dancers to move there. But prior to that, it requires that you know that this is an issue for me. And, of course, to get those dancers, you have to deal with their primary considerations, which might not be dancing.

Also, to get me to move, you need to persuade my wife. And she has her own considerations.

Established big cities have “solved” these coordination problems through a spontaneous order. You can think of them as overlapping networks of coordination. They attract Jane with a particular job opportunity, John with a particular amenity, and someone else with the opportunity to meet John and Jane.

Why American Cities Cannot Compete on Cost

Handle comments,

if a company can move some operations even 50 miles away from a high price place, then why not move them to the cheapest feasible place?

…If a job doesn’t have such distance-limitations regarding interactions with other humans, it will immediately be outsourced from high wage counties to the cheapest place.

If your company needs to plug into a specific talent pool, you want that talent pool close by. If your company can use just anyone, then the lowest-cost place to locate is not a cheap American city but an even-cheaper foreign city.

Average is Over for regional job creation

Janet Adamy writes,

in the mid-1980s, 29 metropolitan areas that contained 45% of the country’s jobs were home to half of the national increase in companies after an earlier recession.

Now look at what happened after the painful 2007-09 economic downturn. The aforementioned five metro areas [New York, Miami, Los Angeles, Houston, and Dallas] housed half of the nation’s net increase in new firms and accounted for 17% of employment between 2010 and 2014. Left behind are thousands of small towns and rural areas that stitch together much of America.

She cites a new report, Dynamism in Retreat. I recommend checking out the report, and in particular the section “How did we get here?”

I think it is important to keep in mind that this is a global phenomenon. Commenter Handle has convinced me to consider a scenario in which wealth becomes more highly concentrated in a few key cities.

In traditional economic terms, think of an economy consisting of three sectors. One sector is monopolistically competitive. A second sector is protected somewhat from competition by licensing rules. The third sector consists of new natural monopolies.

Monopolistic competition is what you see as you drive along a road with strip malls. The nail salons, restaurants, and small financial services firms operate on low profit margins, because entry is easy.

The license-protected sector is where you find medical professionals, teachers, and others where credentials are required. If you can obtain a license and you are willing to work long hours, you can make a lot of money in some of these occupations. But nothing spectacular.

The spectacular profits come from the natural monopolies. These are the software-driven firms that exploit network scale advantages.

For a would-be natural monopolist, the difference between success and failure is so dramatic that the savings that might come from setting up in a low-cost area seem trivial. Better to locate in one of the high-growth cities where the best talent can be found.

As the seekers of natural monopoly gravitate toward big cities, the licensed professionals and the monopolistic competitors follow, because that is where spending on services is high. Tax revenue is high there also, which helps to generate government jobs.

The difference between the few winning cities and the loser regions is widened by self-selection. Talented, achievement-oriented people move to the big cities, and they leave the loser regions.

Firms that Win Big

David Autor and others write,

Possible explanations for the growth of winner take most includes the diffusion of new competitive platforms (e.g. easier price/quality comparisons on the Internet), the proliferation of information-intensive goods that have high fixed and low-marginal costs (e.g., software platforms and online services), or increasing competition due to the rising international integration of product markets. New technologies may also have strengthened network effects and favored firms that are more adept at adopting and exploiting new modes of production.

The main point of their paper is that the increasing prevalence of winner-take-most firms is reducing labor’s share of income. However, other research shows that these firms pay more than other firms.

The way I see it, the intuition is that the returns to implementation of superior business methods have increased. It is hard to compete with Google in search or with Amazon in logistics. (As an aside, I wrote long ago that I thought that WalMart would wipe out Amazon, because WalMart would figure out how to build a web site before Amazon figured out logistics. That prediction turned out to be wrong.)

Think of cultural intelligence as a factor of production within a business. The firm’s owners reap most of the benefits from its cultural intelligence.

Career Guidance Question from a Reader

He writes,

I am keen to work with individuals who are exploring how technology is affecting everything – communications, cars, transport, jobs, health, education – an all-round view of the world.

What plausible career alternatives could be available to a telecommunication professional with no formal training in economics but is keen to work with economists as such?

1, Going from one standard occupational identity (telecom professional) to another (economist) is probably not the best strategy. I recommend trying to work toward a hybrid identity. It could involve economics and telecommunications. Or it could combine economics with some other interest.

2. One way to expose yourself to applied economics is to get into management consulting.

3. Venture capital firms also do a lot of applied economics. The Marc Andreessens of the world have to think about how technology is affecting everything. But I have no idea how one goes about joining the VC industry.

4. Get out more. Attend events where you think that you will meet people of the sort with whom you want to interact. To have good luck making and cultivating contacts, project a positive outlook and be a good listener. Do not expect this to come easily or to feel rewarding at first.

Price Discrimination in Service Industries

A commenter asks,

“The real world in which most businesses live is one with high fixed costs and low marginal costs.”

Is not two-thirds of the US economy services? I do not see services having the above characteristics, so are you really characterizing all sectors?

I see services as having those characteristics. The biggest service industry is health care. Why do hospitals charge $15 for a carton of orange juice? Because their prices have nothing to do with variable cost. They are trying to cover fixed cost. Doctors’ offices have the same issue.

Another major service industry is education. Why do colleges have such high list prices, and then offer discounts to those prices? Again, they are trying to cover fixed cost.

Yet another service industry is entertainment. The costs of creating a movie or covering a football game are fixed costs. The marginal cost of reaching an additional person in the audience is close to zero.

When UPS delivers a package, the marginal cost is nearly zero. They are allocating fixed cost.

If your business is financial services, the marginal cost of an additional customer is close to zero.

I have to think hard to come up with a service industry that has low fixed costs relative to marginal costs. Maybe day care, or home health care. Or haircuts.

Price Discrimination Explains Everything

Two years ago, the Executive Office of the President wrote,

Ultimately, whether differential pricing helps or harms the average consumer depends on how and where it is used. In a competitive market with transparent pricing, the benefits are likely to outweigh the costs. For example, while there is lots of differential pricing in airline ticket sales, the Internet has made it relatively easy for many travelers to compare prices and itineraries across airlines and to select the best deal for any given trip. Some studies even suggest that differential pricing can intensify competition relative to uniform pricing, by allowing high-margin sellers to compete more aggressively for price-sensitive customers who might otherwise buy from a lower-priced rival.

differential pricing seems most likely to be harmful when implemented through complex or opaque pricing schemes designed to screen out unsophisticated buyers. For example, companies may obfuscate by bundling a low product price with costly warranties or shipping fees, using “bait and switch” techniques to attract unwary customers with low advertised prices and then upselling them on different merchandise, or burying important details in the small print of complex contracts.

Pointer from Timothy Taylor.

The report’s reference to “a competitive market with transparent pricing” is disingenuous. There is little scope for price discrimination in a truly competitive market. If there are only one or two airlines flying a particular route, you can price discriminate. Not so if there were a hundred.

So get the highly competitive model out of your mind. The real world in which most businesses live is one with high fixed costs and low marginal costs. Then marginal-cost pricing is too low, while average-cost pricing is too high.

A numerical example will help. Suppose that the fixed cost is $1 million and each unit costs you $1 at the margin to produce. Think of selling a hundred thousand units, which means a total cost of $1.1 million, or an average cost of $11. If you price at marginal cost, of only $1, you fail to recover fixed cost, and you go out of business. If you price at average cost, $11, you drive away a lot of customers who are willing to pay more than your marginal cost of $1 but less than a price of $11.

If you can price discriminate, then you might charge $2 to the price-sensitive customers and $20 to the price-insensitive customers. That way, both sets of customers contribute to covering your fixed costs.

An Approach to Big-company Innovation at Amazon

Tim B. Lee writes,

At a normal company, when the CEO endorses an idea, it becomes a focus for the whole company, which is a recipe for wasting a lot of resources on ideas that don’t pan out. In contrast, Amazon creates a small team to experiment with the idea and find out if it’s viable. Bezos famously instituted the “two-pizza team” rule, which says that teams should be small enough to be fed with two pizzas.

I believe that ultimately, a big company can have only a few big projects. What is interesting about Amazon’s approach for selecting projects is that it seems to be more bottom-up than top-down. That is, lots of employees are allowed to start small projects. Presumably only a few of those succeed sufficiently well at small scale to become big projects. In contrast, Lee’s description of Google’s selection process makes it seem more top-down.

Thanks to a reader for the pointer.

Oliver Hart on Vertical Integration

He says,

if I’m Firm A, I’m acquiring control over all the non-human assets that Firm B had, which might be machines, land, buildings, but also less physical things like patents, copyrights, existing contracts that Firm B had with other firms. The name of Firm B, all sorts of things like that.

To the extent that the initial contract was incomplete, and will always be incomplete, whatever contract we write will be incomplete. Having, owning those things now means that I can get to decide how they are used to the extent that the contract was silent about that. Whereas previously, it was the owner, Firm B, that wasn’t me, who had those rights. That’s a real change. That, we would argue, is one of the key reasons that Firm A is acquiring Firm B, to get those residual control rights.

Pointer from Mark Thoma.

The whole interview is interesting. Hart shared the 2016 Nobel Prize. Of the last 10 years of Nobel Prizes, I could make a case that 6 have been awarded for the study of institutional arrangements.

2007 Hurwicz, Maskin, and Meyerson: mechanism design
2008 Krugman: agglomeration
2009 Ostrom, Williamson: governance
2012 Roth, Shapley: mechanism design
2014 Tirole: industrial organization and regulation
2016 Hart and Holmstrom

That is a notable trend, and I think it is a good one. When you focus on institutional arrangements, there is more of a tendency to say that the economist’s first challenge is to understand how things operate in the real world. A lot of other areas of focus tend to find the economist creating a hammer (a particular mathematical technique, or a model that is fun to work with) and looking around for nails in the real world that may or may not exist.

Accountability and the Administrative State

On Thursday, I attended an event at Cato where the authors of a new book, What Washington Gets Wrong, presented some of their findings. They had the cute idea of doing an opinion survey of Washington insiders, to find out what they think about the public and to find out how well the insiders’ views correlate with those of the outsiders. I purchased the book and at some point I will check out its contents. Meanwhile, I found myself more stimulated by a conversation I had afterward with Cato’s Mark Calabria, who has experience as a Senate aide.

What Mark believes, and it sounds right to me, is that we have the Administrative State (in which unaccountable and un-elected bureaucrats make important decisions) because Congress wants it that way. For Congress, making the actual policy decisions has more down side than up side. Constituents whose families or businesses are adversely affected will cause a lot of trouble.

Thus, the Administrative State is an adaptation that emerged with the purpose of moving decisions away from a body that is relatively responsive to the people (Congress). You may not like it, but there it is.

There may even be reasons to believe that this adaptation is a feature rather than a bug. That is, you might want decisions to be made by people who have expertise and who are focused on the general interest rather than the particular interests of constituents. This was the view offered by a (non-libertarian) guest speaker at the Cato event.

If what you want is an organization that is accountable to its constituency, then I would argue that you want is a market process rather than a government process. While the government process adapts to diffuse accountability, the market process forces businesses to be accountable to their customers.

In the 1980s and 1990s, many American businesses discovered that their bureaucracies were undermining the firm’s responsiveness to its customers. Under competitive pressure, businesses reformed by adopting “business process re-engineering” and other management tools to ensure a better customer experience. Prior to this wave of reform, a customer’s problems would get buried in the corporate bureaucracy, with no one taking responsibility for finding a solution. Following these reforms, customers encountered businesses that were capable of solving problems, and better yet, anticipating the customer’s wants and avoiding causing problems in he first place.

Government agencies are capable of making these sorts of organizational changes. The guest speaker cited the passport office of the State Department as having become much more responsive in recent years. In side conversations afterward, a couple of Cato folks admitted that the infamous Department of Motor Vehicles in DC is better than it was twenty years ago. But I think you get improvement more rapidly and more reliably when there is market competition.