Category Archives: business economics

The Alleged Problem of Crony Capitalism

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This commenter is not buying it.

It exists in some industries but it’s swamped by other factors, which creates the high turnover among the Fortune 500. Name an industry outside of healthcare or utilities that is “crony capitalist.” Technology? Retail? It’s hard to name an industry. You could name banking but remember that the ROE at Citi and Bank of America is in single digits. Goldman Sachs isn’t doing much better. A good example of crony capitalism is the mutual fund industry, which benefits from the complexity and limited selection of corporate 401k and IRA plans. But even the asset management industry is being decimated by Vanguard. Overall, the ROE for most of corporate America is around 10-12%, and that’s been true for a long time. It’s been going up recently but mostly due to the effect of low-capital technology firms like Google and Apple, which are not crony capitalist. So my argument is, name a crony capitalist outside of healthcare. It’s hard to do.

My thoughts:

1. I am sympathetic to some of his other comments on the same post, where he argues that right-of-center groups are using the crusade against crony capitalism as a positioning tool. I have never bought into the idea of making that crusade a focal point.

2. It is possible that the forces of market competition tend to win out in the long run, in spite of attempts at government interference. Ray Kurzweil used to say that about government regulation of technology–that regulations were merely stones in the river and the river just rolled over them.

3. Citibank is a dubious example. Without cronyism, I don’t think Citi would have a single digit ROE. I think it would have gone under.

4. If Goldman Sachs is not doing well, it is not for lack of government help. GS was the main beneficiary of the AIG bailout intervention.

5. Although creative destruction still exists, there are many indicators that its pace has been slowing down. See Tyler Cowen’s The Complacent Class.

6. For me, the poster child of crony capitalism is cable TV. From its very inception, it was a corrupt bargain between local governments and the cable companies. A lot of telecom in general is crony capitalist, as can be seen by the large lobbying expenses of the main players. If your measure of competition is firms going under, then telecom seems more cronyist now than it did twenty years ago.

7. If your measure of croynism is lobbying expenses, then the big industries include health care, finance, and housing. Energy is up there. Education is surprisingly big, considering that we think of it as mostly non-profit.

8. If your measure of cronyism is absence of creative destruction among the industry leaders, then higher education should be top of the list.

Labor’s “share” in a Garett Jones World

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Timothy Taylor looks at an article on the secular decline in labor’s share of income, and he concludes

These explanations all have some plausibility, but it isn’t clear to me that, taken together, they adequately explain the fall of more than four percentage points in labor share in the decade or so from the early 2000s (roughly 61%) to the years right after the Great Recession (just above 56%). The labor share does show some sign of rebounding in the last couple of year, and it will be interesting to see whether that turns out to be true bounce-back or a damp squib.

“Labor’s share” is one of those macro-Marxist concepts that I distrust. It ignores the heterogeneity of labor. Some workers have few skills. Others have highly marketable skills. It ignores heterogeneity of capital. But perhaps even more important, it ignores the fact that most of us are Garett Jones workers, who do not produce output but instead produce organizational capital.

As an example of a firm with a high labor “share,” consider a 1990s dotcom, which has lots of dreams but little revenue. For many of the dotcom darlings, labor’s share was way over 100 percent, and hence they went bust. Those that survived are now living off the organizational capital that they developed back in the day, which could make for a low labor share today.

In some (many?) firms, the labor share is arbitrary. For example, my guess is that as of now the “labor share” at Google is low, because the organizational capital that it built up during its first decade of existence is very valuable relative to the necessary labor input to keep it running. But Google has a lot of leeway. The more it invests today in organizational capital (research into driverless cars and such), the higher will be its (current) labor’s share. The more it just sticks to its existing business and trims workers in the research areas, the lower will be its labor’s share.

The Coordination Problem and Winner Cities

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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

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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

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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

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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

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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

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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

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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.