Category Archives: business economics

An Approach to Big-company Innovation at Amazon

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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

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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

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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.

Weakest-Link Theory

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In a review of Garett Jones’ Hive Mind, Jason Collins writes,

Jones’s argument builds on that of Michael Kremer’s classic paper, The O-Ring Theory of Economic Development. Kremer’s insight was that if production in an economy consists of many discrete tasks and failure in any one of those tasks can ruin the final output (such as an O-ring failure on a space shuttle), small differences in skills can drive large differences in output between firms.

Let us meditate on this for a while. Toss out all of your intuition based on marginal productivity theory, and instead think of a business as undertaking a set of processes, with the overall profit constrained by its weakest process. It fails if it is great at engineering but lousy at marketing, or vice-versa. A firm that has great engineering and great marketing can be done in by poor internal controls. And so on.

First, this theory helps explain why there are firms. An engineer working by himself automatically has a lousy marketing department.

Second, it may explain why we see higher pay at highly profitable firms. These are firms that know how to identify and retain high-performing workers. That includes giving their high-performing workers appropriate compensation.

If David Cutler were an Entrepreneur

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He would buy a hospital. Let me explain. The IGM forum polled economists to see if they agreed with this statement:

Long run fiscal sustainability in the US will require some combination of cuts in currently promised Medicare, Medicaid and Social Security benefits and/or tax increases that include higher taxes on households with incomes below $250,000.

Most economists agreed, as would I. However, Cutler disagreed, writing

There are ways of making the health care programs much more efficient, which would obviate the need for tax increases for some time.

He thinks he knows how to compensate health care providers more efficiently. If he were an entrepreneur, he would buy a hospital and prove his theories there. But he is a professor, so testing his theories is an all-or-nothing proposition, and we will have to pay for it.

AT&T and Time-Warner

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Tyler Cowen writes,

it is hard to see where the efficiencies from the deal are supposed to come from

That is an understatement. AT&T seems to have some combination of excess cash and ability to borrow at attractive interest rates. If I were a shareholder, I would want the company to pay me a large dividend, and then leave it up to me how much I want to invest in Time-Warner.

My guess is that the people who want to block the merger are concocting scenarios of bad behavior or excessive control that are highly implausible. However, I find scenarios in which the merger provides social benefits to be at least as implausible.

I see this sort of transaction as indicative of some sort of distortion in capital markets. One or both of those companies should have returned more cash to shareholders, and for some reason they didn’t.

The Top-Down Reformer’s Calculation Problem

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Two recent examples.

1. I was invited to attend the Progressive Policy Institute on Wednesday, but not as a speaker. The topic is introduced by saying

Now that Congress has passed the Every Student Succeeds Act (ESSA), states are revamping their federally required systems to measure school quality and hold schools accountable for performance. But most are doing so using outdated assumptions, holdovers from the Industrial Era, when cookie-cutter public schools followed orders from central headquarters and students were assigned to the closest school.

In today’s world, that is no longer the norm. We are migrating toward systems made up of diverse, fairly autonomous schools of choice, some of them operated by independent organizations, as charter, contract, or innovation schools. Before revising their measurement and accountability systems, states need to rethink their assumptions.

2. And David Cutler must be happy to read this story.

Medicare on Friday unveiled a far-reaching overhaul of how it pays doctors and other clinicians. Compensation for medical professionals will start taking into account the quality of service – not just quantity.

A Nobel Prize in economics was just awarded in part for the insight that it is a bad idea to compensate workers on factors that are heavily influenced by luck. In my view, having someone in Washington evaluate a school or a teacher or a doctor does exactly that.

People who are close to the schooling process, including parents, peers, and principals, can use judgment to evaluate teachers. That’s the way it used to work 50 years ago, before the advent of consolidated, unionized school districts.

For doctors, the prevalence of third-party payments means that their compensation is being determined by remote bureaucrats regardless.

Factor-price Non-equalization?

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A commenter wrote,

Given this definition of ‘discipline’, under what condition do you stop believing your intuition? What would you observe that would cause you to drop your belief in price-factor equalization, or, assortative mating?

Coincidentally, Josh Zumbrun writes,

Why would a company pay someone $80,000 if most people with an identical background—clones, in the paper’s parlance—earn $40,000? Conversely, why would someone with that background stay in the job earning $40,000 if another company will pay $80,000 for the same work?

The puzzle is that worker pay increases are highly correlated with the rate at which profit increases at the firms that they work.

My thoughts:

1. I tend to distrust the ability of economists to know more than a firm what the firm’s workers ought to be paid. Imagine an economist trying to tell Google that, based on your regression equation, it is paying its programmers more than the market wage. Google might reply that its programmers earn more because Google has selected better programmers.

2. The article offers the theory that firms with monopoly power will pay workers more. Perhaps, but a monopolist still has an incentive to avoid paying an above-market wage to its workers. In any case, if Google pays more because it has monopoly power, how pervasive is this? Do they pay above-market wages to janitorial staff? Above-market prices for office supplies? When Google employees travel, does Google pay more than the asking prices for hotel rooms and airline tickets?

3. Suppose that we grant that two workers who appear to be identical to someone running a regression equation are in fact identical in practice. It could be that each worker made a long-term commitment to a firm, and one chose a firm that happened to succeed and the other chose a firm that happened to fail. That might lead to factor-price non-equalization.

As you can see, I am very reluctant to let go of factor-price equalization. But if more evidence against it accumulates, I will be willing to change my mind.

However, in Specialization and Trade, I make the point at length that economic propositions are not falsifiable. If you want to stay committed to a proposition, you can. I say that economics deals with very few falsifiable hypotheses and many non-falsifiable frameworks of interpretation.

I can tell from the comments on previous posts that my position bothers some people enormously. They strongly oppose the situation as I describe it. Perhaps it will help to say that I have nothing against rigorous falsifiability in science, I just do not think it can be carried out in economics.

I hope you can appreciate that this is the situation with history. I doubt that we will ever be able to prove that wars are caused by X or that revolutions are caused by Y. Still, there are useful interpretive frameworks that tell us something about these issues.

I believe that all of the disciplines that deal with human society are going to have to live with this. If someone is really attached to their interpretive framework, it will be difficult or impossible to dissuade them. The best that one can hope is that people will not be so unreasonable as to assign 100 percent credibility to any information that supports their view and 0 percent credibility to any information that opposes it.

I think that we naturally try to fight back when one of our views is threatened, as mine are by the research cited above. The ideal would be for us to fight back when a study supports our views and be more accepting of studies that threaten our view, but it is difficult to live up to that ideal.

Why Do Firms Exist?

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Kevin Bryan writes,

A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organized as they are, why they persist over time, and why interfirm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational. Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many “resource” type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.) I believe that there are reasons why the costs of maintaining relationships – transaction costs – endogenously differ within and outside firms, and that Hart is correct is focusing our attention on how asset ownership and decision making authority affects incentives to invest, but these theories even in their most endogenous form cannot do everything we wanted a theory of the firm to accomplish. I think that somehow reputation – and hence relational contracts – must play a fundamental role, and that the nexus of conflicting incentives among agents within an organization, as described by Holmstrom, must as well. But we still lack the precise insight to clear up this muddle, and give us a straightforward explanation for why we seem to need “little Communist bureaucracies” to assist our otherwise decentralized and almost magical market system.

Read the whole post. Pointer from Tyler Cowen.

I still think that Alchian-Demsetz is the best place to start. Suppose that a bunch of computer programmers, loan officers, and bank tellers get together to start a bank. They cannot just bargain with one another on roles, responsibilities, and pay. You need a decision-maker. And that decision maker must serve a definitive owner. The owner is the “residual claimant” on the firm.

I think that this is similar to why we certain key components of infrastructure are centralized. Road systems, sanitation systems, communication wiring, and the electric grid, for example. Imagine a bunch of households get together and say, “Let’s have a road system.” They cannot just each decide to build roads in the vicinity of their homes and then bargain with one another on roles, responsibilities, and tolls to charge drivers. You need a decision-maker. etc.

I think that we know intuitively why firms exist. The challenge is to articulate that intuition.

Hart and Holmstrom win the Nobel

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1. Alex Tabarrok and Tyler Cowen (also here) have the most useful posts.

2. I was very relieved that the prize did not go to a macroeconomist. I do not see how I could write a charitable post if there is another Nobel Prize given for macro. I especially did not want to have to write a post about Bill Buckner getting into Hall of Fame.

3. On Holmstrom, Alex writes,

Suppose that you are a principal monitoring an agent who produces output. The output depends on the agent’s effort but also on noise. It wouldn’t be a very efficient contract to just reward the agent based on output since then you would mostly be responding to noise–punishing hard-working agents when the noise factors were bad and rewarding lazy agents when the noise factors were good. Not only is that unfair–if you setup a contract like this the agents will a) demand that you pay them a lot of money in the good state because they will be taking on a lot of risk that they don’t control and b) the agents won’t put in much effort anyway since their effort will tend to be overwhelmed by the noise, either good or bad. Thus, rewarding output alone gets you the worst of all worlds, you have to pay a lot and you don’t get much effort.

As I read Cosmides and Tooby, hunter-gatherers understood this. You want to let gatherers keep their output, which is not luck-driven, but you want hunters to share output, which is very dependent on luck.

Sometimes, theorists use a lot of math to come up with results that people operating in the real world have arrived at through experience. Indeed, this is a good thing, in my view. Because often the alternative is to come up with results that have no real-world relevance at all.

4. Maybe Cosmides and Tooby should get some consideration for the Nobel.