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I suppose the origin of this particular column came from a rather comical conversation held over dinner.  My wife mentioned that her father used to tease a cook he knew about her efforts in the kitchen. Her father contended that cook’s efforts were proof that Marxism was wrong about the value of a thing made in the economy.  According to Marxism, the value of any object is determined by the total amount of labor required to make it.

The cook would select a great recipe for the main course, would purchase the finest ingredients, and would labor long and diligently over the preparation.  Of course, the meal would often be a great disappointment and, sometimes nearly inedible.  Any restaurant serving such a dish would soon go out of business.

The inverse situation also occurs.  There seems to be many instances were by accident, an entrepreneur just happens to ‘catch lightning in a bottle’.  A simple idea brought to market with minimal effort makes a fortune for its owner.  If you are thinking about the pet rock then you are reading my mind.

A very comic example of this latter situation occurs in the original movie version of the Producers, where Max Bialystock moans:

So what to make of this Marxist idea?  How much truth is there in the idea that if it took twice the amount of effort to grow one type of crop, say a bushel of wheat, as it did to grow another, say a bushel of corn, then the bushel of wheat holds twice the value as the bushel of corn.

Oddly enough the idea originated well before Marx, with roots being traced back to the philosophical works of the Middle Ages.  Thomas Aquinas is credited for noting in his Summa Theologica that:

This concept also shows up in the classical school of economics.  It was touched on by Adam Smith in his Wealth of Nations but it doesn’t seem that Smith actually embraced the idea as being applicable for anything more than the most primitive of societies (or rude societies as he put it).

Other classical economists, for example Ricardo, held more broadly to this concept making it part of their structure for economics.  Although even then, there were doubts about the universality of this idea. The labor theory of value was embraced by Marx as an important and operative principle but it seems clear that the notion, with no additional provisos, is untenable.  The notion that the buyer in the transaction has no place in determining the value of the thing being purchased is short-sighted and laughable.

Perhaps the best illustration of how much of value lies in the eyes of the customer is the following passage from Chesterton’s The Queer Feet:

If the labor theory of value is not a viable approach for determining value, what is?  That is a question that occupies a great deal of economic discussion even until today and there is no universally held belief.  Mainstream economists do lean toward the idea that free trade best uncovers the value of a good or service because in the free market the value of the thing will be determined best by the currency that will be offered to purchase it.

As a result, trade is actually seen as the mechanism by which value is created or imparted to a good or service.  Free trading allows for the assessment of value by letting lots of people ‘vote’ on the value.  To paraphrase Churchill, this economic democracy is the worst form of finding value except all the others that have been tried.

Please pass me the pet rock.

There has been a lot of recent buzz centering on the fear that certain segments of the population have about genetically modified organisms or GMOs.  These apprehensions are a part of an ever-growing concern that people around the world have in the way that their food is produced and how healthful said food might be.  Concerns over GMOs rank up there with the movement to have free range livestock and organically grown foods.  So what does all this biological science have to do with a blog on economics you might ask.  Well, simply put, everything.

At its core, economics is the study what goods and services society produces where, when, and how; who produces it; and who consumes it.  Sometimes, it even ventures a guess as to why but that question is broached far less often than at first it may appear.  Since the production of goods and services happen in the faces of finite resources and perpetual scarcity there is always a downside to every decision.  If resources are being spent one way they are not being spent on something else.

So of course, the decision to embrace GMOs fully, partially, or not at all is, at its core, a decision about how resources will be spent to satisfy on of the most basic human needs – the need to eat.

Identifying the particular risks of using GMOs is the province of a host of people, including the biologist, the botanist, the farmer, the food distributor, the politician, and so on.  Once the risks have been listed, the weighing of these risks is purely economics and is the province of us all.

However, it is hard to properly weigh the risks when a twofold set of errors is in play as it seems to be now.  The first error is one of emotional rather than rational thinking.  The second is the lack of vision is seeing the lost opportunity or unseen costs of choosing one over the other.

I mention these errors because there is mounting evidence that the developed countries are so mired in a dread of the GMO-monster that they are consigning millions of people in the developing world to avoidable chronic hunger, malnutrition, or death.

Emotional Thinking

The first of these errors, the indulgence in emotional thinking, seems to be gaining ground in many of the modern debates.  Within the past decade, there has been a rise in trendy, boutique causes where the passion is profound but the logic is scarce.  A familiar example is the movement in certain circles to avoid vaccinating a child due to the fear that the vaccinations cause autism.  There isn’t strong evidence to support this conclusion but that doesn’t stop certain people from engaging in emotional attacks against those who honestly disagree with this conclusion.

Advertisers and marketers are eager to fan the flames of emotionalism if it helps sell a product and one such case is the recent switch by Chipotle to ‘non-GMO ingredients’.  Chipotle’s website presents a slick picture

with catchy little lead-in phrase (G-M-Over It) and a short paragraph extoling the companies conscientious “Farewell” to GMOs.  Following the ‘Learn More’ link leads to an equally emotion-filled excerpt:

But if the reader were to persist in reviewing the reasons why Chipotle is saying “Farewell” to GMOs that reader would find a lot of far less emotionally-laden and circumspect words.  Buried in the ‘fine print’, are phrases like “we don’t believe the scientific community has reached a consensus” and “we believe it is prudent to take a cautious approach to GMOs”.  Even further in, Chipotle admits that while it is now shunning GMO plants, it has not eliminated GMOs from its supply chain.

So how much of a “Farewell” can they have made?  It seem more likely that this new campaign to eliminate GMOs (or appear to be doing so) is not designed to protect customers from their dangers as much as it is to boost the flagging stock price of company, which has been on a downward trend since February of this year.

Lost Opportunities to Eat

If this emotionalism were simply fueling an advertising campaign to separate consumers from their money, then one might argue that this it is a victimless crime with no real repercussions.  But in world with limited resources, there are significant lost opportunity costs.

One unseen cost is that the use of land, livestock, and crop resources at less than peak efficiency means that less food is being produced than otherwise would be.  That would be okay if there were plenty of food – that is to say the supply of food matched the demand.  In that case, there would be no incentive to raise production and no pressure for prices to rise.  Such is the long term trend in the US (although food prices have been rising recently and it may be that the bottom has been reached) but is not the case in the developing world.

The Genetic Literacy Project recently published an article by Michael Dzakovich that points out fears over GMOs have prevented their use in Africa.

Mr Dzakovich provides a vivid picture of the unseen costs of slow adoption of GMOs when he writes

Other articles on the Genetic Literacy site suggest that GMOs may help reduce carbon emissions and lower toxic pesticide use.

Clearly there are pros and cons in adopting wide-spread use of GMOs and the risks and the benefits need to be carefully considered.  But emotional arguments and slick advertising campaigns only serve to further hide and obscure the lost opportunity costs and people may be unnecessarily dying as a result.

Yes, dear reader, the title of this article is not a misprint.  I am advocating that we take one US city and level it.  Think of all the economic activity that will result as the country bends its time and resources to rebuilding the city.

Now, to be sure, I don’t mean that we do this unannounced and without warning.  There could be a national lottery wherein one city, chosen at random, would be slated for total demolition.  The citizens would be given ample time to pack up their belongings, family pets, and the like.  Spaces for them in nearby cities and suburbs would be secured where these lucky ones wait until their new homes are ready.  Once the city was cleared, a bomber could fly overhead and drop a small nuclear weapon onto the heart of the downtown district.

Once the heat and radioactivity have faded, tens or hundreds of thousands of workers, who had spent the intervening time studying under government sponsored job-retraining programs, can swoop in, clear out the remains, and rebuild the city.  In relatively short order, the residents could return to a brand new, shiny community ready for action.

Note the abundance of economic activity this city-revitalization would spur; how numerous industries would see an influx of revenue.  Local transportation and rental housing (homes, hotels, motels, campgrounds, or whatever) would see a spike in demand during the outflow of the population prior to the extreme makeover.  The military-industrial complex would also get a piece of the action since they would be responsible for the bombing run, which would keep munitions manufacturers and aerospace corporations profitable.  Of course, the greatest win-fall goes to the construction and materials companies whose job it is to rebuild the new and gleaming metropolis.

Hmmm…..

Sounds ridiculous doesn’t it.  Who in their right mind would ever advocate wanton destruction just for the flurry of activity that would result?

Take a peek at some of the places where this idea rears its ugly head.

In our first example in the circus of the economic bizarre, consider, if you will, the possibility of space aliens attacking the planet as a rallying cry for economic production

In this space alien piece, from 17 to 30 seconds, the ‘host’ of the show literally says:

Wouldn’t John Maynard Keynes say that if you employ people to dig a ditch and then fill it up again, ah, that’s fine, they’ve been productively employed…

How strange of a definition he presents for ‘productively employed’.  How is digging a ditch only to fill it up again productive?  Makes the ‘nuke a city plan’ sound positively brilliant.

Our second offering in our gallery is more whimsical.

Taken from the movie ‘The Fifth Element’, this scene mocks the idea that destruction ultimately leads to progress.  But an idea has to exist in the first place to actually be mocked and this particular idea seems to have been around for quite some time.

Perhaps the best argument against this kind of thinking comes in ‘The Broken Window’ parable written by Frederic Bastiat in 1850.  In this short essay, Bastiat examines the unseen costs (lost opportunity costs) of having a perfectly fine window broken and the vapid thinking that says that that destruction is beneficial to society.

Of course, a little destruction may be beneficial when it removes a valueless or costly thing out of the way of a new thing that actually brings value to society, but that we need to be very sure that the thing being replaced is valueless.  As Henry Hazlitt says in his book ‘Economics in one lesson’

It seems to me that the key phrase ‘unless those items [sic] have already become valueless or acquired a negative value by depreciation and obsolescence’ is conveniently omitted from the regular dialog.

Trained economists, no doubt, know and understand this subtlety, but if they do they like to keep it to themselves.  The average level of discourse in the media is well typified by the two clips above.  It seems to me that we should be very cautious in concluding that an object is truly valueless and that destruction is the correct course of action.  I’m not saying that such a conclusion should be rare but rather that it should always be highly scrutinized.  When we get to the point of saying that it would be better to have people dig ditches just to fill them back up then we’ve run out of good ideas.  And when we’ve run out of good ideas, nuking an entire city starts to look a lot more attractive.

One of the hot-button items in the current news cycle is the ‘stinging defeat’ that the Obama administration suffered at the hands of Congress last week.  This defeat took the form of an overwhelming rejection of certain trade provisions that were proposed by the administration be made law.

I am not interested in taking up space in this column to discuss the merits and demerits of the laws themselves.  Even though trade certainly falls under within scope of a blog of ‘musings about time and money’, I haven’t invested the time to really form an intelligent opinion about the proposed powers that the president was seeking.

No, what I want to comment on is the lack of clarity in the terminology associated with these laws.  This lack of clarity was abundantly clear to me as I struggled to keep TPP straight from TPA from TAA.  There were simply too many T’s to keep straight without careful thought and confusion was sure to abound.

Sadly, it seems that even trained journalists (I often wonder if that term is an oxymoron – but I digress) seem incapable of discerning the difference.  A point that was driven home as I listened to NPR’s Steve Inskeep

as he clumsily interviewed Paul Ryan about these matters.

NPR’s bio has the following to say about Mr. Inskeep

Despite his probing intellect and passion and compassion for his fellow man, Steve is apparently unable to keep his alphabet soup straight, so as a public service in the opposite direction of the usual, I present some basic information about the three T’s back to NPR.

The TPP

The Trans-Pacific Partnership (TPP) is a proposed trading framework between the United States of America and eight other Trans-Pacific countries – Australia, Brunei, Chile, Malaysia, New Zealand, Peru, Singapore, Vietnam.

The TPP is essentially a larger, and perhaps more ambitious, version of such free trade arrangements as NAFTA or the Israel Free Trade Agreement.  The United States has entered into many such agreements (14 by my count).  Its advocates tout its promise of open markets in Asia, level playing fields when it comes to such things as intellectual property rights and import/exports, and to the influence the US will have in improving working conditions.  Its opponents point to infringement on US sovereignty, the jobless and rather dismal recovery, and the threat of displaced workers, which brings us to item two – the TAA.

The TAA

The Trade Adjustment Assistance (TAA), is a federal program (or maybe more appropriately a set of programs) designed to help certain segments of the economy that are damaged by the opening of new markets, either domestic or abroad, to new competition.

The largest function of the TAA is to provide assistance to displaced workers who find themselves either out of a job or threatened with weakening wages and bargaining power due to an increase in the labor pool.

A familiar situation in which TAA-like service may have been applied was during the transition from typewriters to word processing programs for the desktop computing (although the TAA doesn’t cover workers displaced by technology or changing tastes).  This relatively sudden change in technology and office process forced almost all employees in the typewriter manufacturing sector out of work. These workers could have received help from the TAA to train new jobs in different sectors (if the TAA had actually been able to help).

Proponents of the TAA point to the continuity it brings to the lives of workers as they transition into new careers: minimizing impact to them and their families and keeping them in the work force.  Most sides agree that the objectives of the TAA are sound, but some point to the particular implementation as being flawed.

The TPA

The final T in the trinity (yet another T-word) is the Trade Promotion Authority (TPA). Also known as Fast Track,  the TPA is a power granted by Congress to the President to act as a single negotiator for the United States.  With this power comes great responsibility, so when a deal had been tentatively struck, the President must then bring the completed deal back to Congress where it is subjected to a single up-or-down vote, with no opportunity for amendments.

The TPA is very controversial, primarily due to the concentration of power to negotiate potentially disruptive trade deals in the hands of a small number of bureaucrats.  Those in favor of granting the president TPA argue that no foreign country wants to negotiate with 536 people (all of Congress and the president) and the fact that Congress has the last word.  TPA opponents insist that closed-room negotiations that impact thousands or millions of workers is un-American and that it places too much power in the hands of people who might be corrupted by it (see Lord Acton’s famous maxim).

Summary

Despite the similarity in their acronyms, the three Ts taking center stage in this current trade debate are really distinct things of varying controversy.  The least objectionable is the Trade Adjustment Assistance (TAA), which seems to have universal support for what it tries to do even if opinions disagree on how to do it or how efficacious the current implementation is. The next two Ts are close in their controversy level, but I think that the Trans-Pacific Partnership (TPP) runs in second.  Sides are divided on whether they like what this deal brings to the table but not as much as they seem to be in disagreement on how it will happen.  Granting the president Trade Promotion Authority (TPA) seems to be a real sticking point and if he doesn’t get this authority the next logical question is how will the US negotiate free trade agreements (maybe there is even debate as to whether it should, but that is a topic for another blog).

So it’s easy to see that the 3 Ts are quite different and that with a little work, even a journalist should be able to keep them straight.

In honor of American Pharoah winning the first Triple Crown in 37 years, this week’s column will concern itself with that fine art of subtle economics – making book.  For those you aren’t familiar with the terminology, to make book is the phrasing used to describe how a bookie balances the risks associated with backing a gambling opportunity. The idea behind making book is to guarantee a positive expected income for the bookie no matter what happens in the event.

The treatment here is patterned after ‘The Parable of the Bookmaker’ found in the book ‘Financial Calculus: an introduction to derivative pricing’, by Baxter and Rennie and the very readable discussion of ‘The Art of Bookmaking’ Matt Elliott.

Both treatments consider, for simplicity, the case with a sporting event with two possible outcomes.  I’ll stick with the horse racing theme used by Baxter and Rennie.

Suppose that we are having a runoff between the great Triple Crown winners of yesteryear and American Pharoah.  I think that, without a doubt, Secretariat is the greatest of the past winners; an opinion that is shared in sporting circles.  Now let’s imagine that we are pitting Secretariat against American Pharoah as our sporting event of the millennium.

As bookies, we want to accept wagers from bettors who are both favor Secretariat and those who favor American Pharoah, but we want to do so in such a way that regardless which horse actually wins, we can meet our payouts and still take home a tidy profit.  How do we do this?

First, let’s start by examining the probability that each horse will win the race.  Since this is a fantasy race, we can run the race as often as we like, and suppose that in doing so we find that Secretariat is 3 times more likely to win than American Pharoah.

Now we have to set the odds.  The actual language and notation associated with quoting the odds seems to differ from country to country and culture to culture so I am going to give a set of definitions that maximize the overlap with all cases.  First define the stake as the amount of money that the bettor (or punter as it is sometimes known as) places on the outcome.  A winning bet pays the bettor back his original stake plus an additional amount of money called the return, since it represents the return on his investment.  Thus the successful bettor walks away from the track with the sum of these two, which is called the payout.  In symbols, if st is the stake and r is the return then p = s + r is the payout.  The unsuccessful bettor simply walks away.

Now if we set our odds consistent with the probabilities found in our fantasy running, we would set the odds as follows:

In other words, the probability each outcome is implied as the stake/payout giving P(Secretariat) = 0.75 and P(American Pharoah) = 0.25, where P(x) is the probability that x will win the race.  Note that as expected, Secretariat is three times as likely to win as is American Pharoah.

Well this is certainly the scientific way to set the odds.  Unfortunately, it is also stupid.  To see this, we calculate the expected payout.  To keep things concise, let’s use add to our symbol vocabulary by letting AP and S stand for American Pharoah and Secretariat, respectively.   In the event that Secretariat wins, the profit the bookie makes as follows:  he gets to keep the stake offered for American Pharoah and has to give up the return on Secretariat.  In symbols, profit(S) = st(AP) – r(S).  In the event that American Pharoah pulls off the upset, the bookie’s profit is the stake on Secretariat minus the return on American Pharoah, which in symbols is profit(AP) = st(S) – r(AP).  To get the expected profit, the bookie multiplies the profits associated with these two events by their probability of occurrence and finds that his expected profit is zero (left as an exercise to the reader).  This result holds no matter how much money is staked on either horse, since there are only two options – they balance out.

So a bookie offering such odds works for free in the long run and finds himself at the end of his career having, on average, earned no money.  More likely, before he gets to the point of having a quiet retirement he finds that he is bankrupt due to the fact that on any given occasion he is liable to lose a huge amount of money.

The amount he is liable for does depend on the stakes offered and the easiest way to understand this is to look at a table of outcomes given different stakes.

Notice that there are four different scenarios with different amounts places as bets on the two horses.  In all cases, the bookies expected profit is zero so that were the race to be run every day, the bookie would, as predicted above, break even.  However, during that time the bookie’s profits would wildly fluctuate between a reasonably handsome profit of $10,000 when American Pharoah pulls of the upset and nobody bet on him to a disastrous loss of $25k when many people back the longshot and he wins.

Obviously, the bookie needs to keep his financial health (and as a result his physical health as well).  In order to do that, he needs to ‘slant’ the odds in his favor.  He does this by actually playing with the percentages sold of the racing contracts so that he has a positive profit no matter which horse wins.

Several examples of how to set the odds to make a profit are shown in this next table.

Before beginning to discuss the results shown in this table, note that the amount bet on the two horses is fixed at $5K for American Pharoah and $10K for Secretariat.  I’ll briefly discuss the added complexity associated with attracting the appropriate amounts for both horses below.

The first case is the fair-odds, break-even case that caused our bookie’s concern.  In that case, the implied percentage of the race came out exactly to 100 percent.  This percentage, denoted by o, is given by o = st/p.  For the first case, o(AP) = 0.25 and o(S) = 0.75; adding up to 1.0, as expected.  In the other cases, the bookie sets the odds in such a fashion that the corresponding percentages add up to be more than 1.0.  In the second case o(AP) = 5/18 = 0.28 and o(S) = 15/19 = 0.79 for a sum total of 1.07. This extra 7-percent margin give the bookie a positive expected profit but still exposes him to substantial loss if the longshot come in.

A better setting of odds is in the third case, where o(AP) = 5/14 = 0.36 and o(S) = 5/7 = 0.71.  Again the margin is set at 7 percent (0.36+0.71 = 1.07), but in this case the bookie is sure to make a profit of $1,000 every time.

In the final case, the bookie can make even more profit by having a margin of 15 percent, but he does so at the expense of the bettor (how else?).  In particular, the bookie realizes this profit by cutting into the return on investment of the bettor who backs the longshot.  The return on investment (ROI) is defined as the return divided by the stake, or r/st.  Notice how the ROI drops progressively as the bookie’s exposure to risk drops.

In realistic situations, the bookie never gets a fixed amount plopped on each horse with the subsequent opportunity to set the odds in such a way that favors him.  Rather, he needs to sell contracts with the bettors and then adjust the odds as bets come in so that he makes book.  More details of how this is done can be found in Matt Elliott’s discussion but I’ll note, in passing, that a margin of 7-percent seems to be a customary target but that it seems that the bookie is happy when he can achieve 5 percent.

I’ll close with one last point.  Throughout this discussion, I’ve intermixed gambling terms like bookie, odds, payout, and longshot, with terms usually reserved for business situations, like return on investment, contract, and sell.  This wasn't by accident.  Gambling and business meet squarely in derivatives trading and hedge funds all across the financial markets.  But that is a topic for another day.

I suppose that the subject matter for this particular column started with the arrival of a magazine in my mail box a few days ago.  The magazine in question is entitled ‘Arthritis Today’ and its presence alongside the more normal mail was a real puzzle.  My first reaction was that this was the typical mix up where my neighbor’s mail makes it into my box and vice versa.    A glance at the mailing label dashed that notion; the name and address clearly indicated that it was intended for a member of my family.

At bit more of reflection soon led to the answer.  One of my clan had been having problems with his hand and had gone to see a doctor.  The diagnosis was mild osteoarthritis and a generic treatment program – indicative of the whole ‘we don’t quite know how to treat this so we’ll say something you could have figured out for yourself’ attitude that sometimes is seen in the medical profession – was prescribed.

I’m sure our insurance company was promptly billed and less than two scant weeks later, this magazine arrives unbidden.  So the questions of who sent it, when was that particular decision made, how did the publisher know where to send it, and why was it thought relevant seemed plausibly answered.  There was only one lingering line of questions.

Who pays for this magazine?  Is it a marketing technique, where one issue is sent in hopes that a permanent subscription will result?  While possible, this idea seems highly doubtful.  There were no indications that the publisher was tempting our dollars from our wallet.  No gaudy disclaimers like “fabulous first free issue” or “trial offer” adorned the front of the mailer.  This issue of Arthritis Today was sent in the standard clear, thin, plastic bag used for existing subscriptions, which is designed to let you see the content while keeping the pages relatively safe from the elements.

The most plausible explanation is that somewhere between money leaving my paycheck to pay for the family’s health coverage and revenue flowing into the publisher’s offices to pay for staff salaries, print costs, marketing, distribution, and the like, there is a complicated shell game that goes on that makes acceptable the risk of sending out the magazine unsolicited to a perhaps disinterested household.

Several possible explanations exist for how that risk can be perceived as low even if the reality is quite different.  Perhaps the doctor’s office pays for the subscription as part of the service they provide.  Perhaps the drug companies with a vested interest in pushing the next big arthritis drug underwrite the cost.  This later explanation seems to be the most likely as there was a 20-page pamphlet entitled ‘Arthritis Today: Drug Guide, 2015’ that piggybacked along with the main publication.

Most likely this last inference is the correct one. But even if the drug companies are directly underwriting the cost of this publication, all that has done is to move the risk associated from one entity (the publisher) to another (the pharmaceutical companies), it doesn’t eliminate it.

We could keep on this way, peeling layer after layer from the onion, but in the end, after all the dust settles and the smoke clears, we still have the undeniable facts that someone is bearing the cost to produce this magazine and the risk that he may not make a return on the investment.

Of course, taking risk and passing on costs is par for the course for businesses.  Almost every business must shoulder risk in order to grow and must bear a cost associated with that risk.  The cost usually has two components; the first is associated with mitigating the risk and the second is associated with how large will the payout be if the risk realizes.  Ultimately some or all of these costs gets passed on to its customers.  The amount of risk taking is held in check by the fact that the customer based may finally have enough and move on to a competitor.  People are willing to bear a cost when it is a mild irritant or when it looks like it will be limited in time.  But push the customer base too far with large or open-ended price hikes and there is an excellent chance that they will leave to find greener pastures, leaving the firm to bear the costs themselves.  Competition acts as the natural balance to risk taking.

What is different in the ‘Arthritis Today’ situation, is that there is no danger that the risk and associated costs will be born directly by the company – no matter which one in the chain from publisher, to doctor, to pharmaceutical company.  Each of them are in a position to take more risk and pass on more cost than a normal business because of the government mandates and regulations regarding health care. All of the businesses in this chain know that the customer base is a captive audience; that there is no real way for them to move onto a competitor.

This situation is then a textbook example of what is known as a moral hazard.  When a moral hazard is present, a firm can and will take a greater risk when they know that some other party will be stuck with the cost.  In this case, the particular cost is born by my health care coverage provider who will then pass the pain directly onto me in the form of higher premiums, larger deductibles, or both.

Overall, the cost of receiving this magazine is small but it is worrisome for two reasons.  The first is the basic principle that I shouldn’t have to bear a cost as a captive customer base.  The second is that this case is a symptom of an endemic problem throughout the economy.  Many of the government-backed, ‘too big to fail’ or ‘special interest’ programs show the same type of moral hazards on a much grander scale.  I’ll be exploring some of the more egregious ones in future columns.

The week’s exploration centers on how a small organization or firm can successfully compete with a larger corporation.  Three substantial advantages associated with economies of scale naturally fall to a large and established firm.  These are ability to amortize sunk costs over a large customer base, the possession of a larger and more specialized workforce, and leverage in buying goods and services.  With all these advantages, how can smaller business ever hope to survive let alone compete?  And, as a corollary question, how come large firms don’t grow unboundedly?

The simple answer is that firms also suffer from a host of disadvantages, called diseconomies of scale, that grow larger as the size of the firm goes.  Initially, these disadvantages are not active in smaller firms.  But at some point, above a critical size, they turn on and begin to offset the economy of scale advantages.

There are two primary areas where diseconomies of scale present themselves: delegation of authority, span of control, and the principal agent problem; and poor communication, coordination, and standardization.

Let’s start with the first broad category which covers problems associated with delegation of authority, span of control, and the principal agent problem.  Collectively, these problems describe the down side of the principle behind comparative advantage.  No matter how talented and dedicated the original founders and staff of a firm are, they are limited in the amount they can do based simply on the number of hours in a day.  For the firm to grow, additional staff needs to be hired to not only perform the basic functions (manufacturing, delivery of services, etc.) but also manage the growth.

In this process, a vast amount of control and authority has to be delegated to new staff and this is always accompanied by growing pains.  Friction between the old guard and the young turks is natural even under the best of circumstances.  When rapid growth occurs in a firm it is usually due to a highly motivated core group (e.g. the owners of the company).  These individuals obviously have strong notions about what works and what doesn’t.  In addition, they want go-getters just like themselves and they tend to hire people who are just as opinionated and strong willed as they are themselves.  I’ve experienced the tremendous clash that happens next.  The new blood yells about micromanagement and rigid and inflexible approaches of the existing management, who can’t delegate and reduce their span of control.  The original staff can’t understand why there is a sudden rush to change the culture that has been so successful.  Harsh words are exchanged, people quit or get fired and, meanwhile, the business of the firm is left fallow.

As bad as this is, an even worse circumstance occurs when the new blood has designs on the existing corporate structure for their own purposes.  They may see a niche area left undeveloped or may want to move the company in a direction more suited to their personal liking.  In some cases, they may even be dishonorable people looking to exploit the existing cash cow with some scheme or another.  This is the principal-agent problem.  Central to this situation is a difference in the amount of knowledge the two parties possess.  The principal is the term used to describe the existing management/ownership.  In hiring the new staff, which are called the agents, the principal must trust the agent and delegate some ability for the agent to make decisions on behalf of the principal.  Both the principal and the agent have their own self-interest, but while the principal has the advantage in authority, the agent has the advantage in terms of information.  In all cases, the agent is required to report back to the principal (even if the reporting is a token report) and all agents filter the information at their disposal before sending it on to the principal.  The larger the firm the more likely it is that at least one of its agents is using this asymmetry for this own ends at the expense of the firm.

The second broad category of diseconomies of scale includes problems with communication, coordination, and standardization.   Overall, I tend to refer to these problems collectively as the Dinosaur Problem.  The organization in question has the same issues that the Jurassic behemoths had.   Small organizations can comfortably handle peer-to-peer interactions since the number of people involved is relatively small.  Once the size exceeds a critical threshold it is more efficient for interactions to happen through a central location, a manager who facilitates the activities of a whole.  As the numbers continue to grow more managers come on board and the interaction between them may be handle by peer-to-peer even though the employee interactions are not.  At some point, however, the number of managers becomes too large and a new layer of management is conceived and implemented.  This layering continues until some point where the right-hand no longer knows what the left hand is doing.

Along the way, such a firm begins to exhibit all the tell-tale signs of being too large.  The implementation of a one-size-fits all strategy to avoid liabilities.  Having meetings about how to have meetings or for the sake of having meetings.  An emphasis on fairness rather than performance and other idiocies to numerous to mention follow.

I've lived through many of these types of insanities.  One of the firms where I worked had a supply requisition form on which one could order refills for X-Acto knives (this was for the actual paper-and-glue version of cutting and pasting) but not the knives themselves.  I was issued a corporate American Express card with the very explicit admonition to only use it for business travel and not for personal use.  A scant 6 years later I received a letter from legal saying that they were going to revoke my American Express card because I had failed to 'live up to' my promise on the amount of expected use of the card.  All told, I had never wanted the card in the first place and I was sent on only two business trips in those 6 years.  I’ve been required to attend a meeting about how to have meetings.

All of this factors contribute to limiting the practical size of a firm.  In the economic lingo, the economies and diseconomies of scale are best summarized on an average cost diagram.

On the x-axis is the number of units of some good or service produced by the firm, which is taken as a measure of the firm’s size.  On the y-axis is the cost to produce a unit of the good.  The optimum occurs at the place where the benefits from the economies of scale balance the diseconomies.  It is important to note that as business factors change, what once contributed to a cost savings can turn around and cause an increase in cost.

So it isn't remarkable that the small business Davids can take down the big business Goliaths.  It also isn't remarkable that today’s Goliaths were yesterday’s Davids and tomorrow’s has-beens.  That is the nature of the creative destruction of the free market economy. It also isn't remarkable that economies of scale one day can become diseconomies of scale on another as society evolves.  What is remarkable is how many people refuse to accept this dynamic.

There is a curious unasked question that serves as a back drop to much of the media’s reporting on the economy.  If big business is so powerful, why is it that most people in the private sector of the United States work in small and medium businesses?  Surely both the power that big businesses yield (lobbying, political, and resources) and the economy of scale they enjoy would allow them to outperform and outlast their competitors in the smaller firms.  Asked differently, why isn’t the world dominated by huge multinational corporations?

This idea of the dominance of big business is certainly common fare in the daily fiction that passes in movies and TV.  Many tales come out every year featuring the evil, predatory practices and near omnipotent power of big business, and yet the small and medium rebellion continues unabated every year.

Now, to be clear, I am neither suggesting that big business is benevolent nor that it exercises its power gently.  Businesses, large or small, have a right and perhaps an obligation to aggressively protect their market share and to continue to grow.  In addition, crony capitalism and political favoritism tends to give the larger firms political concessions that the smaller firms lack.  What I am suggesting, or at least exploring, is the notion that smaller can be better, and that we tend to remember economies of scale and forget about diseconomies of scale.

To better understand the staying power of small and medium business, consider some elementary statistics.

Small businesses make the bulk of the US economy, both in terms of the number of firms and in terms of the number of employees.  According to statistics provided by the Census Bureau, 61% of the firms in the country are sized between 1-4 employees, and 99.6% of the firms have fewer than 500 employees.  Nearly 50% of the employees in the economy work in this segment.

The wages these employees make, in aggregate, are comparable to the wages earned by their big business counterparts. Although a more detailed analysis by labor segment (e.g. secretary to secretary) in addition to size of firm is needed to make clear conclusions, there doesn’t seem to be obvious evidence that being in a big business significantly increases wages.

The table below, adapted from 2007 data from the Census Bureau, shows the details:

Now let’s talk a little about all the advantages enjoyed by big business (say, more than 1000 employees) that are either available to a lesser degree for smaller firms or unavailable entirely.  This discussion will focus only on the legitimate advantages afforded to these firms from economy of scale effects and will ignore additional, unfair, advantages due to lobbying and crony capitalism.

As a reminder, an economy of scale is the term that is used to describe any effect that allows the cost per unit of production to lower as the number of units produced grows. Large firms generally have three areas that provide them with economy of scale advantages.

The first is in the form of non-reoccurring costs or what is sometimes known as sunk costs.  This category covers all the initial investment in the production capital, such as factories and specialized machinery.  A milling machine comes with a fixed price tag whether it is used to produce 1 unit of goods or 100.  In the latter case, the initial outlay for the machine can be recouped over a large customer base and so allows the cost per unit to be reduced.  Similar advantages occur for advertising and marketing, where the price passed onto consumers is smaller per good the larger the number of consumers, and for shipping, where it is cheaper to have a truck that ships 200 goods than to have two smaller trucks that ship 100 goods each.  Finally, a large firm typically has greater financial resources and can bear the risk associated with research and development of new goods and services more easily than smaller ones.

The second advantage of larger firms comes in the form of the workforce.  Employees at larger firms can more easily specialize, leading to production.  The prototypical example of this is given in Adam Smiths ‘The Wealth of Nations’.  Smith examined how straight pins were made, and identified 18 distinct tasks.  A single worker performing each of these 18 tasks might be able to produce 20 pins in a day.  By dividing up the tasks amongst several workers so that one worker performed only 1 or 2 of them, Smith estimated that a group of 10 workers could produce 48,000 pieces in the same time.  Division of labor and specialization enabled each worker to increase his output by over a factor of 200.  Large-firm employees also enjoy a larger community from which to learn, and an environment filled with greater intellectual capital and corporate knowledge.

The third advantage is the leverage that big businesses have in procuring goods and services.  They can bulk-buy from suppliers and vendors and receive a discount that is out of reach for the smaller firms.  They can also command better terms and concessions on loans and related financial instruments that can be used to increase their production.

So, having enumerated all these great advantages, how can small firms ever compete?  And yet, they not only compete; they also dethrone the giants of yesterday.  Not so long ago, IBM was the unassailable provider of computers and business machines.  Within two or three decades, Microsoft had supplanted IBM.  As time progresses there is mounting evidence of Microsoft losing ground to both Apple and Google.  Other examples from every enterprise and industry can be found where yesterday’s giants are today’s has-beens; simply look at Abercrombie & Fitch, or Nokia, or Borders, or… well, you get the picture.

In next week’s column, I’ll discuss how the Davids of the economy can defeat the Goliaths.  Stay tuned.

As I geared up for this week’s column, a variety of forces interfered with my peace of mind.  I found myself perpetually starting on an idea only to find that another idea shot in from an unseen direction to wreak havoc on my concentration.  I pondered this state of affairs for a while and realized that my mental state was in some sense reflecting the state of country and the economy as a whole.  It was at this point that it seemed most prudent to take up blog space this week to rant about the many little things weighing on my mind and on the nation’s recovery.

Since this is going to be a rant, I’ll excuse myself from the usual rule of trying to produce a logical flow and a clean narrative.  Who knows perhaps it will work better.  It may even make me feel better, but I doubt it.

First let me point out that the state of the economy is hardly in recovery mode.  A recent trip to a nearby mall left me feeling depressed and deeply concerned.  The mall in question contains about 200 separate slots for storefronts.  Despite being relatively upscale, it was, in my estimation, doing quite poorly.  As I walked up and down in front of the various shops I noticed that a large number of storefronts were vacant. By the time this observation had wormed its way into my conscious mind I was conveniently at one end of the building.  I decided to turn around and make a careful count of the vacancies.  When I reached the other end, my tally was 18 store fronts boarded up and idle, corresponding to about a 9 percent vacancy.

A short trip later found me at a strip mall a notch or two down the glamor ladder from my previous visit.  Even this bastion of thriftiness was not left unmolested by this so-called recovery.  Of the 30 storefronts, about 4 were vacant and the local RadioShack was sporting banners reading “Store Closing!” and “Everything Must Go!”, all in an attempt to lure shoppers in to take advantage of the liquidation.

The next set of ‘good news’ came in the form of a seemingly never-ending set of statistics being pushed at my face, some correctly interpreted and worrisome, some poorly interpreted and annoying.

On the worrisome front, all indications on the horizon showed that the April jobs numbers were going to be disappointing.  This news comes hard on the heels of a March report that showed that job growth failed to match population growth.  It seems that period of time in which job creation was out-pacing population growth in the fall and early winter has evaporated and the new trend is the same old jobless recovery we've seen for the prior 5 years.

In addition, both IMF Chairman Christine Lagarde and Federal Reserve Chairman Janet Yellen and spoke at length of the risks that still face the economy in this post fiscal-crisis world at a joint conference at the Institute for New Economic Thinking on May 6, 2015.  Lagarde warned of continued distortions in the incentives for the financial markets that focus on short-term profits over sustainable gains. A few rays of sunshine did poke through from this discussion, including Yellen’s assertion that improvements in the financial markets, mostly occurring before the start of the financial crisis in 2008, were mostly aimed at helping the poor.  But mostly it was the same type of ‘doom and gloom’ about stability, liquidity, and ‘too big to fail’ that we’ve been hearing over the past 6 years.

On the poorly interpreted and annoying statistics front, society, as a whole, and journalists, in particular, can’t seem to get over the hump in their understanding to realize that correlations in data don’t imply causation – no matter how fervently they want it to.  Just to frame the frustration I feel on this point consider the following two statistical statements.

First is a statistic about America’s energy usage, courtesy of Washington State University, that states:

The message being conveyed is that American’s consume profligately and waste so many resources that could be used by the poor.  However, this message is only supported by the statistic itself and not with any of the usual machinery by which we make inferences.  That is not to say that America doesn’t ‘waste’ energy – if by waste we mean that we leave lights on when they could be turned off, that we are casual with our energy consumption because the cost of energy is relatively cheap.  But it also needs to be recognized that we consume more energy than the rest of the planet because we are more productive.  On the same page, the anonymous compiler of statistics points out that each American uses the same energy as two Japanese.  But Japan has about 1/3 the population of the United States, implying that the per capita usage of the average Japanese citizen is about 1.25 times more energy than the average US citizen.  So much for this statistic.

Equally interesting, is what is missing from the WSU statistical diatribe against the very country this so-called academic calls home.  In his audio lectures entitled ‘The History of Moral Thought’, theologian Peter Kreeft notes the following statistic.

This per capita wealth of lawyers doesn't seem to even raise an eyebrow in the academic circles.  But if the common belief that the economy is a zero-sum game is true, then surely we in the United States have taken lawyers from other, less fortunate people.  I say, let’s give them back.

Sigh…

In a column some months back, I presented the basic concept behind the Prisoner’s Dilemma and talked about some of the most common applications in economic circles.  In this column I will discuss a somewhat discouraging application of these concepts to the relationship between business and workers (or firm and employee or management and labor, etc., as you prefer).

The particular type of business I will be talking about is a government contractor in the technical sector.  Businesses like these depend on a highly-trained and technically savvy work force to be able to bid on and win new work.  Central to the ability to credibly bid on new work is the idea that the firm and/or its workforce can set itself apart from its competitors in one or more of three distinct ways: 1) offering equal technical competency for a lower cost, 2) offering structured processes that lower risk and ensure delivery on cost and schedule, or 3) offering innovative solutions that enable new technology or a new opportunities.  The application I will deal with is the last case, but the attentive reader can adapt this example to the other two.

Typically the ability to innovate new technology on government contracts is limited by two factors.  The first is that government contracts with a specific research and development (R&D) focus are rare and becoming even rarer as federal spending on basic research drops.  Second, unless otherwise negotiated, the intellectual property for any research done on a federal contract is typically owned by the government.  Even in those cases where rights are granted for commercialization, the government retains limited ownership and exercising the ability to commercialize may be hard to do.

As a result, the general idea is to own the intellectual property itself and to leverage the intellectual property into increased profits.  And therein lies the rub – who owns the intellectual property and who benefits from the increased profits?

From management’s point-of-view, the firm wants to produce a body of intellectual property by engaging the employees’ talents in creating innovative technologies for the good of the firm.  The business: 1) provides the work environment in which the employee can tackle interesting problems, 2) actively pursues new business, 3) insulates the employee from the day-to-day hassle of running an enterprise, and 4) maintains the employee’s wage level even when profits decrease or disappear (‘sticky wages’).

Since the continued existence of the worker’s job is predicated on the health of the business, it is natural for management to expect that the worker will contribute to the overall health of the firm by shouldering some of the burden of making the company competitive.  How then does the business encourage the worker to apply his talent to creating intellectual property that the business can own?

Likewise, an employee wants to produce his own intellectual property for continued advancement and increasing wages and compensation.  The two main components of this capital are the technical skills required to perform the jobs in his sector and the external recognition that he can muster these skills to bring a complicated piece of work to fruition.  The employee provides: 1) the technical expertise and education need to be able to innovate, 2) the dedicated time needed to concentrate on a problem and deliver solutions and 3) the perseverance and intellectual fortitude to find these solutions.

Since the continued health of the business depends on the condition of its workforce, it is natural for the worker to expect that the business will provide opportunities for the employee to develop innovative solutions to complicated and challenging technical assignments and will support and assist the employee in generating tangible proof that he actually developed intellectual property rather than just use the fruits of someone else’s labor (e.g. patents or papers).  How then does the worker encourage the business to provide the infrastructure that benefits him?

If both sides could trust that the other will cooperate and compromise, then they each would get an attractive payoff.  The problem is that the business worries that, after all their investment in securing interesting work, the employee will either shirk his responsibilities and just collect a paycheck or that he will take all the credit and then head off to greener pastures.  Likewise the employee worries the business will keep all the intellectual property for itself and take credit for the hard work and talent that he mustered.  The situation abounds with questions of trust and with structured payoffs that are directly related to the Prisoner’s Dilemma.

Consider first the payoff matrix from the perspective of the business.  Its choices are either to trust the employee and invest in increased wages and/or improved infrastructure (e.g send the employee to a conference) or to safeguard against the employee shirking his responsibilities by keeping wages static and by avoiding infrastructure investments that benefit the employee, until the employee delivers.   The payoffs are then described by the company as:

Next consider the payoff matrix from the perspective of the employee.  His choices are to invest extra hours of his own time to develop intellectual property that he then turns over to the firm in the hopes of a reward or to perform the minimal amount of work to meet expectations, until such time as the company begins to show concern for his needs.  The payoffs are then described by the workers as:

Both of these perspectives can be combined into one common payoff matrix where, for consistency with the original language of the Prisoner’s dilemma, the word ‘cooperate’ will mean either ‘trusts’ or ‘rewards’ for business and ‘delivers’ or ‘invests’ for the employee, depending on context.  Similarly, the word ‘betray’ will mean either ‘safeguards’ or ‘ignores’ for business and ‘shirks’ or ‘meets expectations’ for the employee.  Also the payoffs will simply be given a single letter value ‘C’, ‘L’, ‘S’, and ‘M’ with the relative ranking between these of the largest payoff  (L) > cooperative payoff (C) > mutually-betrayed payoff (M) > sap payoff (S).  The payoff matrix now looks like:

Ordinarily, if the employee and the business were engaged in a one-time only deal, the equilibrium solution of this game is for both sides to betray leading to lousy payoffs (M) for both sides.  This is a well-known feature of the strategies for both players in the Prisoner’s Dilemma.

But the usual relationship between a business and an employee is one of repeatedly playing this game.  This is the iterated version of the Prisoner’s Dilemma (with no known limit of turns) and the best strategy that has been currently discovered is the tit-for-tat approach.  In this strategy, each player’s optimal response for the current turn is to perform the same action as the opposing player performed in the previous turn.

This observation then provides some insight into the employee/management scenario.  It is obvious that once one side betrays, it starts a long line of subsequent betrayals by the other side unless one side decides to unilaterally cooperate.  Thus once a business had been burned by a few bad employees it will have a tendency to not meet the goals of its employees.  They, in turn, will be less willing to innovate and both sides suffer.

There is no easy way to extricate both sides from this vicious circle without one side risking a substantial loss.  That said, there is an asymmetry between the two sides as management in these types of business are more consolidated and organized than the work force.  So it is up to management to offer the first olive branch (and perhaps many more) when the situation gets into one of these downward spirals.