Entrepreneurs often do not know why they survived in competition. George Stigler in his autobiography told this wonderful story about how you could not get businessmen to admit in a survey that they maximise profits.
You go to their office and asked them: Do they maximise profits?
Their answer would be, of course, not. I am here to provide employment to my workers and put a small amount aside for the education of my children.
The surveyor would then ask them: if you do were to raise your prices, do you expect to increase your profits?
The businessman answers no.
The surveyor how would then ask them: if you were to cut your prices, do you expect to increase your profits?
The businessman answers no.
The survey would then ask: can you point to a time in the last 12-months where you substituted profit for some other objective?
At this point of time, you would be thrown out of their office as some sort of lunatic.
Half of all invested assets will outperform the market return before costs. After costs, a much smaller portion outperforms the market return.
The indexing concept makes no judgment as to market efficiency, size, or style, nor does it need efficient markets to be effective: Every market will always have an average return, whether the market is deemed efficient or otherwise. Indexing works because
whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur
Active investors in strategies are exposed to commissions, management fees, bid-ask spreads, administrative costs, taxes, liquidity constraints, and other costs. In 2008, French in “The Cost of Active Investing” analysed the total cost to investors who have hired active managers to be more than $100 billion:
Professor French notes that while the total cost of trying to beat the market has grown over the years, the percentage of individuals who bear this cost has declined — precisely because of the growing popularity of index funds.
From 1986 to 2006, according to his calculations, the proportion of the aggregate market cap that is invested in index funds more than doubled, to 17.9 percent. As a result, the negative-sum game played by active investors has grown ever more negative.
The bottom line is this: The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.
Figure 2: Percentage of active funds underperforming low-cost index funds, For the ten years ended December 31, 2013
Workers exploit capitalists who start businesses that fail. Workers are paid more than they add in labour value to failed start-ups.
A self-employed farmer scraping a living with the help of a part-timer is exploiting that worker while a manager who owns no shares on a salary of $500,000 a year is a downtrodden and exploited member of the proletariat!
Elite athletes, celebrities and TV and movie stars are the most exploited of all proletarians. Itinerant workers with no income security at all. At the mercy of the selectors, record companies and studios. 15 minutes of fame is fleeting.
Many capitalists scrape a living and often go bankrupt and lose their house and marriage after business failures while many workers are highly paid.
The university educated are well-paid proletarians with low unemployment rates.
How is your superannuation portfolio going? Riding high on the fat of the working class?
Pension fund socialism was never a promise of long-run super-normal profits.
Despite the majority of labour surplus now going back into the hands of workers in their retirement savings, the share market is still a dog or is it?
Luke Froeb found that his MBA students fell asleep when he lectured on market failure and the standard possible public policy responses. His teaching evaluations were so poor that keen threatened firing him if he didn’t improve.
Froeb repackaged market failures as a business opportunity. His students sat up in class and paid close attention. The end result of his efforts is the best single MBA textbook around.
Inefficiency from market failure implies the existence of unconsummated, wealth-creating transactions.
Froeb told his students that the first to fill these gaps in the market or be the market maker for the missing market stands to profit.
Alert entrepreneurs make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them.
Froeb argued that mistakes are made – business opportunities are missed – for one of two reasons:
lack of information or
bad incentives.
To diagnose a problem, ask 3 questions:
Who is making bad decision?
Do they have enough info to make a good decision?
Do they have the incentive to do so?
The solution is in the answers to these questions:
Let someone else make the decision, someone with better information or incentives.
Change the information flow.
Change incentives
Froeb argues that the art of business consists of identifying assets in low-valued uses and devising ways to profitably move them to higher-valued ones.
There are at least 98 regulated occupations in New Zealand covering about 20% of the workforce. In 2011, this amounts to 440,371 workers. The skills that are regulated range across all skill sets and many occupations:
49% of regulation is in the form of a licence;
18% of regulated work is in the form of licensing of tasks;
31% of regulated workers require a certificate; and
4% of regulated workers require registration.
There are 32 different governing Acts that regulated occupations in New Zealand with 55% of the workers subject to occupational regulation are employed in just five occupations:
98,000 teachers;
48,500 nurses;
42,730 bar managers;
32,733 chartered accountants; and
22,749 electricians.
The Health Practitioners Competency Assurance Act 2003 regulates 22 occupations and a total of 89,807 workers. The next best is the 10 occupations regulated by the Health and Safety in Employment Act 2002 which regulates an unknown number of occupations. The Civil Aviation Act 1990 regulates eight occupations and 19,095 workers, the Building Act 2004 regulates seven occupations and 21,101 workers and the Maritime Transport Act 1994 regulates six occupations and 20,500 workers. 12 of the regulated occupations are regulated under laws passed since 2007.
The purpose of occupational regulation is to protect buyers from quacks and lemons – to overcome asymmetric information about the quality of the provider of the service.
Adverse selection occurs when the seller knows more than the buyer about the true quality of the product or service on offer. This can make it difficult for the two people to do business together. Buyers cannot tell the good from the bad products on offer so many they do not buy to all and withdraw from the market.
Goods and services divide into inspection, experience and credence goods.
Inspection goods are goods or services was quality can be determined before purchase price inspecting them;
Experience goods are goods whose quality is determined after purchase in the course of consuming them; and
Credence goods are goods whose quality may never be known for sure as to whether the good or service actually worked – was that car repair or medical procedure really necessary?
The problem of adverse selection over experience and credence goods present many potentially profitable but as yet unconsummated wealth-creating transactions because of the uncertainty about quality and reliability.
Buyers are reluctant to buy if they are unsure of quality, but if such assurances can be given in a credible manner, a significant increase in demand is possible.
Any entrepreneur who finds ways of providing credible assurances of the quality of this service or work stands to profit handsomely. Brand names and warranties are examples of market generated institutions that overcome these information gaps through screening and signalling.
Screening is the less informed party’s effort, usually the buyer, to learn the information that the more informed party has. Successful screens have the characteristic that it is unprofitable for bad types of sellers to mimic the behaviour of good types.
Signalling is an informed party’s effort, usually the seller, to communicate information to the less informed party.
The main issue with quacks in the labour market is whether there are a large cost of less than average quality service, and is there a sub-market who will buy less than average quality products in the presence of competing sellers competing on the basis of quality assurance. This demand for assurance creates opportunities for entrepreneurs to profit by providing assurance.
David Friedman wrote a paper about contract enforcement in cyberspace where the buyer and seller is in different countries so conventional mechanisms such as the courts are futile in cases where the quality of the good is not as promised or there is a failure to deliver at all:
Public enforcement of contracts between parties in different countries is more costly and uncertain than public enforcement within a single jurisdiction.
Furthermore, in a world where geographical lines are invisible, parties to publicly enforced contracts will frequently not know what law those contracts are likely to fall under. Hence public enforcement, while still possible for future online contracts, will be less workable than for the realspace contracts of the past.
A second and perhaps more serious problem may arise in the future as a result of technological developments that already exist and are now going into common use. These technologies, of which the most fundamental is public key encryption, make possible an online world where many people do business anonymously, with reputations attached to their cyberspace, not their realspace, identities
Online auction and sales sites address adverse selection with authentication and escrow services, insurance, and on-line reputations through the rating of sellers by buyers.
E-commerce is flourishing despite been supposedly plagued by adverse selection and weak contract enforcement against overseas venders.
In the labour market, screening and signalling take the form of probationary periods, promotion ladders, promotion tournaments, incentive pay and the back loading of pay in the form of pension investing and other prizes and bonds for good performance over a long period.
In the case of the labour force, there are good arguments that a major reason for investments in education is as a to signal quality, reliability, diligence as well as investment in a credential that is of no value the case of misconduct or incompetence. Lower quality workers will find it very difficult if not impossible to fake quality and reliability in this way – through investing in higher education.
In the case of teacher registration, for example, does a teacher registration system screen out any more low quality candidates for recruitment than do proper reference checks and a police check for a criminal record.
Mostly disciplinary investigations and deregistrations under the auspices of occupational regulation is for gross misconduct and criminal convictions rather than just shading of quality.
Much of personnel and organisational economics is about the screening and sorting of applicants, recruits and workers by quality and the assurance of performance.
Alert entrepreneurs have every incentive to find more profitable ways to manage the quality of their workforce and sort their recruitment pools.
Baron and Kreps (1999) developed the recruitment taxonomy made up of stars, guardians and foot-soldiers.
Stars hold jobs with limited downside risk but high performance is very good for the firm – the costs of hiring errors for stars such as an R&D worker are small: mostly their salary. Foot-soldiers are employees with narrow ranges of good and bad possible outcomes.
Guardians have jobs where bad performance can be a calamity but good job performance is only slightly better than an average performance.
Airline pilots and safety, compliance, finance and controller jobs are all examples of guardian jobs where risk is all downside. Bad performance of these jobs can bring the company down. Dual control is common in guardian jobs.
The employer’s focus when recruiting and supervising guardians is low job performance and not associating rewards and promotions with risky behaviours. Employers will closely screen applicants for guardian jobs, impose long apprenticeships and may limit recruiting to port-of-entry jobs.
The private sector has ample experience in handling risk in recruitment for guardian jobs. Firms and entrepreneurs are subject to a hard budget constraints that apply immediately if they hire quacks and duds.
Blackboard economics says that governments may be able to improve on market performance but as Coase warned that actually implement regulatory changes in real life is another matter:
The policy under consideration is one which is implemented on the blackboard.
All the information needed is assumed to be available and the teacher plays all the parts. He fixes prices, imposes taxes, and distributes subsidies (on the blackboard) to promote the general welfare.
But there is no counterpart to the teacher within the real economic system
Occupational regulation comes with the real risk of the regulation turning into an anti-competitive barrier to entry as Milton Friedman (1962) warned:
The most obvious social cost is that any one of these measures, whether it be registration, certification, or licensure, almost inevitably becomes a tool in the hands of a special producer group to obtain a monopoly position at the expense of the rest of the public.
There is no way to avoid this result. One can devise one or another set of procedural controls designed to avert this outcome, but none is likely to overcome the problem that arises out of the greater concentration of producer than of consumer interest.
The people who are most concerned with any such arrangement, who will press most for its enforcement and be most concerned with its administration, will be the people in the particular occupation or trade involved.
They will inevitably press for the extension of registration to certification and of certification to licensure. Once licensure is attained, the people who might develop an interest in undermining the regulations are kept from exerting their influence. They don’t get a license, must therefore go into other occupations, and will lose interest.
The result is invariably control over entry by members of the occupation itself and hence the establishment of a monopoly position.
Friedman’s PhD was published in 1945 as Income from Independent Professional Practice. With co-author Simon Kuznets, he argued that licensing procedures limited entry into the medical profession allowing doctors to charge higher fees than if competition were more open.
Data Source: Martin Jenkins 2012, Review of Occupational Regulation, released by the Ministry of Business, Innovation and Employment under the Official Information Act.
Q: I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.
A: That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact.
I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high.
People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them.
They are typically right and wrong about half the time…
I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy.
People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.
Many studies, formal and informal, have been made of the record of forecasting by economists, and it has been consistently abysmal.
Forecasters often complain that they can do well enough as long as current trends continue; what they have difficulty in doing is catching changes in trend. But of course there is no trick in extrapolating current trends into the near future.
You don’t need sophisticated computer models for that; you can do it better and far more cheaply by using a ruler.
The real trick is precisely to forecast when and how trends will change, and forecasters have been notoriously bad at that. No economist forecast the depth of the 1981–82 depression, and none predicted the strength of the 1983 boom.
The next time you are swayed by the jargon or seeming expertise of the economic forecaster, ask yourself this question: If he can really predict the future so well, why is he wasting his time putting out newsletters or doing consulting when he himself could be making trillions of dollars in the stock and commodity markets?
Entrepreneurs are simply those who understand that there is little difference between obstacle and opportunity and are able to turn both to their advantage.
As it is, it is one of the great paradoxes of economic science that every act of competition on the part of a businessman is evidence, in economic theory, of some degree of monopoly power, while the concepts of monopoly and perfect competition have this important common feature: both are situations in which the possibility of any competitive behaviour has been ruled out by definition
Why Evolution is True is a blog written by Jerry Coyne, centered on evolution and biology but also dealing with diverse topics like politics, culture, and cats.
In Hume’s spirit, I will attempt to serve as an ambassador from my world of economics, and help in “finding topics of conversation fit for the entertainment of rational creatures.”
“We do not believe any group of men adequate enough or wise enough to operate without scrutiny or without criticism. We know that the only way to avoid error is to detect it, that the only way to detect it is to be free to inquire. We know that in secrecy error undetected will flourish and subvert”. - J Robert Oppenheimer.
Utopia, you are standing in it! 
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