Creative destruction: the product life cycle versus the revenue life cycle
24 Dec 2014 Leave a comment
The SkyCity bailout: it is common for private sector mega-projects to fail
24 Dec 2014 3 Comments
in entrepreneurship, politics - New Zealand, rentseeking, survivor principle Tags: casino regulation, corporate welfare, SkyCity
SkyCity is sniffing around the New Zealand government for a $130 million bailout. The initial project estimate was $402 million for a convention centre and enlarged casino.
SkyCity was very clear when the convention centre deal was announced that it would be at no cost to either taxpayers or Auckland ratepayers. That is a clear assumption of the entrepreneurial risks – both the upside of high profits and the downside of cost overruns and losses.
The literature on mega-projects suggests that large engineering projects frequently fail to achieve their intended financial and operating objectives. Nine out of ten mega-projects have cost-over runs:
- Miller and Lessard (2000) studied 60 large engineering projects with an average size of $1 billion. Almost 40% of the projects performed very badly and were abandoned totally or restructured after a financial crisis.
- Merrow et al. (1988) found that four of the 47 megaprojects they studied came in on budget – the average cost overrun was 88%. Of the 36 projects that had sufficient data, 26 failed to achieve their profit objectives.
- Flyvbjerg et al. (2003) analyzed 258 large transport projects (toll roads, bridges, railroads, etc.). Cost overruns of 50% to 100% and revenue shortfalls of 20% to 70% were common.
Table 1 below gives more details on cost overruns in rail, bridge and road engineering projects overseas. Cost overruns averaging 27.6% were found with rail having much larger cost overruns than road or bridge construction.
Table 1: Inaccuracy of transport mega-project estimates
| Project type | Number of projects | Average cost escalation |
| Rail | 58 | 44.7% |
| Bridge | 33 | 33.8% |
| Road | 167 | 20.4% |
| All projects | 258 | 27.6% |
Source: Flyvbjerg et al (2003).
Cost over-runs are not the preserve of the public sector. Merrow (2011) found that over half of large-scale engineering and construction projects – off-shore oil platforms, chemical plants, metals processing, dams, and similar projects – had poor results: Billions of dollars in total overruns, long delays in design and construction, and poor operability and revenue shortfalls once completed.
Alchian (1950) illustrated the unreliability of cost estimation with the range of bids made in tendering processes. When contractors bid for the same project, they routinely disagree over its likely cost by margins of 20 percent. The contractors are predicting their own costs, about which they are knowledgeable, and they have an incentive to be truthful to win the initial tender. Initial cost estimates by engineers have margins of error of 25 percent (Alchian 1950).
Central to capitalism is the notion of profit and loss. Entrepreneurial endeavours that anticipated the matort well make a profit. The rest fall by the wayside.
SkyCity is a private investment that should stand or fall on the same criteria as any other business venture in New Zealand.
What should be asked by the taxpayer in all these business subsidies is what the value for money for their tax dollars is?
What is the problem that has been solved other than common garden business failure? Can this problem be solved by market process on its own at its own pace subject to hard budget constraints, competition in the market place, the threat of innovation at home and abroad, and continuous updating of the knowledge available to the entrepreneurial decision-makers by changes in prices and profits and losses. As Friedman said:
The strongest argument for free enterprise is that it prevents anybody from having too much power.
Whether that person is a government official, a trade union official, or a business executive, it forces them to put up or shut up.
They either have to deliver the goods, produce something that people are willing to pay for, are willing to buy, or else they have to go into a different business.
Losses and bankruptcies are fundamental to the success of the market economy. Losses are a clear signal that need to restructure, cut costs or go out of business. The paraphrase Mao, ‘Bankrupt one, educate a thousand’.
Corporate welfare, such as a bailout to SkyCity and at such an early stage in the investment postpones these difficult choices. As George Stigler explained:
One great invention of a private enterprise system is bankruptcy, an institution for putting an eventual stop to costly failure.
No such institution has yet been conceived of in the political process, and an unsuccessful policy has no inherent termination.
Indeed, political rewards are more closely proportioned to failure than to success, for failure demonstrates the need for larger appropriations and more power.
The fact that the government regulates part of SkyCity’s business because it is a casino is no case for a bailout. The purpose of casino regulation is to constrain the size of that industry, not help it grow.
How Your Face Shapes Your Economic Chances – The Atlantic
23 Dec 2014 Leave a comment
in labour economics, personnel economics, population economics, survivor principle Tags: economics of beauty
Attractive CEOs raise their company’s stock price when they first appear on television, according to a working paper by Joseph T. Halford and Hung-Chia Hsu at the University of Wisconsin.
Taller people are richer. In fact, every inch between 5’7” and 6 feet is “worth” about 2 percent more in average annual earnings.
Being better looking than at least 67 percent of your peers is worth about $230,000 over your lifetime.
Having blond hair is worth as much as a year of school—for women.
Being an obese white woman is particularly punishing for your potential lifetime earnings.
via How Your Face Shapes Your Economic Chances – The Atlantic.
Wind welfare – time for this infant industry to grow up
22 Dec 2014 1 Comment
in environmental economics, rentseeking, survivor principle Tags: corporate welfare, green rent seeking, infant industry argument, wind welfare
The slow diffusion of modern human resource management
19 Dec 2014 Leave a comment
in entrepreneurship, human capital, industrial organisation, managerial economics, market efficiency, organisational economics, personnel economics, survivor principle Tags: firm size, modern human resource management, technology diffusion, The meaning of competition
Modern human resource management gained ground in the 1980s, slowly replaced the centralising of people management in personnel departments that was widespread by the 1960s.
Modern human resource management stressed rigorous selection and recruitment, more training at induction and on-the-job, more teamwork and multi-skilling, better management-worker communication, the use of quality circles, and encouraging employee suggestions and innovation.
The aim is a highly committed and capable workforce that pulls toward common goals. This drive for employer-employee unity is in contrast to the old days of detachment and formality with managers directing and controlling workers.
Modern human resource management replaced compliance with rules with genuine employee commitment and a unified corporate culture.
Modern human resource management is a technology and there is a long lag on the widespread adoption of any new technology.
The lag on the intra-industry diffusion of new technologies from 10% to 90% of users is 15 to 30 years long (Hall 2003; Grubler 1991). The literature on technology transfer is full of examples of the slow and costly diffusion of new technologies even with the on-site help of the original innovator and experienced consultants (Boldrin and Levine 2008).
New management practices are often complex and they are often slow and costly to introduce successfully without the assistance of consultants with prior experience with the new practices (Bloom and Van Reenen 2007, 2010).
Managerial innovations such as Taylor’s scientific management, Ford’s mass production, Sloan’s M-form corporations, Deming’s quality movement and Toyota’s lean manufacturing diffused slowly over decades. These technologies required large investments in learning, retraining, reorganisation, trial and error and adaptation and there were many failures (Bloom and Van Reenen 2010).
Bryson, Gomez, Kretschmer and Willman (2007) found that workplace voice and modern, high-commitment human resource management practices diffused unevenly across British workplaces. More employees, larger multi-establishment networks, public or for-profit ownership and network effects all increased the rates of diffusion of the new practices.
Large firms may invest more in skills because they are the early adopters of new management practices. Large firms are organisationally complex and they require more structured, explicit management practices to survive. Higher levels of worker skills have been linked with firms having better management practices (Bloom and Van Reenen 2007, 2010).
Employers who pay higher wages lose more if they mismanage or under-utilise well-paid workers. Large firms pay more, on average, so they lose more if they do not adopt good management practices in a timely fashion.
There are fixed costs to adopting new technologies and management practices, so large firms may be the first to find them profitable (Hall 2003). Later adopters may follow this lead when the new practices are more proven and, through experience and adaptation, cheaper to adopt.
The organisational disruption from switching to any new technology can reduce production and profits for several years and the new way of doing business may fail perhaps at a great cost (Holmes, Levine, and Schmitz 2012; Atkeson and Kehoe 2007; Roberts 2004).
These costs and uncertainties slow technology diffusion and explain why smaller firms use seemly out-of-date management practices. The new ways are not yet profitable for them. The pace of adoption of new technologies is driven by changes in the profitability of using the new technology as compared to the old (Karshenas and Stoneman 1993).
Firms of different sizes will invest in skills development and new management practices to the extent that is profitable to their circumstances.
On some occasions, large firms will find it profitable to invest in more skills development because this is part of the costs of investing in more capital per worker. On other occasions, skills development is necessary to reduce the costs of a growing corporate hierarchy.
No firm cannot invest in more skills development unless this growth is buoyed by market demand. Precipitate investments in skills development are fraught with risks.
Who to trust for news now that we live in an infotopia?
18 Dec 2014 Leave a comment
in economics of information, economics of media and culture, industrial organisation, survivor principle Tags: information cocoons, information overload, infotainment, infotopia
Robert Lucas and where have all the small entrepreneurs gone?
18 Dec 2014 1 Comment
in applied welfare economics, economics of regulation, entrepreneurship, industrial organisation, Robert E. Lucas, survivor principle, theory of the firm Tags: entrepreneurship, firm entry, firm exit, occupational choice
Robert Lucas predicted the decline in the number of small business people and small firms in 1978. The number of small firms will fall and the number of large firms will rise with increases in real wages (Lucas 1978; Poschke 2013; Gollin 2008; Eeckhout and Jovanovic 2012).
Lucas closed his 1978 discussion of the size distribution of firms, and how firms are getting larger an average over the course of the 20th century, with a discussion of a lovely restaurant he visited on the Canadian border. He predicted that in couple of decades time, these type of restaurants will be fewer.
Nations that are more productive over time and have higher wages because they have accumulated more capital per worker.
One consequence of more capital per worker is real wages increase at a faster rate than profits (Gollin 2008; Eeckhout and Jovanovic 2012). For example, the rate of return on capital was stable over the 20th century while real wages increased many fold (Jones and Romer 2010). This relationship turns out to be crucial in terms of occupational choice and the decision to become an entrepreneur – a small business owner
Higher wages reduces the supply of entrepreneurs and increases the average size of firms because entrepreneurship becomes a less attractive occupational choice (Lucas 1978; Gollin 2008; Eeckhout and Jovanovic 2012).
For example, in the mid-20th century, many graduates who were not teachers were self-employed professionals. With an expanding division of labour because of economic growth, many well-paid jobs and new occupations emerged for talented people in white-collar employment.
OECD countries richer than New Zealand should have less self-employment and more firms that are large because paid employment is an increasingly better-rewarded career option for their high skilled workers.
The U.S. had the second lowest share of self-employed workers (7 per cent) in the OECD in 2010 – the latest data – which is less than half the rate of New Zealand self-employment (16.5 per cent) in 2011 (OECD 2013). The Australian self-employment rate was 11.6 per cent in 2010 (OECD 2013).
A companion reason for larger average firm sizes in countries richer than New Zealand is more capital-intensive production can prosper in larger corporate hierarchies than can labour-intensive production (Lucas 1978; Becker and Murphy 1992; Poschke 2011; Eeckhout and Jovanovic 2012).
The more able entrepreneurs can run larger firms with bigger spans of control in richer countries because their employees can profitably use more capital per worker with less supervision. The diseconomies of scale to management and entrepreneurship should rise at a faster rate in less technological advanced countries such as New Zealand because they are more labour intensive economies (Lucas 1978; Becker and Murphy 1992; Poschke 2011; Eeckhout and Jovanovic 2012).
Importantly, the more able entrepreneurs benefit most from introducing frontier technologies because they can deal more easily with their increased complexity and more uncertain prospects (Poschke 2011; Lazear 2005; Shultz 1975; 1980). Growing technological complexity reduces the supply of entrepreneurs because it takes longer to acquire the necessary balance of skills and experience needed to lead a firm (Lazear 2005; Otani 1996).
The more marginal entrepreneurs will switch to be employees as technology advances so the average size of firms will increase. The entrepreneurs that remain in business will be the most able, more skilled and more experienced entrepreneurs and will be more capable of running larger firms that pioneer complex, frontier technologies (Poschke 2011; Lazear 2005, Otani 1996; Lucas 1978).
Countries more technologically advanced than New Zealand will have both larger firms and less self-employment because of growing technological complexity.
The greater is the exposure to foreign competition, the smaller is the fraction of self-employed and small firms in a country (Melitz 2003; Díez and Ozdagli 2012). More foreign competition increases wages because of lower prices, which makes self-employment less lucrative. More exporting favours larger firms both because of the fixed costs of entering export markets and because the stiffer competition will weed-out the lower ability entrepreneurs who run the smaller firms (Melitz 2003; Díez and Ozdagli 2012).
Other factors can countermand the effects that occupational choice, frontier technologies, exporting and capital intensity have to increase the average size of firms as real wages rise.
For example, tax and regulatory policies reduce the average size of firms in many EU member states to levels that are similar to New Zealand. The EU is less likely to have large firms in its labour intensive sectors. Employment protection laws, product market and land use regulation and in particular, high taxes stifled the growth of labour intensive services sectors in the continental EU (Bertrand and Kramatz 2002; Bassanini, Nunziata and Venn 2009; Rogerson 2008).
EU firms are are more capital intensive with fewer employees than otherwise because labour is so expensive to hire in the EU. Small and medium sized firms can struggle to grow in much of the EU because of regulatory burdens that phase in with firm size (Garicano, Lelarge and Van Reenen 2012; Hobijn and Sahin 2013; Rubini, Desmet, Piguillem and Crespo 2012). Average firm sizes are 40% smaller in Spain and Italy than in Germany. Obstacles to firm growth originate in product, labour, technology and financial and the binding constraints differ from one EU member state to another (Rubini, Desmet, Piguillem and Crespo 2012).
Average firm sizes in the USA and UK may be larger because of fewer tax and regulatory policies that limit business growth. Bartelsman, Scarpetta and Schivardi (2005) found that new entrants in the U.S. started on a smaller scale than in Europe but grew at a much higher rate. This willingness to experiment on a smaller scale was worth the risk because the payoff was much larger in terms of growth in the more flexible U.S. markets.
In summary, many factors drive the size distribution of firms countries including taxation and regulation. Underlying this, nonetheless, is Lucas’s point from 1978 that rising real wages makes starting a small business a less inviting occupation choice.
Utopia, you are standing in it! 
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