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.
Why are we always restructuring the workplace? The economics of organisational fickleness
16 Dec 2014 2 Comments
in entrepreneurship, industrial organisation, managerial economics, market efficiency, organisational economics, personnel economics, survivor principle Tags: industrial organisation, survivior principle
Ok, whatever is, is efficient, but I always had my doubts when we are always restructuring wherever I worked. This continual organisational upheaval and restructuring was also a phenomena in the private sector.
What was the survival value of this continual disruption of organisational form and organisational capital in competition with rival firms with more stable internal organisational forms?
Internal reorganisations divert management time away from more profitable pursuits such as facilitating production. Managerial resources are scarce, like any other resource, and must be allocated to their highest value uses.
But as a firm grows, waste accumulates through the duplication of employee effort and the assignment of unnecessary tasks within the organisation.
Jack Nickerson and Todd Zenger wrote a great paper in 2002 on the efficiency of being fickle – of repeated reorganisations of the workplace. Their point was simple: times change and they change a lot faster than we think so organisations have to adapt to their rapidly unfolding new market conditions.
They illustrated their point about the need for regular reorganisation inside a short period of time with a case study of the alternating waves of centralisation and decentralisation in Hewlett-Packard.
Throughout the 1970s, Hewlett-Packard was a thoroughly decentralised organisation and was successful in the market. It had a remarkable record of innovation in the 1970s.
In the early 1980s, Hewlett-Packard hard found this decentralisation was starting to work against it in the rapidly evolving computer market. The Independent divisions developed computers, peripherals and components that will both incompatible with each other and competed with each other.
This redundancy between the independent divisions was costly and was confusing to consumers because they had a hodgepodge of products that really won’t related to each other. The computer industry in the early 1980s was involving very rapidly with many incompatible computers and programs, but the few that turned out to be the best became immensely profitable.
In 1984 and 1985, Hewlett-Packard hard centralise product development in headquarters and put all marketing and sales into one unit. Financial performance recovered after this reorganisation.
By 1990, Hewlett-Packard was on again in a steep financial decline. The centralisation of decision-making has slowed product development and there was a significant drop in innovation.
In 1990, computers was separated into competing products and computing systems. Individual product lines were decentralised and treated a separate business units.
In 1994, Hewlett-Packard again decentralised customer support of all computer activities. Three years later, it decentralised the same activities into three organisations. In 1999 it spun off its instruments and medical business.
Over 16 years, Hewlett-Packard, experience five fundamental ships alternating between decentralisation and centralisation. Each one of these reorganisations was greeted with the share price increase.
The reason why this fickleness in organisational form was efficient was the market changes rapidly. Organisational forms and organisational capital become obsolete rather quickly.
The form of organisation that survives in competition with actual and potential market rivals is that specific form of organisation which allows the firm to deliver the products that customers want at the lowest price while covering costs (Alchian 1950; Fama and Jensen 1983a, 1983b).
Each time Hewlett-Packard decentralised was a time in the product life cycle of their industry where there was rapid innovation. Hewlett-Packard tended to centralise in the consolidation phase of product life cycles.
New technologies are unproven and they come with much less information and prior experience to guide the top of a hierarchy in directing their successful adoption from a distance (Acemoglu, Aghion, Lelarge, Van Reenen and Zilibotti 2007). In any hierarchy, the top faces two problems with their subordinates: communicating their desires and seeing that they are carried out (Tullock 2005).
When a large firm directs major changes from the top of a hierarchy, failures of communication in the chain of command are a growing risk. More employees require more supervisors. More supervisors require more supervisors of supervisors at every tier of the hierarchy – the layers of supervision multiply (Posner 2010; Williamson 1975, 1985).
There are delay in executing orders, a loss of information and feedback on the way up, and the truncation of the directions from the top: there is a general weakening of control and coherence (Posner 2010; Williamson 1975, 1985). The daily implementation problems of new technologies cannot go up and down a hierarchy for resolution.
Firms must decentralise (rather than grow in hierarchy) to profit most from a line manager’s superior local knowledge about the implementation of the latest, more complex technologies. Delegating initiative to managers downstream is vital when a large firm introduces frontier technologies about which information flows upstream are slow and considerable learning by doing and rapid adaptation are required (Acemoglu, Aghion, Lelarge, Van Reenen and Zilibotti 2007; Jensen and Meckling 1995).
New technologies usually bug-ridden and require considerable refinement, adaptation and consumer feedback on their use before the mature product emerges (Greenwood 1999; Greenwood and Yorukoglu 1997). This costly process of learning, improvisation and product and process re-design explains the multi-decade long 10-90 lag in technology diffusion across firms in the same industry and the slow rate of consumer acceptance of new products.
Larger firms may struggle with striking the most profitable balance between greater local managerial discretion and effective corporate governance of a large diverse organisation with professional managers and diffuse ownership structures.
A risk of greater local managerial discretion in a large firm is less effective governance (Williamson 1975, 1985; Fama and Jensen 1983a, 1983b). The risks of separating of ownership from control and the distortions to knowledge flows in hierarchies drives the internal organisation of large firms and the division of decision control and decision management rights between the board and management (Fama and Jensen 1983a, 1983b; Williamson 1985).
The separation of decision management rights, vested in hired managers, from decision control rights, vested in the board of directors, is a common governance safeguard against conflicts of interest in business, professional and non-profit organisations, large and small (Fama and Jensen 1983a, 1983b).
Decision management rights cover the initiation and the implementation of decisions. Decision control rights involve the ratification and the monitoring of decisions. Managers and division heads carry out the production decisions, budgets and policies on wages, hours, staffing and job designs developed by head office and which are ratified by the board of directors (Fama and Jensen 1983b, 1985).
Competition between different sizes, shapes and internal organisational forms of firms all vying for sales, cheaper sources of supply and investor support sifts out the keener priced, lower cost, and more innovative enterprises (Alchian 1950; Stigler 1958). These lower-cost firms will be able to under-sell their higher cost rivals.
The winning firm size and internal organisational shape is that configuration which meets any and all problems the firm is actually facing and seizes more of the entrepreneurial opportunities that are within its grasp (Stigler 1958; Alchian 1950).
Large firms invest heavily in mimicking the nimbleness of small firms. Some firms re-create some of the advantages of being small by organising into M-form hierarchies made up of product divisions to improve performance monitoring, identify managerial slack, encourage mutual monitoring, promote competition within the firm for top-level management positions and facilitate comparisons of compliance with the policies of head office (Klein 1999; Fama and Jensen 1983a, 1983b; Williamson 1975, 1985).
Large firms must develop organisational architectures to assign decision rights, reward employees, and evaluate the performance of employees and business units. The aim is to empower subordinates with the requisite local knowledge with the power to act swiftly and the incentive to make good decisions. The organisational architecture of a firm encompasses the assignment of decision rights within the firm, the methods of rewarding individual employees, and the structure of the systems that evaluate the performance of individual employees and business units.
Poor cost control, budgetary excess and any lack of innovation and initiative over products designs and pricing, input mixes and wage and employment policies will reflect in relative divisional performances and overall corporate profits.
Any news of less promising current and future net cash flows will feed into share prices and into the labour market prospects of both career managers and the members of boards of directors (Manne 1965; Jensen and Meckling 1976; Fama and Jensen 1983a, 1983b; Demsetz 1983; Demsetz and Lehn 1985). To survive, managerial firms must balance delegation with more centralised control (Fama and Jensen 1983a; McKenzie and Lee 1998).
One way of balancing delegation with centralised control is simply to reorganise the firm on a regular basis as market circumstances change and entrepreneurial judgements about the future are updated. This regular reorganisation of the firm may seem fickle, but the firm must adapt or die. Firms must be efficiently fickle in their organisational forms.
Not only is whatever is, is efficient, any attempt to change whatever is, is efficient, because otherwise it wouldn’t be attempted. Of course, these reorganisations are entrepreneurial ventures that are never guaranteed success.
Can you invest in a trend?
14 Dec 2014 Leave a comment
in entrepreneurship, financial economics, industrial organisation, survivor principle Tags: creative destruction, efficient market hypothesis, market selection, survivor principle, The meaning of competition
The Attack on Concentration: Yale Brozen (1979)
06 Dec 2014 Leave a comment
in applied price theory, applied welfare economics, industrial organisation, survivor principle Tags: anti-trust law, competition law, creative destruction, The meaning of competition
There is a distinction between controlling the supply of a product and producing or selling most of the supply of a product.
“Dominant” producers who sell a major portion of a product’s supply usually have no control over the supply. They have no power to set any lower level of industry output and a higher price than that which would prevail in a market with many suppliers and no dominant firm.
Usually, a dominant producer is the most efficient firm in the industry. Its large output is the result of its efficiency in supplying the market. The market price is as low as it would be with many producers frequently lower.
Any attempt by a dominant firm to restrict its own supply and increase price after reaching a “dominant” position simply results in the expansion of output by other firms, the entry of additional firms, and loss of its dominance. A dominant firm can keep its dominance only by behaving competitively.
The fact that there is a dominant firm, or small group of firms, in an industry is evidence of competitive behavior not of monopolization.
via The Attack on Concentration: Newsroom: The Independent Institute.
Utopia, you are standing in it! 
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