Armen Alchian | Utopia, you are standing in it!

George Stigler on do business owners maximise profits?

29 Jul 2014 Leave a comment

by Jim Rose in applied price theory, Armen Alchian, entrepreneurship, George Stigler, survivor principle, theory of the firm Tags: george stigler, market selection, profit-maximisation

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.

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The separation of ownership from control

24 Jul 2014 3 Comments

by Jim Rose in Armen Alchian, industrial organisation, Ronald Coase, survivor principle, theory of the firm Tags: Armlen Alchian, Eugene Fara, Harold Demsetz, Ronald Coase, separation of ownership and control, theory of the firm

Eugene Fama divides firms into two types: the managerial firm, and the entrepreneurial firm.

The owners of a managerial firm advance, withdraw, and redeploy capital, carry the residual investment risks of ownership and have the ultimate decision making rights over the fate of the firm (Klein 1999; Foss and Lien 2010; Fama 1980; Fama and Jensen 1983a, 1983b; Jensen and Meckling 1976).

Owners of a managerial firm, by definition, will delegate control to expert managerial employees appointed by boards of directors elected by the shareholders (Fama and Jensen 1983a, 1983b). The owners of a managerial firm will incur costs in observing with considerable imprecision the actual efforts, due diligence, true motives and entrepreneurial shrewdness of the managers and directors they hired (Jensen and Meckling 1976; Fama and Jensen 1983b).

Owners need to uncover whether a substandard performance is due to mismanagement, high costs, paying the employees too much or paying too little, excessive staff turnover, inferior products, or random factors beyond the control of their managers (Jensen and Meckling 1976; Fama and Jensen 1983b, 1985). Any paucity in knowledge slows the reactions of owners in correcting managerial errors including slip-ups in the recruitment and the retention of experienced older employees.

The entrepreneurial firms are owned and managed by the same people (Fama and Jensen 1983b). Mediocre personnel policies and sub-standard staff retention practices within entrepreneurial firms are disciplined by these errors in judgement by owner-managers feeding straight back into the returns on the capital that these owner-managers themselves invested. Owner-managers can learn quickly and can act faster in response the discovery of errors in judgement. The drawback of entrepreneurial firms is not every investor wants to be hands-on even if they had the skills and nor do they want to risk being undiversified.

Many of the shareholders in managerial firms have too small a stake to gain from monitoring managerial effort, employee performance, capital budgets, the control of costs and the stinginess or generosity of wage and employment policies (Manne 1965; Fama 1980; Fama and Jensen 1983a, 1983b; Williamson 1985; Jensen and Meckling 1976). This lack of interest by small and diversified investors does not undo the status of the firm as a competitive investment.

Large firms are run by managers hired by diversified owners because this outcome is the most profitable form of organisation to raise capital and then find the managerial talent to put this pool of capital to its most profitable uses (Fama and Jensen 1983a, 1983b, 1985; Demsetz and Lehn 1985; Alchian and Woodward 1987, 1988).

More active investors will hesitate to invest in large managerial firms whose governance structures tolerate excessive corporate waste and do not address managerial slack and error. Financial entrepreneurs will win risk-free profits from being alert and being first to buy or sell shares in the better or worse governed firms that come to their notice.

The risks to dividends and capital because of manifestations of corporate waste, reduced employee effort, and managerial slack and aggrandisement in large managerial firms are risks that are well known to investors (Jensen and Meckling 1976; Fama and Jenson 1983b). Corporate waste and managerial slack also increase the chances of a decline in sales and even business failure because of product market competition (Fama 1980; Fama and Jensen 1983b). Investors will expect an offsetting risk premium before they buy shares in more ill-governed managerial firms. This is because without this top-up on dividends, they can invest in plenty of other options that foretell a higher risk-adjusted rate of return.

The discovery of monitoring or incentive systems that induce managers to act in the best interest of shareholders are entrepreneurial opportunities for pure profit (Fama and Jensen 1983b, 1985; Alchian and Woodward 1987, 1988; Demsetz 1983, 1986; Demsetz and Lehn 1985; Demsetz and Villalonga 2001). Investors will not entrust their funds to who are virtual strangers unless they expect to profit from a specialisation and a division of labour between asset management and managerial talent and in capital supply and residual risk bearing (Fama 1980; Fama and Jensen 1983a, 1983b; Demsetz and Lehn 1985). There are other investment formats that offer more predictable, more certain rate of returns.

Competition from other firms will force the evolution of devices within the firms that survive for the efficient monitoring the performance of the entire team of employees and of individual members of those teams as well as managers (Fama 1980, Fama and Jensen 1983a, 1983b; Demsetz and Lehn 1985). These management controls must proxy as cost-effectively as they can having an owner-manager on the spot to balance the risks and rewards of innovating.

The reward for forming a well-disciplined managerial firm despite the drawbacks of diffuse ownership is the ability to raise large amounts in equity capital from investors seeking diversification and limited liability (Demsetz 1967; Jensen and Meckling 1976; Fama 1980; Fama and Jensen 1983b; Demsetz and Lehn 1985).Portfolio investors may know little about each other and only so much about the firm because diversification and limited liability makes this knowledge less important (Demsetz 1967; Jensen and Meckling 1976; Alchian and Woodward 1987, 1988).

It is still unwise to still suppose that portfolio investors will keep relinquishing control over part of their capital to virtual strangers who do not manage the resources entrusted to them in the best interests of the shareholders (Demsetz 1967; Williamson 1985; Fama 1980, 1983b; Alchian and Woodward 1987, 1988).

Managerial firms who are not alert enough to develop cost effective solutions to incentive conflicts and misalignments will not grow to displace rival forms of corporate organisation and methods of raising equity capital and loans, allocating legal liability, diversifying risk, organising production, replacing less able management teams, and monitoring and rewarding employees (Fama and Jensen 1983a, 1983b; Fama 1980; Alchian 1950).

Entrepreneurs win profits from creating corporate governance structures that can credibly assure current and future investors that their interests are protected and their shares are likely to prosper (Fama 1980; Fama and Jensen 1983a, 1983b, 1985; Demsetz 1986; Demsetz and Lehn 1985). Corporate governance is the set of control devices that are developed in response to conflicts of interest in a firm (Fama and Jensen 1983b).

Spans of control and the cost of entrepreneurial time

20 Jul 2014 Leave a comment

by Jim Rose in applied price theory, Armen Alchian, industrial organisation, Ronald Coase, theory of the firm Tags: markets and hierarchies, Oliver Williamson, Robert Lucas, Ronald Coase, span of control, theory of the firm, Walter Oi

One constraint on the growth of any firm is entrepreneurs have a limited span of control (Coase 1937; Williamson 1967, Lucas 1978; Oi 1983a, 1983b). A span of control is the number of subordinates that an individual supervisor has to control and lead either directly or through a hierarchical managerial chain (Fox 2009).

There are only so many tasks that even the most able entrepreneurs can carry out in one day. Over-stretched spans of control motivate entrepreneurs to hire professional managers and delegate to them a wide range of decision-making rights over the firms they own (Williamson 1975; Foss, Foss and Klein 2008).

Entrepreneurs and the professional managers they hired to assist them must divide their respective time between monitoring employees, identifying new business opportunities, forecasting buyer demand and running the other aspects of their business (Lucas, 1978; Oi 1983, 1983b, 1988; Foss, Foss, and Klein 2008). The larger is the firm, the more employees there are for the entrepreneur to direct, monitor and reward. These costs of directing and monitoring employees will increase with the size of the firm and larger firms will encounter information problems not present in smaller firms (Alchian and Demsetz 1972; Stigler 1962).

The cost of entrepreneurial time spent monitoring employees will increase with the size of the firm (Lucas 1978; Oi 1983b). The time of the more talented entrepreneurs is more valuable because they had the superior managerial skills and entrepreneurial alertness to make their firms large in the first place and remain deft enough to survive in competition. Time spent on the supervision of employees is time that is spent away from other uses of the talents that got these more able entrepreneurs to the top and keeps them there (Williamson 1967; Lucas 1978; Oi 1983b, 1988, 1990; Idson and Oi 1999; Black et al 1999).

Firms in the same industry tend to exhibit systematic differences in their organization of production and the structure of their workforces because entrepreneurial ability is the specific and scarce production input that limits the size of a firm (Lucas, 1978; Oi 1983b). The less able entrepreneurs tend to run the smaller firms while the more able entrepreneurs tend to lead both the currently large firms and the smaller firms that are growing at the expense of market rivals (Lucas 1978, Oi 1983b; Stigler 1958; Alchian 1950).

Alchian and Allen on the irrelevance of economists and economic principles to progress

24 Jun 2014 Leave a comment

Image by Jim Rose

Alchian and Allen’s list of economic fallacies

13 Jun 2014 Leave a comment

by Jim Rose in applied price theory, Armen Alchian Tags: Armen Alchian, Bill Allen

Price controls prevent higher costs to consumers;
reducing unemployment requires creating more jobs;
larger incomes for some people require smaller incomes for others;
free, or low, tuition reduces costs to students;
unemployment is wasteful;
stockbrokers and investment advisors predict better than throwing a dart at a list of stocks;
international trade deficits are bad and surpluses are good;
inflation is caused by government deficits;
government budget deficits reduce saving and raise interest rates;
new taxes are borne by the consumer of the taxed items;
employers pay for "employer provided" insurance;
tax-exempt bonds avoid taxes;
minimum wages help the unskilled and minorities;
housing developers drive up the price of land;
foreign imports reduce domestic jobs;
"equal pay for equal work" aids women, minorities and the young;
very low unemployment causes inflation; and
the Federal Reserve Board controls the rate of interest.

Source: Universal Economics

Armen Alchian would have been 100 today

13 Apr 2014 Leave a comment

by Jim Rose in applied welfare economics, Armen Alchian, market efficiency Tags: Armen Alchian, price system, property rights

From Alchian’s and William Allen’s 1968 “What Price Zero Tuition?“

Since the fiasco in the Garden of Eden, mankind has suffered from scarcity: there cannot be enough goods and services to satisfy completely all the wants of all the people all the time.

Consequently, man has had to learn the hard way that in order to obtain more of this good he must forego some of that: most goods carry a price, and obtaining them involves the bearing of a cost.

Poets assure us that the best things in life are free. If so, education is a second-best good, for it decidedly is not free. But if education is not free, if a price must be paid, who is to pay it?

By developed instinct, the economist initially presumes it to be appropriate that payment of the price should be made by those who receive the good.

"Those who get should pay" is a strong rule of thumb; the economist will deviate from it only for profoundly compelling reasons.

via Quotation of the Day…. Cafe Hayek

Alchian and Allen wrote the best economics textbook ever.

Product Details

Exchange and Production: Competition, Coordination and Control in 1977

Armen Alchian on property rights

Alchian, Demsetz and the efficiency enhancing roles of unions

31 Mar 2014 Leave a comment

by Jim Rose in Armen Alchian, labour economics, theory of the firm Tags: transaction costs, unions

Many look at unions as a cartel that raises wages at the expense of non-members.

What has been under-sold is the efficiency enhancing role of unions in Alchian and Demsetz (1972) – their modern classic on the theory of the firm.

Employee unions, whatever else they do, act as monitors for employees.

Are correct wages paid on time? Usually, this is easy to check.
But some forms of employer performance on the employment contract are less easy to meter and is at risk to employer shirking.

Medical, hospital, and accident insurance and retirement pensions are contingent payments paid in kind by employers to employees. Each employee cannot judge the character of such payments as easily as with money wages.

A specialist monitor – a union hired by the employees – monitors those aspects of employer payments that are more difficult for employees to monitor. As an example, many unions sit on the board of directors of pension funds as an employee watch dog.

Because of economies of scale in monitoring and enforcing contracts, unions may arise as an institution to reduce the costs of contracting for employees with investments in specific human capital and back-loaded pay, including employee pension plans.

In addition to these narrow contract-monitoring economies of scale, a union creates a continuing long-term employment relationship that eliminates the last-period (or transient employee) contract-enforcement problem and creates bargaining power (a credible strike threat) to more cheaply punish a firm that violates the employment contract.

As a union makes it more costly for a firm to cheat an individual worker in his last period of work, workers are more likely to invest in specific human capital and accept back-loaded pay schemes, both of which raises their career wages and productivity.
A strike is a cheaper way to enforce a contract than is litigation. Many firms stop dealing with a bad customer/unreliable supplier until a bill or problem is fixed. A quick strike is no different.

Unions are more likely to exist when the opportunistic cheating problem is greater, namely, when there is more firm-specific human capital present in the employment relationship.

Unions perform many of the functions carried out by professional agents in the sports and entertainment industries. These specialists know the going rate for specific talents; act as a credible and informed negotiating agent; warn their clients off working for bad employers; and punish bad employers by not referring future clients to them.

The traditional literature on unions argues that unions act as a productivity shock and give employee voice in workplace affairs, which lowers job turnover. Unions as an institution to reduce contract negotiation and enforcement costs is better nested in the modern theory of the firm. Of course, unions can also act as cartels.

The next blog on unions will be on the withering away of the union wage premium. The final blog will be on how strikes can enhance the profits of employers!

Whatever is, is efficient – part 1

27 Mar 2014 Leave a comment

by Jim Rose in Armen Alchian, behavioural economics, industrial organisation, labour economics, market efficiency Tags: Armen Alchian, behavioural economics, rational behaviour, rational choice economics, Richard Posner

Armen Alchian would ask “If something is so optimal, why don’t we see it then?”

The best way Alchian related this discipline on thinking was to point to something like the question of optimal taxes. If optimal taxes are so optimal, why don’t we see more of these optimal taxes in practice?

There must be other costs left out of your optimal tax analysis. There might be less obvious costs in the political system in organising support or other changes that are required that are overlooked, making optimal taxes such a ‘low-cost’ option. Most objectives look better than they are if you ignore some of the costs of achieving those objectives.

Alchian asserted that “whatever is, is efficient.”

If the status quo was not efficient, something else would eventuate;
Of course, if you try to change anything that is – that too is efficient because otherwise you would not try to do so.

The key point is why are we weighing only some costs and not others? Why are these costs (involved in minimizing particular dead-weight losses that would be involved in setting a particular optimal tax) less important than other types of costs (those involved in informing people of what the options are or of organizing them to go and try to adopt the alternative option)? Optimal taxes are also decidedly less optimal if they allow governments to raise more revenue, and the extra revenue is not spent wisely.

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Alchian’s analysis of institutions and processes spent a lot of time showing that many often puzzling institutions and practices arose to lower various costs of decision making and transacting in the market and within organisations and groups. Many of these costs are far from obvious and must be teased out through difficult, time-consuming analysis.

Alchian was a great teacher. He taught in the Socratic Method. He posed countless questions to force his students to think harder and deeper.

Behavioural economics is an example of a whole field that expanded not by thinking harder and deeper using standard economic tools. It explains anomalous behaviour and seemingly irrational choices as the result of cognitive quirks or short-sightedness and a range of people’s other shortcomings. That is easier than spending a few more decades getting to the bottom of the matter.

George Stigler in the 1960s made a marvellous critique of what became behavioural economics back in the early 1960s by saying that in every decade for the last 150 years, economists dabbled in psychology.

Stigler said that they missed the point of economics as a method. He argued that the simple hypothesis of rational behaviour is so powerful because it can account for so much of human behaviour. Stigler adds this in his Tanner Lectures in 1981:

Members of other social sciences often remark, in fact I must say complain, at the peculiar fascination that the logic of rational decision-making exerts upon economists.

It is such an interesting logic: it has answers to so many and varied questions, often answers that are simultaneously reasonable to economists and absurd to others. The paradoxes are not diminished by the delight with which economists present them…

The power of self-interest, and its almost unbelievable delicacy and subtlety in complex decision areas, has led economists to seek a large role for explicit or implicit prices in the solution of many social problems.

Richard Posner went further and argued that behavioural economics may not be a science in Popper’s sense of falsifiability.

Posner referred to Cardinal Bellarmine’s famous description of what he saw in Galileo’s telescope which was pointing to the moons rotating around Saturn. Cardinal Bellarmine explained it as a trick of the devil.

Behavioural economics, in Richard Posner’s view, is close to Cardinal Bellarmine’s trick of the devil methodology because it explains anomalies away either as cognitive quirks or as rational behaviour. Nothing is an anomaly for behavioural economics so nothing can falsify it. Instead of the devil making me do it, a cognitive quirk made me do it.

Posner’s key point was:

Rational-choice economics makes the analyst think hard. Faced with anomalous behaviour, the rational-choice economist, unlike the behavioural economist, doesn’t respond, “Of course, what do you expect?” Troubled, puzzled, challenged; he wracks his brains for some theoretical extension or modification that will accommodate the seeming anomaly to the assumption of rationality.

Rather than attribute odd behaviour to cognitive quirks or short-sightedness, the better explanation is the behaviour is not fully understood.

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Utopia, you are standing in it!

George Stigler on do business owners maximise profits?

The separation of ownership from control

Spans of control and the cost of entrepreneurial time

Alchian and Allen on the irrelevance of economists and economic principles to progress

Alchian and Allen’s list of economic fallacies

Armen Alchian would have been 100 today

Alchian, Demsetz and the efficiency enhancing roles of unions

Whatever is, is efficient – part 1

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