What happened when a restaurant chain abolished tipping?

16 May 2016 Leave a comment

by Jim Rose in labour economics, labour supply, managerial economics, minimum wage, occupational regulation, organisational economics, personnel economics, politics - USA, theory of the firm Tags: , ,

Joe’s Crab Shack tested a no-tip model in 18 of its 130 restaurants. A 12-15% service charge replaced tips. Joe’s Crab capture is the first major restaurant chain to experiment with a tipping policy to experiment with abolishing it. The tipping minimum wage is far less than the federal, state and local minimum wages.

Joe’s Crab Shack had high hopes. The aims were customers would pay less, get a greater value experience, reduce labour costs and increase profits. The reactionary left represented by Salon and Huffington Post have quite strong views on tipping. Salon says

Tipping is a repugnant custom. It’s bad for consumers and terrible for workers. It perpetuates racism. Tipping isn’t even good for restaurants, because the legal morass surrounding gratuities results in scores of expensive lawsuits.

Tipping does not incentivize hard work. The factors that correlate most strongly to tip size have virtually nothing to do with the quality of service. Credit card tips are larger than cash tips. Large parties with sizable bills leave disproportionately small tips.

We tip servers more if they tell us their names, touch us on the arm, or draw smiley faces on our checks. Quality of service has a laughably small impact on tip size.

According to a 2000 study, a customer’s assessment of the server’s work only accounts for between 1 and 5 percent of the variation in tips at a restaurant.

Salon adds that federal and state law requires restaurants to ensure that tips bring employees up to minimum wage, but few diners know that.

Huffington Post managed to marshal 9 reasons why tipping should be abolished arguing that it was in no one’s interests either employers, employees or customers. The old efficiency at wage argument was rolled out arguing that employers gain in terms of diligent motivate employees by paying a straight wage rather than leaving it up to customer judgements of the services tended.

Not surprisingly this sounded like a business opportunity to Joe’s Crab Shack. Better customer service, better motivated employees and lower labour costs were promised by abolishing tips. You wonder why tipping survived in competition against alternative forms of restaurant service formats for all these decades?

Well, Joe’s Crab Shack got more than it bargained for when it abolished tipping. The pilot restaurants lost an average of 8-10% of customers during the test run.

The restaurant’s research showed that around 60% of customers disliked the policy because it took away an incentive for good service and that they don’t necessarily trust that management is passing along the money to workers.

The no tipping structure worked at four restaurants and will continue to work out why it succeeded there but failed at 14 other places.

What is even more interesting that the abolition of tipping lead to some workers quitting. This outcome at Joe’s Crab Shack is inconsistent with the notion that tipping is a by-product of the inequality of bargaining power between workers and employees. Turnover is supposed to reduce when tipping is abolished rather than increase with the employer losing their best workers.

Lazear found in data for Safelite Glass that average productivity will rise and the firm will attract a more able workforce will rise when it shifts to piece rates. The 44% increase in output per worker suggested the firm previously had a suboptimal compensation system. Half of the increase in labour productivity came from workers quitting when piece rates are introduced and being replaced by workers motivated to apply by the lure of piece rates. The average worker received a 10% increase in pay as a result of the switch to piece rates.

The only economic analysis of any value on tipping was written in 1985 by David Sisk at the Federal Trade Commission. He wrote a paper about both tipping and commissions. Sisk approached tipping not as a motivational device but a form of contracting.

Sisk points out that tipping takes the place of reputation as a way of guaranteeing good services are at a restaurant. Many do not plan to return to a restaurant  so an alternative form of contracting emerges to ensure good service because the threat of taking future custom elsewhere does not work.

In the case of a tip, the buyer (or customer) is provided with a final means of automatic redress which serves to prevent unsatisfactory performance on the part of the seller.

The possibility of unsatisfactory performance arises when the brand-name, repeat purchase mechanism is not effective or because employees of the seller are too costly to monitor.

An example is tourists. They are protected from inferior service relative to the locals because they pay tips too and are well able to judge good and bad service.

Sisk argues that once a customer sits down at a restaurant, the customer commits ever increasing amounts of time and the restaurant commits ever increasing amounts of physical resources. As one commits more irrevocable resources, the greater is the incentive of the other to renege on the contract.

A tip allows the customer to withhold a portion of the price without further negotiation. The tip serves to protect the customer from bad service and to protect the restaurant from bad service by an errant employee

The system of tipping provides the motivation for the waiter to properly identify and accommodate the individual desires of customers subject to the profit maximizing constraint of the restaurant owner…

The tip protects the buyer from exploitation by a seller (when the brand-name mechanism is insufficient) or from exploitation by the shirking employees of the seller

The worst tippers are single males; the best are couples and groups. The biggest tippers are single males on a date.

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Source: OkCupid, A woman’s advantage.

Profits Are Progressive

10 May 2016 Leave a comment

by Jim Rose in applied price theory, economics of media and culture, entrepreneurship, industrial organisation, survivor principle, theory of the firm Tags: , , , ,

@Economicpolicy shows that top CEO pay has been a miserable rollercoaster for 15 years

25 Apr 2016 Leave a comment

Image by Jim Rose

What a $15 Minimum Wage Would Do

20 Apr 2016 Leave a comment

by Jim Rose in applied price theory, economics of media and culture, entrepreneurship, job search and matching, labour economics, managerial economics, minimum wage, organisational economics, personnel economics, theory of the firm Tags: , ,

Forever Contemporary – The Economics of Ronald Coase | Free book from Institute of Economic Affairs

11 Apr 2016 Leave a comment

by Jim Rose in history of economic thought, industrial organisation, law and economics, property rights, Ronald Coase, theory of the firm

Summary:

  • R. H. Coase (1910–2013), a leading modern figure in the classical liberal tradition, was awarded the Nobel Prize in Economics in 1991 for his analysis of the significance of transaction costs and property rights for the functioning of the economy.
  • Before Coase’s work in the 1930s, there was no real understanding of the relation between the theory of the firm and the theory of markets. Coase showed that the size and structure of firms, and the location of the border between internal exchange within the firm and external exchange through markets, are systematically related to the costs of transactions.
  • These transaction costs, which Coase termed ‘costs of using the price mechanism’, include search and information costs (those involved in finding business partners, rather than having to produce your own inputs), bargaining costs (which rise sharply with the number of contractual partners) and enforcement costs (which, in the absence of a strong and effective legal framework, depend largely on trust in partners). When these costs alter dramatically, for example, as a result of introducing innovative technology, we can expect substantial alterations in firm and market structures.
  • Coase was a pioneer in the modern analysis of environmental issues. He showed that, with clear property rights and low transactions costs, private solutions to many environmental problems can be achieved without government regulation. Such solutions were logically independent of the initial distribution of property rights. This is highly relevant to a number of modern economic problems which the government currently handles badly, such as land-use planning.
  • His work has had a profound effect on later generations of economists, several of whom themselves won Nobel Prizes. His work on environmental issues, for example, influenced another Nobel Prizewinner in Elinor Ostrom, whose work focused on how common pool resources could be used effectively with minimal government intervention. This is especially relevant to debates about environmental and ecological degradation in forestry, fishing and game animal resources – perhaps particularly in developing economies.
  • Similarly his work on the firm led to the development of the ‘New Industrial Economics’, now associated with Oliver Williamson, which has changed our understanding of issues of economic governance. This is relevant to current concerns over corporate social responsibility.
  • Coase’s editorship of the Journal of Law and Economics over many years did much to stimulate economic analysis of legal institutions, an innovation which has had a major influence on public policy, particularly in the US. It has fed, for instance, into recommendations for accident compensation.
  • Coase’s insights have challenged economists’ assumptions about the nature of public goods, which he demonstrated could often be provided more effectively by various forms of private initiative. He also illuminated such varied topics as the allocation of spectrum bandwith, the regulation of financial institutions and water resource management.
  • Methodologically, Coase was opposed to ‘blackboard economics’ which relied on theory or econometric analysis at the expense of more practical investigation. He favoured careful examination of case studies and the history of industries when analysing economic policy issues.
  • His work retains considerable significance in the twenty-first century. Coase’s analysis of China’s economic advance, published shortly before his death, sheds light on its future prospects, while his transaction cost approach can be argued to explain the new phenomenon of the ‘sharing’ economy which is reshaping businesses and employment. Furthermore his work should continue to be at the forefront of debates surrounding regulation, broadcasting and the environment. If policymakers and the economists who advise them ignore Coase, they are in danger of perpetuating policies which may work ‘in theory’ but do not work effectively in practice.

Source: Forever Contemporary – The Economics of Ronald Coase | Institute of Economic Affairs

@LivingWageUK documents the Achilles heel of the #livingwage

09 Feb 2016 1 Comment

by Jim Rose in applied price theory, economics of bureaucracy, economics of regulation, entrepreneurship, managerial economics, minimum wage, organisational economics, personnel economics, politics - New Zealand, Ronald Coase, theory of the firm

Research publicised by a Living Wage UK highlighted the Achilles heel of any living wage proposal. This Achilles heel applies to the voluntary adoption of the living wage and a living wage mandated through minimum wage laws.

The critique to follow accepts pretty much everything claimed by the living wage movement about the benefits of the living wage but simply traces out the consequence of this one promised benefit.

Source: New evidence of business case for adopting Living Wage   Living Wage Foundation.

The living wage is substantially above the minimum wage. Offering the living wage will change the composition of the recruitment pool of low-wage employers. This is the Achilles heel of the living wage which Living Wage UK documents in its study it tweeted about and from which I have taken the above snapshot.

Jobseekers would not have considered vacancies by these employers will now apply because of the living wage increase. These better calibre applicants will win those jobs ahead of the jobseekers whose current productivity levels are less than that to justify the cost of the living wage.

Central to the living wage rhetoric is that somehow employees will be more productive because of the adoption of the living wage.

The simplest way of doing that for an employer is to hire more qualified, more productive employers are no longer a hire the type of people you currently hire. They will be unemployed or pushed into the non-living wage sector of the low-wage market.

A living wage is an exclusionary policy where ordinary workers, often with families who are not productive enough to produce $19.25 per hour living wage plus overheads will never be interviewed.

The workers with the type of skills that currently win those jobs covered by a living wage increase will not be shortlisted because the quality of the recruitment pool will increase because of the living wage.

There will be an influx of more skilled workers attracted by the higher wages for living wage jobs. They will go to the head of the queue and displaced workers who currently apply for and win these jobs before the adoption of the living wage.

Any extra labour productivity from paying a living wage increase is in doubt because low skilled service sectors are notorious for their low potential for productivity gains. They are the bread-and-butter of Baumol’s disease.

The modern theories of the firm focus, in part or in full on reducing opportunistic behaviour, cheating and fraud in employment relationships. The cost of discovering prices and making and enforcing contracts and getting what you pay for are central to Coase’s theory of the firm put forward in 1937.

The profits of entrepreneurs for running a firm is directly linked from their successful policing of the efforts of employees and sub-contractors to ensure the team and each member perform as promised and individual rewards matched individual contributions (Alchian and Demsetz 1972; Barzel 1987). Alchian and Demsetz’s (1972) theory of the firm focused on moral hazard in team production. As they explain:

Two key demands are placed on an economic organization-metering input productivity and metering rewards.

The main rationale in personnel economics from everything ranging from employer funding of retirement pensions to the structure of promotions and executive pay including stock options is around better rewarding self-motivating employees who strive harder and reducing the costs of monitoring employee effort.

At bottom, the efficiency wage hypothesis is entrepreneurs are unaware of the higher quality and greater self-motivation of better paid recruits for vacancies but wise bureaucrats and farsighted politicians notice these gaps in the market. Bureaucrats and politicians notice these gaps in the market before those who gain from superior entrepreneur alertness to hitherto untapped opportunities for profit do so and instead leave that money on the table.

It’s kicking the living wage movement when it is down to mention that low paid workers with families will lose a considerable part of the living wage increase because of reductions in family tax credits and in-kind assistance from the government that are linked to their pay.

Their jobs are put at risk because of a large increase in the cost of employing them to their employers. Their take-home pay after taxes, family tax credits and other government assistance increases by much less. This is a pointless gamble with job security because of the much small increase in the take-home pay of many breadwinners on the living wage.

Workplace safety, spans of control and directors’ duties

19 Jan 2016 Leave a comment

by Jim Rose in applied price theory, applied welfare economics, economics of regulation, entrepreneurship, health and safety, industrial organisation, labour economics, law and economics, occupational choice, politics - New Zealand, survivor principle, theory of the firm Tags: ,

Workplace safety arises as a by-product of economic growth. Risks in the workplace and outside that would not countenance now were routine a few decades ago because the risk of eliminating them was high.

The soon to take effect New Zealand health workplace safety legislation makes it much more difficult to have independent directors and part-time directors of companies. That will both weaken the ability of shareholders to prevent insider control as well as introduce a diversity of views onto boards of directors.

The resignation of Sir Peter Jackson is an example of this. Talented entrepreneurs are no longer able to run large numbers by sitting on the board and intervening on a management by exception basis.

Rupert Murdoch as an example of an executive able to run a global empire. He would ring up the chief executives of his subsidiaries for one minute to month. If they are talking about something interesting, he would listen for longer. He was the ultimate one-minute manager who built a global empire around his supreme entrepreneurial talent.

The new legislation on workplace safety will increase the cost of building a successful business from the ground up. Entrepreneurs will not be able to quickly intervene in the company and dismiss underperforming executives who look after things while they are away. This is because they are not on the Board of Directors.

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 of 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 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 better 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).

There has been a tremendous improvement in the working conditions over the 20th century. The main driver was the incentive and employers to provide safe workplaces as real wages grew. Adam Smith noted that more dangerous and unpleasant jobs always attracted a wage premium as he explains in the Wealth of Nations:

The five following are the principal circumstances which, so far as I have been able to observe, make up for a small pecuniary gain in some employments, and counterbalance a great one in others: first, the agreeableness or disagreeableness of the employments themselves; secondly, the easiness and cheapness, or the difficulty and expense of learning them; thirdly, the constancy or inconstancy of employment in them; fourthly, the small or great trust which must be reposed in those who exercise them; and, fifthly, the probability or improbability of success in them.

First, the wages of labour vary with the ease or hardship, the cleanliness or dirtiness, the honourableness or dishonourableness of the employment. Thus in most places, take the year round, a journeyman tailor earns less than a journeyman weaver. His work is much easier. A journeyman weaver earns less than a journeyman smith. His work is not always easier, but it is much cleanlier. A journeyman blacksmith, though an artificer, seldom earns so much in twelve hours as a collier, who is only a labourer, does in eight. His work is not quite so dirty, is less dangerous, and is carried on in daylight, and above ground.

Honour makes a great part of the reward of all honourable professions. In point of pecuniary gain, all things considered, they are generally under-recompensed, as I shall endeavour to show by and by. Disgrace has the contrary effect.

The trade of a butcher is a brutal and an odious business; but it is in most places more profitable than the greater part of common trades. The most detestable of all employments, that of public executioner, is, in proportion to the quantity of work done, better paid than any common trade whatever.

Hunting and fishing, the most important employments of mankind in the rude state of society, become in its advanced state their most agreeable amusements, and they pursue for pleasure what they once followed from necessity. In the advanced state of society, therefore, they are all very poor people who follow as a trade what other people pursue as a pastime. Fishermen have been so since the time of Theocritus. A poacher is everywhere a very poor man in Great Britain. In countries where the rigour of the law suffers no poachers, the licensed hunter is not in a much better condition. The natural taste for those employments makes more people follow them than can live comfortably by them, and the produce of their labour, in proportion to its quantity, comes always too cheap to market to afford anything but the most scanty subsistence to the labourers.

Disagreeableness and disgrace affect the profits of stock in the same manner as the wages of labour. The keeper of an inn or tavern, who is never master of his own house, and who is exposed to the brutality of every drunkard, exercises neither a very agreeable nor a very creditable business. But there is scarce any common trade in which a small stock yields so great a profit…

The wages in any particular job will vary with the risks that are known to the worker in that job. That is an important qualification.


Competition in labour markets ensures that the net advantages of different jobs will tend to equality. This theory of the labour market originating in Adam Smith, which drives much of modern labour economics became to be known as the theory of compensating differentials.


Firms can choose their production technology to offer workers greater safety or they can economize on safety and offer the savings to workers in the form of higher wages. There is a trade-off in offering more safety or higher wages, holding constant the level of profits. As Kip Viscusi explains:

Wage premiums paid to U.S. workers for risking injury are huge—in 1990 they amounted to about $120 billion annually, which was over 2 percent of the gross national product, and over 5 percent of total wages paid.

These wage premiums give firms an incentive to invest in job safety because an employer who makes his workplace safer can reduce the wages he pays. Employers have a second incentive because they must pay higher premiums for workers’ compensation if accident rates are high.

One of the effects of safety regulation is the employers no longer have to pay this wage premium in more dangerous or disagreeable jobs but as Fishback wrote:

Studies of wages before and after the introduction of workers’ compensation show, however, that non-union workers’ wages were reduced by the introduction of workers’ compensation. In essence, the non-union workers “bought” these improvements in their benefit levels.

Even though workers may have paid for their benefits, they still seem to have been better off as a result of the introduction of workers’ compensation. Many workers had faced problems in purchasing accident insurance at the turn of the century. Workers’ compensation left them better insured, and allowed many of them to spend some of their savings that they had set aside in case of an accident.

What literature there is about suggest that workers overestimate small risks and underestimate large risks. Surveys of manufacturing employment show that one third of workers quit because they found out the job they accepted was more dangerous than they expected.


Source: Evaluating OSHA’s Effectiveness and Suggestions for Reform | Mercatus

One clear trend of the 20th century is as countries got richer, workers demanded more safety at work and larger wage premiums. Market incentives for better worker safety dwarf legal incentives such as from being sued, which in turn dwarf regulatory incentives.

There is also evidence of a glass coffin effect. About 95% of workplace deaths of men. Indeed, there are some interesting journal papers about how occupational choice is affected by motherhood, sole motherhood and sole fatherhood. Single parents are more cautious about their occupational choices.

It is unfortunate that the unions in New Zealand opposes a risk based system of workers’ compensation. The current system is not only no fault, employers pay premiums based on the risks of their industry, not of their individual workplace. There is plenty of evidence to show the charging premiums based on the risks of an accident and the previous record of workplace safety greatly reduces workplace deaths and injuries as Viscusi explains:

The workers’ compensation system that has been in place in the United States throughout most of this century also gives companies strong incentives to make workplaces safe. Premiums for workers’ compensation, which employers pay, exceed $50 billion annually. Particularly for large firms, these premiums are strongly linked to their injury performance.

Statistical studies indicate that in the absence of the workers’ compensation system, workplace death rates would rise by 27 percent. This estimate assumes, however, that workers’ compensation would not be replaced by tort liability or higher market wage premiums.

The firm has nothing to do with economies of scale

08 Jan 2016 Leave a comment

by Jim Rose in applied price theory, industrial organisation, Ronald Coase, theory of the firm Tags:

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Ronald Coase "The Nature of the Firm" (Economica, November 1937, pp. 386-405.

The average age of managers as a cause of the 1970s productivity slowdown

16 Dec 2015 Leave a comment

by Jim Rose in applied price theory, business cycles, labour economics, labour supply, macroeconomics, occupational choice, personnel economics, theory of the firm

Jim Feyrer put forward a clever hypothesis about the sudden decline in the average quality of managers as a major contributor to the 1970s productivity slowdown. His hypothesis is a good contribution to real business cycle theory because what could be more random a shock than a demographic shock arising from the baby boom.

Feyrer’s hypothesis builds on Robert Lucas’s theory of the entrepreneur and the optimal size of the firm. The better entrepreneurs can manage larger spans of control.

Specifically, these more talented entrepreneurs can spread their skills and vision over a larger workforce thereby raising its productivity and that of the firm. Better quality managers are better trainers, better leaders, better problem solvers and better at recruiting and retaining staff.

If managerial skill and talent accumulates with experience, an influx of young workers into the workforce with the influx of the baby boomers into the workforce will lower the average quality of entrepreneurs. This will show up empirically as a decrease in the average age of managers and with that their experience and skills.

With the average age of the labour force lower during the influx of the baby boomers, more marginal managers have to be promoted into managerial positions to supervise younger employees. Lower managerial quality will lower the productivity of the workforce as a whole.

If managerial talent and skill is to have any meaning, a more talented manager should be able to extract greater productivity from the same quality labour force. Lazear points out that

Supervision and management are fundamental in personnel economics and in the theory of the firm… Boss effects are large and significant. Most important, bosses vary substantially in their quality. A very good boss increases the output of the supervised team over that supervised by a very bad boss by about as much as adding one member to the team.

The influx of less able managers in the 1970s, as shown by a five-year reduction in the median age of US managers in the chart below, accounted for 20% of the observed productivity slowdown and resurgence in the 1970s and 1980s according to Feyrer. To fill vacancies, employers had to drop their hiring standards for managers.


Source: Jim Feyrer The US Productivity Slowdown, the Baby Boom, and Management Quality, Journal of Population Economics (2011) and Bureau of Labor Statistics Employed persons by detailed occupation and age (2013).

When the median age of managers rose in the 1990s, and along with it the average of quality of management, this productivity slowdown was reversed. Both the increase in the decrease in the age of managers are random productivity shocks in the tradition of real business cycle theory.

The average age of the US manager was 38 in 1980 and 39 in 1990. There is no US managerial occupation with an average age of less than 40 in 2013. The fifth managerial occupation with the lowest managing age is food service managers. The highest outside of agriculture is chief executives,


Source: Bureau of Labour Statistics Employed persons by detailed occupation and age (2013).

One of the mocking tones directed at real business cycle theory is it was supposed to require a regular forgetting of technologies so that productivity fell and then the loss technologies were remembered a few years later to have a business cycle.

That forgetting and remembering is what happened with the average age of managers and labour productivity in the 1970s. Management quickly lost five years of experience then slowly regained it with matching productivity swings and roundabouts.

Feyrer is another addition to a long line showing that business cycles can arise from the sum of random shocks, rather than one big shock, as Prescott suggested in 1986:

Another Summers question is, Where are the technology shocks? Apparently, he wants some identifiable shock to account for each of the half dozen postwar recessions. But our finding is not that infrequent large shocks produce fluctuations; it is, rather, that small shocks do, every period.

Management hierarchies explained

05 Dec 2015 Leave a comment

by Jim Rose in managerial economics, organisational economics, theory of the firm Tags:

How to show the emergence of a working super rich while attempting to argue they are a rentier class

28 May 2015 Leave a comment

by Jim Rose in financial economics, industrial organisation, managerial economics, organisational economics, survivor principle, theory of the firm Tags: , , , , , , ,

The Washington Centre for Equitable Growth in a review of Thomas Piketty accidentally contradicted their own arguments about the emergence of the top 0.1%. They quote Piketty:

on page 302 of his book that the rise in labour income “primarily reflects the advent of ‘supermanagers,’ that is, top executives of large firms who have managed to obtain extremely high, historically unprecedented compensation packages for their labour.”

according to the Washington Centre for Equitable Growth:

these supermanagers were being vastly overly compensated given their questionable contributions to productivity.

The Washington Centre for Equitable Growth then goes on the argue that in 1979, most of the top managers worked for large, publicly traded firms but by 2005 more were working in closely held firms.

I wish to explore this point about the biggest gains in both percentage terms and magnitude were among privately held business professionals and they are vastly overcompensated relative to their productivity. The key to the argument as explained in a link to a Robert Solow article by the Washington Centre for Equitable Growth is:

Piketty is of course aware that executive pay at the very top is usually determined in a cosy way by boards of directors and compensation committees made up of people very like the executives they are paying.

Piketty is equally direct about the ability of top managers to set their own pay:

It is only reasonable to assume that people in a position to set their own salaries have a natural incentive to treat themselves generously or at the least to be rather optimistic in gauging their marginal productivity.

Emmanuel Saez is less coy:

…while standard economic models assume that pay reflects productivity, there are strong reasons to be sceptical, especially at the top of the income ladder where the actual economic contribution of managers working in complex organizations is particularly difficult to measure. In this scenario, top earners might be able partly to set their own pay by bargaining harder or influencing executive compensation com­mittees.

When arguing that the optimal top income tax rate is 83%, Piketty, Saez, and Stantcheva push for that high top tax rate in part because top executives are more likely to bargain for higher pay when tax rates are lower and receive funds that might go elsewhere within the firm.

The only comment I could find on the increasing number of privately held companies that pay top executives so well is frustration by the Washington Centre for Equitable Growth that it complicates statistical collection. No other analysis is undertaken.

Xavier Gabaix and Augustin Landier found back in 2008 that what a major company’s CEO earns is directly proportional to the size of the firm that they are responsible for running. Executive compensation closely track the evolution of average firm value. During 2007 – 2009, firm value decreased by 17%, and CEO pay by 28%. During 2009-2011, firm value increased by 19% and CEO pay by 22%. Xavier Gabaix and Augustin Landier also found that compensation for executives has risen with the market capitalization. From 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional six-fold matching increase.

What intrigued me about this casual reference to the great number of super managers employed by privately held firms is the argument that they have a cosy relationship with their board of directors immediately collapses. That argument about executive pay is usually in the context of the separation of ownership from control. In large publicly held companies the executives are subject to less scrutiny by shareholders as few of them have a large enough individual stake in the company to gain from the extra effort of monitoring their pay packages.

When the pay packages of top executives is questioned, it is always pointed out that there is an easy way to test for whether top executives cheat shareholders by overpaying themselves.

This simple test is comparing the pay of large private companies and public companies with a large or a few share holders with public companies with diffuse share holdings. Private equity typically also pay its top executives very well, even though the capacity to dupe public shareholders are not a factor.

Privately owned companies and public companies with a few large shareholders can easily keep track of the pay packages of the executives and the board of directors hired to monitor them. Private equity ownership have high pay-for-performance but also significant CEO co-investment.

The standard argument for excessive compensation for CEOs is free rider problems prevent shareholders from  doing sufficient monitoring of executive compensation practices, and that the problems have been getting worse over time. For example, in a classic paper, Bebchuk and Fried (2004) argued that executive compensation is set by CEOs themselves rather than boards of directors on behalf of shareholders,

This argument does not apply to private companies with a few shareholders but they still offer large pay packages to their top executives. Companies, be they public or private that pay any employee more than they contribute risks takeover and loss of market share and failure through higher costs.

The burst of takeovers and leverage buyouts in the 1980s were partly driven by opportunities to profit from reducing corporate slack and downsizing flabby corporate headquarters of large publicly listed companies. Cleaning out the overpaid executives and overstaffing in the headquarters of large corporations was an express purpose of these takeovers and leveraged buyouts.

The response of the Left over Left of the day was support regulation to stop these mergers and takeovers rather than applauding them as giving lazy, overpaid top executives a kick up the backside and from the boot out the door. This regulation to make hostile takeovers more difficult undermined the market the corporate control rather than strengthened it as Michael Jensen explains:

This political activity is another example of special interests using the democratic political system to change the rules of the game to benefit themselves at the expense of society as a whole.

In this case, the special interests are top-level corporate managers and other groups who stand to lose from competition in the market for corporate control. The result will be a significant weakening of the corporation as an organizational form and a reduction in efficiency.

Central to the hypothesis of the Twitter Left of CEOs overpaying themselves is there is free cash within the business they pocket in pay rises, fringe benefits and lavished corporate headquarters rather than pay out in dividends or invest in profitable investments.

CEOs with high pay packages are now much more likely than 20 or 30 years ago to be employed in private companies where the shareholders have far greater opportunities to ensure they get value for money.

All modern theories of the focus in part or in full on reducing opportunistic behaviour, cheating and fraud in employment and commercial relationships. The market for corporate control, and mergers and takeovers realise large benefits from displacing underperforming manager teams. Premiums in hostile takeover offers historically exceed 30% on average. Acquiring-firm shareholders on average earn about 4% in hostile takeovers and roughly zero in mergers.

Another reason for high CEO pay in both public and private companies is CEOs tend to be more risk adverse than their shareholders. The shareholders in any one company has a diversified portfolio and protected by limited liability if the company fails because of a risky venture. Moreover, shareholders  receive nothing in dividends if the  company breaks even so they would prefer that managers pursue business ventures likely to do more than break even.

The agent principal conflict ears as long as the company breaks even, the CEO gets paid. Out of career concerns, a CEO does not want to be at the head of a company that fails because his re-employment prospects are quite grim. High-risk/high-reward ventures are less attractive to top executives because if they fail, their human capital that is specific to the failed company is worthless elsewhere.

To encourage CEOs to take risks, paying them were share options makes them more interested in risky ventures because their pay goes up in line with the risks they take which they would otherwise not take but for option being paid in options. Privately owned companies are well aware of this risk aversion among their chief executives which is why they pay them so well and often in share options and bonuses for taking risks.

The Washington Centre for Equitable Growth simply did not address the reasons for privately owned companies paying the top executives so well.

The incomes of executives, managers, financial professionals, and technology professionals who are in the top 0.1% is very sensitive to stock market fluctuations. This  volatility in the pay of CEOs is inconsistent with the notion that their pay is linked to their ability to form cosy relationships with the boards of directors rather than with their performance.

These top 0.1% CEOs are working super rich whose fortunes rise and fall with the businesses they direct. Top CEOs are paid so much more because they direct the fortunes of large enterprises. In such cases, a small amount of extra talent is worth because the benefits of that small amount of extra talent are spread over such a large firm.

The Rise and Rise of the Super Working Rich

15 May 2015 1 Comment

by Jim Rose in economic history, entrepreneurship, financial economics, human capital, industrial organisation, labour economics, occupational choice, property rights, survivor principle, theory of the firm Tags: , , , , , , , , ,

The rise of the rentiers is nothing new. What is new is the degree of financial globalization and liberalization that has supercharged the fortunes of the super-wealthy even beyond robber baron levels. But it’s no mystery how to reverse this. It’s a matter of setting better rules for markets and taxing earners at the top a bit more.

In the course of a deranged rant against the entrepreneurs in society, the Atlantic collected an excellent set of information suggesting that the working rich have replaced rentiers as the super-rich. Rentiers are the idle rich.  A rentier is a person or entity receiving income derived from patents, copyrights, interest, etc.

In The Evolution of Top Incomes: A Historical and International Perspective (NBER Working Paper No. 11955), Thomas Piketty and Emmanuel Saez concluded that:

While top income shares have remained fairly stable in Continental European countries or Japan over the past three decades, they have increased enormously in the United States and other English speaking countries.

This rise in top income shares is not due to the revival of top capital incomes, but rather to the very large increases in top wages (especially top executive compensation). As a consequence, top executives (the “working rich”) have replaced top capital owners at the top of the income hierarchy over the course of the twentieth century…

The Twitter Left claim that the surge in top compensation in the United States is attributable to an increased ability of top executives to set their own pay and to extract rents at the expense of shareholders. Obviously, from the chart below the pay the top 0.1% goes up and down with the share market. Top  wages do not seem to have any independent power to dupe shareholders into overpaying them in bad times.

Xavier Gabaix and Augustin Landier found back in 2008 that what a major company’s CEO earns is directly proportional to the size of the firm that they are responsible for running. Executive compensation closely track the evolution of average firm value. During 2007 – 2009, firm value decreased by 17%, and CEO pay by 28%. During 2009-2011, firm value increased by 19% and CEO pay by 22%.

Xavier Gabaix and Augustin Landier also found that compensation for executives has risen with the market capitalization. From 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional six-fold matching increase.

Better executive decisions create more economic value. If the number of big companies is greater than the number of good chief executives, competitive bidding will push up executive pay to reflect the value of the talent that is available.

What happens to share prices when there is a surprise CEO resignation? Up or down? Apple went up and down in billions on news of Steve Jobs’ health.

When Hewlett Packard’s CEO Mark Hurd resigned unexpectedly, the value of HP stock dropped by about $10 billion! This makes his $30 million in annual compensation a bargain for shareholders. The fall in share price represents the difference between what the market expected from Hurd as Hewlett Packard’s CEO and what the market expects from his successor. Was Hurd under-paid?

There is an easy way to test for whether top executives cheat public shareholders. Compare the pay of large private companies, and public companies with a large or a few share holders, with public companies with diffuse share holdings. Private equity typically also pay its top executives very well, even though the capacity to dupe public shareholders are not a factor.

The burst of takeovers and leverage buyouts in the 1980s were very much driven by opportunities to profit from reducing corporate slack and downsizing flabby corporate headquarters of large publicly listed companies.

The response of the Left over Left of the day was support regulation to stop these mergers and takeovers rather than applauding them as giving lazy capitalists their comeuppance. This regulation undermined the market the corporate control rather than strengthened it as Michael Jensen explains:

This political activity is another example of special interests using the democratic political system to change the rules of the game to benefit themselves at the expense of society as a whole.

In this case, the special interests are top-level corporate managers and other groups who stand to lose from competition in the market for corporate control. The result will be a significant weakening of the corporation as an organizational form and a reduction in efficiency.

Central to the hypothesis of the Twitter Left of CEOs overpaying themselves is there is free cash within the business they pocket in pay rises, fringe benefits and lavished corporate headquarters rather than pay out in dividends or invest in profitable investments.

The interests and incentives of managers and shareholders frequently conflict over the optimal size of the firm and the payment of free cash to shareholders. What to pay the top executives is a minor manifestation of this common entrepreneurial difference of opinion the future of the business.

These conflicts in entrepreneurial judgements are severe in firms with large free cash flows–more cash than profitable investment opportunities. Jensen defines free cash flow as follows:

Free cash flow is cash flow in excess of that required to fund all of a firm’s projects that have positive net present values when discounted at the relevant cost of capital. Such free cash flow must be paid out to shareholders if the firm is to be efficient and to maximize value for shareholders.

Payment of cash to shareholders reduces the resources under managers’ control, thereby reducing managers’ power and potentially subjecting them to the monitoring by the capital markets that occurs when a firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility that funds will be unavailable or available only at high explicit prices.

Michael Jensen developed a theory of mergers and takeovers based on free cash flows that explains:

  1. the benefits of debt in reducing agency costs of free cash flows,
  2. how debt can substitute for dividends,
  3. why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers,
  4. why bidders and some targets tend to perform abnormally well prior to takeover.

Michael Jensen noted that free cash flows allowed firms’ managers to finance projects earning low returns which, therefore, might not be funded by the equity or bond markets. Examining the US oil industry,  which had earned substantial free cash flows in the 1970s and the early 1980s, he wrote that:

[the] 1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the total cash flows of the top 200 firms in Dun’s Business Month survey.

Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders. Instead, the industry continued to spend heavily on [exploration and development] activity even though average returns were below the cost of capital.

Jensen also noted a negative correlation between exploration announcements and the market valuation of these firms—the opposite effect to research announcements in other industries. Not surprisingly, after a successful corporate takeover, there is major changes to realise the untapped benefits they saw in the company that the incumbent management were not seizing capturing:

Corporate control transactions and the restructurings that often accompany them can be wrenching events in the lives of those linked to the involved organizations: the managers, employees, suppliers, customers and residents of surrounding communities.

Restructurings usually involve major organizational change (such as shifts in corporate strategy) to meet new competition or market conditions, increased use of debt, and a flurry of recontracting with managers, employees, suppliers and customers.

All modern theories of the focus in part or in full on reducing opportunistic behaviour, cheating and fraud in employment and commercial relationships. The market the corporate control, and mergers and takeovers realise large benefits from displacing underperforming manager teams. Premiums in hostile takeover offers historically exceed 30 percent on average. Acquiring-firm shareholders on average earn about 4 percent in hostile takeovers and roughly zero in mergers.

In terms of corporate control, Eugene Fama divides firms into two types:  the managerial firm, and the entrepreneurial firm.

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.

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).

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 nor introduce slack in the monitoring of payments to top executives.

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  and overpaid executives. 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 unwise to 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 will 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).

At bottom, the private sector is highly successful designing forms of organisation that allow large sums of money, billions of dollars to be raised in the capital market and entrusted to management teams.

via The Rise and Rise of the Super-Rich – The Atlantic and How the Richest 400 People in America Got So Rich – The Atlantic.

Are 40% of workers on zero hours contracts, almost?

12 May 2015 1 Comment

by Jim Rose in labour economics, labour supply, managerial economics, organisational economics, personnel economics, politics - Australia, politics - New Zealand, politics - USA, theory of the firm Tags:

The North–South theory of product life cycles

23 Mar 2015 Leave a comment

by Jim Rose in comparative institutional analysis, entrepreneurship, industrial organisation, law and economics, managerial economics, organisational economics, property rights, survivor principle, theory of the firm Tags: , , , , ,

Forecasts of the offshoring of service jobs, as an example, can be constituted into a theory of North-South product cycles. The North-South theory of the life cycle of products starts with their research and development and refinement by entrepreneurs in the advanced countries (the North) with some exporting (Grossman and Helpmann 1991a, 1991b). These innovations require resources to be invested with uncertain prospects of success. Entrepreneurs in the North compete to discover new technology-intensive products using the ample supply of R&D workers and human capital-rich workers in the industrialised countries (Grossman and Helpmann 1991a, 1991b).

As a new product matures and its production becomes more standardised, the bulk of its production can migrate to the less developed countries (the South) to take advantage of lower production costs, and these countries will become net exporters. In the South, entrepreneurs focus more on imitation. They invest resources in importing and learning the production processes developed and proven to be a success in the North (Grossman and Helpmann 1991a, 1991b).

The shifting of production of standardised products to lower-wage foreign locations will frequently be within the originating company via a foreign affiliate, because of uncertainties about property rights and contract enforcement institutions in the host countries, and only later to independent foreign firms (Antràs 2005). Within corporate hierarchies, the high-skilled managers in the developed countries will specialise in problem-solving and non-routine tasks. They will interact with middle managers and production workers in developing countries who perform the routine tasks (Antràs et al. 2006, 2008).

Contracts are typically incomplete either because they are difficult to write and/or because the court cannot enforce them. The World Trade Organization (2005, 2008) concluded that, for example, the location of offshored services depends on:

  • labour costs,
  • trade costs,
  • the quality of institutions, particularly the legal framework,
  • the tax and investment regime,
  • the quality of infrastructure, particularly telecommunications, and
  • skills, particularly language and computer skills.

Risks in contract negotiation and enforcement will influence which types of production is outsourced. Roughly one-third of world trade is infra-firm, and this intra-firm trade is concentrated in the capital-intensive industries because of the costs and risks of investing in contracting with arm’s-length suppliers (Antràs 2003). Considerations about R&D incentives, the availability of human capital and the quality of contract enforcement institutions weigh heavily on the development of new products and their initial and later locations of different stages of production.

image

Products are initially developed in the highly industrialised countries because their sophisticated legal systems allow contracts to be enforced. Even then, in industrialised countries, the difficulties of writing and enforcing complicated contracts over the quality of new products early in the product life cycle encourages firms to make those products internally within the firm. Early in the product life cycle, if sub-contractors were used for key imports,  there would have to be continual renegotiation of contracts contracts to incorporate new innovations and learning by doing. As Antras says:

Global production networks necessarily entail intensive contracting between parties located in different countries and thus subject to distinct legal systems0

As the new product standardises, and product quality in consequence becomes easier to measure and contract over, initially the innovating firm will sub-contract within the industrialised country but in time will import from developing countries. In the first instance, these imports may be from affiliates established in the developing country to ensure greater control of product quality through direct ownership of the factory. As Antras says:

Firms contemplating doing business in a country with weak contracting institutions might decide to do so within firm boundaries to have more control.

The size and shape of the firm is a direct response to mitigate the costs of contracting over quality that is hard to measure  and which is constantly changing early in the product cycle. By assigning ownership rights to the party undertaking the more important investment in quality early in the product life cycle, entrepreneurs  and innovators can minimise the losses caused by lack of enforceable contracts over quality when quality is changing rapidly as the firm moves through the product life cycle.

image

Boeing blamed the delays on the delivery of the Dreamliner on an unwillingness of sub-contractors to stand by their contractual obligations. In response, Boeing acquired some of the key sub-contractors to ensure that they delivered as promised. This is a classic operation of the theory of the firm  where the entrepreneur brings within the firm what is too expensive to transact on the market because of difficulties in measuring quality and defining and enforcing property rights over what has been contracted.

Firms make different sort of production possible

25 Feb 2015 Leave a comment

alchian demsetz

Image by Jim Rose

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