Tag: Harold Demsetz

Demsetz on those wicked corporate raiders of the 1980s

@comcom Commerce Commission understands neither creative destruction nor the scourge of lower prices

In its 2014 Consumer Issues report, released under the Official Information Act, the New Zealand Commerce Commission said:

We are seeing signs that NFC transaction systems are replacing the current eftpos payment system with its lower fee structure.

This could result in a transaction fee structure monopoly, and increased charges to consumers as traders pass on their increased transaction costs through surcharges or increased prices.

The Commerce Commission seems rather concerned that one form of supply will be displaced by another at a lower price. This is the scourge of lower prices – a major preoccupation of competition authorities. They are yet to accept that lower prices should be always lawful under competition law.

The distribution of firm sizes reflects the rise and fall of firms in a competitive struggle to survive with competition between firms of different sizes sifting out the more efficient firm sizes (Stigler 1958, 1987; Demsetz 1973, 1976; Peltzman 1977; Jovanovic 1982; Jovanovic and MacDonald 1994b). Business vitality and capacity for growth and innovation are only weakly related to cost conditions and often depends on many factors that are subtle and difficult to observe (Stigler 1958, 1987).

The New Zealand Commerce Commission, the competition law enforcement authority, seems to have an infuriatingly simple and out-dated understanding of the meaning of competition. Joseph Schumpeter and Ronald Coase would be turning in their graves.

The efficient firm sizes are the sizes that survived in competition against other sizes. To survive, a firm must rise above all of problems it faces such as employee relations, skills development, innovation, changing regulations, unstable markets, access to finance and new entry. This is the decisive (and Darwinian) meaning of efficiency from the standpoint of the individual firm (Stigler 1958). One method of organisation supplants another when it can supply at a lower price (Marshall 1920, Stigler 1958).

What is even more distressing is the Commerce Commission is applying their archaic concept of competition to an industry subject to rapid innovation. Regulating innovation through competition law is never a good idea. The more efficient sized firms are the firm sizes that are expanding their market shares in the face of competition; the less efficient sized firms are those that are losing market share (Stigler 1958, 1987; Alchian 1950; Demsetz 1973, 1976).

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If the firm size distribution in an industry is relatively stable for a time, the firms are their current sizes because there are no more gains from further changes in size in light their underlying demand and cost conditions (Stigler 1983; Alchian 1950; Demsetz 1973, 1976).

Temporary monopoly and rapidly changing market shares with the occasional dominant firm are all characteristics of the early stages of any new or innovating industry. The deadweight social losses from the enforcement of competition law are at their greatest in industries undergoing rapid innovation because of the possibility of error is at its height. Optimum firm sizes continually change over time because of shifts in input and output prices and technological progress (Stigler 1958, 1983).

If large firm size is better at serving consumers, the large firms start to grow and smaller firms will die or be absorbed until the untapped gains from growth in firm size are exhausted. Firms increase in size and decrease in number when this adaptation becomes necessary to survive. If a smaller firm size is now better, smaller firms will multiply and the larger firms will decline in size because they are under-cut on price and quality.

The life cycle of many industries starts with a burst of new entrants with similar products. These new or upgraded products often use ideas that cross-fertilise. In time, there is an industry shakeout where a few leapfrog the rest with cost savings and design breakthroughs to yield the mature product (Jovanovic and MacDonald 1994a; Boldrin and Levine 2008, 2013). Fast-seconds and practical minded latecomers often imitate and successfully commercialise ideas seeded by the market pioneers using prior ideas as knowledge spillovers. Their large market shares are their prizes for winning the latest product races, not the basis of their initial victories.

New entrants regard a large firm size as a premature risk rather than an advantage of incumbency they should mimic as soon as they can. New firms set-up on a scale that is well below the minimum efficient production scale for their industry (Bartelsman, Haltiwanger, and Scarpetta 2009). New entrants choose to start so small to test the waters regarding their true productivity and the market’s acceptance of their products and to minimise losses in the event of failure (Jovanovic 1982; Ericson and Pakes 1995; Dhawan 2001; Audretsch, Prince and Thurik 1998; Audretsch and Mahmood 1994).

Competition law can subvert competition by stymieing the introduction of new goods and the temporary monopoly often necessary to recoup their invention costs and induce innovation. The puzzlingly large productivity differences across firms even in narrowly defined industries producing standard products lead to doubts about the efficiency of some firms, often the smaller firms in an industry. Some firms produce half as much output from the same measured inputs as their market rivals and still survive in competition (Syverson 2011). This diversity reflects inter-firm differences in managerial ability, organisational practices, choice of technology, the age of the business and its capital, location, workforce skills, intangible assets and changes in demand and productivity that are idiosyncratic to each individual firm (Stigler 1958, 1976, 1987; De Alessi 1983).

Technological progress comes from innovations that are the result of profit orientated research and development in the course of market competition. The two main inputs into innovation are the private expenditures of prospective innovators on R&D workers and equipment and the publicly available stock of knowledge on which they hope to build (Aghion and Howitt 2008). Any profits of successful innovators last until others innovate to supersede previous innovations (Aghion and Howitt 2008).

Harold Demsetz argued that competition does not take place upon a single margin, such as price competition. Competition instead has several dimensions often inversely correlated  with each other. Because of this, a competition law disparaging one form of competition will result in more of another. There are trade-offs between innovation and current price competition. Manne and Wright noted in the paper, Innovation and the Limits of Antitrust that:

Both product and business innovations involve novel practices, and such practices generally result in monopoly explanations from the economics profession followed by hostility from the courts (though sometimes in reverse order) and then a subsequent, more nuanced economic understanding of the business practice usually recognizing its pro-competitive virtues.

A competition law enforcement authority should never pretend to know which trade-off between innovation and price competition and between competition and temporary monopoly are optimal. Every competition authority should simplify the regulatory environment by simply saying lower prices are per always lawful. The New Zealand Commerce Commission should do this but it has not.

I have not even touched on the use of competition law to subvert competition such is the pursuit of Microsoft and Google by its business rivals through competition law.

The easiest way to tell if a merger is pro-competition is if the remaining firms in the market oppose it. If it was anti-competitive, they could match the higher prices of the merged firm. The reason they oppose the merger is the merged firm will start undercutting them on price. When was the last time a competitor complained about their rivals putting their prices up? Either they hold their prices and take their business or follow their pricing lead: can’t lose.

This question should be asked more often about the regulation of purported natural monopolies

A firm with no employees is not a firm

Business demographic statistics in New Zealand include companies with zero employees and calls them a firm.

Source: Statistics New Zealand.

Every definition of a firm that I have seen refers to a firm as a relationship between employers, employees and others. There is team production or some sort of nexus of contracts or dependent assets, something social.

The notion is that transactions that normally take place in the market are taken out of the market and take place within the firm. Most profoundly, as Ronald Coase explained in 1937 in his seminal work The Nature of the Firm is what needs to be explained is the existence of the firm, with its

distinguishing mark … [of] the supersession of the price mechanism.

If there’s only one person in the firm, there is no one to transact with within the firm that the parties would normally have otherwise done in the market at arm’s length. There is no suppression of the price system, because all the dealings of the one person firm is with others. There are no transactions outside of the price system. As Barzel and Kochin explain when contrasting Ronald Coase’s theory of the firm with that of Alchian and Demsetz:

Even though they offer an alternative to Coase’s theory of the firm, their firm, nevertheless, is fundamentally a transaction cost phenomenon – it arises in response to the costs associated with measuring and policing various inputs and outputs.

Doug Allen, along with Eugene Fama, argue that all economic organisations are designed to maximise the gains from trade net of transaction costs. Other forms of organisation, forms of organisation that do not maximise the gains from trade net of transaction costs as well would not survive in market competition.

Transaction costs are defined by Allen as the costs of establishing and maintaining property rights. Yoram Barzel  defines (economic) property rights (in this paper, p. 394) as:

… an individual’s net valuation, in expected terms, of the ability to directly consume the services of the asset, or to consume it indirectly through exchange. A key word is ability: The definition is concerned not with what people are legally entitled to do but with what they believe they can do.

A property right, according to Alchian (1965, 1987) and Cheung (1969), is essentially the ability to enjoy a piece of property, but this ability to benefit from an asset or commodity, either directly, or indirectly through market exchange, is seldom unhindered. Eugene Fama observed that:

The striking insight of Alchian and Demsetz (1972) and Jensen and Meckling (1976) is in viewing the firm as a set of contracts among factors of production. In effect, the firm is viewed as a team whose members act from self-interest but realize that their destinies depend to some extent on the survival of the team in its competition with other teams.

If the firm consists only of the owner, there is no internal constraints on the establishment and maintenance of property rights because no one else is in the firm to cause any conflict. There is no nexus of contracts between different suppliers of production inputs whose destinies depend on the ability of them as a team to survive in competition with other teams.

Whatever constraints might arise about the ability of the owner to actually exercise property rights, none of these constraints arise internally to the firm because of the presence of employees or partners.

If there are no employees, if the firm only consist of the owner, the purpose of the firm, which is to make the incentives of workers compatible with those of owners is lost.

Firms, to be a firm, must have employees. If not employees, there must be at least more than one party involved, such as in a partnership.

Firms exist because it is cheaper to organize inputs within a firm than buy and sell in many different markets. This buying and selling requires a continual negotiation, renegotiation, enforcement and monitoring of contracts at arm’s length with independent suppliers of inputs. Barzel stressed this enforcement of property rights in an unpublished paper:

I hypothesize that the firm is organized for the express purpose of creating rights that are more economically enforced by non-state rather than by state means.

Many of these firms with zero employees in the New Zealand business demographic statistics, a classification that accounts for over 60% of all firms in New Zealand, are shelf companies or property investment companies.

There is no measuring and policing of inputs and outputs in a firm that has no employees and only an owner. These entities are not firms. They meet none of the criteria for a firm in the economics of industrial organisation.

This failure to distinguish between a firm and other forms of organisation leads the Minister of Economic Development to say unfortunate things such as:

97 per cent of enterprises in New Zealand are small businesses and have fewer than 20 employees.

Two thirds of that 97% of enterprises has no employees. Any discussion that pretends to know that there are too many or too few small and large firms in New Zealand should not be confused with other forms of organisation of capital that have nothing to do with the topic at hand, which is usually workplace productivity and entrepreneurial competence.

Many of these zero employee firms are not even economic organisations. They are legal mechanisms for exercising legal property rights. Including these property rights in business demographic statistics on business organisations is confusing.

The separation of ownership from control

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).