Gordon Tulloch explains the agent principal problem

Every-man-is-an

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The trade-off between hiring higher-skilled and less-skilled workers

Firms differ in the skill compositions of their labour forces because higher-skilled labour is not always the most profitable type of labour to hire.

A profit-minded firm seeks low costs per unit of labour. In truth, nothing is expensive or cheap. This is because buyers will keep buying until the marginal cost equals the marginal benefit. The next unit was not purchased because it wasn’t worth the cost. The last unit was bought because its cost just matched its benefit.

The most cost-effective labour is the labour with the lowest ratio of wages to output. Low cost per unit of output is the goal whether it is comes from low wages or high labour productivity (Lazear 1998).


The wage spread between high quality and lower quality workers is large enough such that no employer hiring lower quality workers can profitably switch to hire higher quality recruits and no firms hiring high-quality workers will switch to hire lower quality recruits (Lazear 1998).

Employers will buy more of an under-priced skill until the returns to labour equalise again across different skill levels and the hiring of any more of the hitherto mispriced skill is no longer profitable because of rising wages.

Firms of all sizes will revisit their skills strategies when market conditions change if they hope to survive in their new circumstances.

George Stigler on do business owners maximise profits?

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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Profit maximisation gets no respect

Who would own up to personal greed and selfishness? But who sends a tip in with their taxes?

George Stigler said that if you ask business owners if they maximise profits, they say no, no, no. They are just there to provide employment, a service for their customers, and then they put a small amount aside for the education of their children.

Stigler then said that if you asked them if they lowered their prices, would they increase their profits, the answer is invariably no.

Stigler then said that if you asked them if they raised their prices, would they increase their profits, the answer is invariably no.

Stigler then said that if you asked them if they have in the last 12-months substituted some other objective for profit, they throw you out of their office.

What people do is far more important than what they say and what they say motivated them.

Alchian pointed out the evolutionary struggle for survival in the face of market competition ensured that only the profit maximising firms survived:

  • Realised profits, not maximum profits, are the marks of success and viability in any market. It does not matter through what process of reasoning or motivation that business success is achieved.
  • Realised profit is the criterion by which the market process selects survivors.
  • Positive profits accrue to those who are better than their competitors, even if the participants are ignorant, intelligent, skilful, etc. These lesser rivals will exhaust their retained earnings and fail to attract further investor support.
  • As in a race, the prize goes to the relatively fastest ‘even if all the competitors loaf.’
  • The firms which quickly imitate more successful firms increase their chances of survival. The firms that fail to adapt, or do so slowly, risk a greater likelihood of failure.
  • The relatively fastest in this evolutionary process of learning, adaptation and imitation will, in fact, be the profit maximisers and market selection will lead to the survival only of these profit maximising firms.

These surviving firms may not know why they are successful, but they have survived and will keep surviving until overtaken by a better rival. All business needs to know is a practice is successful. The reason for its success is less important.

Great store is placed in industry economics on how firms in direct competition in the same market producing even rather standard products such as cement can have far greater measured productivity than others. Some firms produce half as much output from the same measured inputs as their market rivals and still survive in competition (Syverson 2011).

As is too common, the conclusion is there is something wrong with the firms in these markets rather than with the analysis that fails to understand these puzzlingly large gaps in measured productivity.

Few ask the obvious question, which is how do these firms survive if they are so inferior to the market leaders. The important fact is they do survive. They must be doing something right for their customers that the productivity statistics miss.

One method of organising production and supplying to the market will supplant another when it can supply at a lower price (Marshall 1920, Stigler 1958). Gary Becker (1962) argued that firms cannot survive for long in the market with inferior product and production methods regardless of what their motives are. They will not cover their costs.

The more efficient sized firms are the firm sizes that are currently expanding their market shares in the face of competition; the less efficient sized firms are those that are currently losing market share (Stigler 1958; Alchian 1950; Demsetz 1973, 1976). 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).

An example is in Adam Smith’s study of religion. One thing he noticed was that religious sects with strict codes of honesty and intense mutual monitoring by co-congregants for the slightest moral lapses proliferated in cities. Many successful businessmen belonged to these strict religions. These highly religious businessmen were successful in their businesses because they were looked upon by the public as reliable trading partners in a time of weak law enforcement. These businessmen did not know that this was profit maximising but the businessmen with religious backgrounds slowly gained market share over rival firms that had less efficient ways of communicating both their reliability and that their personal honesty was under daily scrutiny.

Ethnic minorities are advantaged in the same way in business. Because of their extensive social interactions with each other because of their language or religious practices and inter-marriage, the costs of bad business behaviours are much higher due to the risk of social ostracism by everyone you know.  This greater trustworthiness gives them a cost advantage in the marketplace even though they may be unaware of its source.

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