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Lately, I’ve been writing a lot of rambles about a subject that’s been on my mind without necessarily coming to some kind of big, obvious concluding point. I like writing these kinds of things and I’m not certain I deeply care whether anyone else likes to read them, so my incentives are pretty clear and I’m going to write another one! This is one is about theories of the firm

First, read Yanis Varoufakis’ post on this subject, specifically on how it applies to his employer, Valve.

Now, Valve is a little bit of an odd case – it’s likely more homogenous than most firms in a couple key respects, namely age, experience, salary, and job description, and therefore inherently requires less internal management than most firms. But this all still begs the question – why do firms exist at all? Surprisingly, it’s still a question that doesn’t have a clear or even an accepted received-wisdom answer from economics, especially surprising since a) firms are really important parts of the economy and b) they are really weird, at least from a neoclassical perspective. Because, basically, firms are vast marketless spaces in the market. Essentially, in a truly complete and full market, every individual would be an independent contractor, signing small, finite, discrete contracts for each sensible unit of production they create, and the economy would be a multifarious network of one-on-one contracts. It would look like this:

also known as the timeline of primer

Where the black dots are individuals and the red lines are market relationships.

Instead, we have this:

also known as the andromeda strain

Where black dots are individuals and red lines are market relationships but the blue circles represent firms. So most people are in firms, and firms mostly do business with other firms, and inside of the firms there are no market relationships. Basically, individuals sign up for long term relationships with a firm at a fixed wage or something close to it and inside the firm there is hierarchical command-and-control. Certainly there are market-like incentives – good performance can lead to bonuses and promotion – but that’s different from a fundamentally market relationship where the only relationship between two equals is a contract, as opposed to having an employer and an employed.

Now, economists have come up with many theories which Varoufakis excellently summarizes, and each of these theories definitely has a part of the story. Adam Smith talks about the efficiency of labor division, which (other than Stephen Marglin) nobody I know of has thoroughly disputed, and which seems like its some part of the process. But that doesn’t explain firms, it explains specialization. Marx posited firms as basically vehicles for tacit collusion among the capitalist class to ensure uniform wages below the true average value of labor. There’s some truth to that, but I think if the only advantages to firm formation were to the capitalist class then the model would have proven less persistent than it has. Joseph Schumpeter thought that certain kinds of monopoly were necessary to create the economies of scale, both supply-side and demand-side, that financed major innovation. This is probably also true, but doesn’t quite get to the heart of the question because there are plenty of firms that are not part of the Schumpeterian innovation process that simply trudge along at a steady state. Ronald Coase’s transaction costs theory which is obviously correct and also is the only one whose theory so far explains a major corollary of the question – not merely why are there firms, but why do firms form the way they do?

There are two other established theories I’d like to discuss. One is Frank Knight’s classic distinction between risk and uncertainty and how the latter is the wellspring of profit. While not directly a theory of the firm, it is related to the theory of the firm (at least the modern firm) because a key aspect of the firm is limited liability. This is worth breaking down into two parts:

1)     Where does the liability go? It goes to the corporation itself, not its managers and employees. Obviously if someone breaks the law they break the law but no individual employee of the firm is responsible for restituting losses of the firm if it is unprofitable or fails.

2)     How much is the liability? The liability is limited to the assets of the corporation, not its owners.

So, a quick example – I own a firm that owes the bank $1 million. I have five employees, and unfortunately they are stupid and make bad decisions and the firm loses money and is forced to close. The five employees lose their job but keep all their income to date and property; the bank seizes all the assets of the corporation but not my assets.

So what does this have to do with uncertainty? Well, let’s say I have an idea that I think could change the world and/or make me fabulously rich. But I’m not certain that it will. In fact, there is some pretty large uncertainty involved here, which is probably why nobody else has put this idea into action. But thanks to limited liability, if I decide to take the big plunge and start a business to pursue this fabulous idea, I might lose all the (likely substantial) money I put into the business, but I won’t lose my house and my car and my shirt unless I explicitly agree to name those things as collateral. This is good, because it enables risk-taking (or should it be uncertainty-taking?) beyond what a “purely free market” might provide but the thing about uncertainty-taking is that a small number of successes can produce wealth that vastly outstrips the sum of all the failures.*

Another theory is the Nobel Memorial Prize-winning work of Oliver Williamson, who actually wrote about a network of effects, including some proto-behavioral effects like bounded rationality and opportunism, that lead to hierarchical firms emerging, but one in particular that I want to discuss is asset specificity and small-numbers bargaining.

Let’s say the government wants to build a road from City A to City B, and in between there are a thousand small lots each owned by a separate individual. This is a tricky situation. The issue is (and let’s just say for the sake of argument that this is through some narrow valley so you can’t just go around the lots) is that the government absolutely needs each and every lot to build the road. If I want to start a café I don’t need to buy all the coffee beans in the world, just a couple tons. This is oft cited as a clear justification for a government power like eminent domain – to deal with what isn’t one market with a thousand participants but a thousand markets with a sole monopolist.

But private individuals can’t use eminent domain! And fortunately threatening to injure or kill people is illegal and frowned-upon besides. So if a private person, say, that makes a relatively obscure widget needs a relatively obscure component, you’re going to find yourself in monopolist-monopsonist bargaining which as economists will tell you ends up taking a long fracking time and surprisingly just failing altogether. So if you don’t make just novelty birthday cards (which requires commodities like card stock and ink) but birthday cards that sing “Happy Birthday To You” when you open them then you need the computer chip that goes in the card that plays “Happy Birthday To You,” and maybe that’s a small market so there’s really only one dude who makes that, and so you’re the only person buying them and they’re the only person making them and you both have something over the other guy but you also need their thing and this is actually for all intents a purposes a hostage negotiation of sorts.

So instead you basically form a firm (“Irritating and Expensive Cards, Inc”) that internalizes and therefore negates that negotiation, you collaborate to make as many chips and then as many cards as possible and split the profits.

The thing about this logic is that it also brings surprising benefits. Say, for example, the price of card stock jumps up. If there’s no firm then maybe the cardmaker can’t make ends meet and both of you go out of business; if there is a firm you maybe find a way to cut costs elsewhere (hey look China makes cheaper chip components!) but even if there isn’t you could both stay afloat at a narrower margin for at least a little while. There’s security in a firm.

There are also network effects. This gets us to Sears. Mina Kimes wrote a phenomenal and fascinating story about how idiot Master-of-the-Universe Eddie Lampert basically attempted to atomize Sears – he should have read about the theory of the firm! Each individual element of Sears is an undiversified and volatile investment, but Sears on the whole is a diverse portfolio that creates security and stability. More importantly, there is branding and internal unity of purpose and harmony that is undermined (maybe we’ll talk about that later).

Theories of the firm can explain why firms might arise but can’t necessarily explain why firms settle, at least for some time, at the size and diversity they do. Here’s an odd case – Terminix. Terminix is a company that, superficially, eradicates pests, especially termites. But in truth Terminix is an insurance company – once Terminix certifies your home as termite-free, you can sign a contract with them that obligates them to not merely eradicate termites should they emerge but also to pay for all damage those termites would cause. My question: why do existing homeowner insurance companies not do what Terminix does? What distinguishes termites from the other long list of things that insurance companies will protect you from? Why hasn’t State Farm or AIG purchased Terminix? Why doesn’t Terminix merely exterminate as a contractor for home insurance companies who offer termite protection?

The answer is likely branding and inertia. The former is difficult to quantify, difficult to accumulate, extremely valuable, but also easy to squander. The latter has something to do with Coase’s transaction costs theory – that the Terminix/homeowner’s insurance division could emerge for arbitrary reasons, but once emerged, it could persist simply because there is not enough benefit inherent in undoing the status quo. Private equity essentially exists to find sufficiently large “inefficiencies” in the status quo that it is profitable to invest the time and resources to undo them (inefficiencies, in this case, often meaning non-legally-binding trust networks), but certainly there must be some non-negligible number of cases where the status quo persists because even if it is less inefficient than some hypothetically superior alternative the cost of transition is less than the net benefit (or at the very least the capturable benefit for the transactor).

Things like this make you wonder what, exactly, binds the now Washington Post-less Washington Post Company. My guess is just that, in general, to phrase it econometrically the best predictor of t is t-1; that is, intertia is a large force, and the finitude of human experience alone means that most of the time most things persist over the short-to-medium term. This force is worth incorporating into one’s model of the world – one should not overly privilege the status quo in any case, but certainly not when someone argues that free markets inherently lead to just or efficient outcomes.


*It’s worth noting here that this is why universal health care is a really good idea.


The Washington Post busted open the big story about the raisin market, then opined about it, then Planet Money did an excellent story about it. For those without time to click through the genuinely fascinating links, the basics of the story is that raisins, somewhat uniquely, have their supply and demand managed centrally by a government committee, who essentially confiscates a share (sometimes a very large one) of raisin farmers’ output and with varying levels of compensation. This is probably bad public policy, and there’s no reason that this shouldn’t be done away with.

However, there is a sense in all these stories that there is something unusually unjust about the structure of this market. But I’m not sure that’s true. Let’s imagine, instead, that there was simply an additional sales tax on raisins, not unique to raisins at all. In that case, the price would rise, so demand would fall, so supply would contract and the price would rise and eventually we’d settle on an equilibrium where the overall raisin supply is lower and the price is higher and the government collects some revenue. You could even have the tax vary each year to target a price (as opposed to a tax that is a consistent percentage of the otherwise-market-determined price).

In this case, what we have instead is situation where the government targets the supply side rather than the demand side, but to pretty much a similar result, except the government collects its revenue not in money but in-kind.  Now, the fluctuations in the crop portion taken for the reserve and the uncertainty of compensation definitely feels more unfair, but the biggest difference I can see in this scenario is that in the tax scenario you’d probably have fewer raisin farmers, whereas under the status quo there seem to be more raisin farmers than the eventual market price would otherwise produce.

That, to me, is the biggest curiosity – why don’t more farmers do what the one farmer in the Planet Money story does and switch out to a less-regulated crop like almonds? The answer is that if we were in an equilibrium where no raisins were being confiscated then the existing raisin farmers would probably be making substantial profits, thus attracting new entrants into the industry, each one individually having no impact on the market but collectively driving up supply to the point where confiscation would begin. That, along with emotional attachments and the transaction costs of switching crops, probably keeps an equilibrium where you’ll always have more raisin farmers producing more supply than the eventual raisin price would otherwise demand.

In some ways, this solution is more socially optimal – because you still have farmers incentivized to produce as many raisins as possible even as the government is driving up the price, when in the taxation scenario you’d probably have a lower raisin supply. This allows raisins to be donated to school lunch programs, for example, that otherwise wouldn’t exist. In the tax scenario, however, the government could give the money to schools to spend how they see best fit, and that way would probably be better.

Additionally, you could raise the overall sales tax a miniscule amount and deregulate raisins and that would really be socially optimal. Freedom!

doesn't anyone know how to play this game?

So Wal-Mart is threatening to cancel its plans to open three stores in DC if the Council goes forward and passes the “Large Retailer Accountability Act,” which raises the minimum wage from $8.25 to $12.50 only for businesses that occupy more than 75,000 square feet. This showdown has no good potential outcome, is a large embarrassment, was completely predictable, and yet still has a very simple solution.

DC needs work, and it needs groceries and other goods and services easily available to lower-class residents at affordable prices. This is why District officials were wooing Wal-Mart for so long in the first place.

But Wal-Mart is a terribly and notoriously nasty employer and a fiercely spiteful institutional player, one that prizes itself on its willingness to abuse, fire, and sabotage the careers and sanity of its workforce, and its willingness to play chicken and act the bully with political officials. So it’s no surprise that Wal-Mart is reacting to legislation that is all but a bill of attainder with bluster and threats.

So what is a DC Council to do? If they vote for this bill (which they already passed once, 8-5), Wal-Mart may in fact leave, which would be both a short-term setback for living conditions among the District’s worst-off but also a longer-term setback that could prove some of the worst stereotypes about the DC Council true – why would any other non-Wal-Mart business invest in DC if they thought they would wooed until the point of no return, then have the rules changed on them? On the other hand, if the Council fails the bill, it will prove itself powerless in the face of Wal-Mart’s tantrum, leaving itself nakedly toothless for the world to see.

But it’s not quiiiite a no-win situation – the Council does have a winning play, the same play they should have played all along – raise the minimum wage for everybody. Frankly, there is no policy or moral justification for why Wal-Mart and other large retailers should have to pay higher wages than any other business, and the obviousness of this attempt to target Wal-Mart is doubly embarrassing for all the years the District spent wooing the Bully of Bentonville in the first place. Raise the minimum wage for everyone, and the playing field is even, and Wal-Mart suddenly loses either way – if they pull out, they’ve proved their problem is with paying living wages and not with being singled out, and it also shows that all the businesses small and large that will continue to thrive (and they will) prove that Wal-Mart’s protestations of inability to pay living wages are spurious; if they stay, then they’re creating lots of jobs that pay $12.50/hr! And even better, every other minimum wage employee in DC gets a raise.

So I already commented on Ashok Rao’s blog re: the content of Ryan Enos’ op-ed in The Washington Postre: racial polarization and partisan preferences, but after more careful examination following Noah Smith’s call for Richard Florida to refute it, I realized that a substantial part of the op-ed is not only wrong-headed but dishonest as well. He writes:

In that same year, I examined the voting of Latinos in Los Angeles and found that those who lived near predominantly African American neighborhoods were far less likely to vote for Obama than Latinos who lived farther away — suggesting that contact with their African American neighbors may have prompted them to vote against an African American candidate.

The link is to a paper authored by Enos, which, if you read, is about the 2008 Democratic presidential primary. Putting aside (very real) questions about the paper’s internal validity, by citing it in the article without mentioning that it is about the primary and not general election vote in the context of an op-ed warning of partisan polarization, Enos can only be said to be deliberately misleading readers into believing that Latinos who live nearer to African-American neighborhoods were more likely to vote for McCain or Romney as opposed to Hillary Clinton. In fact, the same precints his paper cites as the best examples of polarization in the Democratic primary are precints that went 9-to-1 for Obama in 2012.

At the very least this calls for a substantial correction to the article.

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