Value Competition

Too Big to Fail through an SC Lens

Let's see how we can apply the basic three-part SC public policy framework (1. Make-Long Term Relationship-Spot Market-Fuhgeddaboudit; 2. Dictate-Negotiate; 3. Formal-Informal) that I proposed in an earlier post on ed reform to the "too big to fail" issue that has risen to the fore since the 2008 financial crisis...

Current arrangement: USG under Dodd-Frank is trying to regulate risks created by large financial institutions. The Volcker Rule against proprietary trading and the proscription of systemic risk associated with big banks are two major approaches under the law. In SC terms: USG is treating the big banks as suppliers with which it has a close, complex relationship rather than as firms in the private-sector economy with which it has a more removed “spot market” or "fuhgeddaboudit" connection. On part 1, USG is thus in an "LTR" mode.

As to part 2, the mode is primarily “Dictate”; although the reality of legislation and regulation involves deal-making, in theory Dodd-Frank and the regulations being drafting to carry it out represent commands to the big banks. As to part 3, there is a mix, with a tilt toward “Formal.” Although the law and regulations are designed to be fact-based, rule-oriented, and formal in major respects, there is also contemplation of a more informal, trust-based relationship between the regulators and the banks.

The payoff of the analysis: By thinking of the choice as one between “LTR” and “Spot” rather than between regulation and deregulation, one gains a different perspective on the question of whether to require banks to be small enough that the USG can credibly commit to not bailing them out. In the standard terms of regulation vs. deregulation, such a requirement that banks be small is regulatory, and hence is likely to be questioned by more market-oriented analysts and politicians, even while it may at the same time be supported on the grounds that it embroils the USG less in the banks’ affairs. In SC terms, the analysis is simpler: A requirement that banks be small is equivalent to a firm carrying out a “Spot” policy that it will not be dependent on any single supplier or set of suppliers whose collapse would cause the firm serious problems. A “Spot” policy of avoiding dependence on any single supplier may or not be a good idea for a given firm to implement, and it similarly may or may not be a good idea for the USG to implement with respect to financial services. The SC lens does not solve the problem of “too big to fail” fin reg. But by seeing the issue through an SC lens, a new perspective is gained that may help in clearing away political cobwebs and in gaining fresh insights into sensible fin reg policy.

Social Preferences and the Unpleasant Math of Base Rates

Reflecting some more on the themes of the last post...Dolly Chugh's audit study of academics reminds me of my old days doing real estate tests to look for evidence of racial steering...a key assumption that audit tests like mine and Dolly's use is that to treat people from different groups with equal credentials unequally is discriminatory...

The point here is to introduce a toy model in which neutrality results in a substantial tilt in favor of members of a group with a higher avwerage level of skills, with the aim of suggesting that social preferences play an important role in achieving the social objective of treating people with the same credentials equally.

The toy model: Assume as in the previous post a stronger group S and a weaker group W.  Assume the employer needs a job candidate with an expected level of skill that is good or G.  The average member of S has an S average skill level, SA, while the average member of W has a below average skill level, BSA.  Among S members, 50% are SA, 20% are G, and 5% are very good or VG; 20% are BA and 5% are much below S average or MBSA.  Among W members, 1% are VG, 4% are G, 20% are SA, 50% are BSA, 20% are MBSA and 5% are very much below S average or VMBSA.

All candidates have credentials that allow the employ to evaluate them as VG, G, SA, BSA, MBSA, or VMBSA.  The credentials however are muddy signals.  There is a 20% chance that a candidate will appear to be one notch above his/her actual skill, a 5% chance of appearing two notches above, and a 1% chance of appearing three notches above.  The same numbers apply to the chance a candidate will appear one, two, or three notches below his/her true skill.

Now, suppose a candidate's credentials signal G.  What is the chance the candidate actually has a skill level of G or VG?   Here the base rate math has a nasty twist...

First, the math for an S candidate signalling G: The 20% of G candidates in the pool will signal G 50% of the time and the 5% of VG candidates will signal G 20% of the time.  Thus, 13.5% of S candidates  will sgnal G when they are G or VG.  Now, the weaker side: The 50% of SA candidates in the pool will signal G 20% of the time, and the 20% of BSA candidates will signal G 5% of the time; the 5% of MBSA candidates will signal G 1% of the time.  Thus, 11.05% of S candidates will signal G when they are SA or below.  The probability that a signal of G actually corresponds to a G or VG candidate equals 13.5/24.55 = 54.99%.

Now, the math for a W candidate signalling G: The 4% of G candidates in the pool will signal G 50% of the time and the 1% of VG candidates will signal G 20% of the time.  Thus, 2.2% of S candidates  will sgnal G when they are G or VG.  Now, the weaker side: The 20% of SA candidates in the pool will signal G 20% of the time, the 50% of BSA candidates will signal G 5% of the time, and the 20% of MBSA candidates will signal G 1% of the time.  Thus, 6.7% of S candidates will signal G when they are SA or below.  The probability that a signal of G actually corresponds to a G or VG candidate equals 2.2/8.9 = 24.72%.

Notice that there is a radical difference here in favor of the S candidate signalling G over the W candidate sending the same signal of G.  To achieve a social objective of treating the two candidates equally, social preferences--or a mix or social preferences and netural preferences--on the part of employers are necessary. 

This example can be used to reinforce the point in the last post about a possible efficiency-based rationale for the stigmatizing of negative social preferences toward a weaker group as racism.  In this case as in the earlier one, negative social preferences toward W do not have the utility that positive social preferences toward W do.

 

 

 

 

Social Preferences in the Context of Hiring and Groups

Missing today's Paduano seminar and an interesting presentation by Stern school prof Dolly Chugh on how fictional graduate students with female names and names associated with minority groups did better compared to those with names associated with white males when they asked for immediate appointments rather than appointments a week away.  (Here's a related paper of hers from AER.)

After reading the paper and moving away from thoughts directly related to the study (e.g., it would be interesting to see what would happen if the white male and for that matter the white female names had a less tony, subcultural sound--e.g., Billy Bob Anderson instead of Brad Anderson or Penny Sue Roberts instead of Meredith Roberts), I got to thinking about how social preference modeling could be applied to hiring and positive and negative discrimination...

Suppose employers fall into three types.   Type 1 is egoistic.  Type 2 has positive social preferences for a weaker group W, meaning that it is willing to incur some costs on behalf of members of that group that are not recaptured by the employer.   Type 3 has negative social preferences for the weaker group, meaning that it is willing to incur some costs against members of that group that are not recaptured by the employer.  

Now suppose employers are deciding whether to hire W job candidates for a job with a standard wage and benefits and a number of incumbents in the firm already performing the job.  All three types of employer share a prior that members of the stronger group S are superior in terms of their average job skills.  Information about the individual quality of S and W candidates relative to incumbent employees can be acquired, but doing so costs the employer more than the return from knowing the information.

If all employers are Type 1 egoists, no W candidates will be hired.  The result is socially suboptimal, assuming that some of the rejected W applicants are in fact more qualified than some of the accepted S ones and that the social cost of determining the identity of some or all of these W applicants is less than the corresponding social benefit of hiring tham. 

The analysis is exactly the same is true if all the employers are Type 3 negative discriminators.  That result of this simple model gets us to a perhaps key point: One reason for stigmatizing negative social preferences against a weaker group as racism is that such negative preferences may well not have any positive social value, compared to simple neutrality with respect to that group.

Finally, if all employees are Type 2 positive discriminators, W employees may be hired, depending on the strength of the social preferences for them.   This may produce a social welfare improvement, depending on whether the social benefits exceed the Type 3 employers’ costs.

 

Leading from Below (modeling-rational choice-egoism notes)

[Notes for a paper that would apply the selective altruism concept to workers]

I want to get to a social preferences/beyond egoistic calculation punch line—that there are two main types of partially altruistic, charismatic leadership among “low level” employees like fast-food workers and assembly line workers, one of which helps the firm and society, and the other of which hurts the firm and may hurt society.  To get to the punch line, some set-up is necessary.  

The set-up involves basic rational choice modeling with a standard egoism assumption.  The first core idea to model is that lower level employees may have an incentive to sabotage the firm as a means to get the employer to pay above-market wages.   The second core idea to model is that the very same employees may also have a rational basis to commit to high-level effort to obtain higher than market wages, but that such a commitment is unstable because of the incentive of each individual employee to defect from high-level effort and the difficulty of detecting when that is occurring. 

First, let’s sketch out a sabotage model.  In the game tree, the employer moves first and faces a choice between paying market or above-market (or “efficiency”) wages.  The employee team moves second and faces a choice between having one or more of its members sabotage or not.    The employee then moves again, with the choice being between terminating the employee team or not doing so.  If the employer has been paying market wages, it also faces a choice as to whether to now raise wages above market.   (We will assume that firing a sabotaging team already receiving high wages is better for the employer than lowering their wages, so that choice is assumed away.)  For purposes of the analysis, it will be assumed that sabotage can be detected, but not the identity of the individual saboteur on a work team; the employer in the model thus faces a choice between firing everyone and firing no one.

Here is a back-solve of the logic of a model in which equilibrium is above market wages and no sabotage.   Starting at the end and working backward: The employer faces a choice between firing everyone or no one.  We can assume firing everyone is better for the employer if there has been sabotage and not otherwise.   Knowing that, a team of employees receiving above market will elect not to sabotage, because getting fired from an above market job is costly.   Knowing that, an employer will choose to pay above market as long as the firm’s payoff from doing so is higher than its payoff from paying market.   Assuming that the employer faced with sabotage does best to pay above market going forward to end future sabotage, the employer should simply pay above market from the beginning.

Given the assumptions just noted, the equilibrium is that the firm will choose to pay above market and the employee team will choose not to sabotage.    The outcome is not desirable for the firm compared to an outcome in which sabotage is not a possibility and market wages may be safely paid.   It is also difficult—though not impossible-- to contend that a high wage outcome based on the sabotage possibility is a socially desirable one.    One may assume—as it is reasonable though not clear-cut to do--that low-wage workers should receive more than their market wage through a “social wage” paid by tax credits, public funding of education, and the like.    But for workers to receive above market wages from their employers as a result of employer fear of sabotage would seem to be ethically dubious, and possibly outright wrong.   

An Enlightenment Faith that Engages Business and Politics

Two elements of one such faith:

1.  One believes in the truth/beauty/goodness of competing and cooperating opposites;

2.  One believes in loving/forgiving/embracing one's enemies.

The applicability of these two credo elements to politics is something I've written about before, and won't belabor here.  The applicability to business?...here are some semi-spontaneous ideas...

a) Instead of the substantive/principled opposites of liberalism and conservatism, equality and equity, etc., the process/temperamental opposites of calculation and culture, reason and passion, etc., seem like the applicable yin-yang dichotomies of a faith that engages business...these dichotomies strike me as having at least as much juice as the political ones...

b) Intead of the ideological other, the other in a competing firm or on the other side of a business transaction is one candidate for the enemy to be loved...maybe...that doesn't seem as hard or as inspiring as the ideological other in politics...with that in mind, it seems like the better other to be loved for the business person or the pro-business person would be the taxman (or other government official) or the anti-business person...for the anti-business person, the other to be loved would be business and the business person...

 

For the Moral Equivalence of Business and Politics

There are some major similarities between business and politics in affluent, democratic societies such as the U.S., Germany, Japan, etc.:

1.   Both systems harness the energies of self-seeking, self-promoting entrepreneurial actors to social benefit, both overall and in many, though hardly all, individual cases;

2.   Both systems rely centrally on competition to create social benefit and to restrain the evils that would follow from a single unchecked power center or economic center;

3.   Both systems rely centrally on teams that join together to compete with other teams;

4.   Both systems rely heavily not only on egoistic calculation but also on social emotions such as empathy, competitiveness, shame, and  vengefulness;

5.   A considerable number of people feel imposed upon by one or both systems, and view one or both of them as outside themselves; a comparatively small proportion of the population views themselves as successful entrepreneurs within either system; a very small proportion views themselves as successful entrepreneurs within both systems.

Each one of these major similarities is attended by lesser but interesting differences:

1.  The manner in which individual and social interest are aligned (the invisible hand) and misaligned (market failure) is better understood in business than in politics—economics is substantially better developed than political science; the self-seeking, entrepreneurial political type tends both toward more narcissism and more emotionally-infused idealism than the cooler, more pecuniarily motivated self-seeking, entrepreneurial business type;

2.  Competition in politics compared to competition in business is limited by the underlying fact that government involves a monopoly of force; the basic form of competition in politics between parties and within parties is duopolistic, pitting the center-left against the center-right, while competition in business arrives a much more diverse array of forms--this difference likely stems from the basic fact just noted that politics is a struggle to attain control of the violence monopoly (here again the less developed state of theory in political science compared to economic theory is interesting); political competitors generally differentiate themselves with more universalistic, value-laden appeals than business competitors do;

3.  The competing team institutions in business—notably corporations—are much more clearly structured and better established than political parties and other teams in politics; on the other hand, the overarching or monopoly institutions in government/politics—the courts, legislatures, etc.—are much more clearly structured and better established than trade associations and other overarching, monopoly institutions in business.

4.  Business and the pecuniary motive foster egoistic calculation on behalf of the individual and the firm, and in doing so damp down to some degree on social emotions like competitiveness, vengefulness, empathy, and shame, which are less checked in politics.

5.  Although highly localized political systems like the U.S. are a partial exception, a considerably smaller proportion of the population is engaged as entrepreneurial politicians than as entrepreneurial businesspeople; on the other hand, a fairly large proportion of the population is somewhat detached from business by virtue of working for government or the nonprofit sector, while nearly every adult is a potential voter and potential political participant; successful entrepreneurs in business are considerably more tilted toward the high end in their incomes than successful entrepreneurs in politics are, while successful entrepreneurs in politics are somewhat more tilted toward the high end in their educational backgrounds, and are considerably more tilted toward being highly renowned both positively and negatively, than successful entrepreneurs in business are.

From this array of similarities and matching differences, one can certainly tease out moral distinctions in favor of one domain or the other.  None of them seem especially convincing, though.  Even if one is inclined to give the social utility palm to business over politics if one has to choose—as I would—the two sectors’ deeply intertwined nature, the larger size of the business sector—which has quite a bit to do with its greater utility but does not seem to me a good basis to regard it as worthier--and the greater concentration of the more idealistic, inspiring social emotions as well as the somewhat unpleasant or very unpleasant social emotions in the political sector make the relative moral status of the two sectors a pick ‘em proposition in my view. 

A postscript: Neither of the two sectors, for all the very considerable positive value that both have, feels to me at all like something to center one’s deepest faith on.  The heroic view of business in Ayn Rand and the heroic view of politics in Sheldon Wolin both miss the mark.   It is the case, I think, that a plausible Enlightenment faith needs to engage business and politics sympathetically rather than to detach itself from these central, and in my view basically good, modern social realities.  But a good Enlightenment faith also needs to be apart from both business and its competing corporations and from politics and its warring ideologies.   

How Organizations and Employees outside Top Management Could Compete Management Wages Down

What would it take for a broader, more competitive market for top-level managers to arise in which shareholders pay less than they now have to for top managerial talent?   Here, the social egalitarianism and selective altruism frameworks point in different directions. 

First, social egalitarianism: If one can persuade the shareholders that one is willing to work for less not because one is a worse manager but because one values a relative position perk--the giant corner office, ultra-attentive staff, etc.--that is cheaper from the shareholders' perspective than stock options and other monetary rewards, one is a good candidate to supplant a socially egalitarian top management that expects to get paid its market wage.  The practical problem with this approach is considerable, though.  The very concern for relative as opposed to absolute position that makes one credible in one's willingness to be paid less may very well be taken as a signal that one cares not about absolute return to shareholders but about some other metric, such as the relative size of one's firm, that is not the right one from the perspective of shareholders.  You are credible as a manager who is willing to be paid less, but not as a manager who is equally committed to raising the value of the firm's shares.   

Now, selective altruism: The counsel here is that outside firms or inside lower-level managers to be credible as replacements for the incumbents must have a very substantial degree of altruism toward the shareholders...[to be continued...reaching stop]

Relative Position and Manager-Shareholder Relations

Under Robert Frank's model of relative position, people have concerns not only about their own salaries, bonuses, stock options, and other forms of monetary and psychic returns to themselves.  They also care about their economic and psychic returns relative to others; in other words, they have competitive preferences.   The striking real-world result of competitive preferences in Frank's telling is pay compression, in which a minority of highly productive employees earn considerably less than their marginal product and the broad majority of less productive employees earn somewhat more.   Because they value a position at the top of a hierarchy of status, respect, and recognition, highly productive employees are willing to sacrifice a large amount of salary.  For their part, less productive employees demand compensation to occupy a lower position in the hierarchy.   Compressed pay scales, in which a research university faculty member who is say one hundred times more productive in her contributions to knowledge than a less-productive and equally senior colleague but only earns say 25% more than that colleague, are the rule, Frank contends, in private-sector as well as public sector organizations.

The idea I want to explore here is extending Frank's model from the employee-employee context to the manager-shareholder context, and to managerial compensation in particular.  The first basic point is the following: Managers who are highly motivated by status, recognition, respect, and hierarchy--as manifested in, e.g., a large corner office, a large number of reports, and deference from everyone, including shareholders--are managers who according to Frank's model can be made to work for cheap.  They are compensated largely by status, not by money, and work for less, perhaps far less, than their market wage.  By comparison, managers who are indifferent to status and relative position--e.g., those who are fine with being CEO while sitting in a cheap plastic chair and who see themselves as deferring to customers, employees, and shareholders rather than the other way around--are going to command something closer to their market wage.   They are not interested in being kowtowed to; given that lack of interest, shareholders have to pay them market wage or something approaching it.

A Disappointing Russell Shorto Article, and a Suggestion for a More Interesting One

Based in particular on a very nice article he did in the NYT magazine a while back on birth rates in different countries, I have very high expectations for Russell Shorto. Given that, I was disappointed by his recent NYT mag article on Greece. The article, though fair enough on its own terms--I'm sure lots of Greek businesses, such as the construction business doing work for the government that employed the story's central figure, have indeed gone under--struck me as Hamlet without the Prince of Denmark.

My sense is that the 64K question for Greece (and Portugal, Spain, Italy, and France) is whether to change a system in which the dominant group of employees consists of managers and workers in the private sector and government who have a very high degree of job security. A country in which most of the best people are locked into a highly protected, relatively stationary order is perhaps not a country whose prospects are good compared to countries such as the United States.  Here, a highly protected job market, though it prevails for government employment, does not characterize the private sector in the way that it does in southern Europe.

The issue of a dominant sector of employees that protects itself at the expense of others in the country and of social dynamism--as opposed to an apparently related but quite different issue as to whether Greeks are simply more laid back than Germans--did not surface in Shorto's piece. He would be extremely well qualified to write a piece that treats that issue, regardless of his underlying position on the normative issue of junking the high job security system for the private and public elites of southern Europe.

Just as Shorto's birth rates article wound up using the Nordic countries, with their combination of a big welfare state and high birth rates, as a nice qualifier to a US-centered "don't run too big a government if you want people to have kids" line, he might write a piece on the job security issue that uses the same Nordic countries as a possible counter to a line that a security system for the managerial and employee elite is a serious drain on dynamism. My sense is that higher level private sector employees are not protected in Sweden, Denmark, etc. in the way they are in Greece, Italy, etc., but I'm not sure at all about that--am writing now away from a connection.*  But even after satisfying my curiosity on that point with a net search, I'd be highly interested in reading a future Shorto comparative analysis of the job security and social dynamism issue.  A nice starting point for that article would be an NYT piece the other day comparing the bustling scene in a border town on the more flexible German side of the Rhine with the ossified, high unemployment scene in the counterpart town on the French side.



*Wified-in while waiting to testify on tenure reform in Trenton--checking on job security in the private sector in Scandinavia...looks as though Sweden has a less flexible approach and Denmark has a more flexible one...this is a tricky issue to research because the reality of whether there is an inflexible labor system of high job security lies in the details of whether poor employees can successfully avoid discharge through a hearing process...the NJEA (teacher's union) rep here in Trenton is now advocating for poison pill "due process" changes to the tenure bill that would if applied in a certain way kill the efficacy of reform and keep the current NJ system in which it is virtually impossible to get rid of teachers no matter how incompetent.  (My sense is that the current system also operates in that way for govt employees in in general in NJ and elsewhere in the US.  Teachers are a current flashpoint, but the bigger issue is that an important part of the US, the govt sector, operates in the same way that a broader part of Greece, Italy, etc., does.)

Who Gets What: Social Preferences, the Creation of Social Surplus, and its Division among Managers, Workers, Shareholders, and Society

[Notes for a paper to be written with the above title...]

The Owner-Manager Plays the Insist-Yield game with His Employees

The key to prevailing in the game is a credible commitment to insist, against which the other player will rationally yield.   A "this business is mine," "my way or the highway" state of mind comes more naturally to the owner-manager, it is reasonable to assume, than it does to the employee-centered manager or the shareholder-centered manager.   Accordingly, one expects more credible commitments based on owner-managers having that kind of unyielding character than from the other types.

The problem with a "this business is mine" commitment to having things the owner's way is that it may well not be seen as ethically acceptable by the employees, in which case conflict is likely.  The contentious and occasionally bloody history of nineteenth century capitalism may be seen as involving exactly that type of conflict, with owner-managers who strongly asserted their prerogatives giving rise to angry movements of workers fighting against total control by owner-managers. 

A second, gentler way to prevail in the insist-yield game is to value the other side's payoffs in the situation in which both of you insist on getting your own way.  By doing that, you can wind up in the same place as the dognatic "I will always insist" player, but without the unpleasant, conflict-provoking dogmatism.

So which side is better equipped to value the other's payoff in the insist-insist situation?   Though  no absolute answer can be given, I would suggest that workers in the owner-manager business are in better shape to appreciate the owner's payoff for insisting than the owner-manager is to appreciate the worker's payoff for being feisty.

As long as the owner has not marked himself as unreasonable by being dogmatically insistent, it is not a difficult stretch for workers to understand and even feel for an entrepreneur-owner who has created a business.  It is a much  more difficult stretch for the owner-creator to feel a parallel empathy with the payoffs of rebellious workers.

If the foregoing is correct, it is harder for the owner-manager who has built a business to have a character that is altruistic in a useful way than it is for the worker.  The owner-founder, altruistic as he or she may be in certain ways in caring about the welfare of others, is likely to have difficulty in empathizing with workers who rebel. A  limited caring about the owner helps the workers to get their way against the owner, whose difficulty in  caring for the workers leads him to lose out in the "gentle commitment" game.