Economic profit replaces stocks as executive compensation

Wall St. is finally listening to what economists have been saying for years, that economic profit is a better way to motivate employees.  Not only does it make visible the hidden cost of capital by including a charge for the capital being used, but it also can measure the performance of individual business units.

With better performance evaluation metrics it is easier to align the incentives of employees with the profitability goals of an organization.  In particular, it "tells" employees that using capital has a cost, which makes it less likely that they commit the "hidden cost fallacy."

"Whatever compensation scheme you have, that's exactly what your employees are going to respond to," says Daniel Rinkenberger, CFO of Kaiser Aluminum Corp., KALU +0.47% which has used economic profit to decide short-term incentives for key employees since 2006. "It's driving them to do things our shareholders want, like not having excess assets in the pool. It drives people to be more efficient in how they have inventory deployed."

PepsiCo's new focus on economic profit will lower its capital spending to about 4.5% of sales this year, down from an historical average of about 5.5%, says Mr. Johnston, because employees are making better decisions. The company also has been able to cut the sums of money it has tied up in accounts receivable and inventory, boosting cash flow.

This story ties into several of the themes in the book:

• Chapter 1:  How to give employees enough informaiton to make good decisions, and the incentive to do so.
• Chapter 3:  How to avoid the hidden cost fallacy.
• Chapter 21 and 22:  How to align the incentives of employees and divisions with the goals of a company.

Halloween Candy Markets

Know the rules of Halloween candy trading

What happens when States incur too much debt?

The NY Times takes a look at Illinois:

For years, Illinois has racked up billions in public debt to plug budget holes, pay overdue bills, and put money into its mismanaged pension funds. And for the people who live there, this has resulted in decrepit commuter trains and buses, thousands of unsound bridges, 200 hazardous dams and one of the most inequitable public school systems in America.

Stossel on subsidizing risks

The video illustrates a couple of ideas:

1. From Chapter 2:  subsidies destroy wealth, in this case, by encouraging activities whose cost is bigger than their benefit. 
2. And from Chapter 20:  If you make things safer, people take more risks. 

Aussies Find Cosmetics Firm Guilty of RPM

The Australian Competition and Consumer Commission (ACCC) has clamped down on so-called "resale price maintenance" (RPM) by Eternal Beauty Products. In this case, the cosmetics maker pressured online retailers to either sell goods at certain prices or risk being cut off altogether. Most countries have had some sort of anti-RPM law on the books. At first blush, it seems quite obvious that that a manufacturer requiring a retailer to set higher prices must not be in the public interest. Until, you ask a simple question, "Why would manufacturers do this?"

1. If the manufacturer was a monopolist, it might be a way of getting higher final prices. But, why not simply raise the wholesale price? Given the wholesale price, the manufacturer should want as low a retail price as possible to sell as many units as possible. Anyway, in this this case, like most, the manufacturer was one of many competitors.
2. If the industry was oligopolistic, the manufacturers may be collectively using retailers to enforce higher prices. This could be a way to reduce rivalry. But then all cosmetic firms would be party to the deal and they would have to impose price restraints on all retail channels. This appears to have been far from the case.
3. If the product was new or differentiated and the target market was poorly informed about the product's characteristics relative to competitors, the manufacturer may want to encourage point-of-sale (POS) services. Retail sales associates may be uniquely positioned to demonstrate why this product might be preferred. But this imposes costs on the retailers who perform these POS services. They may be willing to do so for a higher margin. But not if some online retailer offers the same product without the POS services at a discount. Customers will may make an initial purchase with the full service retailer and then shift orders to the cheaper online vendor. In this case, no retailer will be willing to offer the POS services and suffer the free-riding by online discounters. Without POS services, the product fails. To counter this, the manufacturer bans discounting by setting a minimum retail price that includes enough of a margin that retailers want to offer the POS services. In this theory of RPM, customers benefit from small manufacturers bringing new and innovative products to the market. Too bad the ACCC got in the way.

Group Incentives: Teacher pay

An interesting application of group incentives was examined in a new working paper by Scott A. Imberman and Michael Lovenheim called "Incentive Strength and Teacher Productivity: Evidence from a Group-Based Teacher Incentive Pay System." The incentive scheme was for groups of teachers teaching the same subject within a grade and school. One problem with group incentives is free-riding. But different teacher assignments means that the incentive can be stronger for teachers who are responsible for the outcomes of more of the students. So, as a teacher's share of students in a particular school, grade, and subject combination, the incentives get stronger. From their abstract:

We find that student achievement improves when a teacher becomes responsible for more students post program implementation: mean effects are between 0.01 and 0.02 standard deviations for a 10 percentage point increase in share for math, English and social studies, although mean science estimates are small and are not statistically significant. 

While these effects seem small, they are bigger than are found in many previous studies. So, if the incentive dissipates for larger groups, why use group incentive rather than measuring performance at the individual level? I can think of a few reasons (and maybe you can think of more):

1. Individual incentive would lead teachers to try to "cherry-pick" students. These could just be the better students if raw test average is the performance measure or those thought to be able to improve the most if change in score is the metric.
2. To better sort students into classes. Students differ in abilities as well as other characteristics (e.g. unruly versus well-mannered). Some teachers are better with one type of student than another (e.g., former drill sergeant). The group of teachers all benefit from better matching students to teachers.
3. Spillovers within a group. Teachers have heterogeneous abilities and no one likes to be 'corrected' by a colleague. But now there is a stronger incentive for the better teachers to share their methods with those who can improve.
4. Demonstration effects across teacher groups. Other groups of teachers can observe the successful groups and learn.

 So it might be worth weaker group incentives so as to address these issues.

Using patient satisfaction as a performance metric

One of the biggest problem with the US medical system is cost:  every time you put a patient in front of a provider, the provider does stuff.  Sometimes it is what we want the provider to do; many times it is not.  See our earlier blog post:  What do tonsilectomies have in common with auto repair?

The problem, of course is the incentives:  our fee-for-service payment scheme rewards physicians and hospitals for doing stuff to patients, regardless of whether it is the cost-effective thing to do. 

To try and fix the problem, the government is evaluating hospital performance using patient satisfaction scores.  The Wall St. Journal has a funny piece about its obvious shortcomings:

"Donna Barnett, a senior nurse at Grady [Hospital], cites a patient who had a hemorrhagic stroke and recovered swiftly enough to walk out of the hospital about a week later. On the survey the patient complained that meals were served cold and gave Grady low scores. 'It makes you want to throw your hands up,' said Ms. Barnett."

When Vanderbilt asked patients what they wanted, it was easy and free parking, which explains the valet parking and unsightly parking structures all over campus.  Patients didn't seem to care too much about the quality of care, and not at all about the cost because other people (you and I) pay for their care. 

And lets not forget the placebo effect, which means that patients are not satisfied unless providers do something to them.  

Arbs attack the presidential betting markets

There are several political betting markets: Intrade; Iowa Electronic Market, Betfair, Paddy Power, and, Predictwise.com, which averages Intrade, Iowa and Betfair in real time.

What happens when the market prices diverge?  The arbs start betting:

PS: So right now it's October 4, 2012 at 12:50 pm EST. President Obama's got 66 percent odds [of winning the election] on Intrade, 69 percent on Iowa and 73 percent on Betfair. If you were trying to make money right now, what do you do?

AJG: Well, I would if I could -- Betfair is locked for U.S. persons -- sell President Obama's contracts on Betfair and buy President Obama's contracts on Intrade, and wait, because eventually the prices on these two contracts would have to converge. They just predict the same event happening, so they will have to be worth the same once the event happens or doesn't. So come November 6th, both of these contracts will expire at the same value, but because I sold one high and I bought the other one low, I will pocket the 8 points difference between the 2 contracts.

HT:  Merle Hazard

When is inequality bad?

The lead article in the Economist purports to be about income inequality.  It starts out with the reasonable proposition:

... some measure of inequality is good for an economy. It sharpens incentives to work hard and take risks; it rewards the talented innovators who drive economic progress. Free-traders have always accepted that the more global a market, the greater the rewards will be for the winners. 

But then it argues that inequality has reached a stage where it can be inefficient and bad for growth:

That is most obvious in the emerging world. In China credit is siphoned to state-owned enterprises and well-connected insiders; the elite also gain from a string of monopolies. In Russia the oligarchs’ wealth has even less to do with entrepreneurialism. In India, too often, the same is true.

In the rich world the cronyism is better-hidden. One reason why Wall Street accounts for a disproportionate share of the wealthy is the implicit subsidy given to too-big-to-fail banks. From doctors to lawyers, many high-paying professions are full of unnecessary restrictive practices. And then there is the most unfair transfer of all—misdirected welfare spending. Social spending is often less about helping the poor than giving goodies to the relatively wealthy. In America the housing subsidy to the richest fifth (through mortgage-interest relief) is four times the amount spent on public housing for the poorest fifth.

 These examples are strategies employed by firms and individuals to manipulate government policy to their own advantage, which readers of this blog will recognize as examples of "make the rules or your rivals will." 

If this is the problem, I am not sure why the Economist proposes income re-distribution to address it.  Why not attack the problem directly by eliminating too-big-to-fail subsidies, regulatory barriers to entry, and misdirected welfare spending.

 HT:  Cassie

Theatre of the Absurde: banning achievement in France

France's socialist president wants to ban homework in school:

He doesn’t think it is fair that some kids get help from their parents at home while children who come from disadvantaged families don’t. It’s an issue that goes well beyond France, and has been part of the reason that some Americans oppose homework too.

This concern for equality has been satirized by Kurt Vonnegut in his story, Harrison Bergeron:

...In that brave new world, the government forced each individual to wear "handicaps" to offset any advantage he had, so everyone could be truly and fully equal. Beautiful people had to wear ugly masks to hide their good looks. The strong had to wear compensating weights to slow them down. Graceful dancers were burdened with bags of bird shot. Those with above-average intelligence had to wear government transmitters in their ears that would emit sharp noises every 20 seconds, shattering their thoughts "to keep them…from taking unfair advantage of their brains."

I have nothing to add, except to remind people that the story does not have a happy ending,  Harrison breaks free of his device and performs a beautiful dance, the likes of which had never been seen before.  But then, the Handicapper General, Diana Moon Glampers shoots Harrison and his partner, and equality is restored.

HT:  JC

Taxes destroy wealth: France's capital gains tax rises to 62.5%

French businesses are outraged at a proposal by the government to raise the capital gains taxation rate from 34.5% to 62.2%.  This compares with 21% in Spain, 26.4% in Germany and 28% in Britain.

...the Socialist government of François Hollande has yet to understand the “extreme gravity” of the crisis.  ...the policies border on economic illiteracy: “The idea of aligning taxes on capital with those on wages is a profound economic error. It is scandalous that the French have been left in such economic ignorance for years.”

Here is the analysis behind the outrage.  The new tax rate raises the cost of capital (the return you have to promise investors in order to get them to invest in France) by a factor of 1.74.  Suppose, for example, investors were willing to invest in a project that returns 10% under the lower tax rate.  Under the higher tax rate, the same project would now have to earn 17.4% in order to get the investors to invest.  From chapter five, we know that a higher cost of capital means that fewer investment projects will be undertaken (because they have a lower NPV). 

So, the Socialist (deontological) justification for higher taxes is that they re-distribute money from those who have it (rich investors) to those who don't (poor non-investors).

The Capitalist (consequentialist) critique of higher capital gains taxes is that they raise the cost of capital, which reduces investment, which makes us all poorer.

As Winston Churchill said:   

The inherent vice of capitalism is the unequal sharing of blessings. The inherent virtue of Socialism is the equal sharing of miseries.

Unwritten Clauses in Vertical Relationship Contracts

Burger King's supply chain contracts probably do not have an explicit clause that state that dairy suppliers must treat their cows humanely, but it seems as though there is an implicit clause. An animal activist group went undercover at Bettencourt Dairies to video employees beating, kicking, and jumping on cows. A perhaps unanticipated result is that representatives from Burger King said the company had temporarily suspended Bettencourt Dairies LLC. from its suppliers.

This raises a couple of contracting issues:

1. Burger King, as a mass retailer, suffers a reputation loss if customers believe Burger King is indifferent to these issues. They could suffer real losses if this keeps enough customers away. Bettencourt Dairies does not deal with final consumers to the same extent and may not suffer a similar loss.This leads to a possible conflict in acceptable business practices, or at least the diligence with which firms are expected to monitor employees for violations.
2. I could be wrong, but this is probably not an eventuality that negotiators thought they would have to include in the supplier contract. (How would one determine the level of severity that leads to a breach?) Contracts cannot cover all possible contingencies. Knowing this, buyers in the relationship try to include some all-encompassing clause to cover the unanticipated. However, this leaves suppliers open to possible holdup opportunities. Suppliers do not want to be left exposed to the possibility that their customer will claim a breach of contract in order to take advantage of them.

A good contract must balance all of these concerns.

Do increases in energy efficiency increase energy use?

On the one hand increased efficiency reduces the amount of energy needed to power current consumption levels; on the other, it makes energy consumption cheaper, so people consume more.  Energy consumption can go up or down. 

You can model this as an increase in the supply curve.  Price goes down, quantity demanded increases.

The New Yorker has a nice essay on what they call The Efficiency Dilemma:

The problem with efficiency gains is that we inevitably reinvest them in additional consumption. Paving roads reduces rolling friction, thereby boosting miles per gallon, but it also makes distant destinations seem closer, thereby enabling people to live in sprawling, energy-gobbling subdivisions far from where they work and shop.

HT:  Hoyt

Perceptions of Priority Paying

BBC Magazine has a nice story on various recent implementations of schemes to charge extra for patrons to go to the head of the line. It is easy to recognize that these are merely attempts to price discriminate. But the theme of the article is how it affects the perceptions of those opting not to pay.

"What it does is it creates what I call the politics of envy. It separates the haves and the have-nots," he says.

"We've always prided ourselves on not being so stratified. Our founding fathers never had this idea of, 'I got mine, now you go get yours'. That's not anywhere in the constitution, the bill of rights, the declaration of independence. But that's what this creates."

In these cases, the lost profits from serving the 'have-nots' may swamp the gains from serving the 'haves.'

TN Governor gets a "D"

From CATO:

Bill Haslam is a former businessman and mayor of Knoxville. As governor, his best fiscal move so far is to repeal Tennessee’s inheritance tax. Haslam says that the tax is prompting “a whole lot of people” to leave the state because “it’s cheaper to die in Florida.”114 Haslam originally called for an increase in the exemption amount, but he ultimately agreed to a full phase-out of the inheritance tax over three years. Haslam also signed a small cut in the sales tax on groceries. Balancing out those tax cuts, Haslam approved an increase in the state’s hospital tax from 3.5 to 4.5 percent of hospital net income. Haslam has also been leading the charge to increase taxes on Internet sales.115 State general fund spending rose about 14 percent during Haslam’s first year in office, which was a key factor in the governor’s low grade.

In Gov. Haslam's defence, his low grade is a consequence of his response to the perverse incentives set up by the Medicaid matching grants, that pay $2 for every $1 of state money.  We have blogged about this before:

Sunday, February 7, 2010

Tax us, please!

If you ever wonder why the government keeps growing when most people want it to shrink, look no further than Tennessee's Medicaid program, "TennCare."  Tennessee is facing a budget short fall, and the usual reaction would be to cut back spending.  In fact, the Governor has proposed steep cuts in funding, which would cut revenue to the state's hospitals who provide services to TennCare patients. 

The state hospitals have come up with a clever alternate plan.  Instead of cutting back TennCare spending, they want to increase it, financed by a tax on the state's hospitals.

Because the Federal government matches spending (with $2 for every dollar spent on TennCare), the taxes paid by the hospitals would be more than offset with increased revenue coming to TennCare from the federal government:

Regulatory "backdoors": act quickly, ask questions later

One of the recurrent themes of this blog is that firms use regulation strategically, summed up by the maxim, "make the rules or your rivals will." 

When they do, it is sometimes possible to circumvent regulatory barriers with what are known as "hacks" or "back doors."  

Nextel was one of the all-time great regulatory hacks. In the late 80s and early 90s, the FCC’s rules banned more than two cellular operators per city. As Nextel’s cofounder said, “the FCC thought a wireless duopoly was the perfect market structure”. Nextel (called Fleet Call at the time) circumvented these rules by acquiring local (e.g. taxi, pizza truck) dispatch radio companies, which they then connected to create a nationwide (non-dispatch) cell phone service.

 Predictably, the incumbent cellular companies responded tried to block Nextel's entry, arguing that  Nextel’s service would interfere with public safety frequencies and would be too expensive. Uncharacteristically, the regulators (the FCC) decided to let Nextel keep operating:

Nextel grew to become a top five US cellular operators before it was acquired by Sprint in 2004 for $35B. Their service turned out to be cost-competitive, high quality, and safe. The only thing endangered were the incumbents’ profits.

HT:  Lamar

Mexican gas is a substitute for San Diego gas

The main idea behind purchasing power parity is that similar goods--in the absence of trade barriers or transportation costs--should have the same price, when expressed in the same currency units.  Trade is the force that links these prices together.  But sometimes, "trade" means that the consumers, rather than the goods, move to the lower priced country.  Gas prices in the San Diego near $5, consumers are driving across the border to fill up with Mexican gas for only $3.30

"I don't buy gas in the U.S. anymore I'll buy it in Mexico," said one Chula Vista resident.

This driver, who identified himself only as “Joe,” has a Hummer, an Expedition, an Excursion and a BMW so he says he has no choice but to find the cheapest gas.

HT:  Matthew

AA Pilots Up the Ante

Sheila Heen, from Harvard Law School, discussed a possible slow down by American Airlines pilots as a negotiating tool on Marketplace this morning.

...the pilots' tactics may be working, "the pilots are actually doing a reasonably good job of bringing other players into the negotiation by saying, 'look, other people here are on our side, and those other people also have decision making power because they can choose to fly with someone else.'"

Toward the end she points out that each side is testing the other's BATNA (Best Alternative To A Negotiated Agreement). Our Managerial Economics students will recognize this as their 'disagreement value.' If you know what this is, you know how much you can expect to take away from the negotiations.

Vertical not-quite-integration in medical care

The NY Times has a good story about the opportunity created by the closing of the old St Vincent's hospital in Manhattan.  Rushing to fill the void are retail clinics, affiliated with bigger medical centers:

Without building a hospital, one large chain, Continuum Health Partners, is establishing a beachhead in Chelsea and the Village by connecting with outpatient clinics, trying to dominate the market and create a feeder network for its hospitals in other neighborhoods. It is joining forces not just with traditional clinics but also with newer experiments like doctors working out of drugstores. A competitor, NYU Langone Medical Center, is expanding its physician practices downtown, and like Continuum, it has hired dozens of stranded St. Vincent’s doctors.

The integration will reduce costs if it is cheaper to see patients in a clinic than in an emergency room or physician's office.  Regardless, the vertical relationship benefits both the retail clinic and the hospital:

The hospital system checks doctors’ credentials and provides — and bills for — laboratory, radiology and imaging services prescribed by the [retail] doctors. The system also gets a potential trove of patients referred by the clinics. The [retail] clinics earn the cachet of being associated with major hospitals, and as with other affiliated practices, the [retail] patients are given expedited access to Continuum specialists and direct access to hospital admission if needed.

Libertarian experiment in Honduras

Honduras is experimenting with limited government:

Small government and free-market capitalism are about to get put to the test in Honduras, where the government has agreed to let an investment group build an experimental city with no taxes on income, capital gains or sales.

Proponents say the tiny, as-yet unnamed town will become a Central American beacon of job creation and investment, by combining secure property rights with minimal government interference. 

“Once we provide a sound legal system within which to do business, the whole job creation machine – the miracle of capitalism – will get going,”

Is "organic" sustainable?

Elsewhere we have argued that some of the arguments for organic food are anything but sustainable. Now we get estimates of the opportunity cost of locally grown organic food:

Studies show somewhere between a 20 and 50 percent decline in yield per acre from organic methods. So, is the environment better served by more land being used for farming, and less land left to nature? Conventional agriculture has given society both more food and more land, in the form of rainforests not farmed, the millions of acres in the United States which were once farmed and are now returning to the wild, or the 35 million acres taken from production in the last 30 years and planted to native grasses in the American Midwest and West.

The entire essay is well written, and funny.

HT:  Germain

Electronic Medical Records boost hospital bills

The potential benefits of electronic medical records (EMR's) induced the Obama Administration to provide billions of dollars for physicians and hospitals to use them.  The result is new kind of irony:  instead of lower costs, EMR's are instead making it easier for hospitals and physicians to bill more for their services, whether or not they provide additional care:

The share of highest-paying claims at Baptist Hospital in Nashville climbed 82 percent in 2010, the year after it began using a software system for its emergency room records.

So if you make it easier to bill, you get more billing.  Who could have predicted this?

HT:  Don Marron

Which organizational forms can best adapt to change?

One of the themes in this blog is that it is not necessarily the strongest firms that survive, but the most adaptable.  Kodak once dominated the film industry but now it is bankrupt.  How did this happen?

Part of the fault lies with Kodak's centralized structure which was slow to react to the expiration of its patents, and the advent of digital photography.  Colby Chandler, former CEO of Kodak, admitted as much at the 1984 annual meeting:

Like many companies, we are not used to working in an environment where there is rapid technological transfer from laboratory to the marketplace. But we know that will be important in our future.

In 1984, in the hopes of encouraging innovation, Kodak decentralized decision making to 17 different business units with profit and loss responsibility.  However, the decentralized decision making was not accompanied by incentive pay.  Instead, small bonuses were doled out by officious bureaucrats, according to office politics. 

As a result, Kodak continued its slow decline, and in 1993 the board of directors fired its CEO for not holding its managers accountable for failure.  This year, Kodak entered bankruptcy.

The moral of the story seems clear to me:   decentralized decision making is better for adapting to technological change, but only if accompanied by strong incentive pay.  This may be the reason that much of certain types of innovation is done by small firms:  owner/operators have the strongest incentives to perform.