Chapter 3 Principles of Rational Behavior at Work in Society and Business 18 Scott Cook, who in 1983 developed the widely used home-finance software package called “Quicken,” the major product of Cook’s firm, Intuit, Inc., which was courted for a buyout in 1994 by Microsoft. Cook eventually agreed to sell Intuit to Microsoft for $1.5 billion in Microsoft stock, 40 percent above Intuit’s market price at the time. Microsoft agreed to pay a premium price for a couple of reasons. First, Bill Gates, CEO of Microsoft, saw a need to have a dominant personal finance program that could be integrated into his Microsoft Office line and that would allow him to pursue his goal of transforming the way people manage their money. The value of Intuit was greater as an integrated part of Microsoft than by itself. Second, and more importantly for the purposes of this chapter, Cook agreed to become a vice president of Microsoft and to retain an interest in the future development and use of Quicken, if Microsoft bought Intuit. This way Cook could minimize the impact of the last-period problem, and the sale of Intuit would mean that Quicken might continue to develop. The proposed buyout of Intuit eventually was terminated by the Justice Department, which threatened to sue Microsoft for antitrust violation. However, the example is still a good one not only because it involves prominent business personalities and their successful firms, but also because of the moral it illuminates: Sometimes, by selling only a part of the company, an owner can increase the value of the part that is sold, enhancing the combined value of the part that is sold and the part that is retained. The last-period problem also helps to explain why fathers (or mothers) are so anxious for one of their sons (or daughters) to go into their business as retirement age approaches. This not only extends the life of the business, but it also increases the amount of business that can be done as the retirement age is approached, given that with the elevation of the son or daughter, the last period is then put off until some time in the future. Why do signs on business establishments sometimes read, for example, “Sampson & Sons” or “Delilah & Daughter”? The usual answer is that the parent is proud to announce that a daughter (or son) has joined the business. That is probably often the case, but we also think it has a lot to do with the parent seeking to assure customers and suppliers that the original owner, the parent, will not soon begin to take advantage of them. Economists David Laband and Bernard Lentz have found that the rate of occupational following within families with a self -- employed proprietor is three times greater than within other families, which suggests that proprietors have good reason -- measured in continuing the value of their companies -- to bring their children into the business that other people don’t have. 8 Caterpillar, the manufacturer of farm equipment and heavy machinery, depends on its dealers to maintain customer trust and goodwill. One way Caterpillar has attempted to enhance customer trust is to set up a school to help children of dealers learn about and pursue careers in Caterpillar dealerships. 9 8 David N. Laband and Bernard F. Lentz, “Entrepreneurial Success and Occupational Inheritance Among Proprietors,” Canadian Journal of Economics, Vol. 23, No. 3 (August 1990), pp. 101 -- 117. 9 William Davidow and Michael Malone, The Virtual Corporation, (New York: Harper Collins Publishers, 1992), p. 234. Chapter 3 Principles of Rational Behavior at Work in Society and Business 19 Firms commonly complain that goods delivered in the last days of the supplier’s operation are of inferior quality. The problem? It may be one of the incentives, or lack thereof, that people have to deliver goods of waning quality during their last days. Bankruptcy laws can be explained in part as a means of reducing these end -- period problems. 10 They extend the potential end of the firm, and can give the firm a new lease on life and set back the last-period problem indefinitely. Also, a firm in financial trouble can be pressed into liquidation by nervous bondholders, a fact that can exacerbate the last-period problem, given that suppliers would have to worry that nervous bondholders will encourage firms to deliver shoddy merchandise, which can make customers more nervous about dealing with the financially strapped firm. By allowing firms in financial trouble to continue operating, bankruptcy laws make it more likely that the bankrupt firms will keep up the quality of the products, and provide more motivation for suppliers to keep up honest dealing. The Keiretsu As a Solution to the Last-period Problem Japanese firms are renown for organizing themselves into groups of firms called keiretsus. Keiretsu members buy from one another, share information, and organize joint ventures to produce goods and services in concert with one another. The largest and best-known keiretsu is Mitsubishi, which has 28 core member firms and hundreds of other firms that are loosely tied to the core firms. They integrate their activities in a number of ways, not the least of which is having their headquarters close together, having the CEOs of the various firms meet regularly to exchange information, and organizing social and business clubs that are open to employees of the keiretsu member firms. The members often own stock in one another. In the United States, many of the activities of any keiretsu would likely worry the antitrust authorities because the organization would be construed as monopolistic. No doubt, some keiretsu activities might indeed restrain competition in some markets, causing prices of Japanese goods to be higher than they otherwise would be (especially in the domestic market where competition from other producers from around the world might be impaired by import restrictions). The keiretsu might also be seen as a highly efficient means by which Japanese firms are able to make use of new technologies, quickly incorporating them into products. The Japanese have demonstrated a knack for bringing new products to market quickly. However, we mention the keiretsu organizational form here only because of one of its more unheralded benefits: it is a form of business organization that seeks to solve the last-period problem. The integration of the member firms’ purchases and sales and strategic plans for the future is a means by which members can assure one another that their business relationship will be enduring -- or that the member employees have minimum incentive to behave opportunistically in the short -- run and have maximum 10 Gibbons and Murphy, “Optimal Incentive Contracts in the Presence of Career Concerns.” Chapter 3 Principles of Rational Behavior at Work in Society and Business 20 incentive to work with their joint future income stream in mind. 11 Being ousted from the keiretsu can inflict substantial costs on the opportunistic firms and their employees. Even the social gatherings of keiretsu employees can be construed as a means by which the employees can “bond.” Here, we are not so much concerned with the “warm and fuzzy” feelings people might have from integrating their lives. Instead, we mean that by integrating their lives at the social level, employees can provide each other mutual assurance that they will live up to expectations in their business dealings, that they will not act opportunistically. The employees can lose the long -- term benefits of their social and business relationships. 12 In short, the keiretsu is a clever means by which opportunistic behavior is made more costly. It seeks to reduce some of the shirking and monitoring costs of doing business, when business is done at arm’s length. Indeed, one of the more unrecognized benefits of the firm in general is that it does, under one “roof,” what is attempted under a keiretsu. The firm seeks to bring people together and have them associate and work together on a continuing basis for the purpose of minimizing the last-period problem. As we noted early in the book, it’s quite possible for all departments within a firm and all stages of an assembly line to be operated on a market basis, with every department and every stage of the assembly line buying from one another. However, you can imagine that such an organization of economic activity would give rise to a multitude of last-period problems, especially if there were no attempt to ensure that everyone “worked together” as something approximating a keiretsu. The Japanese relatively greater use of formal and informal long -- term buyer -- supplier relationships – sometimes cited as “strategic industrial sourcing” combined with so -- called “relational contracting” -- may be partially explained by the fact that the Japanese, as commonly argued, have the required business culture, one grounded in a long -- term, future -- oriented business perspective that prescribes long -- term contracts. The Japanese may, to a greater degree than Americans and Europeans, have a pervasive sense of duty that insures that the parties will abide by any contracts that have been consummated, and the Japanese may have a greater aversion than others to ongoing contentious bargaining relationships that would be required if contracts were always up for grab by the low -- cost bidders. 13 The long -- term business relationships may also be a consequence of the growing affluence in Japan, which has elevated the importance of quality over price that, in turn, has induced large Japanese firms to work with their suppliers in an effort to enhance product quality. 14 The long -- term contracting can also be explained partially by the encouragement the Japanese government gave to the 11 For an interesting discussion of the keiretsu, see Clyde V. Prestowitz, Jr., Trading Places: How We Allowed Japan to Take the Lead (New York: Basic Books, Inc., 1988), pp. 156 -- 166. 12 As Clyde Prestowitz notes, “Thus the Keiretsu system reduces risks for the Nippon Electric Company and the other Japanese companies through the accumulation of relationships that can be counted upon to cushion shock in time and trouble” (ibid., p. 164). 13 This explanation for long -- term contracting has been argued at length by Ronald P. Dore, Taking Japan Seriously (Stanford, Calif.: Stanford University Press, 1987). 14 Ibid., p. 188. Chapter 3 Principles of Rational Behavior at Work in Society and Business 21 creation of long -- term buyer -- supplier relationships in the past (especially during World War II) and the existing laws and legal sanctions against abusive treatment of subcontractors by their customers. 15 But it seems to us altogether reasonable that long -- term contracting must be grounded in factors other than culture and affluence. One economic explanation may start with a recognition of the extent to which firms are integrated in Japan. The fact of the matter is that in some industries Japanese production is far less integrated into identified “firms” than, say, in the United States and other countries. In the United States and Western Europe, for example, 50 to 60 percent of the automobile manufacturing costs are incurred “in -- house.” In Japanese firms, on the other hand, only 25 to 30 percent of the automobile production costs are typically incurred “in -- house,” or inside Japanese firms. 16 Only 20 percent of Honda’s production costs are incurred inside, which means it buys 80 percent, or $6 billion, of its inputs from outside suppliers. 17 Because of the lack of integration, Japanese firms may need to develop long -- term buyer -- supplier relationships to a much greater degree than more highly integrated firms do just to overcome the potential last-period problems, if nothing else. Put another way, Japanese firms are able to engage in what is called strategic outsourcing, and do so competitively, because they are willing and able to develop long - - term working relationships. If they didn’t, they would have to endure the added costs associated with the ever -- present closing of those relationships. It doesn’t surprise us that many buyer -- supplier relationships in Japan give the “look and feel” of integrated firms with buyers and suppliers helping each other and investing in each other (which is what happens, to more or less degree, within unified firms). When Honda signs a contract with a supplier, it expects the working relationship to continue for 25 to 50 years, which effectively means that the last-period problem is set back considerably. 18 Moreover, the permanence of the buyer -- supplier relationship is two -- way, with commitments on the parts of both buyers and suppliers. Buyers agree to stay with the suppliers, and vice versa, through ups and downs (at least up to a point). Hence, Honda can justify incurring the costs associated with helping its suppliers increase productivity, even provide the needed technology and specialized equipment. Moreover, such expenditures, plus investments in the specific assets of the suppliers, by Honda have the added advantage of being a bond, the value of which is forgone if Honda does not abide by its agreement. Managers at Honda are basically saying to suppliers, “Look at what we are doing. We are serious in our commitment. If we renege, our up -- front investment will be worth very little. We will lose our projected income stream from the investment. Because of those costs, you can count us in for the long run.” Such tie -- ins aid in making the contracts self -- enforcing and durable; they help to make the long run a viable perspective. 15 Ibid. 16 As reported in Toshihiro Nishiguchi and Masayoshi Ikeda, “Suppliers’ Process Innovation: Understated Aspects of Japanese Industrial Sourcing,” in Managing Product Development, edited by Toshihiro Nishiguchi (New York: Oxford University Press, 1996), pp. 206 -- 230. 17 As reported in Lisa H. Harrington, “Buying Better,” Industry Week, July 21, 1997, pp. 74 -- 80. 18 Ibid. Chapter 3 Principles of Rational Behavior at Work in Society and Business 22 The Role of Markets Should production be rigidly integrated as in American firms or more loosely integrated as in Japanese business consortiums? We surely cannot answer that question with the certitude that many readers will want. Japanese firms obviously gain the benefits of keeping their suppliers in a position that is marginally more tenuous and, maybe, more competitive with other potential suppliers, but they have to deal with the marginally more severe last-period problems. Many factors, which are offsetting and subject to change with the costs associated with contracting and with principal/agency problems we have discussed, are involved. We suspect that different organizational forms will suit different situations and eras (as has obviously been the case in Japan where relational contracting has not always been prevalent 19 ). Answers will come from real -- world experimentation in the marketplace. We suspect that competition will press firms to adjust their organization forms, and the inherent incentive structures, as some variation of organizational form is relatively more successful. Many American firms have had to seriously consider and, to a degree, duplicate the added organizational flexibility of Japanese firms. Why? Their management methods have obviously worked in some industries, most notably the automobile industry. It takes 17 hours to assemble a car in Japan and 25 to 37 hours to assemble a comparable car in the United States and Europe. Japanese firms can develop a new car in 43 months, whereas it takes American and European firms over 60 months, and Japanese cars come off the production lines with 30 percent fewer defects. The worst American -- made air conditioning units have a thousand defects for every defect in the best Japanese -- made units. 20 Firm integration and relational contracting are hardly the only means of moderating last-period problems. Joint ventures, which more often than not require up -- front investments by the firms involved, can also be seen as extensions of firm efforts to reduce last-period problems, with the potential of enhancing the quality of the goods and services produced and lowering production costs. Joint ventures might lower production costs because they give rise to economies of scale and scope through the application of technology, but they also can lower production costs by lowering the potential costs associated with opportunistic behavior and monitoring. They make the future income streams of each party a function of the continuation of the relationship. * * * * * The “last-period” problem is nothing more than what we have tagged it, a “problem” that businesses must consider and handle. It implies costs. At the same time, firms can make money by coming up with creative ways of making customers and suppliers believe that the “last period” is some reasonable distance into the future. Failing firms have a tough time doing that, which is one explanation why the pace of 19 See Toshihiro Nishiguchi, Strategic Industrial Sourcing: The Japanese Advantage (New York: Oxford University Press, 1994), chap. 2. 20 As reported with citations to other sources by Nishiguchi, Strategic Industrial Sourcing, pp. 5 -- 6. Chapter 3 Principles of Rational Behavior at Work in Society and Business 23 failure quickens when the prospects are recognized, given that customers and suppliers can be expected to withdraw their dealings as the expected date of closing approaches. Firms that want to continue to exist have an obvious interest in making sure there is a resale market for their firm, not just the assets that might be sold separately. The owners and workers can then capture the long -- run value of their efforts to build the firm. By highlighting the last-period problem, we are suggesting that the firm resale market can boost the long -- term value of those assets simply by alerting people to the fact that the firm can continue for some time into the future. This means that those firms -- brokers -- who make a market for the sale of firms add value in a way not commonly recognized, by giving firms the prospect of longevity. The “hollow corporation,” in which everything is “outsourced,” or nothing is produced directly, is sometimes viewed as the organizational ideal, given that the firm owners can rely on competitive forces to keep the prices of what they sell as low as possible. We doubt that the “hollow corporation” will ever dominate the economic landscape of any country for a simple reason that comes out of the analysis of this “Manager’s Corner”: The absence of the continuing association of employees under one roof would mean that the last-period problems would arise in spades. This is because the direct association of people under one roof has an unappreciated benefit: as in the keiretsu in Japan, the firm permits the creation of abiding relationships that reduce the incentive individuals have to behave opportunistically in the short run and enhance their incentives to work with their long -- term goals in mind. “Bonding” is something that firms do. Concluding Comments The concept of rational behavior means that the individual has alternatives, can order those alternatives on the basis of preference, and can act consistently on that basis. The rational individual will also chose those alternatives whose expected benefits exceed their expected costs. Traditionally economics has focused on the activities of business firms, and much of this book is devoted to exploring human behavior in a market setting. The concept of rational behavior can be applied to other activities, however, from politics and government to family life and leisure pursuits. No matter what the activity, we all tend to maximize our well -- being. Any differences in our behavior can be ascribed to differences in our preferences and in the institutional settings, or constraints, within which we operate. Institutional settings affect people’s range of alternatives and thus the choices they make. It makes sense to examine the constraints of institutional settings. In this part of the book we will investigate the specific characteristics of the market system, the subject of microeconomic theory. Later we will look at the constraints of government. In both cases the range of choices open to individuals affects the ability of the system to produce the results expected of it. Chapter 3 Principles of Rational Behavior at Work in Society and Business 24 We have also indicated in this chapter how individual rationality can give rise to a nontrivial problem for managers, the last-period problem, which can make deals costly. At the same time, we have indicated how thinking in terms of rational precepts can suggest ways managers can deal with their last-period problems to lower firm costs and raise firm profitability. Review Questions 1. What are the costs and benefits of taking this course in microeconomics? Develop a theory of how much a student can be expected to study for this course. How might the student’s current employment status affect his or her studying time? 2. Some psychologists see people’s behavior as determined largely by family history and external environmental conditions. How would “cost” fit into their explanations? 3. Why not base a course on an assumption of widespread “irrational” behavior? 4. Okay, so no one is totally rational. Does that undermine the use of “rational behavior” as a means of thinking about markets and management problems? 5. How could drug use and suicide be considered “rational”? 6. If your firm were consistently dealing with “irrational behavior” among the owners and workers, what would happen to correct the problem? More to the point, what might you do to correct the problem? 7. Develop an economic explanation for why professors give examinations at the end of their courses. Would you expect final examinations to more necessary in undergraduate courses or MBA courses? In which classes – undergraduate or MBA – would you expect more cheating? CHAPTER 4 Government Controls: How Management Incentives Are Affected Without bandying jargon or exhibiting formulae, without being superficial or condescending, the scientist should be able to communicate to the public the nature and variety of consequences that can reasonable be expected to flow from a given action or sequence of actions. In the case of the economist, he can often reveal in an informal way, if not the detailed chain of reasoning by which he reaches his conclusions, at least the broad contours of the argument. E. J. Mishan arlier chapters showed how the models of competitive and monopolistic markets illuminate the economic effects of market changes, such as an increase in the price of oil. This chapter will examine the use of government controls to soften the impact of such changes. We will consider four types of government control: excise taxes, price controls, consumer protection laws, and minimum-wage laws. As we will see, government controls can inspire management reactions that negate some of the expected effects of the controls. Who Pays the Tax? Most people are convinced that consumers bear the burden of excise (or sales) taxes. They believe producers simply pass the tax on to consumers at higher prices. Yet every time a new (or increased) excise tax is proposed producers lobby against it. If excise taxes could be passed on to consumers, firms would have little reason to spend hundreds of thousands of dollars opposing them. In fact, excise taxes do hurt producers. Figure 4.1 shows the margarine industry’s supply and demand curves, S 1 and D. In a competitive market, the price will end toward P2 and the quantity sold toward Q 3 . If the state imposes a $0.25 tax on each pound of margarine sold and collects the tax from producers, it effectively raises the cost of production. The producer must now pay a price not just for the right to use resources, such as equipment and raw materials, but for the right to continue production legally. The supply curve, reflecting this cost increase, shifts to S 2 . The vertical difference between the two curves, P 2 and P 1 , represents the extra $0.25 cost added by the tax. E Chapter 4 Government Controls: How Management Incentives Are Affected 2 2 ____________________________________ Figure 4.1 The Economic Effect of an Excise Tax An excise tax of $0.25 will shift the supply curve for margarine to the left, from S 1 to S 2 . The quantity produced will fall from Q 3 to Q 2 ; the price will rise from P 2 to P 3 . The increase, $0.20, however, will not cover the added cost to the producer, $0.25. Given the shift in supply, the quantity of margarine produced falls to Q 2 and the price rises to P 3 . Note, however, that the price increase (P 1 to P 2) is less than the vertical distance between the two supply curves (P 2 to P 1 ). That is, the price increases by less than the amount of the tax that caused the shift in supply. Clearly, the producer’s net has fallen. If the tax is $0.25, but the price paid by consumers rises only $0.20 ($1.20 - $1.00), the producer loses $0.50. It now nets only $0.95 on a product that used to bring $1.00. In other words, the tax not only reduces the quantity of margarine producers can sell, but makes each sale less profitable. Incidentally, butter producers have a clear incentive to support a tax on margarine. When the price of margarine increases, consumers will seek substitutes. The demand for butter will rise, and producers will be able to sell more butter and charge more for each pound. The $0.25 tax in our example is divided between consumers and producers, although most of it ($0.20) is paid by consumers. Why do consumers pay most of the tax? Consumers bear most of the tax burden because consumers are relatively unresponsive to the price change. The result, as depicted in Figure 4.1, is that consumers bear most of the tax burden while producers pay only a small part (20 percent) of the tax. If consumers were more responsive to the price change, then a greater share of the tax burden would fall on producers who would then have more incentive to oppose the tax politically. Indeed, we should that the amount of money producers would be willing to spend to oppose taxes on their product (through campaign contributions or lobbying) will depend critically on the responsiveness of consumers to a price change. The more responsive consumers are, the more producers should be willing to spend to oppose the tax. Chapter 4 Government Controls: How Management Incentives Are Affected 3 3 Price Controls Price controls are by no means a modern invention. The first recorded legal code, the four-thousand-year-old Code of Hammurabi, included regulations governing the maximum wage, housing prices, and rents on property such as boats, animals, and tools. And in A.D. 301, the Roman Emperor Diocletian issued an edict specifying maximum prices for everything from poultry to gold, and maximum wages for everyone from lawyers to the cleaners of sewer systems. The penalty for violating the edict was death. More recently, wage and price controls have been used both in wartime (during the Second World War and the Korean War) and in peacetime. President Richard Nixon imposed an across-the-board wage-price freeze in 1971. Prime Minister Pierre Trudeau imposed controls on the Canadian economy in 1975. President Jimmy Carter controlled energy prices in 1977 and later proposed the decontrol of natural gas. Wage and price controls are almost always controversial. Like attempts to control expenditures, they often create more problems than they solve. We will examine both sides of the issue, starting with the argument in favor of controls. Figure 4.2 The Effect of an Excise Tax When Demand is More Elastic Than Supply If demand is much more elastic than supply, the quantity purchased will decline significantly when supply decreases from S 1 to S 2 in response to the added cost of the excise tax. Producers will lose $0.20; consumers will pay only $0.05 more. The Case for Price Controls The case for price ceilings on particular products is complex. On the most basic level, many people believe that prices should be controlled to protect citizens from the harmful effects of inflation. When prices start to rise, redistributing personal income and disrupting the status quo, it seems unfair. Price controls may seem especially legitimate to people, like the elderly, who must live on fixed incomes, and have little means of compensating for the effects of price increases on goods like oil and gas. . This explanation for long -- term contracting has been argued at length by Ronald P. Dore, Taking Japan Seriously (Stanford, Calif.: Stanford University. maximum prices for everything from poultry to gold, and maximum wages for everyone from lawyers to the cleaners of sewer systems. The penalty for violating