Wednesday, July 17, 2013

Paul Krugman says: Don't send a Randian in to do a Smithian or Coasean's job


"Bloomberg Businessweek has a great piece about how an Ayn Rand-loving hedge fund guy is driving Sears into the ground...

But back to the economics: Eddie Lampert’s big idea is that markets and competition rool, so he’s forcing the different parts of Sears to compete for resources just as if they were independent firms, with individual division profitability the only criterion for success. According to BB, it’s not going well; but they don’t get much into the broader issues.

The first issue that should pop into anyone’s head here is, if the different divisions of Sears have no common interests, if the best model is competition red in tooth and claw, why should Sears exist at all? Why not just break it up into units that have no reason not to compete?

For that matter, why should any large firm exist? Why not just have small firms, or maybe just individuals, who make deals for whatever they need?

Of course, that’s not how we do things. We may live in a market sea, but that sea is dotted with many islands that we call firms, some of them quite large, within which decisions are made not via markets but via hierarchy — even, you might say, via central planning. Clearly, there are some things you don’t want to leave up to the market — the market itself is telling us that, by creating those islands of planning and hierarchy.

Now, why exactly that’s true — why some things are better done through market mechanisms, while others are better done through at least a bit of command-and-control — is a deep issue. Oliver Williamson (pdf) got a Nobel for helping elucidate some aspects of that issue (although that may not mean much to you, considering some of the people who’ve gotten Nobels)."
He mentions the Coase/Williamson argument. Of course the other argument is the Smithian one - the division of labor is limited by the extent of the market. As an undergraduate I was pretty interested in IO, and in fact my senior thesis contrasted the Coase/Williamson transaction cost theory of the firm with the Smithian division of labor ideas. It was an awful mess of a research paper... but I guess that's just a step along the path of learning to do research.


  1. My preference would be for a Chandlerian.

  2. It'll be interesting to see how well Sears do.

    Towards the end of my time working for a large PC maker they did the same thing. They divided the company into 4 or 5 divisions; operations, consumer, business and public. Operations provided resources such as factories and outsourcing and the other groups were sort-of layered on top of it. This isn't necessarily a crazy way to work. Certainly transaction costs increase, but having a profit figure from each unit can be very useful. The CEO said he did it because "profit and loss accounts don't lie", I believe the implication in that statement was that the directors of each business area do lie.

  3. Daniel: what do you mean, the Smithian DOL view of the firm? The division of labor can be coordinated either via hierarchy - Smith's pin factory - or via the market. The question is when is the one or the other adopted. O don't know of anything in Smith that speaks to this, Coase's and Williamson's, problem.

    1. Smith used DOL to discuss behavior inside and outside the firm, but I think he does provide an answer to this question and I think it's fundamentally different from Coase and Williamson's answer. He said that division of labor is limited by the extent of the market.

      If the pin-maker is supplying enough of a market he will engage in hierarchical allocation within the firm - we'll have a pin factory. If the market gets bigger and surpasses the technical capacity of one pin factory we'll have division of labor and production will be divided across firms.

      It is entirely a scale economies/technical question and the ultimate location of the production is going to be determined by the extent of the market. Given a production technology, bigger markets mean more division of labor, first within firms and then between firms.

      A more modern rendition is available in Stigler (1951).

      This is different from Coase/Williamson who introduce transaction costs to the question.

      Of course "different" doesn't mean mutually exclusive - they're both relevant. But I see one as technology based and one as contractually based.

  4. It's actually not uncommon for companies to do this, especially when it is an open question over whether the operation is best done in the firm or in the market. If you have a large firm that, for whatever reason, provides its own electricity, splitting their electrical department off and letting the rest of the company choose between either "in house" power or "outsourced" power (e.g., the grid), this process can reveal that the in house power is hugely unprofitable because of economies of scale.

    A lot of large companies have done this with their IT departments; Volvo did it several years back, and Volvo IT ended up doing better as a company than the auto company. Companies do this with custodial work, too.

    It's always a matter of degree, and a matter of how much synergy there is between departments. The last thing you want in a firm is to encourage negative spillover effects between departments, or to discourage positive spillover effects. I mean, if product testing and R&D are split up, you're gonna have a bad time.

    As an unimportant side note... Rand loved big firms! I mean, Taggart and Rearden were all in charge of big firms, weren't they?

    I guess I don't see much point in Krugman's post. He's taken an interesting question and used it to bludgeon people he doesn't like. Krugman is capable of educating people about complex issues, and he certainly seems to have a grasp on the literature. Instead, his purpose seems to be to provide a new talking point in the health care debate "But, look how the market approach worked with Sears!!" without providing the argument for why health care might be special--he could have substituted any industry at all in there, and since we are not privy to his selection criteria, we could not have evaluated his argument.

    1. "But, look how the market approach worked with Sears!!"

      Actually, I would say that the market is doing a fine job of dealing with Sears. It's being managed terribly, and the market values it accordingly. Sears/Kmart is almost worthless ($4.5 B) compared to Target ($46 B) or Wal-mart ($253 B). At this rate, Sears will be taken over or run out of cash.

  5. Daniel, I understand your exasperation with anti-Krugman sentiment in the blogosphere. But this PK post is both bad business analysis and a rather large leap in logic (one biz example to health care)?

    The biggest problem of Sears (plus Kmart, which comprises 35% of Sears' revenue) isn't Lampert's management (although that is also a big problem, namely his takeover of Kmart in the first place)--it's competition from Wal-mart, Costco, Home Depot, and Amazon. Unless you live right next to a Sears, is there any compelling reason to shop there instead of at one of the above? No.

    Sears' other major problem is a horribly confused brand identity. Their only hope might have been to dump clothes and school supplies and focus on appliances, where they actually did have some success (but prob too late now, since big box specialty stores are slowly dying, as Best Buy is discovering).

    But what does any of this have to do with health care, which isn't even close to a free market today?

  6. why should any large firm exist? Why not just have small firms, or maybe just individuals, who make deals for whatever they need?

    Large vs. small is a flawed way of analyzing firm structure. It's more illuminating to look at focused vs. unfocused. There are large, focused firms (Intel) and large, unfocused ones (HP).

    In most cases, the focused firm will perform better than the unfocused one. Look at Canon vs. Sony and Panasonic in Japan; Canon, with half the revenue of either, is worth as much as the latter two combined. This success was a direct result of Fujio Mitarai's emphasis in the early 2000s on profitability and selling off the non-core units.

  7. A CEO who lets his Operating Unit Managers call the shots and allocates budgets to them based largely on ROI, is nothing new and certainly not an example of "decentralization".

    I fail to see how the lens of contract is the low hanging fruit for Sears. My guess is that the lens of choice would be a better place to focus, particularly on the place that most failing businesses ignore - the customer. Plus it needs to be a "new customer". Loads of innovation required!

    I think the difference between Krugman and the "free market believers" is in their perspectives on why health care is so high. Krugman seems to see it as a problem of primarily transaction inefficiencies, which he believes will be fixed via the "lens of contract". "Free market believers" see it as a problem of primarily pricing insulation, which could be fixed via the "lens of choice". FMBs also see innovation suppression as a problem which they believe could be fixed via regulatory changes.

    Personally, I see innovation as having the potential for "hockey stick change". In the short term, I expect to see increases in transaction inefficiencies, and decreases in customer choice inputs. Longer term, I expect innovations to improve via endruns around the sluggish bureaucracy. I also expect that customer choice will play a role in disruptive innovation via developing markets, where insurance and government subsidies are less prevalent.


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