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Firms: The Basics "The big rumor now in Washington is that President Bush is ready to invade Iraq. What we should do is take the CEO's of Enron, WorldCom, and Adelphia, drop them into Iraq and let them have at the infrastructure. Within a few days the country will be ruined." —Jay Leno
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It's time to look more
carefully at another important group of players in the economy - the 26.5
million firms in the
United States (2002 IRS
data) that hire workers to make the goods and services we consume. We
begin with a brief "inventory" of firms in the modern economy, then
examine the act of taking a company public - the process of taking an idea and
turning it into a corporation worth many millions, or even billions, of
dollars, and then look at the structure of corporations. The unit ends with an
introduction to production and cost concepts that are part of the language of
business and public policy.1 The work here will not involve the
traditional graphs or tables, but there is a quantitative example of a
hypothetical university that turns inputs (faculty) into outputs (students).2
Alternative classifications of industry
Ownership
There are three basic forms of
ownership of firms - proprietorship, partnership and corporation - each with
its own advantages and disadvantages.
A proprietorship is a firm with
a single owner. These tend to be small operations where the owner provides
the managerial skills as well as the labor. The primary advantage of this
business structure is control - one person controls the entire
operation. You are your own boss, which appeals to many. There are also some
disadvantages - primarily limitations on the ability to raise funds and
unlimited liability for the owner. You need money to open and run a business,
and while you may mortgage the house or hit up the family to help you start,
without a track record of success, you are unlikely to find a bank willing to
back your business venture. As a proprietor you are also responsible for all of
the liabilities of the company, which exposes you to considerable risk. If
your company loses money then the people to whom the business owes money can
force you to sell your assets to pay the company's bills. Despite these
limitations, the majority of firms in the US are proprietorships, and they are
most prevalent in professional services, retail trade, and construction. In
2002 proprietorships accounted for 72% of the nation's firms, but they tend to
be small so they accounted for only 4% of the total sales - a share that has
been declining in recent years.
A partnership is a firm with two or more owners. These firms tend to be
larger than proprietorships, with sales per firm averaging 5 times those
of proprietorships in 1980 and 20 times higher in 2002. They also tend to be
most popular in operations emphasizing team production involving creative or
intellectual skills where monitoring is difficult. This is likely to be the
case in real estate, medicine, accounting, consulting, law, and until recent
years, investment banking. The largest share of partnerships is in real
estate that accounts for a full 45% of the nation's partnerships. The primary
advantage of partnerships is control - you are almost working for yourself,
while the disadvantages remain limited access to funds and unlimited liability.
You do have greater access to capital ($s) since now you can tap into your
partners' funds and backers (family) as well as yours, but the downside is each
partner is liable for the entire loss. In 2002 partnerships accounted for 8% of
the nation's firms and 10% of the total sales.
A corporation is the third
type of firm. A corporation is a firm owned by one or more individuals who own
shares of stock that define ownership and rights to company profits. The
primary advantages of the corporation is it provides a means for the
accumulation of BIG money, protection from liability since liability is limited
to the value of corporate assets, and life expectancies not tied to that of any
individual. The owners of a corporation are the people who own shares of stock.3
You could buy a piece of IBM stock and you would be an owner of IBM with voting
rights, plus you could sell the stock at any time and you would not be liable
for any loss greater than the price you paid for the stock. This was not
comforting to the workers of Enron who lost their savings when Enron's stock
crashed in 2001, but it was certainly comforting to the owners of stock in
asbestos companies that paid out billions in lawsuits and eventually went
bankrupt. As for life expectancy, Ford and Wal-Mart continued on long
after Henry Ford and Sam Walton died.
Given the structure of corporations,
it is no surprise that corporations tend to be BIG - accounting for 20% of the
business firms in the US in 2002 and nearly 84% of sales. And these sales were
concentrated in the mega corporations - those with sales exceeding $50 million.
In 2000, while these mega corporations accounted for less than 1% of
corporations, they accounted for 72% of the corporations' sales and 85% of
corporate net income (profit). These corporations will play an enormous part in
the modern economy, which you could "test" for yourself if you simply
record each expenditure you make in a day and think about who gets the
money.
Number
and Size of Businesses: 1980 & 2002
|
|
Number of Firms (thousands) |
Business Receipts ($billion) |
Share of Firms |
Share of Receipts |
||||
|
|
1980 |
2002 |
1980 |
2002 |
1980 |
2002 |
1980 |
2002 |
|
Proprietorship |
8,932 |
18,926 |
411 |
1,030 |
69% |
72% |
6% |
5% |
|
Partnership |
1,380 |
2,242 |
286 |
2,669 |
11% |
8% |
4% |
12% |
|
Corporation |
2,711 |
5,267 |
6,172 |
18,849 |
21% |
20% |
90% |
84% |
Source: 2006 Statistical Abstract of the US: Business Enterprises
Firms can also be
differentiated by the nature of the product they sell. In the US is 2003,
<1% of all firms were in mining, 10% were in construction, 5% in
manufacturing, 24% in trade, 3% in transportation and utilities, 12% in
finance, insurance and real estate (FIRE), and 37% in services which includes
personal services (ex. laundry and beauty shops), hotels and lodging, business
services (ex. advertising and computer and data processing agencies), amusement
and recreation, legal services, education services, and health care services.
The share of business sales, however, looks substantially different with 6% of
sales in construction, 19% in manufacturing, 38% in trade, and 17% in services.4
Services is the fastest growing
sector, which is what you would expect in a post-industrial society such
as the United States. In the nation's earliest days agriculture was the leading
industry, employing more than 90% of the workforce, but as a result of dramatic
technological improvements, most notably Eli Whitney's cotton gin
and Cyrus McCormick's reaper,
output was able to expand and by the end of the twentieth century agriculture
workers accounted for less than 3% of the total workforce. These workers
were freed up to move into the factories that were sprouting up around the
country, but once again dramatic technological improvements allowed for output
of manufactured goods to expand with a declining share of total employment as
workers moved from the nation's factories into its offices.
The shift in employment during
the post WWII period is evident in the two graphs below. The explosive
growth in the service sector and the decline in mining are evident in the first
graph. In the year 2005, employment in services was about 3 times higher than
it was in 1960, with the fastest growing segments being education and health
care. Employment in mining, meanwhile, peaked in the early 1980s after a decade
of growth spurred by rising oil prices, and then fell to 80% of its 1960 level
by 2005. Government employment grew slightly slower than services, while
manufacturing, after peaking in 1980, was down 10% from its original level. In
the construction industry you see the volatility of the industry - when things
are good in the economy, it is real good in the construction industry, and when
the economy turns down, it is real bad in the construction industry.
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A somewhat different
perspective on the shift in employment is provided by the second graph that has
the share of employment in each industry. The largest losses were in
manufacturing which went from 30% of jobs in 1960 to about 10% in 2005, while the
largest gains were in services that went from about one-half of all jobs to
more than two-thirds of jobs.
Size and market structure
In business, size matters, at
least if it translates into market power. You experienced this if you ever
bought a T-shirt on the streets of NYC and a computer operating system.
Microsoft had the power to influence the outcome of your operating system
purchase because they are just about the only game in town, while if you just
wanted a T-shirt you could get the T-shirt at a very low price because the
sellers were everywhere. The same is true with coffee. If you do not need
Starbucks and just want a cup of coffee, you will get it for very little
because you have the power to decide who to buy it from. This is a picture of a
perfectly
competitive market
where consumers have the power, and you expect increased competition among
sellers to push prices down. This is precisely what The Economist identified as a factor behind the fall
in prices of illicit drugs in 2004.5 According to The Economist, the declining price can be attributed
to police failure and the fact "that the drugs business has got more
competitive."
On the other end of the
spectrum would be monopoly - markets where the firm is the market and thus the pricing
power rests with the firms. In the late 1980s Microsoft had a virtual monopoly
on operating systems for personal computers and Intel had one in the processors
that power these computers. It was also the case in many small communities in
the US where there was only one hardware store, one clothing store, or one
grocery store. While these firms were small, they had little competition- at
least until Wal-Mart decided these were wonderful locations to locate one of
their "Big Boxes." This is why many of you live in communities where
the coming of a Wal-Mart was fought by the local businesses and where it
brought with it store closings. This certainly caught the attention of the
government that set about the task of reigning in the power of
monopolists.
In between the two extremes is
the world of imperfect competition. On one end of this shortened spectrum is monopolistic competition where we have many firms selling slightly different
products - what we might find in many retail sectors. There are many sellers of
shoes and winter jackets, although the sellers to differentiate the products
incur considerable effort and expense. On the other end is oligopoly - markets
dominated by a few very large firms. There are only a few major players in
the market for film, aircraft, breakfast cereal, and electric bulbs and the
behavior of anyone is likely to be affected by the anticipated behavior of the
others. It is here you will be introduced to game theory as a way of explaining
behavior.
A summary of the characteristics
of the four market structures appears below.
|
|
Market Structure |
|||
|
|
Perfect competition |
Monopolistic competition |
Oligopoly |
Monopoly |
|
# of firms |
many |
many |
few |
one |
|
Barriers to entry |
none |
low |
high |
high |
|
Control over price |
none |
little |
much |
complete |
|
Market power |
none |
some |
much |
complete |
|
Economic profit |
none |
none |
some |
some |
Because the outcome of the
market is influenced by the market's structure, there will be two units - one focused
on perfectly competitive markets and one on imperfectly competitive markets. In
the US economy, it is not difficult to see where the power lies when you look
at the size of today's corporations - they are HUGE.6 One of the
best sources of information on size would be Fortune magazine where you can find the Fortune 500 companies, and below you have
information for three years that give you an insight into what has been
happening in the US economy during this period.7
Fortune 500: Largest US Companies
|
1998 |
2002 |
2005 |
||||
|
Company |
Revenues
($ millions) |
Company |
Revenues
($ millions) |
Company |
Revenues
($ millions) |
Profits
($Millions) |
|
GM |
178,174 |
Wal-Mart |
219,812 |
Exxon Mobil |
339,938 |
36,130.00 |
|
Ford |
153,627 |
Exxon Mobil |
191,581 |
Wal-Mart |
315,654 |
11,231.00 |
|
Exxon |
122,379 |
GM |
177,260 |
GM |
192,604 |
-10,600.00 |
|
Wal-Mart |
119,299 |
Ford |
162,412 |
Chevron |
189,481 |
14,099.00 |
|
GE |
90,840 |
Enron |
138,718 |
Ford |
177,210 |
2,024.00 |
|
IBM |
78,508 |
GE |
125,913 |
ConocoPhillips |
166,683 |
13,529.00 |
|
Chrysler |
61,147 |
Citigroup |
112,022 |
GE |
157,153 |
16,353.00 |
|
Mobil |
59,978 |
Chevron
Texaco |
99,699 |
Citigroup |
131,045 |
24,589.00 |
|
Philip
Morris |
56,114 |
IBM |
85,866 |
American
Intl. |
108,905 |
10,477.00 |
|
AT&T |
53,261 |
Philip
Morris |
72,944 |
IBM |
91,134 |
7,934.00 |
Going public and the evolution of industries
In the late 1990s the press was
filled with stories of companies "going public," a process that
created many overnight millionaires including many under age 30. It was an
amazing time, and we're going to talk a little bit about this process that
created these millionaires during this period of time referred to as the
Information Revolution. Success in this era required an ample supply of
individuals willing to take risks, individuals willing to look relentlessly for
a better way to build that mousetrap - and the US had more than its share of
these change agents, while Japan had less than its share. And the innovation
process will also matter as we move forward because the addition of China and
India into the world marketplace dramatically increased the size of the world’s
labor supply that will push down the wages of labor. For increasing numbers of
people in the world’s rich countries entrepreneurship is a way around falling
wages. 8
The entrepreneurial act
involves risk taking, and to promote that you need a system that rewards risk
taking. One requirement would be a less rigid corporate structure, one where
advancement relies less on longevity and more on value created. This is why you
find numerous studies showing that countries with high levels of
"red-tape" tend to have lower growth rates. It is also generally
accepted that one of the reasons Japan "missed" the Internet
revolution was because large firms with hierarchical structures dominated its
economy.
But how is the creative power of the
entrepreneurs unleashed since the large corporations, which tend to be risk
averse, are the ones that have access to the necessary funds? How would small
entrepreneurial individuals or firms be able to bring an idea to market given
the increasing complexity of the product creation process? What would motivate
the best and brightest to devote their energies to highly risky ventures? What
would prompt those engineers from Stanford and MBAs from Harvard to take jobs
in the high-risk information technology industry where a start-up firm would
pay them substantially less than an established firm?
The process that begins with
your idea and ends with the formation of a corporation is outlined in the
diagram below. It begins with the new idea – the better mousetrap – but it
quickly moves to financing. People need to eat, so the funds needed to finance
the research must be obtained. Even if you did not pay much in salary, there
were still costs to be incurred before the money rolls in. You could tap into
your own savings, or the funds of friends and family, but this is probably not
the BIG money you need. A second option would be banks, except they have never
been keen on funding risky ventures, which is a good thing since they are
'playing' with your money. This is why the heavy reliance of Japanese companies
on borrowing from banks (debt financing) worked against them in the 1990s, and
why the reliance of US companies on selling stock (equity financing) helped
them during the Internet boom years.9
The “solution” to the
problem of raising funds came from two sources - the nature of the financing and
the compensation packages for employees. We’ll start with the compensation
packages that were loaded with stock options - basically a promise to pay
future $s for work done now. This provided the means to attract the best
and brightest from around the world to US high tech companies and to
motivate the "nerds" to work long hours for low pay. Rather than
paying a high salary, which is what a company would have to pay in established
firms like Xerox, GE, GM, and American Airlines, a high tech start up could pay
them in stock options - ownership of stock in the company that would be issued once
the company went public.
The beauty of this system is
that the entrepreneurs would work very long hours with little compensation to
bring a product to the market if they were promised ownership rights to some of
the company's stock when it went public. Furthermore, they would have a strong
incentive to succeed in their work because if they did succeed and take the
company public and the stock price went up, as it tended to do in the boom
market, then they would make BIG bucks.
Going Public
But now we are back to the
financing. Even if you could get by largely on promises, you still needed money
and this is where the venture
capitalists entered
the picture. In the simplest terms, the venture capitalists are very wealthy
individuals who lend their money to entrepreneurs to support the research they
believe will produce a marketable product. For a more detailed description of
the venture capital market, you might want to visit some venture capital web
sites.10 In general the "deal" is that the venture
capitalists provide the funds to finance early research and product development
when the company is burning through money with little, if any, revenue since
they have yet to develop a marketable product.
Once you have developed your
idea and are ready for the big time, it is time to place a call to the next
important group - investment bankers -
the suits who will help the start-ups take their companies public with an initial public offering (IPO) The investment
bankers arrange for the advertising and sales of stock in the new company. Some
of the stock is be given to the employees as part of their compensation – those
stock options mentioned earlier, a BIG block would be given to the venture
capitalists that initially funded the operation, a large block would be given
to the entrepreneurs who began the company, and some would be sold on the open
market at an initial price set by the investment bank. The issuance of stock
that accompanied its "going public" is
an important step because it allows the venture capitalist (VC) to make money
and easily exit the business and look for the next BIG idea. It also allows the
company to tap into a worldwide pool of money rather than relying on the deep pockets of the venture capitalists that
supplied the seed money. Once you get your company listed on a national stock
market, probably NASDAQ since the older established companies are sold on the
New York Stock Exchange, investors from all over the world will be able to buy
the initial shares at a price initially set by the investment bankers. The
instant millionaires were the holders of the stock who saw its price rise
dramatically, sometimes on opening day.
The rest, as they say, was
history as the stock market boom took off. Just 'do the math" for a small
initial public offering of 5 million shares at $24. This means that the owners
of the company, those with the stock, own assets worth $125 million once the
stock is sold. All that hard work turns into real money. And it gets even better when the price
rises to $71 and an additional value of $220 million in value is created. Equally
important was the run up in the price of the stock after it was initially
offered to the public. In one study conducted by Kent Womack from Dartmouth, it
was shown the price of a company's stock rose on average 65% during its opening
day - not a bad return on your money if you were lucky enough to get a few
shares of the company at the IPO price. As a result, over the next few years
the number of IPOs exploded as entrepreneurs and venture capitalists tried to
cash in on the Internet phenomenon. To get a feel for it, you might also want
to watch the semi-documentary, Start Up.com.11
One measure of the boom is the
price of stocks. It didn't seem to matter there were many new companies
offering stock since demand continued to outpace supply and the price of stock
was driven up by the worldwide demand. At the end of 1994 the NASDAQ average
was in the mid 700s, but by early 2000 it had reached 5,100 and articles were
being written about the DOW average rising to 32,000 from a late 1994 value of 3,900.
It was a true speculative bubble, that as you can see burst in 2000.
It was pretty clear by the late
1990s the booming
stock market was very close to a sure ticket to untold wealth for many since
very often the price of the stock would rise sharply after its initial opening
price and money poured into these stocks. It was also an opportunity for some
of the big investment banks to 'reward' some of their best clients with IPO
stocks - something that had caught the attention of regulators and
investigators looking into the situation after the bubble burst.12 This
payoff to the 'friends" of the investment bankers could have gone to the
initial investors and entrepreneurs, and therefore it was not too surprising to
see Google - the company behind the search engine many of you use - to
come up with an alternative way of going public using a Dutch auction.13
Now that you have an idea of
how to take a company public, let's look more closely at the structure of those
corporations.
Corporate structure and corporate scandals
The other big stories of the
Internet boom - bust years were the outrageous compensation of corporate
executives and the corporate scandals, and to understand them you need to
understand the structure of corporations, or more specifically, the separation
of ownership and control. In corporations it is the stockholders who
"own" the company. This is good for the business because it can raise
funds by selling stock to millions of people to finance its operations, but it
makes it virtually impossible to run a company with millions of owners. To get
around this the interests of the owners are represented by the Board of
Directors that, at least in theory, is responsible for running the business.
The members of the Board
of Directors, under the
direction of the Chairman
of the Board, are often
high-level executives from other companies who are elected by the stockholders
and are responsible for meeting occasionally to oversee a business' operation. In
reality you will find that at the core of the Boards of Directors of the
nation's largest companies is a fairly small group of individuals who sit on a
number of Boards and are paid pretty handsomely for their efforts that might
entail a few official meetings a year. To check out who these people are
and how well connected they are you might want to check out They Rule web site that shows who the people on
the Boards are and the web of interlocking directorates. If you are
interested in the directors of a particular company you can usually check out
their web site. For example, those interested in the Directors of IBM, you
would go to the IBM site where you would
access the link to investors and
then corporate
governance where you would find the link to the directors.
It turns out, however, that
there is a wide gap between theory and practice since the Board of Directors
often plays a very small role in the running of America's corporations where
professional managers and executives run the day-to-day operations of the
company. The chain-of-command in a modern corporation can be visualized as a
pyramid. At the top of the pyramid is the Chief Executive Officer - the CEO who is chosen by the Board.
This is the "boss," or as Jack Black's character in movie The
School of Rock would
say, this is "the man." This is where the buck starts and stops; this
is the person with the "vision," the person most responsible for
setting the overall direction in which the company will move, for making the
decisions such as determining what countries the company might enter and what
products it might produce. In the dot.com boom-bust era, these corporate CEOs
were also at the center of two BIG business stories - extraordinary CEO
compensation and corporate scandals.
America's top bosses have
always been well paid and there has always been a substantial gap between what
was paid those at the top and those at the bottom of the corporate pyramid. In
1990 the average pay of CEOs was about 85 times that of the average production
worker, more than double what it was about a decade earlier, but substantially
less than the multiple of 400 it was believed to be in the early 2000s. At
the Forbes web site you can find a special What the Boss makes
that provides compensation leaders for a number of years, which is presented
below. We are talking about some serious bucks here with Reuben Mark of
Colgate-Palmolive earning $148 MILLION for his efforts that year. Larry
Ellison from Oracle, who spent nearly $100 million to lose in the America's Cup
trials, probably didn't feel too much since the stock he owns in the company is
worth $16 BILLION.14
2004
CEO Compensation (Forbes)
|
CEO |
Company |
Compensation ($thousands) |
Value of owned stock ($millions) |
|
Reuben Mark |
Colgate-Palmolive |
147,970 |
312.7 |
|
George David |
United
Technologies |
70,527 |
68.5 |
|
Richard S Fuld Jr |
Lehman Bros
Holdings |
67,682 |
365.6 |
|
Henry R Silverman |
Cendant |
60,023 |
197.8 |
|
Dwight C Schar |
NVR |
58,105 |
259.8 |
|
Lawrence J Ellison |
Oracle |
40,589 |
16,621.6 |
|
Richard M
Kovacevich |
Wells Fargo |
37,842 |
104.0 |
|
Howard Solomon |
Forest Labs |
36,089 |
545.1 |
|
James E Cayne |
Bear Stearns
Cos |
33,925 |
580.6 |
|
Todd S Nelson |
Apollo-Education
Group |
32,812 |
0.2 |
These extraordinary sums are in
part a reflection of the increasing complexity of the job in a world of rapid
change and great uncertainty. The CEO during the dot.com boom and the go-go
days of the late 1990s had become American aristocracy, hailed as the
visionaries who helped reestablish American businesses at the top of the
world's pecking order. In the late 1980s, the focus of attention was on how the
US could become more like the German, and especially Japanese corporations who
were "taking over the world," but a decade later it was American
companies who "ruled the world" and everyone else wanted to be like
them. So who should complain about the compensation of corporate
executives in the US who were compensated for engineering this turnaround and
making many stockholders very rich. But this was not the entire compensation
story. The high levels of CEO compensation were also a reflection of the
process of setting executive pay since the pay was usually set by a committee
of the Board, often "stacked" with other top executives - a little
game of tit-for-tat.15
The move toward stock options
as a form of compensation also was an important factor contributing to the
explosion in executive compensation. In the 1980s when American CEOs were being
well compensated even though their companies were not performing all that well,
an effort was made to better align the goals of the CEOs with the goals of the
stock holders - the owners of the company. In their 1990 article, "CEO
Compensation: It's Not How Much You Pay, But How" that appeared in Harvard
Business Review,
Michael Jensen and Kevin Murphy argued for the linkage via stock options. The
issue was not new. It was just another example of what economists refer to
as the principal-agent
problem. It's quite
easy to understand. Think of you working for me as a manager. It's my company
and I am interested in making as much profit as I can since the profit goes to
the owner. But you are the manager and you are most interested in your own
financial and personal welfare. What happens on the weekend when a problem
arises at the office on Cape Cod. It needs to be dealt with now or my profits
will take a BIG hit, but you have a golf date planned. It should be clear your
objectives (a good golf date) and mine (more profit) are not consistent, they
are not both pointing you in the same direction.16
Now take this problem and move
it to the corporation. The stockholders want higher stock prices and the
managers want higher compensation, so there is a "deal" here - stock
options that became an increasingly important component of executive
compensation in the 1990s. A CEO would be awarded shares of the company stock
that could be sold at a specified price that was often closely linked to the
price at the time the compensation was established. If the stock price
increased then the value of the stocks owned by the CEO would increase. The
thought was that the corporate executive, whose compensation was now influenced
by any changes in the company's stock, would have a strong incentive to run the
company in such a way as to raise the company's stock prices.17
The system was not without its
own problems, which brings us to the second big issue - corporate
scandals the corporate scandals that filled the business press and
nightly news until they were "pushed" aside by 9/11 and the wars in
Afghanistan and Iraq.18 Although most corporate leaders try hard to
keep a low public profile, during the peak of the corporate scandals a number
of corporate leaders became regulars on the nightly news as Americans got to
know companies they had never heard of before and see corporate scams involving
many billions of dollars.19 By early 2006 some of the biggest trials
were over and some of those executives have been given lengthy prison terms.
One result of the scandals was a new law on the books - the Sarbanes-Oxley passed at the height of the corporate
scandals designed to raise the penalty for faulty bookkeeping and make the
corporate executives responsible for the books by personally signing off on
them.20
Before leaving our analysis of
firms, we will look briefly at what it is that firms do - turn inputs, such as
labor and computers, into outputs, such as iPods and Honda automobiles. In this
section we will look at some of the key production concepts, and as we do you
will see it is important to make the distinction between the short-run and the
long-run.
The short-run is defined as a period of time short
enough so that capital (machines and facilities) cannot be changed, and the long-run is defined as a period of time
sufficient to allow for changes in all inputs - long enough, for example, to
build a new plant. Here we will look at the short-run relationship between
output and input, which in the university example we will look at the
relationship between the number of faculty (input) and the number of students
(output).
The key piece of the analysis
is the production
function - the
conceptual link between inputs and outputs. Average product measures the average number of units of output produced
by each input. If we were talking about the university we would use a
number for the teacher/student ratio as a measure of efficiency, or you might
have how many iPods produced per worker. This is what the US government
measures with its published
labor
productivity
figures. The marginal product measures the relationship between the
change in inputs and the change in output. [MP = D output/D input] In general we expect that as
output increase marginal product will fall, in part because you keep adding
units of an input to an operation with a fixed facility. Eventually, however,
the additional output produced by the additional input will begin to decline.
Once this happens we have
diminishing
marginal product, which should not surprise you. If you were at
the university, as you hire more faculty the number of students would increase,
but at some point each additional faculty will increase the number of students
by a smaller amount.
The definitions and formulas
for important production concepts that will be at the center of our analysis
are presented below.
Definitions and formulas of short-run production concepts
- Total (physical) product
- Definition: amount of output
obtained from given amount of input
- Average (physical) product
- Definition: amount of
output obtained per unit of input
- Formula: Output /
Input
- Marginal (physical) product
- Definition: additional
output obtained by 1 more unit of input
- Formula: DOutput / DInput
- Diminishing
marginal product: as input use expands the marginal product begins
to decline
Production in the long-run production
How do things differ in the
long-run? The major difference is there that in the long run all inputs are
variable. In the analysis of the long run there is also an important new
concept that you are likely to hear mentioned frequently. The concept is economies of scale and below you have three examples of
where it showed up in the press.
1. ... Economies of scale are reducing
costs up to 7 percent a year, but the progress is too slow to make solar truly
competitive without subsidies. ...
2. The theory was consolidation would let
companies cut costs and build profits. The new radio empires could run multiple
stations with thins staffs - for instance, by spreading around their DJs via
voice tracking...
3. BMW ranks only 14th among the world's
automakers, ahead of Mazda and behind Mitsubishi in global unit sales, which
severely limits its economies of scale.
The concept is simple enough.
By expanding output - more solar panels, automobiles, or stations and customers
- you would be able to lower average costs. A good example of this is presented
in the article Economies of scale and continuing consolidation of credit
unions where you see the following graph of
expenses at the credit unions broken down by bank sizes. For the smallest class
of credit unions, those with under $1 million in assets, the noninterest costs
(think operating costs) represent 4% of the assets, while for the largest
class, those with over $1 billion in assets, the costs are about 2.2% of
assets. What this means, as we will see later, is the cost of doing business
falls with larger sizes which should create an incentive for consolidation on
the industry in an effort to drive down costs.
To differentiate between the
short and long-run concepts we use a simple production matrix such as the one
below describing the level of output that can be produced with various
combinations of the two inputs - capital and labor. By reading down a row or
across a column you are looking at the short run picture and can calculate
productivities, while reading down the diagonal gives you the long run where
you can calculate economies of scale. For example, assume that the firm has
decided to use 10 units of capital. The relationship between the amount of
labor inputs and output is given by the first column - when 10 units of labor
are used production is 130 units, and when labor expands to 30 units, output
expands to 260 units. If you wanted to you could create a new table of marginal
products that would be similar to what you saw earlier. If you want to see the table and graph, you can check them out at the bottom of the
page. For the long run, you would want to increase inputs by the same multiple
and examine what happens to output. In this case we can begin with 10 units of
each input that will allow production of 178 units of output. When both inputs
are doubled to 20, output increases to 246 - less than double its original
level so in this example production exhibits decreasing returns to scale.21
Production Matrix
Economies of Scale
|
|
Amount of
Capital |
|||
|
Amount of Labor |
10 |
20 |
30 |
40 |
|
0 |
130 |
170 |
220 |
290 |
|
10 |
178 |
210 |
256 |
323 |
|
20 |
222 |
246 |
289 |
353 |
|
30 |
260 |
278 |
319 |
381 |
|
40 |
296 |
308 |
347 |
406 |
When examining economies of
scale there are three possibilities defined below.
- decreasing returns to scale: if we double all
inputs and output less than doubles
- constant returns to scale: if we double all
inputs and output doubles
- increasing returns to scale: if we double all
inputs and output more than doubles
Not surprisingly, there is the
cost equivalent of the returns to scale. Just as there is a relationship
between diminishing marginal product and increasing marginal cost in the short
run, there is a relationship between decreasing returns to scale and increasing
average cost in the long run. The three long-run cost concepts are:
- increasing cost industry: as we expand
output, average cost rises
- constant cost industry: as we expand
output, average cost remains constant
- decreasing cost industry: as we expand
output, average cost falls
What are the conditions likely
to generate economies of scale (decreasing cost industries)? Here is a list of
five factors that have been identified as contributing to economies of scale.22
(a) Indivisibilities in inputs. When inputs are lumpy in nature or
non-rival in consumption they are, at least in part, independent of scale and their
costs can be spread over a larger level of output resulting in lower unit
costs. Such inputs include capital, R&D and advertising.
(b)
Specialization in inputs:
When the scale of the plant or the firm increases, opportunities for
specialization for both the labor force and the capital equipment become
available resulting in increased efficiencies.
(c)
Lower input costs: Input
costs may be lowered due to volume discounts, lower transaction costs, reduced
inventories and other similar cost efficiencies resulting from large scale of
operations.
(d)
Advanced techniques and organizations: Expanded scale of operations may make possible more efficient
methods of production and distribution (e.g. automation) and allow improved
organization of resources resulting in efficiency gains.
(e)
Learning: Efficiencies may
result from increased scale due to rapid learning. Such economies are more
readily available in production and distribution processes involving high
degrees of tacit knowledge."
You should also know about
economies
of scope defined
in the Dictionary of Economics as: "A situation in which the same
investment can support multiple profitable projects or activities less costly
together than separately. For example, an airline selling round trips from New
York to Los Angeles can produce air transportation less expensively than one
selling only one way-routes." Another example would be where the same
company can produce trucks and autos.
Now it is time to move to
the revenue side of the firm's finances and then combine the revenue and cost
information to examine the choices made by firms. First, however, you might
want to check out the graphs.
1. If you are looking for information on firms, start with the business press. For newspapers you have the Wall Street Journal and Financial Times, and for magazines there are Forbes, Fortune, Business Week plus my favorites, Fast Company and The Economist. For data, a place to start would be the Census Bureau, which is part of the Commerce Department that conducts the census of business just as it conducts the census of population. If you happen to want some information on employment, unemployment, and earnings by industry you should check out the Bureau of Labor Statistics web site. Another invaluable resource for data is the Statistical Abstract where you would look in the Business Enterprise section.
2. As we work through the university example be sure to not lose sight of the fact that we have a very narrow definition of output since there is no mention of quality - a very important, yet hard to quantify, part of output. It is also important to note that we will use tables rather than graphs in our analysis of business decisions, but the graphs are available for those interested in the more traditional analysis. You also might want to check out two additional examples of these important concepts (Shoplifting Example) Tutoring Example)
4. There are some real limitations of proprietorships and partnerships as the scale and risk of operations increases. For example, put yourself back in the 16th century in England and think about the magnitude of the operation of importing spices from the orient - a part of the world barely known to Europeans. How many people would have enough money to pay for a boat and crew and cash to purchase the spices and other treasures from the orient and ship them back halfway around the world before they could sell them? Or what about 19th century America? Who had the money to pay for the construction of the thousands of miles of tracks plus the engines and the rail cars needed to carry the freight and passengers - and this was all before receiving any revenue from transporting freight or passengers? In both instances - the trading companies in the 16th century or the railroads in the 19th century - the limitations of the partnerships and proprietorships were evident since it was highly unlikely that any one individual would have the funds necessary to undertake these risky and expensive endeavors. As so often happens, however, the appearance of a problem brought with it a solution - a new form of business ownership. In England we saw the emergence of Stock Trading Companies - the East India Company (1600) and the Hudson Bay Company (1670) being two early examples. [For those interested, you can view an online copy of the charter establishing the Hudson Bay Company]. Generally the company was formed when a group of wealthy people got together and pooled their money and agreed that anyone could take out their money if they wanted to do so and those who left their money in would split any profit or loss. A similar situation arose in the US where wealthy people would buy stock in a railroad company that would then issue them stock - ownership rights in the company.
4 2006 Statistical Abstract of the US.
There is also a pronounced pattern in terms of ownership. Partnerships tend to be concentrated in the insurance and the real estate sector that in 1998 accounted for 45% of all partnerships, while 43% of all proprietorships are concentrated in services. Corporations, meanwhile, tend to be over-represented in manufacturing and wholesale.
Number
and Size of Businesses by Industry: 1997 & 2003
|
|
# of Establishments (thousands) |
Business Receipts ($billion) |
Share of Establishments |
Share of Receipts |
||||
|
|
1997 |
2003 |
1997 |
2003 |
1997 |
2003 |
1997 |
2003 |
|
Mining |
25 |
|
174 |
|
0% |
|
1% |
|
|
Utilities |
16 |
19 |
412 |
478 |
0% |
0% |
2% |
2% |
|
Construction |
656 |
698 |
859 |
1,140 |
10% |
10% |
5% |
6% |
|
Manufacturing |
363 |
344 |
3,835 |
3,833 |
6% |
5% |
22% |
19% |
|
Wholesale trade |
453 |
442 |
4,060 |
4,379 |
7% |
7% |
23% |
22% |
|
Retail |
1,118 |
1,112 |
2,461 |
3,171 |
17% |
17% |
14% |
16% |
|
Transportation |
178 |
201 |
318 |
|
3% |
3% |
2% |
|
|
Information |
114 |
137 |
623 |
905 |
2% |
2% |
4% |
4% |
|
Finance & insurance |
395 |
449 |
2,198 |
2,616 |
6% |
7% |
12% |
13% |
|
Real estate & rental
& leasing |
288 |
326 |
241 |
348 |
5% |
5% |
1% |
2% |
|
Professional, scientific,
& technical services |
621 |
747 |
595 |
896 |
10% |
11% |
3% |
4% |
|
Management of companies
& enterprises |
47 |
|
92
|
|
1% |
|
1% |
|
|
Administrative/support
waste management/remediation services |
276 |
276 |
296 |
414 |
4% |
4% |
2% |
2% |
|
Educational services |
41 |
50 |
20
|
32
|
1% |
1% |
0% |
0% |
|
Health care & social
assistance |
646 |
712 |
885 |
1,234 |
10% |
11% |
5% |
6% |
|
Arts, entertainment, &
recreation |
99 |
111 |
105 |
138 |
2% |
2% |
1% |
1% |
|
Accommodation &
foodservices |
545 |
565 |
350 |
452 |
9% |
8% |
2% |
2% |
|
Other |
520 |
528 |
266 |
315 |
8% |
8% |
1% |
2% |
5. "The Price of Powder," The Economist, 11/27/2004.
6. How did firms get this big? Let's begin with the second question and look at the pattern of growth and structural change in industries. Hal Varian, in his article "5 Habits of Highly Effective Revolutions" identifies five stages in the evolutionary process. The first is experimentation, the stage when entrepreneurs work to figure out how to make money our of some new idea. This is the stage immortalized in those images of garages and basements where successful products were launched, a time where there are few employees and few sales. The problem is the entrepreneurs seldom can tap into the pools of money to support the development of the product and the production of the early prototypes. This stage, the capitalization stage, is where the financiers come in - the venture capitalists and investment bankers we talked about earlier. And then what often happens if the venture succeeds - and many do not - the firm grows too large for the entrepreneur to effectively manage. This is what happened to Apple when Steven Jobs was "pushed out" of Apple. Apple had grown to the point where conventional wisdom was that professional managers were needed to guide Apple's growth, so Jobs was out and the professional managers were in - the management phase. Eventually, the dust begins to settle in the industry in a phase Varian refers to as hypercompetition. Here some of the competitors fail and others are bought out in a race to see who survives. As we will see later, in the information industry the race will have all too predictable a result. Because of enormous advantages of being early and being big, the industry will move eventually into the consolidation phase where the industry is established and the product has become a commodity. This is what happened at IBM, one of the early giants in computers, when they decided that the company was no longer selling a hot technology company but rather a commodity. Once this had happened the company brought in Lou Gerstner, former chairman and chief executive officer of RJR Nabisco, Inc., a company with considerable success in markets of mature products.
7. A few observations based on the list.
- The effect of the increase in gas prices in 2005 shows
up in Exxon Mobil's #1 status with sales of $339 billion, which means it
"rings up" almost $1 billion a day. In fact 3 (Exxon Mobil,
Chevron, Conoco) of the top 10 companies were oil companies that together
earned about $64 billion in profit, and Exxon Mobil saw its profit
increase 77% in 4 years - a lot more than wages increased.
- The rise of Wal-Mart that has nearly tripled its sales
in the 8-year period so that in 2006 it was making about $1 billion in
profit a month - about $41.3 million an hour. Fortune, in the March 3, 2003
edition, gave some alternative indicators of the size of Wal-Mart.
Wal-Mart was the largest employer in 21 states; it was responsible for
purchasing 39% of Tandy Brands Accessories sales and at least 20% of the
sales of Clorox, Revlon, and RJR Tobacco; it sold over 30% of the nation's
dog food, disposable diapers, and photographic film and over 20% of
toothpaste and pain remedies; and sales on one day reached $1.42 billion.
- The meteoric growth and then implosion of Enron. It went
from nowhere to # 5 to nowhere in the 8 years.
- The troubles with America's car companies. Their
rankings slipped on slow growth and in 2005 GM was losing almost as much
as Wal-Mart was making ion profit.
It is also important to note that size is not an American phenomenon as you can see from the Global 500 rank. In the 1998 ranking, US companies took 3 of the top 10 spots, the Netherlands had 1 (Shell) and Japan had the other 6, but by 2005 the explosive growth of the US economy and the slide of the Japanese had substantially altered the list. In 2005 only 1 Japanese company (Toyota) remained, while US based companies held 6 of the 10 slots plus Daimler Chrysler.
8. To better understand the situation in the New Economy consider the situation in Megacorp, a hypothetical world leader in the production of high tech widgets. This is an organization with a well-developed management hierarchy, a structure that has made it the world leader, a structure filled with individuals who have learned the secrets of success in the industry. Now imagine yourself as a young hot shot working in the company who has to tell the boss, a person who has been there for many years, that there is a need to change strategies, that all the boss has been responsible for creating in his or her professional life will need to be destroyed to enable the creation of a newer, better, faster, cheaper way of doing things. It will not be an easy meeting for you, and as the company gets bigger, it will be even more unpleasant and difficult to elicit change. Unfortunately for large companies, and for economies such as Japan's that have been dominated by large companies with strict hierarchical structures, the rate on entrepreneurial activity will generally be lower as the entrepreneurs look for environments more open to change. A good example of the problem faced by Japan can be found in the title to an article that appeared in the New York Times, "A Rebel in Japan, an Inventor is Hailed as an Innovator in U.S." (September 18, 2002) It turned out that Shuji Nakamura was ordered by his superiors to stop the scientific research that he continued to do without company knowledge - research that resulted in a number of important patents that generated substantial revenues - revenues that went almost exclusively to the company. Why work hard if you are discouraged, or if virtually none of the profits from your work show up in your paycheck? To many potential entrepreneurs in Japan the answer was either not to work or to leave the country. A second perspective on this "paralysis" is presented in "The Great Disruption where the authors examine the microeconomic roots of disruptive technologies they believe hold the secret to macroeconomic growth. In their view Japanese companies were so well managed and so risk averse that they missed the disruptive technologies behind the Internet revolution.
9. Another problem is that in the "old economy" loans would often be made to purchase physical capital (machinery) or construct a new factory - and these could be used as collateral on a loan. If you didn't pay back then the bank would get the machinery or the building. In the new economy, however, where the value is in the knowledge the entrepreneur possesses - where is the collateral there - what can the bank collect if the product goes bust? Not much - which is why this funding option was not viable.
10. At one, Vcapital, you will find the following description of what the company does for entrepreneurs and business owners.
"Entrepreneurs and business owners who qualify for the Vcapital network gain access to high-quality investors. Investors in the Vcapital network are interested in deals spanning a wide variety of industries and investment stages. To accelerate the capital-raising process, Vcapital targets deals to investors who have already expressed interest in similar opportunities. Data transmission is secure and the release of information is permission-based, so entrepreneurs and business owners in the Vcapital network always control which parties may view their data. By integrating Web technology with traditional private equity processes, Vcapital delivers significant time savings over traditional capital-raising procedures."
11. One of the most famous IPOs that was identified as signaling the birth of the Silicon Valley system that brought us the Internet revolution was Netscape, which produced the world's first user-friendly browser. The situation has been described in a Silicon Valley.com article as follows, and if you want another perspective on it you might check out the Netscape IPO Funnies.
Netscape's initial public offering in August 1995 set the scene for the speculative Internet stock frenzy that continues to this day. Prior to the IPO, the intense buzz around the stock saw the original number of shares go from 3.5 million to 5 million and the offering price go from $12-$14 to $21-$24 -- and finally to $28. On the first morning of trading, the stock opened at $71. It closed the day at $58.25 -- about double what the most optimistic experts had expected. On Wall Street and in Silicon Valley the news was tantamount to a messenger riding at a full gallop through San Francisco in 1849 shouting "Gold! There's gold on the American River!"
If you wanted any "proof" of the Internet hype you could look at the events of the late 1990s, some of which are captured in the following news clips.
"iTurf, which operates the gURL.com website for teenage girls, had sales of only $US100,000 in 1998 and no income. Even so, its 980 per cent sales growth seemed impressive enough to justify seeking $US46 million in a listing underwritten by BT Alex.Brown, Hambrecht & Quist and CIBC Oppenheimer. The offering, filed on Monday, could bring a big payoff for its parent company, clothing retailer dELiA*s." Blumberg Capital 1/1/1999
The Santa Monica, California, company [Etoys] celebrated Wednesday by filing a US$115 million public stock offering that will be underwritten by Goldman Sachs. Wired 2/17/1999
Analysts also smiled on market research and planning firm AtPlan. The company has seen losses of more than $1.8 million on revenues of $3.1 million, but hopes to make up to $34.5 million in its initial public offering. Hambrecht and Quist will underwrite the offering. Wired 5/14/1999
12. For example, if you received 10,000 shares of Cisco stock on October 17, 1991 at the price of $.31 a share rather than a salary of $3,100, and if you held onto the shares until July 20, 2000, the price would have been $69.50 so the $10,000, which is actually not real money to the company, would have grown to $2,241,935. The good times did not last, though, and when stock prices began to fall the number and value of IPOs dropped as investors thought more carefully about throwing money into companies that were losing money - and with the drying up of funds we saw a decline in employment in the Internet / technology sector. Once the Internet hype and IPO's slowed we also saw the seamier side of the Internet bubble when the New York Attorney general brought suit against some of the investment banks for setting low initial stock prices and handing out shares of the under priced stock to their best clients, those who spent many millions of $s on other services at the investment bank and who would now earn millions when the stock price "exploded" on opening day.
13. Bill Mann, in a May 26, 2004 article on Motley Fool describes the differences.
The
classic IPO
In a normal IPO, an investment bank will come in, do some evaluative work on
how much a company is worth, survey the market to determine the interest
of potential buyers of a company at X, Y, or Z price point, and then recommend
a pricing formula to the management of the company. Once upon a time, this
process was used to generate as much capital as possible for the company, but
starting with IPOs such as Netscape, Yahoo! (Nasdaq: YAHOO), theglobe.com,
and so on in the mid-1990s, IPOs came to be measured by how much of a
"pop" they generated on the first day of trading. Want a successful
IPO? That's easy -- price your shares at about 35% of what they're actually
worth, and watch the market swarm, driving the price sky high....
The
Dutch auction
As a result of this chicanery, several companies that have IPO'ed in the recent
past have elected to sell by Dutch auction, including Overstock.com (Nasdaq:
OSTK), RedEnvelope (Nasdaq: REDE), and now Google. Overstock's CEO, Patrick
Byrne, notes with some satisfaction that Google's decision to go the Dutch
route "could be the thing that breaks a sleazy Wall Street system."
Our 2002 coverage of the Overstock IPO -- a company that went on very
quickly to become a TMF Select and then Hidden Gems
recommendation, offers a good view into some of the more recent Dutch auction
IPOs. ...
A Dutch auction curtails or removes the ability of the investment bank to influence the opening price of the shares and its ability to allocate IPO shares at all. It's share democracy at its finest. If you're willing to name an insane price for shares in a Dutch auction IPO, you're going to get 'em. (It should be noted here, though, that Google reserves the right to have "speculative bids" nulled, but the company doesn't define what that means. What's in question is the price you'll pay -- which isn't necessarily the one you commit to paying.)
What
you (and everyone who gets shares) will end up paying is the price that the last
person past the post has bid. Generically, if there are 1 million shares
available, it will work like this:
|
Investor |
Bid Amount/share |
# of Shares |
Shares Remaining |
|
A |
$10,000 |
1000 |
999,000 |
|
B |
$100 |
250,000 |
749,000 |
|
C |
$30.42 |
100,000 |
649,000 |
|
D |
$29 |
550,000 |
99,000 |
|
E |
$25 |
100,000 |
-1000 |
|
F |
$24.99 |
50,000 |
0 |
And so on.
It's important to note that no one who has bid can see anyone else's bid. So once the auction has closed, the shares are all allocated. As you can see, the lowest bidder for whom shares were remaining was Investor E, who offered to buy 100,000 shares at $25 apiece. Every investor who bid higher than Investor E is thus guaranteed shares, but they get them not at the price they bid, but at the one that Investor E bid, $25. So even though Investor A, clearly a delusional soul, offered to spend $10 million for 1000 shares, she will only have to pay $25,000 -- Investor E's price times 1,000 shares. In exchange for this phenomenal cosmic power, Investor E runs the risk of not receiving as many shares as he bid. In this case, though Investor E bid on 100,000 shares, there were only 99,000 left once all of the higher bidders' orders had been filled, so he only gets 99,000.
And what of Investor F, whose bid came in only a penny per share below Investor E's? You guessed it -- neither she nor anyone else with lower bids gets any shares at all in the IPO, and will have to buy them on the open market once they start trading. The total capital raise for the company, gross of fees, is $25 million.
There's one more catch to Google's IPO. At management's discretion, once the bidding is done, it has the right to adjust down the price that successful bidders are required to pay. Let's just say that management thinks that $25 per share is just kooky. It can say "OK, bidders, your price is actually $17." This only goes for the successful bidders though -- Investor F, even though her bid is now $7.99 higher than the price paid, is still out of luck. To pay you must first win.
14. In addition to the compensation for their efforts while running the show, corporate executives also managed to bargain for two additional perks - enormous severance packages, sometimes referred to as golden parachutes, and lavish retirement benefits. One of the more notable examples of the excesses surfaced during the divorce trial of Jack Walsh, the former CEO of GE who was one of the most widely respected CEOs in the late 20th century. Included in his "retirement package' Welch was access to the corporate jet, use of a Manhattan apartment including all expenses and meals purchased at the restaurant Jean Georges, and floor seats at the Knicks and courtside seats at the US Open. It should be no surprise that during this time that income and wealth became more inequitably distributed in the US, but we'll hold of discussing this until the section on the labor market.
15. And it worked - sort of. In the days of the booming dot.com stock market, the compensation of CEO's exploded with countless stories in the business press of mind-boggling executive compensations - and at the center of the compensation were the stock options that had become the largest component of CEO compensation. There were the stories of Steven Jobs and Larry Ellison receiving 20 million shares of stock or Disney's CEO cashing in some of his stock options in 1997 for a gain of $565 million. In a USA Today article from April 6, 2003, Gary Strauss and Barbara Hansen report the following compensation deals:
· Walt Disney shares lost 19% in 2002 and are off 60%
since 2000. Yet Michael Eisner received a $5 million bonus.
· Shares of Texas Instruments, the maker of
semiconductors, have slumped 80% since early 2000. Yet the past three years,
its board has granted CEO Tom Engibous stock options potentially worth $142
million.
· Apple Computer shares plunged 80% during its fiscal
year. Yet Apple directors agreed to swap Steven Jobs' 27.5 million worthless
options for 5 million restricted shares, valued at $75 million.
· Sam Palmisano oversaw 15,000 layoffs and a sharp drop
in earnings after taking over for IBM's Lou Gerstner last March. IBM shares
lost 36% . Directors gave Palmisano a $4.5 million bonus and stock options
potentially worth $47 million, citing his management "through
extraordinarily difficult times."
· Jeffrey Immelt, who became GE's CEO in September 2001,
received $6.9 million in pay and stock options potentially worth $43 million in
2002, when GE shares fell 39%.
16. Two good examples of the principal-agent problem are provided by Levitt and Dubner in their book, Freakonomics. In a chapter entitled, "Why Do Drug Dealers Still Live With Their Moms?," we see the inside of the drug business in a Chicago gang, including the potential for a disconnect between those at the top and those at the bottom of the pyramid. It turned out that the "crack boss didn't have as much control over his subordinates as he would have liked. That's because they had different incentives.” The boss wanted no violence because that was good for business, while the foot soldiers used violence to establish their reputations which were critically important to them. The second example comes from the chapter, "How is the Klu Klux Klan like a bunch of real estate agents? where the authors look closely at the relationship between the seller of a house and the real estate agent hired to sell it. In the eyes of these authors, "a big part of the real estate agent's job is to persuade a home or to sell for less than he would like all the same time letting potential buyers know that the house can be bought for less than its listing price," and a big part of that explanation can be found in different incentives. If you assume a real estate agent gets a 6% commission for selling a house, an extra $50,000 in the sales price means only an extra $3,000 for the realtor, so you can see how the realtor might not work as hard for the $3,000 as the owner might like.
17. Part of this problem can be traced to what is sometimes referred to as the "Lake Wobegon" effect. Compensation consultants who are often hired to establish the terms of compensation provide "average" figures for compensation, and any good potential CEO will be able to effectively make the case that he/she is above average and should be paid accordingly. And once these people receive their pay, the average executive compensation will rise before the next CEO compensation package is negotiated, so the next round of compensation packages will be higher. If you are looking for a good example of this process, you should check out the Fortune article "The Fall of the House of Grasso" that describes the process that ultimately led to Grasso's resignation as the head of the New York Stock Exchange. This is how they describe the bonus formula that
"Here's how his bonus money was set: Each year a consultant would calculate the median pay for a CEOs in a select 'comparator group,' which included such highly paid CEOs as Sandy Weil at Citi and Maurice Greenberg at AIG. That figure would be discounted by 10% - a tiny nod to the enormous difference between the 'comparator' companies and the exchange. The resulting figure was then multiplied by an NYSE 'performance' score, which was set, in part, by Grasso himself."
It was also true there were not enough degrees of separation between the corporate executives and the Board of Directors. Too often the Directors were members of a small, select group that simply gave the executives a blank check without any real scrutiny. The problem, is described by Roger Lowenstein in 2003 when the world has just realized that Richard Grass, the head of the New York Stock Exchange, was being paid about $140 million a year: "The true employers (the shareholders) consist of disparate and generally voiceless masses; they must rely on boards of directors to be their agents. In Grasso's case, the board included his Wall Street cronies. Many corporate boards are no better. Henry Kissinger used to collect $350,000 a year as a consultant to American Express while, in his off-hours, he served as a supposedly independent director, charged with monitoring the management that fed him. Such examples are legion. We should not expect a board that is not at arm's length, and therefore not truly "free," to design a free-market incentive."
18. One thing, what was not anticipated cy those promoting stock options was the use of announcements to influence the stock price - issuing bad news prior to the issuance of the options to drive the price down so it would be easier to increase the price after the award of the options, or issuing good news after the issuance of the stock. What was also not well thought out was the "loophole" allowing the executives to sell the stock options without holding them for a long period of time, which provided an enormous incentive to boost the short-term earnings of a company, even if it required some less-than-legal methods to present a good "bottom line."
19. Some of the more notables were Richard Kozlowski, who along with Mark Swartz, were accused of looting $600 million from Tyco including a $6,000 shower curtain for Kozlowski; Bernie Ebbers from World Com that eventually agreed to pay investors$500 million for losses due to faulty bookkeeping; Richard M. Scrushy of HealthSouth Corporation, a company that was accused of overstating its profit by $1.4 billion; John Rigas of Adelphia Communications who was accused of a variety of crimes that are thought to bring losses to $60 billion; and Andrew Fastow and Kenneth Kay of Enron, the poster-company for the scandals, that announced a restatement of its books to the tune of $580 million that led to a bankruptcy filing and collapse of the company's stock that severely hurt company employees' retirement funds that had been invested in the company's stock.
In addition to these corporate leaders who made their way onto the police blotters, there were also some accounting firms that were accused of helping their corporate clients distort their financial statements and investment bankers and institutions that were "caught with their hands in the cookie jar." Among the accounting firms, the big story were the charges brought against Arthur Anderson's for obstruction of justice for shredding evidence in the Enron case. One of the big names of the era was Frank Quattrone, a former investment banker who was charged with witness tampering and obstructing federal investigations for urging employees to destroy documents at Credit Suisse First Boston after a probe of the company's operations was announced. There was also the settlement of about $1.4 billion in a case brought against ten of the nation's largest investment banks for a variety of improprieties including faulty research that misled the investing public and spinning (setting aside shares of IPOs for corporate executives who sent the investment banking company good business. And for lighter spin on the scandals you might ant to check some jokes and cartoons. One of my favorites was from Conan O'Brien: "The corporate scandals are getting bigger and bigger. In a speech on Wall Street, President Bush spoke out on corporate responsibility, and he warned executives not to cook the books. Afterwards, Martha Stewart said the correct term was to sauté the books."
20. There were many proposals for reform. One solution proposed by Jeffrey Garten, Dean of Yale's School of Management, in his 2003 article "A new year; a new agenda" was to link executive compensation to long-term stock performance to avoid the focus on short-term, easily manipulated stock prices. William McDonough, President of the Federal Reserve Bank of New York, in a speech on Issues of Corporate Governance in late 2002 in the midst of the scandals called for some important changes including the need for external directors, individuals with no direct ties to management.
21. Below you will see a copy of the production matrix and the table of marginal productivities and graphs that correspond to the production matrix. Make sure you understand how to use the table to compute the marginal productivities.
Production Matrix
|
|
Amount of Capital |
|||
|
Amount of Labor |
10 |
20 |
30 |
40 |
|
0 |
130 |
170 |
220 |
290 |
|
10 |
178 |
210 |
256 |
323 |
|
20 |
222 |
246 |
289 |
353 |
|
30 |
260 |
278 |
319 |
381 |
|
40 |
296 |
308 |
347 |
406 |
Marginal Productivity Matrix
|
|
Amount of Capital |
|||
|
Amount of Labor |
10 |
20 |
30 |
40 |
|
0 |
|
|
|
|
|
10 |
4.8 |
4 |
3.6 |
3.3 |
|
20 |
4.4 |
3.6 |
3.3 |
3 |
|
30 |
3.8 |
3.2 |
3 |
2.8 |
|
40 |
3.6 |
3 |
2.8 |
2.5 |
22. N.G. Kalaitzandonakes, H. Hu, and M. Bredahl, in "Looking In Some of The Right Places: Where Are The Economies of Scale?"