Perverse Incentives Are Endemic (TM)
Posted by Marc Hodak on October 26, 2007 under Self-promotion | 
2 Comments to Read
Forbes added the first and last line of this article. The rest was (mostly) what I wrote last weekend. For those of you taking my “History of Scandal” class, this is your first reading. Enjoy!
Posted by Marc Hodak on October 24, 2007 under Self-promotion | 2 Comments to Read
I haven’t been that into baseball since I was a kid, when I was really into baseball; I could tell you the stats of every player in the league. But, since we have family in the game tonight, there’s someone to root for. And it looks like a pitching duel!
Posted by Marc Hodak on October 22, 2007 under Executive compensation | Comments are off for this article
Instead, I’m disgusted.
Since I’m an expert on executive compensation, I guess I ought to comment on this stuff. However, I’m a little late to this story, in part because I no longer subscribe to the NY Times. Frankly, I can get rags for free from the worn out clothing generated by my growing kids. Nocera’s column on CEO pay is typical of the reason for my dropped subscription. (Please don’t encourage them; here is an ungated version.)
Nocera is pretending to debate Watson Wyatt’s Ira Kay about the social value of CEO pay, as if they are on the same intellectual plane.
I’ve heard Kay make this point before – and even debated him on it. He really does seem to believe that all of the great economic benefits enjoyed in the United States during the past two decades or so can be traced back, in no small part, to the way chief executives are paid.
I, on the other hand, believe he’s got the cause and effect exactly backward: that it was the rising market that made the lucky fellas running America’s corporations look like geniuses – and made them richer than they’d ever imagined, thanks to the shift to stock options as the primary way to reward executives.
Nocera is basically arguing his feeling against Kay’s experience. He goes on to admit as much: Nocera just doesn’t like the idea that CEOs make as much as they do, regardless of the reason. He doesn’t believe that their pay is the result of market forces, regardless of any evidence (amply provided by Kay). This is what passes for social commentary. Nocera finishes with one of the most disingenuous statements I’ve seen in a long time:
If it turned out that in a real market for CEO pay, their compensation remained in the stratosphere? I might not like it, but I could live with it.
Of course, it’s been a long time since I read the NY Times.
Posted by Marc Hodak on October 18, 2007 under Economics | Read the First Comment
Franklin Allen, Elena Carletti, Robert Marquez raise the age-old question, “Shareholders or stakeholders?” in this study. When finance and economic professors resurrect this popular dichotomy, they invariably blur a much more useful distinction: short-term vs. long-term. From their study:
A surprising finding is that “some companies may choose to become stakeholder-oriented because it increases their value and benefits shareholders,” according to Allen.
I live in two worlds. In the academic world, we can create artificial distinctions like “stakeholders,” and show how concern for stakeholders actually improves shareholder welfare, as this study seems to show. We can show, as these authors do, that over three-quarters of managers across countries actually claim that “a company exists for all stakeholders,” and think that’s surprising or meaningful.
In my other world, the real world, I have to tell managers what to do day-to-day. (Actually, I create incentives to encourage certain behavior.) And I know that managers, like all of us, have this inherent limitation–we can have many objectives at one time, but we can only maximize according to a single rule when they come into conflict. So, when a conflict arises between the interests of the shareholder’s and those of, say, the workers, how do we decide what to do? One has only four choices:
1) Maximize for the shareholders
2) Maximize for the workers
3) Sometimes maximize on (1) and sometimes on (2)
4) Maximize according to some objective function that accounts for both according to some decision rule or formula
Posted by Marc Hodak on October 16, 2007 under Regulation without regulators | 5 Comments to Read
For my Canadian readers, you can check me out on B1 of your Globe and Mail. The author did a good job of representing me. She may have slightly overstated things to say that my “consulting business (is) based mainly on applying mechanism design theory,” (it’s more broadly about using incentives to minimize agency costs and improve decision making), but frankly I don’t know of anyone who incorporates mechanism design theory into actual, internal corporate practices to the extent I do. The author seemed thrilled, in fact, to find someone who actually applied this theory to real life business problems rather than another professor to provide theoretical solutions to hypothetical problems.
Alex Tabarrok did an excellent job illustrating the basic concept of mechanism design theory. The author mentioned two of my business applications (executive incentives and corporate investment decisions), but those are fairly complex, and reading what Alex wrote inspired me to think of a simpler example of an application I’ve implemented. So, here is one:
I some situations, one manager has to transfer an asset (say, real estate) to a particular other manager. There is no possibility of competing buyers or sellers. Manager A must sell it to Manager B. At what price? A simple negotiation would quickly break down. The seller would ask for too much; the buyer would offer for too little; neither side has an incentive to provide an honest valuation. Agreeing to split the difference wouldn’t help–in fact, it would simply polarize the bid and ask prices.
So I overlaid an additional rule to this negotiation. I said that if the two managers couldn’t agree on the price, we would set aside their respective best and final offers, and go to a third party appraiser with some experience with that asset (real estate, in this example) and provide an estimated value. The appraiser wouldn’t even see the offers. We would then open up the best and final offers of the two managers, and the offer closest to the appraised value got their price. Think about how the dynamics are changed with this rule, and why the managers, in fact, were generally able to quickly come to agreement, almost never needing an appraiser to actually get involved.
I didn’t mention to the reporter the fact that I was also a professor.
Posted by Marc Hodak on October 15, 2007 under Self-promotion | Comments are off for this article
For the longest time, my most downloaded paper on SSRN has been my contribution to mechanism design. My paper on the Enron Scandal submitted last June, however, has been downloaded at a rapid clip (it was #5 among “new papers” in the Management Research Network)–a trajectory that would make it my #1 paper sometime next month. Maybe with the publicity of the Hurwicz, Maskin, and Myerson Nobel, my ingenious mechanism may see a surge!
My mechanism, a corporate cost allocation method, was praised at the time of publication (ten years ago) as extraordinarily clever. It was adopted by some very large, complex organizations, and succeeded in getting their managers to reveal reservation prices (a key objective of mechanism design) on major investments, with the effect of significantly improving their corporate returns.
Unfortunately, over the last decade, corporate cost allocations have come to be driven almost entirely by tax considerations rather than internal economics. The impact on organizational efficiency of this sorry trend is incalculable. Imagine E-bay auctions organized by the IRS.
Posted by Marc Hodak on October 11, 2007 under Revealed preference | Comments are off for this article
The WSJ had an article about the difficulty certain communities face in continuing efforts at school integration. It was suggested that the integration debate was driven as much by the politics of test scores as the politics of race. It turns out that the mostly black schools significantly under-perform the predominantly white schools, even where the average income of the black families appears to be fairly high. So, black parents are eager to get their kids into the predominantly white schools because they have a reasonable expectation that their kids will get better educations there. Conversely, white parents don’t want their kids to go to predominantly black schools because…well, they’re racists. Or at least that’s a sentiment that the story writers appear willing to promote.
Ms. Horan says she moved her family to Milton from Boston 10 years ago seeking open-minded neighbors, only to be confronted by the same prejudices that she had hoped to leave behind. “Hurtful as it is to admit, racism is alive and well and living in Milton,” she says. Mr. Lovely, the board chairman, denies any racial tension.
The race card is an unfortunate draw, here, because Occam’s razor provides a perfectly simple and eminently reasonable explanation for why the white families don’t want their kids displaced into predominantly black schools, an explanation that has nothing to do with racism, even if racism exists (which it surely does). If the predominantly black schools were outperforming the white schools, who doubts that 80 percent of the white families would be clamoring for their kids to get into those schools? One can make the case that many of the other 20 percent might be racists, and they’d have a point, but it would have no more bearing on the discussion than pointing out that a similar fraction of blacks are probably racists, too.
I’m fine with the demise of the “separate but equal” doctrine. I think that most people (80 percent of us, anyway) would protest government-enforced segregation. But very few of us (especially those of us who made the tough, personal choices to position ourselves to make useful trade-offs for our kids) see the sense in government-enforced desegregation. Both doctrines treat individuals as tools of the state, trying to coerce a certain social outcome.
Unfortunately, much of this issue is a consequence of the collectivist manner in which most school systems operate. The government is inherently a part of the solution because it is inherently at the root of the problem.
Posted by Marc Hodak on October 8, 2007 under History | 4 Comments to Read
Yesterday’s WSJ has a story about Ohio Attorney General Marc Dann. Dann is nurturing a reputation as a “bad cop” in enforcement against certain business practices. He says:
My job is to be the bad cop, and I’m comfortable with that role because I believe a terrible crime has been committed.
The “crime” he’s referring to is the chance that banks took on turning low-income folks into homeowners, what Dann calls “the largest financial scam in American history.”
Sure, that didn’t work out perfectly, but Santayana’s famous quote works well, here. About 130 years ago, Ohio attorneys general began a crusade against Rockefeller and Standard Oil. Ohioans of the day viewed Standard’s products as superior in quality as well as lower in price. They saw Rockefeller as a local Clevelander who did well, a rags-to-riches story to inspire youths everywhere, and a boon to their state’s move to compete with Pennsylvania and New York as a major industrial and financial center. Ohio’s political and media elite had other ideas.
Euclid Avenue, 1912
Ohio’s politicians began what can only be called an obsessive campaign against Standard Oil. Ohio tax authorities began the relentless pursuit of Standard, and Rockefeller personally, for highly questionable tax liabilities. In 1890, Ohio’s attorney general, successfully went after Standard’s charter, forcing the trust to temporarily dissociate. These attacks propelled the careers of these prosecutors, and sold a lot of newspapers based on the narrative of the “tough” public servant pursuing a big business “unaccountable to the people.”
Rockefeller eventually, and with a heavy heart, moved his family and his headquarters east to escape the persecution. Standard’s mammoth financial and business activities followed him to New York. The oil refining industry shifted to what would become the “Chemical Coast” of New Jersey. Despite the fact that Cleveland is where the mighty New York Central, Erie, and Pennsylvania railroads converged on a fine harbor, Cleveland lost its industrial anchor, and the transportation hub of the U.S. would migrate west to Chicago.
Euclid Avenue, 2006
Today, when a New Yorker or Philadelphian wanders the streets of Cleveland, it seems like a city that has been largely bypassed by the 20th century. While other cities went through ups and downs with the economy, from the late 1800s Cleveland only went down. Unlike Philadelphia, Chicago or Pittsburgh, Cleveland never bounced back from the depression. Most businesses along what was once a thriving Euclid Avenue remain shuttered to this day. No major business calls Cleveland its home.
The destruction of Cleveland’s hopes of becoming a major city on par with Philadelphia, Pittsburgh, or Chicago was not an economically driven loss. It was a politically driven forfeit.
So, Ohio’s current attorney general comes from a distinguished line of “tough” guys going after “criminal” business interests.
At least the Indians are still in the pennant race.
Posted by Marc Hodak on October 7, 2007 under Practical definitions | 2 Comments to Read
I’ve been seeing these ads on TV with a child saying, “I’m too young to vote, but if I could…” they say they would vote for the candidate who will “fix” health care, and protect Social Security and pensions. This ad is sponsored by the AARP.
This is my new definition of chutzpah.
For those of you who haven’t studied the numbers, AARP is the organization most committed to the greatest inter-generational wealth transfer in world history. They have saddled today’s kids, those cute ragamuffins who can’t yet vote, with $39 trillion in liabilities in excess of assets for Social Security and Medicare. Now, the AARP wants to continue that campaign in the name of the kids.
(Below the fold is a math challenge)
Posted by Marc Hodak on October 4, 2007 under Economics | 4 Comments to Read
A Wharton professor, Joel Waldfogel, has just published a book called “Tyranny of the Market,” a play on Mill’s notion of the tyranny of the majority. Waldfogel’s thesis is this:
– Everyone think markets provide what everyone wants in the right amounts
– Everyone thinks that governments are grossly inefficient at providing what people want
– Markets, in fact, sometime leave minorities behind because their preferences cannot be profitably met for high fixed-cost products or services
– It may be efficient to not always let the market decide what or how much to produce
I think Waldfogel is making a thoughtful argument, here, but I don’t like it on several grounds:
– Far from everyone, including most economists, thinks that markets are all that great, let alone perfect
– Far from everyone, especially those dealing with voters, considers government to be grossly inefficient
– The idea that high fixed-cost products don’t permeate as easily into minority populations makes sense in theory, but is vastly overstated
– Many economics professors, including those with a high profile, continuously and exhaustively make the claim that market inefficiency provides some rationale for government intervention
Although a lot of good stuff has been written about that last point, none of those writings, including Waldfogel’s, provides a decent explanation, or even convincing examples in the real world, of how government imperfections can be sufficiently overcome to make their remedy of market imperfections an efficient solution.
In fact, history speaks with one voice when it comes to comparing government remedies for market imperfections versus market evolution around those imperfections. Government interventions, even if they seem to work for a little while, almost invariably become a story of waste, fraud, or astronomical costs–and often all three. Most things that people historically said the market couldn’t do have been done, including private mail, private toll roads, an explosion of products and services accessible to minorities of all types, even the poor (still not “perfect,” but a generation ago non-existent, like cell phones and mortgages).
In fact, government intervention is a powerful reason that minorities and the poor don’t have more choices. Nearly every business is subject to regulatory costs that are a huge source of the overall fixed costs that Waldfogel properly laments. How much of our uninsured are that way because well-intentioned minimal coverage regulations make health insurance unaffordable for so many people?
