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Passing the Family Business On: The Sad Example of the Mondavi Family

Fascinating article in today's WSJ ($) on the turmoil within the Mondavi family:

For decades, Robert G. Mondavi worked with his brother for their family's Charles Krug Winery, where they argued regularly. Robert wanted to expand the business while Peter was more conservative. In 1965, Robert punched Peter during a dispute over a mink coat. Seeking a resolution, the Mondavis forced Robert to take a paid leave. When he returned, Robert left the family firm and founded what would become Robert Mondavi Corp., a Napa Valley pioneer that helped transform an agricultural backwater into a world-class wine-producing region. Desperate to ensure the tensions bedeviling his generation wouldn't be repeated, Robert, who is now 90 years old, spent 30 years planning how he would transfer control of the company to his two sons.

But last year, Robert's son, Timothy, 53, abruptly left his job as "winegrower," took a six-month sabbatical and went to Hawaii where he shaved his head. In January, Robert helped oust his other son, Michael, 61, as chairman of the company. Michael and Timothy, following the tradition set by their father and uncle, had paralyzed the business by fighting over details large and small, from whether Mondavi should go public to the design of its labels.

For the first time, there is no Mondavi family member managing the winery, and Michael is starting to branch out on his own. Many in the industry think Mondavi, the U.S.'s sixth-largest wine company -- ranked by volume -- and valued at nearly $600 million, may be broken up or sold.

In my experience, there is almost nothing harder than successfully passing a family-owned business from one generation to another. It becomes even harder when the business is publicly held. You lose some of the legal devices that allow you to fine tune control of the corporation, such as shareholder agreements constraining director discretion, which are available only to close corporations. You pick up outside investors, to whom you owe fiduciary duties. You become subject to SEC disclosure rules, which limit your ability to keep family business confidences. (I discuss the relevant legal issues in the chapters on close corporations and going public in my Corporation Law and Economics treatise.)

To be sure, there is a whole consulting industry designed to help family business plan successions, of which the Mondavis seem to have made use:

In building the company, Robert devised mechanisms to tackle the family's problems. He hired a team of family-business specialists, including a psychologist and a psychiatrist, which created an annual "family council." Once a year, the council invited family members to a retreat that usually took place in June or July.

Vis-à-vis outside investors, they used dual class stock so that the family could maintain voting control (I'm going to post separately on that issue.) Yet, despite their best efforts, the Mondavis seem to have failed.

There is probably something hardwired in all of us that wants to pass our empire, such as it may be, on to our heirs. Yet, it rarely works. Often the founders are control freaks who can't let go, which seems to be part of the Mondavis problem:

Friends of Robert and his second wife recall being invited to private tastings at Mondavi's Oakville winery. Robert, Michael and Timothy, hosting these events together, would interrupt each other or grab the microphone in order to get in the last word on the style or the taste of a wine. Usually, Robert won the battles. "You'd walk out of there and shake your head," recalls a longtime Mondavi friend.

And, very often, the kids turn out not to have the entrepreneurial or managerial skills possessed by the founding generation. (Indeed, in their book The Company: A Short History of a Revolutionary Idea, John Micklethwait and Adrian Wooldridge attribute the rise of professionally managed corporations in the 1800s in part to precisely this problem.) Again, this appears to be an issue for the Mondavis. Under Robert, there were few California wineries making better or more influential wines. Under Timothy and Michael, by contrast, there have been a series of oenological and managerial mistakes:

Timothy's winemaking style came under fire. Influential critic Robert Parker Jr. blasted the company's 1998 and 1999 vintages in his newsletter as, "indifferent, innocuous wines that err on the side of intellectual vapidness." Wine Spectator critic James Laube said the wines were "not terribly inspiring." [I've noted this myself.]

The market was changing as consumers became enamored of so-called cult wines from boutique vineyards and inexpensive foreign imports pushed by low-cost retailers such as Costco. It wasn't easy for Mondavi, which was caught between these two trends, to adapt. "Michael's exuberance caused the company to bite off more than it could chew," says Gayle Dargan, a former senior vice president at the winery.

And so now things are starting to sound like a Falconcrest episode (boy will that allusion date me):

In January, the family and outside directors voted to replace Michael as chairman of the company. In his place, they installed Ted Hall, a former McKinsey consultant who owned a nearby farm and had been recruited to the board just one month earlier. The company says the vote was unanimous. Robert played a role in the ouster of his eldest son. According to Robert's nephew Mr. Ventura, and friends of the family, Robert sided with the company's advisers who argued the business needed to be run by professionals and that the two sons should be given time off.

What a sad outcome it will be for what was probably the most influential Napa winemaking family of the latter half of the 20th Century if they end up as both a TV movie and a business school case on how not to manage family succession.

Professional Service Income in LLCs and Partnerships

In doing some research for my forthcoming book and agency and partnership law, I ran across a statistic that I found both interesting and, at least initially, rather puzzling. According to the IRS, in 2001 there were 64,985 partnerships in the professional and business services industry classification (with a total of 183,475 partners). Those partnerships had net total income of over $18 billion. In contrast, there were 99,006 LLCs in that industry group (with 373,336 members), but the much larger number of LLCs pulled in less than $8 billion in total income. Why are per firm and per member income so much lower in LLCs than partnerships?

Upon reflection, I suspect the answer is that many large and potentially high revenue professional services firms (such as law firms) are opting between the old fashioned general partnership and the newer limited liability partnership, rather becoming LLCs. Indeed, in some states (I believe California is still one), professional services firms like law and accounting cannot organize as LLCs. There's a very good discussion of the choices law firms are making Baker & Krawiec, The Economics of Limited Liability: An Empirical Study of New York Law Firms.

Do Gooders Doing Bad with My Money

Front page article in today's WSJ ($) on how a coalition of disgruntled pensioners, university students, and newspapers have used state FOIA requests to force the University of California to reveal financial performance data on the venture capital funds in which it invests. The VCs, of course, resent this - and rightfully so:

Venture capitalists argue that it's only fair to judge results after the full life of the fund, typically 10 years. Interim results are likely to look bad because they reflect the fund's fees, the quick failure of some start-ups and the immaturity of others. As those early numbers are made public, institutions like the University of California may feel pressure to nit-pick every decision. That would make it hard to invest for the long term, venture capitalists complain. Besides, they say, people might figure out how badly some of their start-up companies are doing, which would discourage potential business partners of those companies.

We have done remarkably well here at the UC by investing in VC funds:

Data released by UC show just how lucrative venture-capital investments can be. For the 10 years ended June 2003, the university earned an average annualized return of 41% from venture-capital funds. That was largely thanks to windfalls from funds that started life in the mid-1990s, just before the Internet boom. In the case of one Kleiner Perkins fund, UC put in $15 million starting in 1994 and earned $483 million as of March 31, 2003. The fund's remaining investments had an estimated value of $4.7 million on the date, giving UC a total return of 32.5 times its original investment. The UC system has assets of $58 billion under management. UC's more recent funds mostly show negative returns so far, partly due to the collapse of the Internet bubble. But the university predicts that performance will turn upward in the next few years as some of the venture-capital-backed start-ups mature and either go public or are sold.

Indeed, presumably due at least in part to these VC investments, the University's equity retirement fund has outperformed the S&P; 500 over the last 5 years and did reasonably well relative to the index over the last 10.

As a result of a suit by Woodward & Bernstein wannabes in the press, wet-behind-the-ears students who probably can't even spell investment let alone read a financial statement, and grumpy old fart pensioners, however, the university has been required to disclose a host of financial data on its VC fund investments. The predictable result?

[Big VC] Sequoia sent [a] letter severing relations with UC. "It is not in the interests of Sequoia Capital's other clients that we be hounded, badgered, and stalked by entities wishing to either profit from or publicize our private and confidential information," wrote Mr. Moritz, the Sequoia partner. He called it "the saddest business letter ever dispatched on Sequoia Capital stationery."

FYI: Sequoia put the UC into a fund that made a major early investment in Google that is about to pay off to the tune of zillions. And it's not just Sequoia or, for that matter, the UC:

Since [the adverse lawsuit, UC investment manager] Russ says, calls by his office to some of the leading firms go unreturned. As venture capitalists reduce the size of their funds, public institutions are often the first to be left out. Charles River Ventures, a leading venture-capital firm, has rejected new investments from public institutions, as reported by Private Equity Week. The University of Michigan and the state pension funds of Massachusetts, Pennsylvania and Virginia are among those who have gotten the snub from venture capitalists.

These do gooders are messing with my retirement money. If I had my way, they'd all get a swift kick in the pants.

Update: Gordon Smith has more, concluding:

Given that most public institutions invest only a small portion of their funds in venture capital, the drive to disclose venture capital results seems motivated more by politics than principle. This seems like a pyrrhic victory for the public.

Yep.

Reparations Column

I've got an op-ed opposing corporate reparations over at TCS.

Eisner: What will it take?

The box office receipts confirm that "The Alamo" is the latest big-budget Disney epic to flop on Michael Eisner's watch. It finished fourth for last weekend, coming in behind a movie I hadn;t even heard of: "Fox Searchlight's "Johnson Family Vacation," which collected $9.4 million in about half as many theaters as "Alamo" commanded." Ouch.

Might this be the straw that finally breaks the camel's back and induces Disney's board to fire Eisner? If this doesn't, what would? Coming so soon after the shareholder revolt at the last annual meeting, you'd have to think that the board will take another long look at finding a replacement for Eisner.

On the other hand, I don't understand the buzz in the investor community that the Alamo's flop will revive the Comcast bid for Disney. Granted, the post-flop drop in Disney's stock price makes the Comcast bid marginally more attractive, but it doesn't change any of the fundamentals of the business case. It still looks like a lousy deal for both Disney and Comcast shareholders. (In fact, Comcast stock was trending up mainly because investors thought the Disney deal was dead.)

James Flanigan on Corporate Tax Dodges

I find James Flanigan's business columns unimpressive, even by the lax standards of the LA Times (R). Today's illustrates why. Flanigan objects that corporations aren't paying enough in taxes:

A fuse was lighted under the old tax reform bonfire last week when the Government Accounting Office reported that 60% of U.S. corporations didn't pay a penny in taxes on their income from 1996 to 2000. That wasn't exactly a bolt out of the blue for most Americans. Maybe it was a surprise to some that the corporations didn't commit any crimes, but just engaged in some complicated and counterproductive — to the Treasury, at least — sheltering transactions.

Bombshell or no, the GAO report renewed interest in the tax escapes that, particularly as April 15 approaches, have rankled all the working people who share big chunks of what they earn every year with Uncle Sam. ... Both parties on Capitol Hill and tax experts from conservative and liberal think tanks in Washington are complaining that corporate tax abuses have been growing and that it's again time to plug some of the leaks. Dozens of shameful sheltering plots abound....

U.S. taxpayers would only be surprised if corporations these days lived up to their obligations.

Even setting aside the longstanding and perfectly legitimate debate over whether corporations should even be taxpaying entities, Flanigan's moral outrage is misplaced for three reasons.

1. Corporations are not moral actors. Edward, First Baron Thurlow, put it best: "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and nobody to be kicked?" The corporation is simply a nexus of contracts between factors of production. As such, there is no basis for assigning moral blameworthiness to the corporate entity. Instead, the relevant moral actors are the directors and managers who make decisions for the legal fiction we call a corporation.

2. Directors and managers owe duties to shareholders rather than society. As the Michigan supreme court’s famouslyexplained in Dodge v. Ford Motor Co.: "A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end." Or, as Milton Friedman even more famously put it, "the social responsibility of business is to increase its profits." Directors and officers who maximize corporate returns by minimizing corporate tax payments thus are performing the precise function society assigns them. (See generally my articles Catholic Social Thought and the Corporation and In Defense of the Shareholder Wealth Maximization Norm, which discuss the board's duty to maximize shareholder wealth.)

3. Directors and officers are obliged to maximize shareholder wealth within the law. When Congress creates a Byzantine tax code full of complexities, inconsistencies, and gaps, it ill-behooves Congress to complain if business avails itself of the loopholes thereby created. None of the dodges of which Flanigan complains are illegal; to the contrary, all are the creatures of the tax code. Flanigan's complaint is properly directed at Congress rather than business. Typically, however, the LA Times' chief business columnist much prefers the interests pf regulators to those of business.

ISS has lost it

The highly influential proxy advisory service Institutional Shareholder Services, whose voting recommendations many institutional investors slavishly follow, is urging shareholders of Coca-Cola to withhold their votes for director Warren Buffett:

ISS recommends shareholders withhold their votes for Buffett because he is an affiliated outsider and sits on the Coke board's audit committee. ISS's corporate governance policy guidelines call for completely independent board committees, a spokeswoman said.

Not to put too fine a point on it, but this is insane. Warren Buffett is probably the most respected investor of all time. Not only is he tremendously successful as an investor, but his integrity is remarkable for a businessman of his stature. Buffett owns almost 10% of Coke's stock, moreover, which means that his personal financial interests are closely aligned with those of other shareholders (albeit not perfectly). Finally, Buffett qualifies as an independent director under the NYSE's listing standards. To rigidly apply ISS' more demanding standards to Buffett is absurd. If a sizeable percentage of Coke shareholders end up withholding their votes from Buffet, it will prove that the institutional investor community's unthinking reliance on ISS has become a danger to good corporate governance and that ISS has become too powerful for the good of the capital markets.

Who Needs Personal Responsibility When You've Got a Plaintiff's Lawyer?

Here they come again:

People may have laughed 16 months ago when obese teenagers unsuccessfully sued McDonald's, saying its food made them fat. But a well-honed army of familiar lawyers who waged war against the tobacco companies for decades and won megamillion-dollar settlements is preparing a new wave of food fights, and no one is laughing. ...

"I think it's a mistake, and I've told clients this, to underestimate the creativity and the imagination and very frankly the aggressiveness of the plaintiffs' bar," said Joseph McMenamin, a defense lawyer and doctor in Richmond, Va. "They have a hell of a track record, frankly. They kept slogging away on tobacco and eventually they prevailed, and the sums of money companies had to pay exceed the gross national product of some third-world countries."

Which is precisely why tort reform is long overdue.

Guilt by Ostentation

I have been trying to popularize a phrase for the approach taken by white collar crime prosecutors in cases like Tyco: "Guilt by Ostentation," by which I mean prosecutorial use of class warfare to obtain convictions based on little more than envy of rich CEOs who spend ostentatiously. Larry Ribstein has a nice post that speaks to this issue:

It’s hard to avoid the conclusion that the criminalization of corporate misconduct, including Martha Stewart and Dennis Kozlowski recently, and Mike Milken of old, is about resentment. Not merely envy (one’s discomfort at comparing oneself with another), or wanting to have what another person has, but disliking that person for having it and believing that his good fortune is undeserved. The resenter wants to lower the envied person to his level. ...

The law can attempt to reduce resentment by bringing the rich to heel. Politicians are more than willing to serve as "envy entrepreneurs" to garner votes. One example of an anti-resentment law is progressive taxation. Hence politicians’ criticisms of “tax cuts for the rich.” Other strategies for bringing the successful to heel include insider trading laws, antitrust laws, regulation of executive pay, and criminalizing corporate misconduct. ...

If greed is good, criminalizing corporate misconduct is bad. Corporate executives' fear of being sent to a New York state prison (where Dennis Kozlowski may be bound) can put a damper on more than just Sardinian party planners.

As they say, go read the whole thing.

Update: Larry writes that:

Our positions may be similar, but they're not identical. I don't think it's ostentation that gets business people into trouble, but wealth. Bill Gates and Mike Milken have famously modestly lifestyles, compared to their wealth, though of course Gates has a nice house, and "compared to their wealth" opens up a rather broad range in Gates' case. It's the wealth that triggers resentment, not how it's spent. So I'd prefer to call it "Guilt by Gelt" (using the Yiddish word for money, for the uninitiated).

If true, however, why do people respect Warren Buffet but loathe Donald Trump? I think it is ostentatious display of wealth that elicits resentment rather than the wealth itself. So I think I'll stick with "Guilt by Ostentation."

Hollywood Liberalism: Take 2

Larry Ribstein has a must-read post on Bush-bashing during network TV entertainment programs. Only Larry would have thought of this issue as an agency cost problem! And he's absolutely right.

White Collar Prosecutions Go Awry World-Wide

US white collar criminal prosecutors have had their problems lately: The securities fraud charge against Martha Stewart dismissed, although a conviction was obtained. Mistrials due to hung jurys in the cases against Frank Quattrone and Denis Kozlowski. Now we learn that German prosecutors likely will lose their case against senior management of Mannesmann:

The trial revolves around extra bonuses paid to Mannesmann’s senior managers after its €180 billion ($177 billion) takeover by Vodafone in February 2000. Six former Mannesmann officials, including Josef Ackermann, the chief executive of Deutsche Bank, are accused of committing or abetting a breach of trust in awarding bonuses worth €57m.

At issue are the level of the bonuses, the sloppy way in which the paperwork was done, and exactly who instigated the payments and why. The German public sees this as corporate greed on trial. The prosecutors have tried to suggest that the payments were bribes to secure the biggest hostile takeover in history.

The lead judge isn't buying it:

On Wednesday March 31st, Brigitte Koppenhöfer, the leading judge, said that so far, in the opinion of the Dusseldorf court, there had been breaches of German securities law, but none serious enough to convict any defendant of a criminal breach of trust, or Untreue.

What's going on here? Obviously each case is unique, but I wonder whether we're seeing a reaction to the over use of criminal law against conduct that is more appropriately addressed through intra-corporate remedies. Motivated by political considerations, most notably the necessity to be seen as doing something about high profile corporate misconduct, politicians and prosecutors have dramatically expanded the reach of federal criminal law without much regard to whether the conduct should be criminalized at the federal or state level - or indeed to whether the conduct should be the subject of the criminal law at all. Many of the crimes charged in these cases have been malum prohibitum; i.e., conduct that is wrong only because the state says so rather than because it is morally wrong. Indeed, in some of these cases (e.g., Stewart) there was no real misconduct charged - all Martha did was the classic American tradition of lying to the cops. Maybe juries (and German judges) have recognized that even zillionaires are innocent until proven guilty and, moreover, that the criminal law is best directed at conduct that is morally wrong rather than merely a violation of regulatory proscriptions.

You're fired

He may have a hit TV show, a new book and a stable of high-profile real estate, but "The Donald's" Trump Hotels & Casino Resorts Inc. may be on shaky ground. In a statement accompanying Trump Hotels' annual regulatory filing, the company's auditors, Ernst & Young, said there are conditions that "raise substantial doubt about the company's ability to continue as a going concern." Auditors' statements in annual filings usually are standard statements; it's rare for an auditing firm to question the client's ability to continue as a company.

rare? Try almost unheard of. It's a very, very bad signal.

LLC Formation and Employment

Chuck Simmins has an interesting post on the relationship between LLC formation and employment, from which he concludes that:

The truest statement that can be made at this time is that LLC's are being formed at record numbers nationwide. Since small businesses drive the employment numbers and the economy, this should portend a robust recovery for the United States in the next year.

LLCs

During spring break, I've been busily working on a law review article on veil piercing in limited liability companies (given that I wrote an article entitled Abolishing Veil Piercing about corporation law, you can predict where I'm going with the new one!). Several years ago I wrote a primer on limited liability companies, which you can download here. Accordingly, I was very interested to discover blogger Bill Hobb's project of collecting data on the rate of LLC formation (his posts are archived here, albeit mixed with other business-oriented posts). His latest post reports that "Texas is yet another state were LLC formation set a record in 2003." It's a very useful project, which I hope he eventually collects into a single file for easy access.

Update: My friend (and now supporter) Larry Ribstein is one of the leading scholars of LLC law. He's got a new post at his blog providing links to his writing on LLCs. Anybody interested in this fascinating form of business organization, which Larry reports "are gradually replacing general partnerships and corporations," needs to check out his work.

Diversity and Participation

Kevin Drum writes:

Do Americans hate welfare because they think all the money goes to blacks? Alberto Alesina and Edward Glaeser don't put it quite that baldly, but that's their basic thesis. Robert Tagorda says this argument is "a bit hard to swallow" but quotes a couple of other economists who say there's something to it:

Over the last five years, at least 15 different empirical economic papers have studied the consequences of community heterogeneity, and all of these studies have the same punch line: heterogeneity reduces civic engagement. In more diverse communities, people participate less as measured by how they allocate their time, their money, their voting, and their willingness to take risks to help others.

I looked at a similar question when I was doing my research on employee involvement in corporate governance. In my articles, Privately Ordered Participatory Management: An Organizational Failures Analysis and Participatory Management within a Theory of the Firm, I discussed studies finding that workforce demographics are correlated with the effectiveness of participatory management - the more homogeneous the workplace, the more successful such programs proved. One important study found that activist employees, defined as those most likely to seek an active role in participatory management, tended to be white males who were younger, more politically active, and better educated than their peers. They also tended to be far more ambitious than their peers, while simultaneously being less tractable to supervision. On the other hand, I also identified studies finding that management demographics are relevant, finding that female managers tend to provide more frequent opportunities for employee involvement than male managers.

Why might diversity and participation be at odds? At least in the workplace, participation seems to be correlated with trust among workers and between workers and managers. I explored this link in my article Corporate Decisionmaking and the Moral Rights of Employees: Participatory Management and Natural Law, which recounted evidence that:

Trust is essentially social and normative, rather than individual and calculative. It arises out of a set of shared background assumptions and norms. As Fukuyama himself acknowledges, trust thus derives from shared values and, accordingly, is most likely to arise in homogeneous groups. ... According to Donald McCloskey, for example, the importance of trust to market exchange explains why members of the same ethnic group can deal so profitably with one another.

I then explained that:

Under modern working conditions, workers and senior managers can hardly be described as close knit. In particular, two factors seem especially significant with respect to the erosion of trust in U.S. workplaces: diversity and the loss of shared values formerly held by both managers and workers. As to the former, U.S. workers are required to function in increasingly diverse work forces. Without intending to get into the current public policy debate over diversity, I note that the importance of ethnic and similar ties to the development of trust within a group has demonstrable consequences for the viability of participatory management in a diverse workplace. Even within communitarian societies, egalitarian relationships are often limited to homogeneous cultural groups. In heterogeneous groups, mandated due process rights tend to substitute for spontaneous and genuine trust. This conclusion is supported by empirical evidence that worker participation in corporate decisionmaking is most effective in homogeneous work forces. The success of the well-known worker cooperatives at Mondragon in Spain, for example, is attributed to the ethnic and cultural homogeneity of the Basque workforce. Consider also the observation that many Japanese-owned U.S. manufacturing firms, “particularly in electronics, have adopted very few Japanese production methods. Rather, they utilize paternalistic and low-wage employment strategies with little evidence if any sophisticated work practices.” Practices found in the homogenous Japanese society apparently have not been transplanted to the more diverse U.S. workplace.

Reasonable people can disagree as to the relative merits of diversity and participation, but there is a lot of evidence that one must choose between them. As Robert Tagorda concludes, we need to debate these issues honestly. Perhaps there are ways of promoting participation in a diverse society, but we won't know if we continue to sweep these issues under the rug. One avenue of exploration, for example, is whether the one-time American ideal of cultural assimilation promotes participation by allowing cultural homogeneity to trump ethnic heterogeneity.

Microsoft and Bundling

The critical defect in the US settlement with Microsoft and the critical thing the EU got right goes to the issue of bundling. Brad DeLong writes:

Remember the days when there was not one single dominant browser that came preinstalled on 95% of PCs sold? Back then there was ferocious competition in the browser market, as first a number of competitors and then Netscape and Microsoft worked furiously to upgrade their browsers and add new features to them. Most of these new features turned out to be idiotic. Some turned out to be very useful. Progress in making better browsers was rapid, because browser-makers wanted to make a better product and any new idea about what a browser should be was rapidly deployed to a large enough user base to make it worthwhile for web designers to try to use the new feature.

And now? There is no progress in browsers at all. Why should anyone (besides crazed open sourcies) write a new browser? Why should Microsoft spend any money improving its browser? The point of giving Internet Explorer away for free is to protect Windows's market, after all.

Yeah, I know some antitrust experts opine that bundling is good for consumers. And, yes, some of them don't even work for Microsoft. But I don't see it. Bundling of private goods is fundamentally anti-competitive and, accordingly, reduces innovation. (As an alert reader pointed out, bundling private and public goods can be beneficial because public goods tend to be underproduced. In this case, however, neither WMP nor Windows are public goods.) Prohibiting Microsoft from bundling, say, media players and search engines into the Windows operating system is critical to preserving competition and promoting innovation.

Henry Farrell elaborates:

Albert Hirschman’s Exit, Voice and Loyalty ... points out that the real costs of monopoly are much greater than the inefficient prices they maintain to extract rents. Monopolies are lazy. They have no reason to respond to their customers - where else, after all, can dissatisfied customers go? Without the threat of exit, monopolies face few incentives to improve their service.

I like Hirschman's book a lot, and recommend it highly, but had forgotten he made that argument therein. I'm glad to be reminded; must pull it off the shelf and reread it soon (it's a very short and highly accessible text).

Update: I got a surprising amount of flack on this post, which I find very surprising. Barry Nalebuff quite conclusively rebutted the standard argument that bundling is efficient because it allows a monopolist to price discriminate. As Nalebuff's paper Bundling shows, bundling creates significant barriers to entry. He also showed that the gains to the monopolist from price discrimination are minor compared to those that come from impeding competition by creating barriers to entry. Which is precisely what Microsoft does!

Gordon Smith on Entrepreneurship in Iraq

American entrepreneurs in Iraq have become targets for insurgents, but still the entrepreneurs show. At least we know this: being an entrepreneur in Iraq today is not more dangerous than being an opponent of Saddam before the war.

More tidbits and a link at Venturprenuer.

Eisner Poll

Tung Yin has a poll going over at his blog on when Eisner will leave Disney. (He even flags my date in the pool - January 2, 2005.) Go Freep that baby.

Satellite Competition

Interesting Slate article on efforts by "local" broadcasters to block XM from offering local programming - traffic, news, weather, etc... - over its satellite radio. The radio interests claim that satellite competition would be bad for local mom and pop stations - or something like that. As Thomas Hazlett points out, however, there are very few - if any - of those stations left:

But in this era of industry consolidation, relatively speaking, there are fewer small, independent broadcasters left to protect. And the FCC's regulations, no matter what their original intent, now serve mainly to spare incumbent broadcasters—tiny or huge—the effort and expense of competing with their satellite rivals.

The notion that traditional broadcasters deliver idiosyncratic menus closely tailored to local audiences is a quaint one. Nationally syndicated content has become the order of the radio day, and satellite programming is, if anything, less cookie-cutter than its earth-bound analogs. That this debate has been framed along such outmoded lines illustrates how increasingly strained the concept of "local" has become.

What this debate is really about is whether Clear Channel, Infinity, et al. can block competition. They know what's at stake. After all, Direct TV and other satellite broadcasters became a much more attractive option relative to local cable when the satellite broadcasters began offering local channels. If competition's good in the TV market, why not extend it to radio? (On a related note, why doesn't somebody offer a combined satellite radio, CD player, and navigation system into which I could pug my iPod? If some car maker had one as OEM, that might well determine my next car.)

Regulatory Burdens

A must read post over at Asymmetrical Information on the burdens regulation places on business, with an interesting digression into the relative merits of public and private enforcement. The bottom line strikes me as being absolutely right, based on what I see happening in corporations:

It isn't just highly-ranked professionals or insurance and technology budgets. Simple open discourse is jeopardized. Institutions are beginning to govern intra-firm correspondence, or even investigative legal work product with an eye towards protecting themselves when this correspondence is made public. Critical expression must be oral and off-the-record, or it must be without substance. The ultimate effect is not just to disclose communication but to impede it. Without open, direct communication the firm stagnates. Writ large, these trends would seem to be a strong force for economic stagnation.

This is one of those "I wish I'd written that" posts. Go read the whole thing.

Jobs and the recovery

Interesting pair of articles in the Wall Street Journal ($) today. On page 1, Improving Economic Signals May No Longer Deliver Votes explains that doubts about job security continue to pull down President Bush's poll numbers even as most economic indicators remain strong or even improve:

The equation used to be simple: If the economy was growing strongly, the incumbent had a huge edge. By that measure, Mr. Bush should be cruising to easy victory. Gross domestic product grew at an eye-popping 6% annual pace in the second half of 2003, and should expand at a brisk 4.7% rate through 2004, according to the consensus forecast of Blue Chip Economic Indicators. ... But even Mr. Bush and his aides acknowledge something different is going on this year. New technology, higher productivity and broader globalization have made American businesses more efficient, profitable and dynamic, and the past year's rapid growth dramatically lifted the stock market.

Yet that dynamism has done little to generate new jobs overall and contributed to a heightened state of anxiety for millions of Americans who feel less confident about the size and certainty of their piece of the pie. ... At the same time, many families have seen the fraying of conventional safety nets, such as health insurance, pensions and government services, that are especially important in just such times of instability. The share of Americans lacking health insurance of any kind rose to 15.2% in 2002 from 14.6% the year before. And while overall inflation is down, the bills for some major household expenses - including gasoline and prescription drugs - are leaping upward. Public college tuition rose 13% during the current school year.

Nagging insecurity amid prosperity is the emerging economic theme of the 2004 campaign. In that debate, the question of whether free trade helps average Americans by opening up the economy or causes those anxieties has become the boldest rhetorical dividing line between the two candidates.

Turning to page 2, however, we discover that the source of much of the current dissatisfaction with President Bush - outsourcing - appears to be less of a problem than many believe. Indeed, we are told that More Work Is Outsourced to U.S. Than Away From It, Data Show:

Despite the political outcry over the outsourcing of white-collar jobs to such places as India and Ghana, the latest U.S. government data suggest that foreigners outsource far more office work to the U.S. than American companies send abroad. The value of U.S. exports of legal work, computer programming, telecommunications, banking, engineering, management consulting and other private services jumped to $131.01 billion in 2003, up $8.42 billion from the previous year, the Commerce Department reported Friday. Imports of such private services -- a category that encompasses U.S. outsourcing of call centers and data entry to developing nations, among other things -- hit $77.38 billion for the year, up $7.94 billion from 2002. Measuring imports against exports, the U.S. posted a $53.64 billion surplus last year in trade in private services with the rest of the world.

At least in services, free trade benefits the US. Protectionist impulses that ignite a trade war in srevices are therefore highly likely to backfire.

In any event, for more coverage of the allegedly jobless recovery check out Tyler Cowen's analysis of why the recovery has been jobless - and what not to do about it and Alex Tabarrok's devestating critique of Paul Krugman's latest column, about which Alex concludes: "Has political progaganda taken the place of professional analysis? Indeed."

Eisner pool

My blog buddy Tung Yin and I have been kicking around by email the idea of setting up a blogosphere pool on when Michael Eisner will step down. Naturally, we would not want to violate any laws on gambling. And, of course, I never gamble myself (well, at least not outside the boundaries of Clark County, Nevada). Just in case we figure out how to do it, however, don't count on January 2, 2005 being available.

The Successor

Disney President Robert Iger reportedly has admitted that somebody suggested creating a new reality show called "The Successor" to find a replacement for Disney CEO Michael Eisner, which would "meld the elements of Survivor, Millionaire and The Apprentice." Heh. I don't watch reality TV, but I might make an exception for this one. Or, I might just rely on Tung Yin and Ann Althouse to keep me posted on it.

New Column on Business Ethics

I've got an op-ed column up at TCS on Incentives and Business Ethics, which deals with some of the issues discussed in my longer law review article The Tournament at the Intersection of Business and Legal Ethics.

MSO's Woes

If I were a shareholder in Martha Stewart Omnimedia, I don't know who I'd be madder at: Stewart or the Feds. The combination of Stewart's stupid greed and the Feds over-zealous exercise of their prosecutorial discretion is probably going to destroy a successful company. Oh sure, MSO's board is trying to devise a survival strategy, but it's really hard to successfully rebrand a company so fixated on the image of one person.

Update: Steve of Thoughts on Line quibbles with a lot of my arguments about Martha, but also chimes in with this point about rebranding:

I have experience with such businesses. The good professor is right about how hard it is to rebrand a company. But it's a lot harder to do so after that one person is off the scene. Successful rebrandings, take place before they need to take place. Of course, rebranding a company in that way means giving up somewhat on the old brand in order to go with the new brand image. In this case, MSO's board and management chose to push their luck, didn't look to hedge their bets by positioning someone else ready to step in and are now paying the price.

Read CNN Money

CNN Money is, if you'll pardon the expression, on the money this am:

1. Their latest showdown, The Don v. The Donald, compares the management style of Tony Soprano and Donald Trump.
2. The fate of Martha Stewart Omnimedia.
3. Final roundup on the Martha story.

Downsizing and Participatory Management

Tyler Cowen had an interesting post the other day with all sorts of data on downsizing. I got interested in downsizing a few years ago when I was working on participatory management - i.e., the various ways in which employees participate in corporate governance. In my article, Privately Ordered Participatory Management: An Organizational Failures Analysis, I advanced a "new hypothesis" about the relationship between downsizing, restructurings, and employee involvement:

These examples appeared to call for a new hypothesis in which restructuring and participatory management are complementary rather than competing adaptations to the irreversibility syndrome. Restructurings can have strongly negative morale effects, especially when the restructuring includes a significant down-sizing of the workforce. Retained workers frequently experience a survivor’s syndrome, whose symptoms include risk aversion, demoralization, loss of commitment, and high stress levels. This phenomenon appears to be one reason that the expected economic benefits of a restructuring often fail to materialize. Here is where the emphasis on group cohesion in the participatory management literature comes into play. By building team spirit, participatory management helps off-set the negative morale effects associated with a restructuring.

Restructurings can also disrupt internal information flows. The most obvious effect of the layoffs associated with a down-sizing restructuring is the loss of the departed workers’ expertise and knowledge, but their more subtle effect is to break up the informal mechanisms by which managers and workers bypass hierarchy. One party (or both) to an informal bypass may be laid off. Lost trust and enhanced risk aversion may result in a communication breakdown even if both parties remain with the firm. Once severed, these informal links are slow to heal. Informal relationships of the sort at issue here typically develop around social interactions such as company sporting events, outings, car pools, and break rooms. By one estimate, a strong internal organization can take three to seven years to evolve. In the low morale post-restructuring environment, the longer estimate seems perfectly plausible.

Participatory management’s information gathering and transmission effects provide a systematic way of replacing and reestablishing the informal mechanisms damaged by a major down-sizing. By bringing together employees from various areas of the plant or firm, a quality of work life program or quality circle may facilitate reestablishment of the “grapevine” within the firm. Until then, the information-extracting function of such programs replaces the disrupted informal communication channels.

A final speculation is that managers bold enough to embark on a major down-sizing may also be bold enough to try shaking up the workplace by introducing participatory management. Hence, although it initially seemed counter-intuitive, I now suspect that participatory management and restructuring may go hand-in-hand. Indeed, there is some evidence of a correlation between the economic success of down-sizing restructuring and the introduction of participatory management.

Comcast won't raise Disney bid

Comcast announces it won't raise its bid for Disney. Is it all over? No. Comcast has a well-deserved reputation for being a patient and cautious bidder. Its long stalk of AT&T; Broadband, for example, was a thing of beauty. (Comcast management clearly knows about the winner's curse.) The problem Comcast has is that its stock price went down and Disney's went up after the bid was announced, which drove its offer under water. (Comcast was offering a specific number of Comcast shares - 0.78, if memory serves - for each share of Disney stock, so the value of the offer depended on the relative price of the two stocks.) As long as no competing bid emerges, however, there is no reason for Comcast to increase the number of Comcast shares it is offering Disney stockholders for their shares. Over time, the price of Comcast stock could go back up, while Disney's stock price likely will drop (a large part of the uptick in Disney's price likely was market anticipation of a competing bid). Given how weak Disney's takeover defenses are, and the minimal likelihood that Disney can do anything particularly effective as a deterrent, there is no reason for Comcast to rush into a higher offer. Unless a competing bid does emerge, the smart move is for Comcast to wait and see if the stock price swings in its favor.

The Pope and Capitalism

Over at Mirror of Justice, I've got a long post critiquing Tomasz Teluk's TCS column The Pope and Capitalism. Teluk claims: "Examine the works of Pope John Paul II and you'll find some of the strongest examples of support for a free-market economy by the Catholic Church since Leo XIII's Rerum Novarum in 1891." To which I respond "well, yes, but...."

Disney Board rejects Comcast Bid

Disney's board of directors has rejected Comcast's offer. No surprise there. With Comcast's $23 per share offer well-below Disney's Friday close of $26.92, the Disney board arguably would have violated its duties to shareholders by accepting what looks like - at least for the moment - a low-ball offer. Push has not yet come to shove, however. If Comcast sweetens its bid, especially by including a cash component, Disney's board will have an obligation to rethink and re-evaluate. In any event, moreover, Disney's board has relatively few options available that would prevent its shareholders from eventually having an opportunity to accept a Comcast tender offer.

Micromanagement as Business Model: Walt v. Eisner

WSJ ($) reporters Bruce Orwall and Emily Nelson recently observed that:

Today, Mr. Eisner sometimes draws fire for management tactics that hearken back to Walt [Disney]. ... Walt Disney was widely praised for paying special attention to details. He personally oversaw construction of the bobsleds on Disneyland's Matterhorn ride. But Mr. Eisner, known to pick out hotel room carpeting and the like, has been branded a meddling micromanager.

The gist of the article seems to be: micromanagement worked for Walt, so people are being unfair by picking on Eisner for micromanaging Disney. There are two rather serious problems with Orwall's and Nelson's attempt at moral equivalence, however: First, Disney was a much smaller company when Walt ran it. Micromanagement rarely is a successful business model in any firm, but it has more of a fighting chance when the business is small enough for top management to dust the trees without losing sight of the forest. Second, Eisner isn't anywhere near as skilled at micromanagement as was Walt. In fact, Eisner may be one of the most overrated executives in recent history. As the Economist ($) explained:

In his first 13 years in charge he impressively raised revenues from $1.65 billion to $22 billion, and market value from $2 billion to $67 billion. But he lost his way some years ago, and the swelling crowd of influential critics of Mr Eisner has surely emboldened Comcast to make its bid hostile.

Mr Eisner seems to have difficulty getting on with people and thereby retaining senior talent. A long list of executives, such as Paul Pressler and Steven Bornstein, have left Disney. Mr Eisner seems to have made insufficient effort to keep up good relations with Steve Jobs, chief executive of Pixar, which has been responsible for over half of Disney's studio profits in recent years. That Mr Eisner infuriated Mr Jobs, himself a fiery and short-tempered man, was confirmed recently when Mr Jobs unexpectedly ended talks to re-negotiate Pixar's co-production deal with Disney.

Mr Jobs noted that Mr Eisner told Disney's board that, after seeing an early cut of “Finding Nemo”, he didn't think the film was as good as its others—an embarrassing incident since it went on to become the highest-grossing animated feature film of all time. Mr Eisner told the board that, once the film hit movie-theatres, the Pixar people would get a reality check and become easier to negotiate with. On another occasion, Mr Eisner called Mr Jobs a “Shiite” in a Disney board meeting, according to a board member who participated in it.

Eisner may yet prevail, but if he does it will once again be Disney shareholders who pay the price.

Tom Kirkendall on Disney's Hiring of Martin Lipton

Apropos of my earlier post on Disney's decision to hire famed takeover lawyer Martin Lipton, Houston lawyer Tom Kirkendall writes:

My sense is that Disney will not be adopting a poison pill strategy in defending against the Comcast bid. The Board has already been heavily criticized for its unwavering support of CEO Michael Eisner despite Disney's lagging stock price. A poison pill strategy would be widely viewed as the Board again supporting a strategy mainly benefitting Mr. Eisner and an unproductive management team at the expense of Disney's shareholders. However, Mr. Lipton is a heavyweight in defending these matters, so Disney is clearly signaling to Comcast its willingness to rumble by retaining him.

Exactly.

Disney hires Lipton

The other day I posted a short essay on the poison pill, prompted by Comcast's bid for Disney. In it, I noted that Disney is especially vulnerable to a takeover bid because Disney allowed its poison pill to lapse several years ago. Apropos of which, today's LA Times (R) reports that Martin Lipton -widely credited with having invented the poison pill - has been hired by Disney to advise it. Does this presage adoption of a new pill by Disney's board? I doubt it. Disney's board is under real pressure to demonstrate its independence from Eisner, which argues against erecting defenses except maybe for purposes of delaying a bid long enough to either seek out a higher-valued alternative or negotiate a higher price with Comcast.

Disney as Takeover Target: Are King Michael's Days Numbered?

Comcast's unsolicited bid for Disney is the most exciting business news since, well, just about forever. (WSJ$ story.) The premium being offered - 8% - is pretty miserly. The business model is also a bit suspect. Comcast claims there would be various operating synergies. In a synergistic acquisition, the sum is greater than the whole of the parts. Synergy might be generated if two activities have greater value when conducted within an integrated firm than by separate firms. Suppose a movie studio merged with a magazine publisher, and the combined entity then merged with an internet services provider. The magazines could cover a major movie release, while the ISP provided advertising, ticket sales, and the like. The combined efforts of the various divisions might significantly leverage the value of the movie in a way that a stand alone studio could not. The logic sounds plausible, but in practice the synergies promised when media conglomerates merge have often failed to bear fruit. It's hard to see what synergies Comcast gets from owning Disney's theme parks, for example, or vice-versa.

There are other reasons why one company might take over another company, however. Consider, for example, the gains to be had from displacement of inefficient management. The agency cost literature describes two basic types of managerial inefficiency. The first is misfeasance: If managers worked harder, were smarter, or were more careful they would earn more money for shareholders. The second is malfeasance: Managers cheat the corporation or lavish perks on themselves. The annals of American business corporations are replete with examples of both forms of shirking, ranging from congenital unluckiness, to incompetence, to outright theft.

No matter the source or form of director or management shirking, it should be reflected in a declining market price for the stock of the company. Bad management is just another form of information that efficient markets are able to process. When a declining market price signals shirking by directors or management, among those who receive the signal are directors and managers of other firms, who possess the resources to investigate the reason for the potential target's deteriorating performance. Sometimes it will be something that is beyond anybody's ability to control, such as where highly specialized assets are languishing because of a permanent shift in consumer demand. Sometimes, however, it will be due to poor management, which presents real opportunities for gain if the personnel or policies causing the firm to languish can be corrected. A successful takeover gives the acquirer the ability to elect at least a majority of the board of directors and thereby control personnel and policy decisions. The resulting appreciation in value of the acquired shares provides the profit incentive to do so. It is partly for this reason that we refer to the takeover market as "the market for corporate control."

Michael Eisner's Disney looks like a ripe candidate for a disciplinary takeover. Eisner has made a string of highly questionable business decisions, such as: the spat with Jeffrey Katzenberg, the hiring and firing of Michael Ovitz, the grossly excessive compensation paid Ovitz, losing the Pixar deal, triggering a revolt by Roy Disney and Stanley Gold (check out their SaveDisney website). Since Frank Wells died, there has been nobody at Disney with the power or guts to say no to Esiner. In large part, this is because Eisner was so good at stocking the board with ceremonial directors and, even worse, personal cronies. The board included such luminaries as Eisner's personal lawyer, his architect, and the principal of the elementary school attended by one of his children. Granted, in 2002, reforms at Disney, including changes to the board, led to corporate governance improvements. Yet, we have since learned that Eisner managed to turn those reforms to his own advantage. Roy Disney was forced out by a mandatory retirement provision, which exempts only former CEOs! The only other persistent Eisner critic on the board, Disney's ally Stanley Gold, was kept off key committees because his business dealings with the firm meant he did not qualify as an independent director under those reforms.

The long-term problem at Disney has been that virtually every mechanism we have for holding boards accountable has failed. Director independence failed because the board has been comprised of nominally independent folks who in fact were cronies of Eisner or know-nothing ceremonial directors. Shareholder activism failed because it never made a serious dent in the board's complacency. Litigation failed because the board was willing to pay zillions to Ovitz, Katzenberg, etc.... SOX and the other post-Enron reforms failed because Eisner is so good at boardroom politics that he was able to use even those reforms to further entrench himself.

There is one tool left: Have somebody buy the company and fire Eisner. It was long thought that Disney was essentially invulnerable to takeover bids due to its size and complexity. The combination of Roy Disney's proxy insurgency and Comcast's bid changes the dynamic dramatically. In order to survive, Eisner may finally have to start taking investor concerns seriously. Query, however, whether it is too late. If another media conglomerate jumps into the fray with a competing bid, it may well be all over at last.

Anyway, hang on to your hats. This should be a very fun ride - much more fun than any ride at Disneyland. (hey, I think this fit's Kate's letter of the day!)

Talking up the dollar. Good idea?

According to the WSJ ($), "The Bush administration [has given] in to European demands for a coordinated verbal effort to stem the dollar's sharp fall and the euro's sharp climb." This is most puzzling. As the Economist recently observed:

America's current-account deficit stands at 5% of GDP, and most economists reckon that this percentage needs to be reduced by at least half. That would stabilise the ratio of America's foreign liabilities to GDP, which has surged in recent years. So far the dollar has fallen by 15% in trade-weighted terms against a broad basket of currencies. Nevertheless, after adjusting for inflation, its value is still close to its 30-year average. It may need to fall by another 20% over the next few years if the current-account deficit is to be halved (see article).

Oracle Developments

Larry Ellison - the man of whom it was once said: "as long as Stanford keeps turning out good-looking 22-year-olds, he will date them" - has gone and gotten married. To a romance novelist no less. Huh. On a more substantive note, Oracle has joined the growing trend towards separating the positions of CEO and chairman of the board of directors. Curiously, however, the newly appointed chairman - Jeff Henley - is an insider (he's Oracle's longtime CFO). Most companies that have separated the two slots have gone with a nonexecutive chairman, since a chairman who is also an executive subordinate to the CEO is less likely to bite the hand that feeds him. As a result, Oracle's move seems less like good corporate governance than a way for Ellison to avoid duties he now finds onerous: "Ellison, [insiders] explain, has simply grown tired of investor relations, 10-Qs, SEC filings and the like."

Karl Rove's Lawsuit Against Dick Thornburgh (Part II)

In my post yesterday on Karl Rove & Co. v. Thornburgh, 39 F.3d 1273 (5th Cir.1994), I asked two questions: First, how could a candidate for office structure the business relationship between the candidate, the election committee, and contractors so as to minimize the candidate's potential liability? Second, according to former President Ronald Reagan's famous dictum, the 11th Commandment reads, "Thou shall not speak ill of a fellow Republican." Why then is a GOP operative like Rove suing one of the party's most prominent candidates? What downside, if any, is there to a suit by Rove?

As to the former, the court explained that a candidate for federal office has at least two methods by which he could protect himself from personal liability for the contracts entered into by his principal campaign committee. First, he could incorporate his campaign committee. If the committee were incorporated (presumably as a nonprofit), then the candidate–whether or not he is a shareholder—is shielded from personal liability by the corporate entity, assuming, of course, that he takes no personal action that creates liability apart from the corporation’s. Second, a candidate could include in all contracts entered into by his principal campaign committee a provision expressly stipulating that the contracting party may look only to the committee and its assets for compensation, thereby eschewing the candidate’s personal liability, either directly or indirectly.

As to the latter question, I use it to impress upon students that the decision to litigate is ultimately a business one rather than a purely legal one. In some settings, you may win the legal battle, but lose the business war. As we see it, Rove faced the following trade-off: On the one hand, suing Thornburgh might give Rove a reputation as a tough guy with whom it is a bad idea to trifle. If so, future clients might think twice before welshing on a debt. In addition, if the suit is successful, Rove would recover a not inconsiderable sum. On the other hand, suing a party bigwig might alienate potential clients and thus cost Rove future business. In trying to sort out whether Rove made a wise decision, I note that Mark McKinnon, a former Democratic political consultant, reportedly calls Rove the “Bobby Fischer of politics. He not only sees the board, he sees about 20 moves ahead.”

Karl Rove's Lawsuit Against Dick Thornburgh (Part I)

In my Agency and Partnership class today, I'm teaching Karl Rove & Co. v. Thornburgh, 39 F.3d 1273 (5th Cir.1994). Back when Richard Thornburgh ran for the U.S. Senate, and lost, Thornburgh left behind an unpaid bill of almost $170,000 owed to Karl Rove & Co. for services in conducting a direct mail campaign. It is clear that the authorized campaign committee—the "Thornburgh for Senate Committee"—had hired Rove & Co. and that it was liable. Unfortunately, the committee was broke. So Rove sued Thornburgh personally, seeking to hold Thornburg personally liable on the debt. The court first concluded that the committee was an unincorporated association. As a member of an unincorporated association, Thornburgh would be liable only if he assented to the contract. Because Thornburgh had not personally assented to the contract, the case turned on whether Thornburgh’s longtime aide Murray Dickman, in entering into a the contractual relationship with Rove & Co., acted as Thornburgh’s agent and within the scope of his authority. If so, Dickman's assent to the contract would be binding on Thornburgh. Held: Thornburgh is liable. Because Dickman is Thornburgh’s agent, Dickman’s assent to the contract constitutes assent by Thornbugh.

The case is of interest not only to business lawyers, of course, but also to political junkies in light of Rove's prominence in the Bush White House. After working through the case, I ask my students two analysis questions: First, how could a candidate for office structure the business relationship between the candidate, the election committee, and contractors so as to minimize the candidate's potential liability? Second, according to former President Ronald Reagan's famous dictum, the 11th Commandment reads, "Thou shall not speak ill of a fellow Republican." Why then is a GOP operative like Rove suing one of the party's most prominent candidates? What downside, if any, is there to a suit by Rove? Answers tomorrow.

Rebranding Martha Stewart Omnimedia

As the Martha Stewart insider trading case begins jury selection (check out my archive of Stewart posts), there's an interesting article at CNN Money on how MSO is trying to rebrand its products so as to distance itself from Martha. But what happens if Martha is acquited? Do they de-rebrand? Anyway, I'm always inclined to be skeptical of rebranding exercises. Granted, they sometimes work, but it seems to be rare. And I'm not aware of any business case in which a product line so closely tied to a single personality was successfully rebranded.

At the NYT, it's Still a Jobless Recovery

The NYT is still claiming that the recovery is a jobless one:

Given the growth of the working-age population, the nation needs to add around 250,000 jobs a month to achieve a significant decline in unemployment before the November election. Economists are skeptical that job creation will hit that pace, in part because companies of all types have been getting ever more work out of the same number of workers.

Contrast that pessimistic report. which is supported only by unnamed (and uncounted) "economists," with the WSJ's ($) analysis of 54 named economists, who predict that "the U.S. unemployment rate will slowly descend to 5.5% by November. That could translate into more than 1.5 million new jobs in a 12-month period." (Blogged here.) I'm going to put this one in the vault and report back in November.

A 2004 Prediction: M&A; Activity Will be Up

Two trends likely will coalesce in 2004 to generate a substantial amount of corporate mergers and acquisitions activity. First, continued weakness in the dollar will make US assets (such as companies) look cheap to European and Japanese acquirers. Second, continued strength in the stock market will make doing stock-for-stock deals attractive. You'd think that M&A; activity would drop when stock prices are high, but in fact M&A; activity tends to be positively correlated with boom periods for the stock market. Partly that's due to acquirer confidence (and maybe even irrational exuberance), but it's also because acquirers can offer their own (highly priced) stock as very attractive consideration for a deal.

Films about business: The Forbes survey

My friend UIUC law professor Larry Ribstein has updated his website on business films in reaction to a recent survey by Forbes of The Ten Greatest Business Movies. Larry writes:

The top ten were: Citizen Kane, The Godfather: Part II, It's a WonderfulLife, The Godfather, Network, The Insider, Glengarry Glen Ross, Wall Street, Tin Men, Modern Times. I discuss these films in the latest version of my article.

This film list provides new fodder for my theory. My thesis, again, is that, while films usually portray business in a bad light, they do not really say that business is bad. After all, the films most of us see are produced by big businesses. More precisely, films are made by people working in these businesses. Filmmakers see themselves as artists, the latest in a long line from cave painters through Michelangelo. Yet, unlike many artists, filmmakers’ art is so costly that films cannot get made without lots of money. Filmmakers must get this money from capitalists, who, in turn, must sell tickets. Because film artists resent their shackles, they often show struggling workers, greedy capitalists, and heroic artists. “Good” businesses are those where the artistic types have the upper hand, and bad businesses are those where the artists have lost. In other words, films see firms from the cramped perspective of the assembly line or the cubicle. From way out in Hollywood, firms often seem like beehives or rabbit warrens, unfit for human habitation. We don’t see what businesses actually do – create social wealth and meaningful jobs, and provide means for all of our ends, from writing articles to. . . making movies. In fact, businesses couldn’t succeed in the long run if they ignored the needs of their workers and customers.

Go check out Larry's fascinating site and encourage him to blog more often.

Starbucks v. Subway: A Roundup

It often surprises me which posts get picked up in the blogosphere and which sink into oblivion unnoticed. One recent post that generated a surprising amount of email traffic and responsive blog posts was my riff on The Starbucks v. Subway Puzzle. I thought it the puzzle a nifty problem, but I didn't expect it to attract much attention. I was wrong. In addition to several thoughtful emails, and a number of brief mentions in various places, it also elicited some very thoughtful substantive posts:

Joe Carter: Starbucks vs. Subway: How Strategy Determines Structure
Wayne Eastman: Starbucks and Subway
Paul Jaminet: Subway v. Starbucks: Explaining Vertical Integration with Transaction Cost Economics
Arnold Kling: Starbucks vs. Subway
CE Petit: Joining the Coffee Achievers
Lawrence Solum: Subways, Starbucks & Transaction Costs Economics

There's some very sharp thinking by some very smart bloggers in those links folks. Check 'em out.

The Starbucks v. Subway Puzzle

My day job is studying the legal rules that facilitate and define governance relationships with the sub-set of economic institutions known as business associations. I decided a long time ago that economic analysis was the only way to make sense of those rules. A bit later I decided that I got the most bang for my analytical buck from transaction cost economics a.k.a. new institutional economics. Most of the time, if I work at it long enough, I can come up with a transaction cost story that explains the particular governance structure I'm studying (at least to my own satisfaction). I've done it for things like insider trading, participatory management, the existence of boards of directors, the business judgment rule, and limited liability. There is one governance problem that vexes me, however; namely, why are Subway stores owned by franchisees, while Starbucks stores are owned by the corporation. (Links to WSJ; sub. req'd.)

The usual suspects when it comes to transaction costs include such things as search costs, uncertainty, complexity, bounded rationality, opportunism and shirking, collective action problems, bilateral monopolies, and, especially, asset specificity. When we observe differing governance structures, it is usually because the two institutions in question face differing transaction cost schedules in one of these areas. A classic example is Klein, Crawford and Alchian's explanation for why we observe vertical integration of the printing process in newspapers but not in book publishers. The risk of ex post opportunism in the former case coupled with the difficulty of forming complete contracts makes vertical integration the transaction cost minimizing solution for the newspaper.

What bugs me about the Subway v. Starbucks problem is that I can't see any reason to believe that Subway's transaction cost schedule is going to differ from that of Starbucks. The businesses are essentially identical; yet, the business model is quite different. A fairly standard transaction cost explanation for franchising is based on the cost of monitoring employees to prevent shirking. In some settings, monitoring must be quite intrusive. One reason Subway is successful is that the experience in one Subway restaurant will be largely identical to that in another restaurant. (When you pull of the Interstate in a strange city, you know what you'll get.) Replicability requires close monitoring. In turn, this leads to the problem of incentives. How do you make sure that the employees work hard? You hire a supervisor? But how do you make sure the supervisor works hard? And so on. Alchian and Demsetz's famous solution to this problem was to give the ultimate monitor the residual claim, so as to provide incentives that monitor to work hard. Franchising gives a residual claimant-like status to the local franchisee, while the franchise contract gives the franchisee incentives to ensure that the local employees comply with brand requirements. Franchising thus can be understood as an adaptive response to the problem of monitoring numerous employees in countless locations.

If this analysis is correct, one would expect to see corporate ownership in settings where monitoring via a vertically integrated management structure can be effected at low cost (relative to situations in which franchising dominates). But does Starbucks really face lower monitoring costs than Subway? If not, did Starbucks make an economic error by not going the franchise route?

Or has Starbucks discovered that franchising wasn't all that efficient to begin with? In other words, the transaction cost story for why franchising is efficient may turn out to be wrong. The franchiser may not be better off giving the franchisee a residual claim. Instead, vertical integration may be the efficient solution for fast food restaurants.

If so, the decision to go the franchising route might be driven not by monitoring efficiencies but by initial access to startup capital and availability of financing on an ongoing basis (as a smart reader suggested). If franchising requires less startup capital on the franchisor's part, since much of the cost of opening new restaurants is borne by the franchisee, a franchisor denied access to capital may have to accept an inefficient monitoring system.

An alternative version of this story depends not on availability of capital but on the consequnces of raising capital. A startup franchisor might well be able to raise capital through a public offering of stock, but public ownership entails a potential loss of control for the initial entrepreneur. Where the entrepreneur places a high value on maintaining control, franchising may allow it to raise the necessary startup capital without having to risk the loss of control that might follow from public ownership.

It's also possible, of course, that the Subway story may have more to do with behavioral economic concepts like path dependence and/or herd behavior than with rational choice among competing givernance systems.

Perhaps now you can see why I find this problem both interesting and vexing. (If not, don't worry; I'll get back to wineblogging and poliblogging soon enough.) Personally, I remain puzzled and fascinated. It's fun to spin out the various possibilities.

UPDATE: Tyler Cowen of Marginal Revolution sent along this email:

Starbucks has pursued the unique strategy of not worrying about cross-store cannnibalization, saturating an area with stores, very close to each other, in the hope of building up a dominant brand name. This is harder to do when you don't own all the outlets, the franchisees fear confiscation of the value of the outlet,etc.

His partner Alex Tabarrok followed up with:

This strategy would probably not have been possible with franchisees since they demand exclusive terrorities and don't take into account the brand externality.

Joe Carter proved he can do econoblogging in addition to his many other talents, by offering up a more detailed version of these arguments. Finally, Econ blogger Arnold Kling blogged a similar analysis:

Starbucks has an unusual real estate strategy that involves "flooding the zone." They are willing to have several stores near one another. That is the opposite of traditional franchise fast food, in which territory is carefully carved up.

The theory of "flood the zone" is that it is better for the corporation to have a lot of franchises in one territory, even though they appear to compete with one another. You need a corporate ownership to implement such a strategy--you could never convince individual franchise owners to do it.

Well, yes, but. What about the monitoring problem? Has Starbucks come up with a unique monitoring mechanism that allows them to achieve efficient levels of monitoring within a vertically integrated structure? Or have they accepted shirking as a cost of doing business? Actually measuring agency costs is very difficult, of course, but it would be interesting to know whether agency costs are higher at Starbucks than at Subway.

UPDATE2: It often surprises me which posts get picked up in the blogosphere and which sink into oblivion unnoticed. I thought it the puzzle discussed here was a nifty problem, but I didn't expect it to attract much attention. I was wrong:

Joe Carter: Starbucks vs. Subway: How Strategy Determines Structure
Wayne Eastman: Starbucks and Subway
WR Harper: Starbucks vs. Subway
Paul Jaminet: Subway v. Starbucks: Explaining Vertical Integration with Transaction Cost Economics
Arnold Kling: Starbucks vs. Subway
CE Petit: Joining the Coffee Achievers
Lawrence Solum: Subways, Starbucks & Transaction Costs Economics

There's some very sharp thinking by some very smart bloggers in those links folks. Check 'em out.

Employees, Pay, and Risk (IV): Paul Jaminet on Just Wage Theory

Paul Jaminet (of the Brothers Judd Blog) sent in a very thoughtful email in reply to what Mark Sargent wrote in this space about Catholic social thought's just wage doctrine. Since I liked Paul's email a lot, but he said he wasn't going to post it over at Brothers Judd, I asked if I could reprint it here. He kindly consented:

Some years back I read a fascinating review of medieval just price theory by some leading economic historians of the 1930s. (Alas, I didn't take notes and can't cite sources.) Apparently, Aquinas and his successors were free marketers in the sense that they thought, as a general rule, that mutually agreed prices should not be interfered with by authorities, but they also felt a need to address the moral process of price determination. (Just price theory, like just war theory, also involves moral & prudential considerations, not just questions of right or legitimacy).

In the medieval economy, most merchants were monopolists, and there was routinely a wide range of mutually agreeable prices -- the buyer (or seller) would willingly pay (accept) a much higher (lower) price than the merchant could profitably sell (buy &dispose; of the good). Just price theory was meant to provide some guidance for buyer/seller and merchant, helping them to reach agreement and avoid giving all the profit to the merchant.

It seems to me there's much less basis for a just price or just wage theory today, when most bargaining situations are competitive. Prices/wages are constrained on both sides -- the would-be employee by other job opportunities, the would-be employer by the need to remain competitive; so a just price theory for wages, even if both parties believe in it, can only slightly alter the bargain. Meanwhile, if just wages are mandated by law, they risk harming both parties by outlawing the mutually acceptable terms and destroying the possibility of a bargain. If the prices involved are wages, this leads to unemployment, as Professor Sargent notes. On the other side, advocates of mandates can point to some existing 'just price' regulation, e.g. for electrical utility rates and telephones, which are arguably beneficial.

If the goal of modern just wage theory is to give every household an income that 'enables a parent to stay home with the children,' then eliminating poverty is what we are after; and this is a very different goal than Aquinas's. If eliminating poverty is the goal, then other means beside price regulation (or price moralizing) are necessary. And this modern goal will only be accomplished by proving Jesus wrong!

Boy do I love having really smart readers. I don't have a dog in this fight (yet), as I am still sorting out for myself both the theological and prudential aspects, but I am enjoying providing a forum for the discussion and I'm learning a lot!

Employees, Pay, and Risk (III): Mark Sargent on Just Wage Theory

My good friend Mark Sargent, Dean of the Villanova law school, leading corporate law scholar, and general good guy, sent me an email earlier today following up on my living wage post. Mark brought Catholic social thought's just wage doctrine to bear on the problem. I liked Mark's comments so much that I asked him if I could post his email. He kindly consented; so with no further ado, herewith Dean Sargent on just wages:

The Sanders/Graham exchange on the Santa Monica Living Wage proposal raises questions that are very familiar in the debate in Catholic Social Thought over the concept of the “just wage.” While the concept has its origin in pre-modern notions, it was amplified in the industrial era both in papal encyclicals and the theoretical literature to give weight to the CST concept of the dignity of labor. It is often invoked by modern Catholic theorists and activists in debates over minimum wage policy, and thus may be relevant to the Santa Monica question.

1. At first blush, the CST just wage tradition would seem to support the Living Wage proposal. In fact, it would even seem to refute Prof. Sanders' argument that some consolation can be drawn from the fact that low wages are often paid to people not dependent exclusively on that wage. In the CST tradition, a just wage is one that enables a parent to stay home with the children, which is obviously something that reflects the centrality of the family in Catholic social teaching, particularly under the principle of subsidiarity. Wage policy that undermines family structures can't be a good thing, in the CST view.

2. Upon closer examination, however, the just wage concept is a statement of basic principle that would allow prudential judgment leading to a counterintuitive application of the CST principle. An example of this is my colleague Michele Pistone's argument that traditional CST opposition to "brain drain" emigration of educated elites from developing countries is misguided, because such emigration creates a very significant flowback of financial and human capital to the home country. With respect to the Living Wage question, the argument would be twofold: first, the imposition of such a minimum wage requirement on employers in a local market subject to significant competition from outside that jurisdiction is likely to result in fewer jobs, particularly with employers who are marginal competitors. The less needy also may derive unintended benefits (i.e., tipped employees). That hardly serves the goals of just wage theory. Second, the unworkability of a high minimum wage, however, does not eliminate the social responsibility to develop alternative mechanisms that would put low-income workers into something like the position they would have been in had a just wage have been paid. That alternative mechanism may be the EITC or some other tax change that benefits the poor. The key point is that we can't be simple-minded in arriving at the "just wage"; we need to recognize that the goal may be achieved through a means other than high minimum hourly rates. But we do need to do more about achieving that goal!

3. I draw less comfort than Professor Sanders from the observation that most minimum wage earners are not depending exclusively upon those wages for family support. Many of those families are depending upon two minimum or near-minimum salaries to live. That's not easy, as Barbara Ehrenreich showed so painfully in her well-known field study, Nickel and Dimed. I don't think Professor Sanders intends to dismiss that dilemma (and I am sure he is aware of it), but it's not like hotel maids are the wives of professionals looking for pin money. The problem of two-earner families that can’t make a decent living is a real one, and one of major concern from a CST perspective.

Thanks Mark. I knew I should work just wage theory into the discussion, but I also knew I would only be exposing my ignorance! I'm glad to have provided a forum for Mark's very thoughtful comments.

Employees, Pay, and Risk (II): A Living Wage

My post on employee pay and risk generated some very thoughtful emails. One of the more common points was the observation people can't live on what Wal-Mart pays them, which is almost certainly true. But what are we to do about it, as a matter of social policy? One option popular with the Left is living wage legislation. My UCLA colleague Richard Sander, however, has demonstrated that living wage laws don;t work and even prove counterproductive. His extensive research culminated in a report on a proposed living wage ordinance in Santa Monica, whch Sander summarized in an excellent op-ed, in which he explained:

Most people who have low-wage jobs do not live in low-income households -- they are usually secondary earners in their families. This was obviously true for the teenagers working the rides at Santa Monica Pier, but it is even true for hotel maids. In Los Angeles as a whole, less than 20% of maids (and fewer than 15% of low-wage workers generally) are the primary wage-earner for a family with children, and fewer than 5% are the sole wage earner for a family. The argument that minimum wages should be determined by what is enough money to lift a family out of poverty is, therefore, logically a non-starter. Overall, Prop JJ [Santa Monica's living wage ballot proposition] was so poorly targeted that 65% of the benefits went to households with incomes in the top half of the Los Angeles income distribution, and only 7% went to households that were poor or near-poor (that is, within 50% of the federal poverty line).

He goes on to explain how the proposition would have cost an enormous number of jobs to leave Santa Monica. Granted, one example is hardly enough to condemn the whole enterprise, but Sander's research does raise doubts about the merits of such legislation. (Also of interest is Sander's report on the Los Angeles living wage law, which supported a modified version of that law.)

Constructively, Rick did not simply shoot down the living wage law. Instead, he advocates a local version of the Earned Income Tax Credit (in effect, a local negative income tax). A very promising idea for really helping low-income workers. As they say, go read the whole thing. Update: Check out Chris St Pierre's rebuttal.

Employees and Risk

An earlier post picked up on Rob the Business Pundit's take on the relationship between risk and the residual claim to firm profits. As you'll see if you backtrack, I'm in agreement with Rob's main point re the "right" to a share of the profit. I want to quibble with one point he made, however. Rob wrote:

The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.

Rob’s argument only works with respect to employees whose jobs do not require investments in firm specific human capital, because employees who do make such investments fairly can be said to be taking an entrepreneurial-like risk.

Consider an employee who invests considerable time and effort in learning how to do his job more effectively. Much of this knowledge will be specific to the firm for which he works. The effort and opportunity costs incurred in developing such knowledge constitute an investment in firm specific human capital upon which the employee can earn a return only so long as he remains with that firm.

A rational employee will invest in firm-specific human capital only if rewarded for doing so. An implicit contract thus comes into existence between the employee and the firm. On the one hand, employees promise to become more productive by investing in firm-specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. Accepting deferred compensation, in which salary or wages rises with seniority, provides such a bond because the employee will carry out his side of the bargain in order to avoid being terminated before compensation rates rise at the end of his career. In return, the firm promises to fulfill its part of the bargain by providing job security so that the employee will be able to collect that deferred compensation. This bargain exposes the employee to firm specific risk. If the firm fails, their investment will be lost. If the firm behaves opportunistically, such as by terminating older employees, again their investment will be lost. These employees thus are taking an entrepreneurial-like risk. They can't just "simply move on to another job," as their investment has created a bilateral monopoly. As for Rob's employees, however, I gather that Rob will be helping his employees develop their general human capital to a higher level, rather than requiring them to develop human capital that is specific to your firm, in which case he is quite right that they are not taking entrepreneurial-like risk.

As for employees who do invest in firm specific human capital, do such employees have a “right” to a share in firm profits? Of course not. As an economic matter, however, failing to provide such employees with credible protections for their investments in firm specific human capital will significantly increase labor costs and/or reduce firm productivity. Firms that want to encourage such investments will find a variety of ways of providing the requisite assurances. Promotion ladders with ports of entry, profit-sharing, seniority systems, and the like are all options.

From a management perspective, an entrepreneur needs to figure out whether his new business will require employees with general or firm specific human capital. In many front-line industries, skills evolve so rapidly that the skills of even quite young employees become obsolete and are replaced by still younger workers. This has led to a situation in which the old implicit contract between workers and companies, in which workers traded loyalty for job security, is virtually dead. Instead, the labor relationship is increasingly viewed as temporary by both sides. Job mobility is increasingly more common than job security. In such an environment, workers need – and are more likely to develop – general human capital rather than firm specific human capital. Figuring out which type of employees you need is a key management decision for any entrepreneur.

Update: Scheherazade has a really good post over at her Stay of Execution blog on how lawyers invest mainly in general rather than firm specific human capital, which goes a long way towards explaining the increasingly high mobility among law firms (social norms used to constrain that movement, but they've really eroded). Meanwhile, Scheherazade also makes some good points about the transaction costs that impede job mobility even for employees with little firm specific human capital. In between reports on her marathon training, Scheherazade offers very useful insights on the perspective of a young lawyer on the law business. I drop by daily. (I also like the way she calls me "The Professor.")

Employees, Pay, and Risk

I've been thinking a lot today about employee compensation. Yesterday's LA Times had a long article on Wal-Mart, the gist of which is that Wal-Mart's employees should be unionized and paid a lot more. One of the article's key points is that Wal-Mart's low pay has ripple effects, driving down the pay and benefits of unionized grocery store workers at Safeway and Albertson's. The subject came up again when I surfed over to CalPundit, where guest blogger Barbara Maynard, the chief spokesperson for UFCW Locals 770 and 1442, the grocery store unions on strike here in the Southland, asks:

Would you rather that these 70,000 middle class jobs become poverty level jobs filled by workers who have to turn to the taxpayer for healthcare and food stamps? That’s what the companies are proposing because that’s what Wal-Mart has. The CEOs of these three companies are just trying to keep up with the Waltons. Their combined operating profits have gone up 91% in the past five years...but Wal-Mart’s have gone up even more. Good lord — when is enough enough? At what price profits??? [Ed.: My emphasis]

I think unions serve important social and economic functions, as I've explained before, but when I hear actual union leaders talk I am reminded of an old Peanuts cartoon in which Linus says: "I love Mankind, its people I can't stand!" It's a lot easier to think positive thoughts about unions at the level of economic theory than when watching them work in practice.

Anyway, I was thinking about whether I wanted to write up Maynard's and CalPundit's comments, when I discovered a post by Rob at Business Pundit that provides a powerful answer to Maynard's question(to be clear, Rob's post didn't say anything about either the Times article or the CalPundit post):

What people don't accept is that some people make almost nothing while the company they work for makes a huge profit. The question seems to be that if a company is profitable, why should all the money go to the shareholders? Why not give some to the employees who are barely getting by? I think I have an answer to this, based on my own recent experience - the profits belong to those who take the risk, not those who do the work....

I am in the process of starting a company. ... I am the one who, by doing this, is on the hook for 300K if it fails. I am the one who may lose my house and file bankruptcy if it doesn't work. This could ruin my life. Why would I take such a risk? Because if things go well, I will have significantly more money than I do now. ... The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.

Gordon Smith at Venturpreneur followed up with a great post putting fleshing out Rob's framework with some economic theory:

Instead of asking who is entitled to the profits, let's ask who is most likely to maximize profits? (After all, from a societal standpoint, maximizing the residual claim maximizes value creation, and we generally like value creation.) On the one hand, anyone who has a claim to the profits will want to maximize them. On the other hand, the only person who has a chance of success is the person who controls the firm. Here is a kernel of insight: profits attach to residual control. ...

Well, maybe I failed to mention that people can exercise residual control only by "purchasing" the right (not necessarily from another person, but by exposing oneself to substantial personal loss). This is where the notion of risk comes into the picture. If control were cheap, everyone would want it (which, of course, would cause the price rise ... so that was a silly game, wasn't it?). Residual control is expensive relative to other forms of participation in the firm.

Requiring entrepreneurs to take this step of puchasing residual control acts as a defense against adverse selection: people who know that they have limited competence would not be willing to purchase residual control because the costs of failure are too high.

As I explained in my article, In Defense of the Shareholder Wealth Maximization Norm, maximizing the value of the residual claim is just as important for established public companies as it is for the startups Rob and Gordon are discussing. In sum, Ms. Maynard is asking the wrong question. It's not "at what price profit" but "at what price not making a profit?" Take away the profit motivation and Ms. Maynard's union members won't be dealing with higher health benefit costs, they'll be out of a job.

The Official Carnival of the Capitalists Site for the Week of November 17th

Business and ManagementThe A Penny For... blog thinks the folks behind naming United's new low-cost airline Ted did a good job, as explained in his post Congratulations! It's A Boy!

Kevin Aylward of Wizbang muses on a business model for the sex tape du jour in Why I Gave In ....

Steve Bainbridge of ProfessorBainbridge.Com offers a behavioral economics theory for why so many otherwise intelligent business people get caught up by management fads in his post Management fads: A behavioral explanation.

The Business Pundit reviews Barbara Ehrenreich's book Nickel and Dimed, offering a comparison of his own experiences in low wage jobs as a counterpoint to Ehrenreich's analysis in Rob's post Nickel and Dimed - The Book Vs. My Experience.

Dave Foster of Photon Courier discusses globalization within the production process, including a "man bites dog" story about a Chinese appliance plant in the United States in Factory Without Walls.

Jay Solo takes on a subject that bugs me a lot too -- supermarket discount cards -- but then goes beyond his initial, visceral reaction as a customer to outline the pros and cons of the business model in Please Don't Card Me.

Alex Whitlock of Rawbservations describes a job interview from hades with a Dilbertesque manager in UFC: Getting the Job.

Jeremy Wright of the Ensight blog argues that the values underling the Open Source movement can be generalized to wide array of business settings in his post Open Source Business.

EconomicsSteve of Deinonychus antirrhopus decided "to geek out" on the theory of the second best. This is an incredibly important, but all too often overlooked principle of economic analysis. So go read The Theory of the Second Best.

Robert Prather of Insults Unpunished critiques the modern Southeast Asian of mercantilism, which he defines as "a government policy aimed at creating a trade surplus," and which he argues is "unsustainable" in his post A Chinese Bubble.

RegulationJoe Carter of The Evangelical Outpost has come up with a system for using patent law and the free market to finance the Medicare drug benefit, which he outlines in A Patent Solution - How to provide a Medicare drug benefit.

Mike O' Sullivan of the Corp Law Blog describes a recent California case holding that it is illegal for California employers to award a traditional profits-based bonus to low-level employees, noting that economic reality must yield to regulatory imperative. O' Sillivan suggests that, instead, economic reality will dictate a result that may be far from what the regulatory imperative had in mind in his post Must Economic Reality Yield to Regulatory Imperative?.

Sales and MarketingJim Berkowitz on writing effective sales copy in Long, Emotional, In-Your-Face Sales Copy: It Works!

TJ of the Technology, Venture Capital and Entrepreneurship blog analyzes competing online used car marketplaces in online car exchanges.

One would think that sales and marketing departments work hand in glove. According to The Window Manager, however, one would be wrong. He explains why (and offers some suggestions for improvement) in Justifying my Existence: Marketing 104 -Sales Support.

Deb Yoder (last week's host) -- The Accidental Jedi -- is another Capitalist tackling sales and marketing issues, with sound advice for salesfolk, in her post Quick Sales Tips.

Securities and Securities MarketsKarsten Junge of CurryBlog offers up an amusing reworking of an old Bob Dylan song to make a rather thoughtful argument that we are observing a return of irrational exuberance to the stockmarket in The Bulls They Are A-Ragin'.

Michael Kantor of The Calico Cat argues an expected privatization of the French government owned nuclear power company Areva presents a good investment opportunity in his post The return of nuclear energy.

Chris Noble a.k.a. The Noble Pundit fisks news reporting on mutual funds that uses "manipulation and misstatement to hype a problem into something more than it is" in Mutual Fund Misinformation.

Robert Tagorda of Priorities & Frivolities takes on those bloggers who spun Wal-Mart's less-than-sanguine forecast to dump cold water on economic bulls, arguing they ignored the context of the Wal-Mart statement in his post Wal-Mart, the Economy, and the Many Manifestations of Spin.

Stock OptionsCap'n Arbyte uses the economic concept of opportunity costs to justify his position that that the exercise of stock options represents a cost to the owners of a company, through share dilution, but is not in any way an expense to the company itself, in Opportunity Cost and Stock Option Expensing.

Catallarchy.net also uses opportunity cost economics to argue that it is not the granting of stock or options that is a real expense, but rather the repurchasing of shares to mask dilution of shareholder ownership, hence he argues that only the latter should be expensed in Why stock options and grants should not be expensed, but stock repurchases should be expensed.

TaxesGoobage colorfully explains the folly of the internet taxes Lamar Alexander is trying to foist on us in On to Tax Absurdity!

Barry Ritholtz of The Big Picture analyzes the commonly made yet false comparison between Oil price increases and tax hikes in his post Repeat after me: Oil price rises are not a tax increase.

Geitner Simmons of Regions of Mind (a real journalist) tackles international tax competition. He argues for the existence of regulatory competition across borders in the tax arena and notes that the US has put itself at a competitive disadvantage in his post International Tax Competition.

Michael Williams -- Master of None predicted that California's increased car tax would have a substantial impact on car sales, which of course turned out to be right. The next question is whether the hit is permanent or just temporary. Michael advances some good reasons to think it might have a permanent effect in California Car Sales Down 35%.

Next WeekThe Next Carnival of the Capitalists will be hosted at Truck and Barter. Kevin requests that people put CotC in the subject of entries sent to him for next week's Carnival.

Ernie on Louisiana's Business Climate

From Ernie's blawg:

Yesterday, the Times Picayune's "Money" Section announced in bold headlines: "La. held ground in economic quake." ... Gee, I wonder why? ... Only a moron would fail to grasp that it isn't good news that we were left out of the tech bust (because it means that we have no tech industry at all). You need an educated workforce to have a technology industry, which we don't have. ... Is the lack of an educated workforce our only problem? Most certainly not. Just recently our most populated County/Parish was just rated as one of the 13 litigation 'hellholes' in the Country, which is the sort of pedigree that businesses look for when deciding where not to move to.

Sounds almost as bad as California. If it makes Ernie feel any better, Louisiana has much better crawfish etouffee than we do, but I guess that sort of went without saying.

Management fads: A behavioral explanation

Back in the mid- to late-1990s, when I was writing a lot about participatory management and employee involvement, the business section of every bookstore overflowed with books on how to manage corporate employees. Management consultants proliferated, as they still do. Scarcely a day went by without the appearance of some new management theory that was going to restore US competitiveness, while solving any number of social ills on the side.

Participatory management in one form or another was among the most common themes in this burgeoning industry. Some books and consultants recommended TQM, while others pushed quality circles. Some urged managers to go “lean,” while others urged them to go “team.” Some even urged managers to go back to traditional command and control models.

Did participatory management make sense? For some firms, you bet, but not for all. Lots of firms adopted participatory management not because it fit well with their corporate culture, but just because it was the current flavor of the month.

Just as some consumers have to have the latest product fads, some managers seem to have to have the latest industrial relations fad. As a result, some firms repeatedly make radical shifts in the way their firms make decisions.

The proliferation of management fads is hardly surprising from the supply side. Like the fashion industry, the management consultant industry always has to have something new to sell. There must be continuous churning of ideas if the consultants are going to have continuous work. After all, you don't become a management guru with lucrative consultancies, huge speaking fees, a bestseller if all you can say is "everything's great." But whence comes the demand for these new fashions?

Is it possible that rational managers would chase fads? Herd behavior, which refers to the tendency to imitate the actions of others, ignoring one’s own information and judgment with regard to the merits of the underlying decision, provides an answer. Corporate managers are scarcely immune to herd behavior; to the contrary, the faddish aspects of participatory management suggest the possibility that herd behavior is relevant to the demand side of the equation. An American Society for Training and Development report, for example, observed that many companies adopt team-based management structures, inter alia, “in response to success stories from other companies.” (For the citations, see here). Another study reported: “In a number of cases we studied, the CEO of the company had seen a TV program or read a magazine article praising quality circles and decided to give them a try.” I love that one.

Herd behavior is partly attributable to cognitive biases, especially the conformity effect. When one’s decisions are publicly observable by peers, conformity has a positive psychic pay off, whose existence has been experimentally demonstrated. But there is also an agency cost phenomenon at work. Following the crowd may have a pay off even if the chosen course of action fails. Because even a good agent can make decisions resulting in a bad outcome, the market evaluates the agent by looking at both the outcome and the action before forming a judgment about the agent. If a bad outcome occurs, but the action was consistent with approved conventional wisdom, the hit to the manager’s reputation is reduced. This phenomenon explains both the tendency to follow fashion and the growing importance of management consultants. When a manager follows a management consultant’s advice in selecting a human relations system, he is buying insurance against a bad outcome. Hence, the observation that U.S. managers “have abdicated their responsibility to a burgeoning industry” of consultants.

Kaizen as human resources tool

Business Week offers up an interesting article on Toyota's Kaizen (continuous improvement) process. (Link via Business Pundit.)

[Toyota] executives created the doctrine of kaizen, or continuous improvement. "They find a hole, and they plug it," says auto-industry consultant Maryann Keller. "They methodically study problems, and they solve them."

While kaizening works well as an engineering process, it's less clear that it makes an effective human resources tool, at least in the US. I wrote about kaizening, TQM, and other types of employee involvement in in my article Privately Ordered Participatory Management: An Organizational Failures Analysis, in which I quoted a worker at NUMMI (the Toyota-GM joint venture), who said:“Kaizening is supposed to be creative, but I mean how many times can you sit there and Kaizen a job after you’ve done it for four and one-half years? ... [J]ust keep me in a job and I’ll do it the way you want me to do it.”

This worker seemingly would prefer a more structured environment. Studies of formalization—the creation of written rules, procedures, and instructions—suggest that it reduces role conflicts and ambiguity, which increases work satisfaction and reduces feelings of alienation and stress. Kaizening and other forms of employee involvement can trigger role stress because many employees lack the quasi-management skills—agenda building, conflict management, and problem solving—required for successful employee involvement. Alienation can result from the greater workload and negative changes in peer group relationships experienced by some participants in employee involvement.

Not all employees respond well to formalization, of course. Many prefer a less structured and less hierarchical workplace. A good manager manages to his/her people, not to the latest management fad. Understanding your workers' tastes is the essential first step in making decisions about how workplaces are structured. All too many managers, however, manage to the latest fad rather than managing to the preferences of their people. I explain why in the post above.

Amazon's new search feature

CalPundit praises Amazon's new search inside feature:

So has everyone heard the news that Amazon has introduced a feature that allows you to do a full-text search of the books they sell? This is incredibly cool. I am now willing to worship the ground that Jeff Bezos walks on and (more important to him, I assume) buy all my books from Amazon in the future. ...

[I]t turns out the Author's Guild has some problems with this. I can certainly understand their concern, but I sure hope they find a way to live with this. I suspect that the danger is small for the vast majority of books, and Amazon has taken measures to make it difficult (or impossible) to browse or print out large sections of books. In general, I'm pretty supportive of authors' rights, but I've been concerned for a while that the AG's hardline stance on royalty issues is a real threat to enormously valuable services that the internet makes possible. (Then again, I'm not an author. Opposing viewpoints are welcome!)

As an author of reference works, I share the Author Guild's concerns. The guild explains:

When we learned of the program, we thought that it would be impossible to read more than 5 consecutive pages from a book in the program. It turns out that it's quite simple (though a bit inconvenient) to look at 100 or more consecutive pages from a single lengthy book. We've even printed out 108 consecutive pages from a bestselling book. ... Other books at especially high risk include those that sell to the student (particularly college student) market as secondary reading. A student could easily grab the relevant chapter or two out of a book without paying for it. Students certainly have the time and most likely the inclination to do so, and, with the help of some willing colleagues, could print out the entire texts of books in the program.

Books sold to law students for secondary reading are my stock in trade. From my perspective, what Amazon is doing is no different than what Kazaa is doing to music. They are creating a way for university students with highspeed broadband connections to routinely evade copyright laws. Some folks seem to think that's a good thing. One of CalPundit's readers commented, for example:

I am a writer and an artist and I don't see where any creative gets off thinking they deserved to get paid, or that they own the work. You make art, that's it, it should not be available for cap. gain. Copyright is a bad bad bad thing.

Where does he find these people? How does this person make a living? I suspect what we have here is somebody rationalizing their commercial failure by arguing that commerce is bad. So let me see if I can explain it to you simply:

Protecting the economic incentive to produce socially valuable information is the standard policy justification for creating property rights in information. As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred in developing it. It took me thousands of man-hours to write each of my books. If people can freely copy my book without having to buy it, I will not earn a return on my investment of time and effort.

In the past, authors had some technological vulnerabilities. Students could photocopy a library copy, for example. But at least the library had bought a copy. Academic libraries have tried to limit copyright violations, moreover, although perhaps not without much success. In contrast, Amazon can apply thise service to one of my books without buying a copy -- or without even having sold a single copy! At the same time, Amazon has done far too little to make it difficult for students to download huge chunks of the text.

If economically rational authors (like me) anticipate that technologies like Amazon's will prevent them from generating positive returns on their up-front costs, they will be deterred from developing socially valuable information. If this technology starts chewing into my royalties, for example, I will shift my efforts from writing books into, say, consulting. Accordingly, society provides incentives for creative activity by using the copyright system to give authors a property right in new ideas. By preventing readers from appropriating the text, the copyright allows the author to charge monopolistic prices for the product, thereby recouping his sunk costs. Trademark, patent, and trade secret law all can be justified on similar grounds.

UPDATE: It was particularly surprising to see my friend and colleague Eugene Volokh apparently favor what Amazon is doing. As an author and expert in information property rights, Eugene should know better. I would be interested to see his defense of the Amazon program.

UPDATE2: Ernie the Attorney explains why he thinks Amazon's new feature could be incredibly useful:

Okay, now I get it. I can search literature using Amazon in the same way I can search the web using Google.

As a researcher, I have to agree: it is incredibly useful. It will help me satisfy law review editors insatiable desire for citations. As an author of low volume reference works, however, I am afraid it will evsicerate my modest sales for the reasons discussed above.

Former SEC Commissioner Laura Unger on Expensing Stock Options

Interesting TCS interview with former SEC Commissioner Unger on stock options. Highlights:

I think the average investor doesn't really understand financial statements. But most investors do understand a narrative that describes what compensation plan for a particular company and whether it includes stock options....

What I think is important to the analyst community or to the analyst generally, is the dilutive effect of options that are exercised. ... By dilution I mean the impact on the number of shares that are outstanding and the impact on existing shareholders that an exercise of options resulting in more shares outstanding has on holdings and the market in general. I can speak from first-hand experience on this because I'm on the board of a software company that issues broad-based stock option plans. The majority of shareholders, the institutional shareholders, care about the dilutive affect of the option grants, not the impact on the bottom-line financials.

Executive comp

The Economist's lead editorial this week blasts executive compensation and urges increased shareholder activism:

This one-way trend in top executives' pay has rightly raised eyebrows, on both sides of the Atlantic. The supply of good bosses may be short, but can it be that short, even during an economic slowdown and stockmarket slump?

This is the right question, as I explained in a prior post, from which the following remarks are adapted.

How much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees – all more or less fungible – competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for law professors is relatively thick. The market for CEOs of Fortune 500 companies is thin. I’d guess the number of people who have what it takes to run a Fortune 500 company isn’t much larger than the number of people who can run a NBA fast break. Hence, its not surprising that corporate CEOs make Shaq-like dollars. Its just supply and demand, folks.

Having said that, however, the Economist does have a point. Although I don't have the citations at the tip of my fingers, I have seen a couple of recent studies to suggest that boards erroneously believe the CEO market is thinner than it actually is, which tends to artificially inflate CEO salaries. Boards tend to want proven track records (picking an unproven CEO who tanks is bad for the board’s reputation), which limits the pool through the “Experience Required” phenomenon. Boards also tend to pick CEO candidates who resemble the prevailing demographics of the directors, which further artificially limits the pool. Hence, the Economist doubtless is right -- the supply of potential good bosses is not as short as directors believe.

The problem is that neither solution the Economist considers is desirable. The Economist is surely right that we don't want to direct government regulation of executive comp -- in particular, as I've said before, we definitely don't want to imitate Germany by criminalizing excess compensation. On the other hand, as I've also argued before, shareholder activism is hardly a panacea for the ills of corporate governance. Shareholder activism is not a solution but a problem. The only solution I can come up with is the imperfect one of independent directors incentivized to monitor executive compensation. It's not perfect, but its better than the alternatives.

Also noteworthy is the following huge whopper in the Economist's editorial: "Few public companies today in either America or Europe have a majority of independent directors." I don't know about Eurpose, but as to the US the statement is flat wrong. According to the NACD's latest survey of public corporations, 61% of US corporations had a majority of independent directors (29% had a board that was more than 75% comprised of independent directors). These are 2001 figures. Given the emphasis on director independence in the NYSE's listing standards and Sarbanes-Oxley, moreover, the figure is almost certainly higher now than it was in 2001. Once the new NYSE and NASDAQ listing standards kick in, moreover, almost all listed companies will have to have a majority of independent directors.

Stock options versus restricted stock

In a Washington Post op-ed, Intel's Andrew Grove and Reed Hundt explain why Intel is not going to follow Microsoft's lead and switch from stock options to restricted stock grants:

What about restricted stock? Would it not be a better deal for investors? Not at all. With restricted stock it's possible for employees to gain while stockholders lose. Here's an example. An employee may be granted a share of restricted stock when the stock is publicly traded for $10 per share. When the vesting period ends, usually after one to five years, the employee will make money no matter what has happened to the stock price. For example, if during that time, the stock price drops to $9 per share, the employee is ahead by that same $9, but anyone else who bought stock on the open market would have lost $1 per share in value. This is why critics have called restricted stock "pay for pulse." The granting of restricted stock puts greater emphasis on longevity and tenure than on owner-like motivations.

I have seen this argument before, but have never understood it. It seems to assume that the employee got got the restricted stock for free. As one otherwise useful article on the choice between stock options and restricted stock grants put it: "employees granted stock have not paid for it, while shareholders have." This is clearly wrong. The employee and employer exchanged value -- labor for compensation. The total compensation paid logically should not depend on the form of the consideration (ignoring transaction costs and taxes). Assume the employee's labor is fairly compensated at a rate of $100 per day. The employee could elect to work for a company that pays only cash salaries and receive $100 cash. Or the employee could go to work for a company that pays compensation in the form of both cash and restricted stock. This company is not going to pay the employee $100 cash per day. Instead, it will pay the employee $90 cash and give the employee the $10 share of restricted stock. If the employee takes the second job, the employee has an incentive to do whatever is possible to keep the stock price abpve $10. Otherwise, the employee would have been better off working for the all cash employer. Or am I missing something?

Mike O'Sullivan @ Corp Law Blog also weighs in with criticism of Grove and Hundt:

I also think [their] characterization of restricted stock as "pay for pulse" is unfair. By requiring an employee to stay at the company during the vesting period, restricted stock helps the company retain employees. As such, it can have the same beneficial effect as long-term incentive plans, deferred compensation plans and, yes, stock options. Restricted stock vesting doesn't have to be tied just to retention -- Microsoft's new restricted stock program, for instance, requires its top 600 or so executives to meet certain performance goals before their restricted stock vests. Hardly "pay for pulse." At the same time, options can offer "reward for pulse," as macro events such as interest rates, currency values and GDP growth can increase (or decrease) stock prices independent of any improvement (or failures) at an individual company. In other words, a rising tide can lift all boats, even the ones that are about to sink.

My sense is that one size does not fit all. At some firms and in some economic conditions, options may make more sense. At others, especially in the recent market, grants make more sense.