Market-Based Management®

Of Human Action and Human Design

A debate is raging in Washington about price gouging.  This debate is not between the forces who wish to intervene in markets and those who wish to allow market processes to remain unfettered.  Unfortunately, the debate is about who is price gouging -- gas station owners or large oil companies.

In this post, economists Russ Roberts and Don Boudreaux remind us about how prices are determined.  The price of a gallon of gasoline at the local station is the result of human action but it is not the result of human design.  The special interests in Washington would be wise to learn the simple lesson put forward by Roberts and Boudreaux instead of pointing the finger at each other.

The Frog in the Pot: Incremental Substitution

From Dennis Gartman's The Gartman Letter this morning (TGL is the first thing I read each weekday morning -- highly recommended):

"... Oil has everyone's interest, and Hubbert's Peak was at work in the whale oil market in the latter half of the 19th century, just as we are told that Hubbert's Peak is at work in the crude oil market presently.  Then, the price of whale oil ran up so far and so fast that it presented a problem to those using it to burn in lamps and gave way to kerosene as the first, real competitive replacement for whale oil."

John Pittenger points out that Mr. Gartman's story is an excellent example of incremental substitution.  It's also a great study on the lengths some players in mature industries will go to in the hopes of avoiding the "gales of creative destruction."

Place a frog in a boiling pot of water and he tries to jump out from the shock of it.  But put him in a pot of luke warm water and slowly turn the heat up, he voluntarily stays in place until it's too late.   That's pretty much what happened to the whale industry.  Here's the rest of Mr. Gartman's story, with his kind permission:

"We came across a very interesting article entitled "How Capitalism Saved the Whales," by James Robbins, paying homage to Mr. Abraham Gesner, the gentleman who first began refining kerosene from petroleum.  He did this in 1846, which interestingly is coextensive with the largest number of whaling ships here in the U.S. at 735 ships.  From that point on, the whaling industry declined to the point that by 1876 there were only 39 ships whaling in the waters off the U.S.  In 1825, regular whale oil (often called "train oil") was approximately 35 cents/gallon.  By 1855 it had risen to 95 cents/gallon as demand for the oil as a lighting fuel rose along with the burgeoning population of the U.S.  As prices rose, whaling rose with it.

Dr. Gesner, a Canadian geologist, discovered an economic method of distilling petroleum into kerosene, which was a far better fuel for lamps, street lights, etc.  Until that time, petroleum had been considered a nuisance product, utilised only by indigenous American Indians as a salve for wounds.  Otherwise, it was worthless, bubbling to the ground in favour places, fouling the water and generally being seen as a problem.  Once Dr. Gesner had made it economic to "distill" petroleum and to create kerosene, the market for whale oil began logically to weaken and the top was put in for that industry.  As Robbins notes:

"... as kerosene became generally available throughout the country, the demand for whale oil dropped precipitously.  The 735 ship fleet of 1846 had shrunk to 39 by 1876.  The price of sperm oil reached its high of $1.77 / gallon in 1856. By 1896 it sold for 40 cents / gallon.  Yet it could not keep pace with the price of refined petroleum, which dropped from 59 cents per gallon in 1865 to a fraction over seven cents per gallon in 1895..."

It was John D. Rockefeller who helped propel the price of petroleum and kerosene downward, for he understood the supremacy that petroleum and its products would have over whale oil.  Aided by the advent of new oil discoveries in Pennsylvania, and the rise of the railroad system that could carry this new found crude oil around the country, a new market grew swiftly and violently, usurping the whale oil industry.  Even as whale oil was usurped by a clearly superior product that was available at steadily declining prices, the old guard of the whaling industry found to hold its previous position of superiority.  The "Old Guard" lobbied the state and federal legislatures to ban petroleum and / or to support whaling.  It argued that petroleum was a useless, "nasty," expensive lighting source.  It argued that petroleum was unhealthy; that it was "un-American" to allow for the demise of the whaling industry; that the New England whaling industry was an institution worthy of holding firm to.  Theirs was a losing argument; there's was an argument hoping to dissuade progress, and as such arguments always end, they lost.  Lessons are to be learned from their loss."

History sure does seem to repeat itself.  But we can learn...

Wisdom of Crowds

Over at Google they have a very cool post on using "predictive markets" to forecast everything from product launch dates to new office openings.  Great read.  If you're curious and want a layman's overview of this wonderfully Hayekian approach to life, you should pick up a copy of The Wisdom of Crowds at your local or internet bookstore.

The Market's response to high gas prices

The market response to rising gas prices is simple. When consumers demand and are willing to pay for cars that dramatically reduce the need for filling up at the pump entrepreneurial action can be rewarding to those who are faster, better and cheaper than competitors.

It happened in the U.S in the early seventies when rising gas prices prompted government intervention and consumer response. While the government action was disastrous - causing long lines at the pump - Americans long love affair with BIG gas guzzling cars was over. Many consumers bought smaller more fuel efficient cars the next time they bought. And today its no different. The popularity of hybrid cars (running on both gas and batteries) are increasing. Two years ago European car makers were saying they wouldn't be getting into hybrids, basically leaving it all to the Japanese (Honda and Toyota both already have hybrids on the market). European car makers are now singing a different tune. BMW, Daimler-Chrysler, VW, Porsche and GM are all announcing that they will in the next few years be bringing hybrid models to market.

If you rebuild it will they come?

Recent polls indicate that fewer than half of the evacuees of New Orleans will return to New Orleans. (Washington Post - no subscription required)

While Bush seems to have "a plan" Steve Forbes argues that the government should butt out and leave it to individuals.  Forbes (free subscription requried) argues that

One measure that would cost little and quickly spur an inspiring revival of this impacted area would be making the region a true free-enterprise zone.

Residents and local businesses would be free from both federal and state capital gains levies. Parents would have genuine school choice: If they wanted to move their children to another school, they'd get a voucher or coupon equivalent to the amount spent per pupil in their current school. Pre-Katrina property tax rates would be slashed. Give people who currently live in the region or who move to it an income tax holiday: no taxes owed to Uncle Sam or state capitals for, say, ten years.

With those kinds of incentives small businesses would flourish--a handful might even become tomorrow's Microsoft or Intel or Apple or Oracle. Job opportunities would proliferate. So would good schools. People would gladly migrate to the region and build anew. Critics may cry that all this would give the area an unfair advantage vis-à-vis the rest of the country. Precisely. Which would lead to another constructive move--making the entire country a true free-enterprise zone. America would prosper as never before.

Unfortunately it will never happen.

Today's Links of Interest.

Some links to consider today:

Russ Roberts at Cafe Hayek quotes a news item about a temp worker hired to protest against WalMart.

Holman Jenkins has a riotously funny rant against politicians regarding price gouging and gasoline prices in the Wall Street Journal (subscription required).  If you can't get this online, borrow someone's print edition -- you really should read this one. 

My hero, Walter Williams, weighs in with his own essay on the role of prices over at Townhall.com...

One of my other heroes, Thomas Sowell, asks the question, "Why do we pay attention to the Consitution in the first place?"

Tom Tanton at the Commons Blog - an excellent blog on free market environmentalism - provides a good overview of Rob Bradley's analysis of oil prices over the years as perspective on events surrounding the energy industry and hurricane Katrina.

Ease of doing business

The World Bank has just released it's Doing Business Report (2006). It looks at 155 countries and ranks them in 10 different catagories (such as registering property, protecting investors, ease of hiring and firing and the licensing requirments when starting a business). The country judged the easiest to do business in - New Zealand. The publication got some press in the New Zealand Herald, but if you want to see the whole report you can find it at http://www.doingbusiness.org/. 

New Zealand businesses are well connected to the United States. The U.S. is the second largest market for Kiwi products (behind Australia) and of New Zealand's import market the U.S is once again second (again only behind Australia). 

If you are interested in learning a little more about New Zealand here is a site with some interesting facts. It's hard to talk about New Zealand without mentioning the sheep. From the interesting facts website,

From the early 1980's, when NZ was home to over 70 million sheep, the population has declined to around 40 million. This means the oft-quoted statistic, that NZ has 20 sheep for each human, is wrong! Nowadays it's only about 10 to 1. This decline hasn't stopped NZ from cornering 50% of all international trade in sheepmeat.

Will Microsoft become the IBM of the 80's?

The last five years have seen Microsoft's sales grow by 73% while profitability has only grown by 30%. Much of the sales growth has come in Microsoft's older products - meaning the newer products glitter but are not gold.

Microsoft was for many years run like a start-up but with Gates stepping more and more into the background, to look at the really big picture, much more of the day to day running of the business has been left to Steve Ballmer.  From an article in Forbes (no subscription required):

Shortly after Ballmer took charge, he began looking at how to build some structure into an unwieldy management process. He interviewed a hundred employees at all levels. What emerged was an attempt to create a system with both accountability and flexibility. He recast the company into seven divisions and ordered each to publicly disclose a quarterly profit-and-loss statement, even though accounting rules don't require such revelations.

"This will be a place with some structure, but structure that aids teamwork, not politics and bureaucracy," Ballmer told employees in a company-wide e-mail in June of last year. "Nothing solves ‘big company' ills quite like a strong focus on accountability for results with customers and shareholders."

The emphasis on accountability is essential for a business to focus on what matters most - creating real value for customers. The challenge with internal markets and internal profit centers is when individual groups become overly territorial and engage in behavior which is sub-optimal for the whole business while appearing to do the "right" thing for their own group. This is the challenge Microsoft currently finds itself facing.   Again from the article:

The seven divisions act as rival fiefs, pursuing overlapping technologies and warring over whose code will prevail in the spaces where different divisions' products interact. "Windows and Office would never let MSN have more budget or more control," says Mark Jen, who quit Microsoft eight months ago. "MSN e-mail should talk to Office Calendar contacts and share appointments from Office with friends and family on the Web. But then MSN could cannibalize Office." The squabbling is delaying the release of the next version of Windows, called Vista. In 2001 Microsoft promised that Vista would be ready in 2003; by mid-2003 it said 2005. Now Vista is set for year-end 2006, the company vows; some analysts say early 2007 is more likely.

The purpose of internal profit centers is to provide individuals within the business information to enable more effective, economic decision-making. If they become nothing more than fiefdoms with managers fighting over resources maybe the managers do not connect with the overall vision of the business or perhaps they just don't have the right people in the right roles.

Competition and Customer Focus

Art Rubinfeld, a former Exec VP at Starbucks, presided over their explosive 3800+ store expansion campaign and he's written a book (Built for Growth) about the lessons learned.  One of them is not to get so focused on your competitors that you lose sight of what's most important -- understanding and giving customers what they want. 

This mistake is sometimes made when getting caught up in military-like strategy development that anticipates competitor responses to your actions, etc.  In a recent interview (subscription may be required), Rubinfeld was asked if entrepreneurs might benefit from studying military tactics in addition to business theory.  In the first part of his response, he mentions drawing inspiration from Sun Tzu's Art of War and Karl von Clauswitz's On War, and continues:

"Probably the most important thing is that military planners constantly do what-if analysis, do backup plans.  They constantly think about what would happen if this or that attack went badly.  Their mindset is to constantly move forward, to keep the other guy retreating.  That preparation, that constant state of alert, that desire to always be moving -- all these have many parallels in business."

While it's silly to ignore the expressive power and insights of war / military metaphors in business strategy... they are often over used and taken too far.  For instance, they aren't accurate for describing markets.  As Mises said in Human Action (p 274):

"Catallactic [market] competition is emulation between people who want to surpass one another.  It is not a fight, although it is usual to apply to it in a metaphorical sense the terminology of war and internecine conflict, of attack and defense, of strategy and tactics.  Those who fail are not annihilated; they are removed to a place in the social system that is more modest, but more adequate to their achievements than that which they had planned to attain."

[...]

"Catallactic competition must not be confused with prize fights and beauty contests.  The purpose of such fights and contests is to discover who is the best boxer or the prettiest girl.  The social function of catallactic competition is, to be sure, not to establish who is the smartest boy and to reward the winner by a title and medals.  Its function is to safeguard the best satisfaction of the consumers attainable under the given state of the economic data."

Rubinfeld intuitively resonates with this perspective in the second half of his response, saying, effectively, that you can get so caught up in the spirit of competition that you forget the whole point of what it is your doing -- anticipating and profitably satisfying customers needs:

"On the other hand, you need to be careful not to get too focused on the competition.  Do you remember when Lotus would introduce three new spreadsheet features and Microsoft would retaliate with five new feature, and suddenly you had 20 new features that nobody could figure out how to use?  Two competitors got so focused on each other they forgot to do something the customer needed.  Responding strictly to what the competitor is doing can also lead to what we call the "99-cent burger wars," where everyone converges on the same features and the only differentiation is price.  That's a losing strategy.  So many analogies exist between business and the military in planning and tactics, but there are differences too."

Ahhh.. Whom do we blame for the tragedy in New Orleans

There is an excellent article responding to Ann Rice (the noted author and a resident of New Orleans) in National Review online by Jim Geraghty. To see the article and Rice's criticism of the Federal government click here. (No subscription requried)

The two key takeaways from the article - blaming the Federal government is just misinformed (at best) and the lawlessness in New Orleans has been much more servere than during other disasters because corrupt local officials have not fostered an environment in which the law is respected - in fact elected officials are both corrupt and incompetent (not a good combination).The article points out that even "the law" doesn't respect the law in New Orleans. From the article

"I would also note that this is one hell of a police force your local officials hired and that you and your neighbors tolerated. 50 percent turned in their badges during the crisis and quit. Your police superintendent is conceding that some cops were looting."

Worth a read!