Market-Based Management®

Economists Heart the Planet

A new report from the Energy Information Administration (EIA) shows that U.S. emissions of carbon dioxide (CO2) declined by 78 million metric tons or 1.3 percent in 2006 (HT: Volokh Conspiracy). Meanwhile, according to the Bureau of Economic Analysis (BEA), the U.S. economy grew by around 3.1-3.2 percent in 2006. The confusion is already setting in, and everyone is pointing fingers at the weather. Indeed, I can think of few instances (if any?) where an economy grew rather robustly and experienced a fall in CO2 emissions.

One of my favorite topics in our recent Sustainable Economic Development course was the role of development and the environment. A lot of people think that there is a tradeoff between the two—a country can have either a developed, growing economy or a clean environment. However, most scholarship suggests that economic growth and environmental protection are linked. This is initially because as economic growth starts to satiate more peoples’ most pressing needs (food, water, shelter, work, etc.), folks can then concentrate on the things that are important but less so than basic needs—like the environment. Hence, a certain level of development is needed to have an environmental movement at all (ever wonder why environmental movements seem to be dominated by people from rich countries?). Secondly, as societies grow richer, they acquire the resources necessary to solve more environmental problems. They can then afford the new water treatment plant or finally manage to replace their old, dirty power plants with new ones. True, there is usually an uptick in pollution as economies get going, but environmental damage per unit of GDP actually starts falling at around $6,000 per capita GDP. For example, in the U.S. the economy has roughly tripled over the last 30 years, while the amount of pollution has halved. However, this is not a new trend. Pollution in the U.S. peaked in the 1920s—meaning that emissions of major pollutants actually started declining fifty years before the creation of the EPA. Nor is this trend due to some mistakenly perceived decline in manufacturing; U.S. manufactures are actually churning out more “stuff” than ever before.

The reason for this trend is simple progress. As people discover better ways to do things, they inevitably cause less environmental damage. New machines, cars, and appliances are almost always cleaner and use less energy than those they replace even in the absence of new regulations. The result in the U.S. has been a steady decline in major pollutants, such as nitrogen dioxide (NOX), sulfur dioxide (SOX), carbon monoxide (CO), etc. That being said, the emission of one particular gas (sorry there are differing legal and economic opinions as to whether it is technically a pollutant) has bucked this trend. This gas is carbon dioxide (CO2), and economies tend to produce more of it as they grow and demand more energy.

Despite the rise in CO2 emissions common to economic growth, some have postulated that these emissions will eventually follow the major pollutants and decline. The thought has been that CO2 simply will just begin to decline at a much higher level of GDP than other gases. Well, the EIA’s numbers could very well indicate the beginning of this trend. Of course, it could be the weather, or a strange combination of circumstances, rather than the beginning of a long-term trend. However, CO2 emissions don’t fall outside of recession very often (if at all?). Let us hope that this is the beginning of a long-term trend and not unusually pleasant weather; but rather the fact that as Americans grow ever wealthier they are replacing their older, less efficient homes, cars, appliances, and machines with newer, more environmentally friendly ones.

Unintended Consequences: Are Smoking Bans Driving People to Smoke, Hire Chefs?

This article from the BBC provides an amusing and thought provoking illustration of the rule of unintended consequences. The rule of unintended consequences says that when new laws or rules are imposed, people often change their behavior in response to the new constraints or stimuli in some very unexpected ways--often which run counter to the intent of the law put in place.

A lot of folks (especially lawyers) seem to think that if you promote or restrain certain behaviors, then that is all you get. However, they fail to understand that people will adjust their behavior as they see fit and not necessarily as others wish them to. As the world is a complicated fabric of individual actors, the unintended consequences of rule changes can be many, varied, and downright bizarre. It is the reason that the legislative process (or indeed company policymaking) can sometimes resemble a game of “whack a mole.” A perceived malady will pop up and get beaten down, only to produce many other effects that may either be good or bad but entirely unexpected.

Anyway, the article is on the unintended consequences of the smoking ban in bars in Scotland. There are some real surprises. And if you want a challenge, try to think of a few ways that a smoking ban may actually get more people smoking before you read the article.

The Amorality of Markets

Sorry for the lack of posts lately, but after I started getting e-mails from folks reading posts, I came to a frightening realization—people are actually reading this! So, chalk up the recent dearth of posts, to some stage fright, and let’s get to a topic or two.

There has been a lot of talk in this town (and across the country) about various lending practices to the poor, students, first-time homebuyers, etc., and it brought to mind an important characteristic of markets that is often overlooked. As markets are made up of people, they reflect what these people want. Markets do not judge; they provide. Therefore, a market is not “immoral” but amoral. Now, folks can want some pretty unpleasant stuff sometimes, so this is not to say that some markets shouldn’t be subject to some pretty hefty restrictions or prohibitions (kiddie porn comes to mind). However, we must recognize that if people want something and are willing to pay for it, then someone will usually be willing to provide it. The lending of money is no exception.

Poor people—like everyone else—want credit, with which the market provides them. If actions are taken to curtail the lending of money to the poor via usury laws or other methods, then this will not change the fact that poor people will still want to borrow money. So if the local “payday” loan store is shutdown, or the usual lenders refuse to lend at legal (artificially low) rates, then poor folks will find a willing lender in the form of the local loan shark. The problem with the local loan shark is that he will not only ignore the usury law, but is also likely to discard those pesky bankruptcy laws if debtors default. Liquidation proceedings could mean just that.

Anyway, the point is that folks who are quick to blame “immoral,” “unscrupulous,” or “unrestrained” markets often fail to recognize that what they are observing is simply the market trying to provide people with what they value—for better, for worse, moral, immoral, and amoral.   

The Halo Effect

As you may know, last night was Game 1 of the Eastern Conference Finals, pitting the Cleveland Cavaliers against the Detroit Pistons. I watched both the game and the coverage afterward, noting the musings of one particular sportscaster on SportsCenter who said something along the lines of the following,

If the Cavaliers had won last night, LeBron James would have been celebrated for pulling off a triple-double and leading his team to victory.  Alas, in the closing seconds of the game, James passed the ball to Donyell Marshall who attempted a three-point shot that would have put the Cavs up by one.  But Marshall missed.  Instead discussion of James’s performance will be about how he only had ten points and zero free throws.

A quick disclaimer, this isn’t a perfect quote, but you can see where it’s going. 

I recently read a book entitled The Halo Effect…and Eight Other Business Delusions that Deceive Managers by Phil Rosenzweig, which highlights the phenomenon to which this sportscaster was alluding.  The book discusses how we are fundamentally unable to separate evaluations of performance from the apparent results of those efforts.  In this case, Dr. Rosenzweig talks about the Halo Effect in the context of management writing.  He highlights how, in almost all research into the subject—and certainly in the case of top-selling management books—the methodology is to take a group of successful firms and ask their managers what led to the success.  Because the sample is contingent upon the results, the answers are shaded by the Halo Effect. 

In essence, it’s not so much that successful firms necessarily have great culture, inspirational teamwork, and transparency—characteristics that are often attributed to them through this “research” process.  It’s that in hindsight, managers of successful teams or firms tend to say that such is the case.

While reading the book, I couldn’t help but think about the application of this phenomenon to sports.  Rosenzweig spends considerable time talking about how there is no formula for success, but even more that success is relative.  An organization can adopt all the newest technology and break their own revenue records, but they're only going to get ahead by outperforming their competitors.  Relative performance matters.  The same clearly holds true in sports, which is inevitably what brings a dynasty back down to earth after a few years on top.  Despite relatively stable knowledge and a pretty limited number of variables (at least compared to say, the tech industry), the three-peat remains ever elusive for most teams.

Rosenzweig is wise to warn us to be careful of the Halo Effect in analyzing success in the firm.   He points out that “[s]trategy always involves risk because we don’t know for sure how our choices will turn out.” (p 145)  A certain amount of failure is the predictable result of taking risks, no matter how calculated.  Rosenzweig contends that the trick is navigating risk such that failure will not be detrimental to your operations.  This is indeed what LeBron James attempted to do last night in evading a double-team by passing the ball to a wide open teammate with a stellar three-point record.  He took a risk, and it didn’t work out.  He defended his decision by saying, "The winning play when two guys come at you and a teammate is open is to give it up. It's as simple as that. You're going to make some, and you're going to miss some. Unfortunately, that one was to win the game."

Much like those journalists who cover business news, sports writers have been unable to separate their knowledge of the game’s result from their analysis of James’s decision to pass the ball.  "[T]he only thing anyone is going to remember about Game 1 of the Eastern Conference finals, won by Detroit 79-76, is this: With the game on the line, LeBron James didn't take the biggest shot. He let Marshall take it instead." (ESPN)

(In) Elastic Gas

Here we go again with the gas prices. Although the reasons behind high gas prices are often complicated, there is a major cause that is always almost ignored when people talk about gas prices—elasticity.

We are all familiar with the concept of supply and demand. If a price goes up, then suppliers will supply more quantity and consumers will demand less. When prices fall, consumers will buy more, while suppliers cut back on production. Easy enough, but people often forget that, while price changes will cause buyers and sellers to alter their behavior, the question remains, “but by how much?” Economists measure “by how much” with a concept called elasticity. If a price change of a good causes people to alter their consumption or production behavior dramatically, then the good is said to be elastic. If the quantity supplied or demanded changes very little in response to a change in price, then the good is said to be inelastic. The problem with gasoline is that both its supply and demand are highly inelastic. As gas prices rise people complain a lot (I know I do), but we really do not cut back our consumption very much. The same is true with supply. With prices high, refiners would love to bring more gasoline to market, but they are running into capacity, maintenance, and regulatory roadblocks, so, at least for the immediate future, they can only squeeze so much gasoline out of their capacity—no matter what the price does.

Unfortunately, this leaves the consumer in a tight spot. The law of supply & demand dictates that the quantity demanded must equal the quantity supplied. Something has to give and that something is price. Since peoples’ gasoline consumption barely budges with rising prices, then prices have to rise considerably in order to bring the quantity supplied and demanded into equilibrium. To put it another way, if the U.S. wanted to halve its gasoline consumption, then it would not merely be a matter of doubling the price, but most likely quadrupling or quintupling already high gas prices. There is already a lot of talk about gas prices, and there is only going to be more. However, with all the hot air to be bellowed and ink spilt, there will likely be nary a mention of the “e” word.

The Rule of Law and the Cafeteria

One of the hallmarks of a free and prosperous society is the rule of law, and more importantly that those rules apply to everyone. All should be equal before the law, which should not award different legal status or rights to various “classes” of people. Such was the triumph of English law, which applied to King, noble, and commoner alike (at least de jure but not necessarily de facto—however the latter seldom ended up in writing). If the laws apply to the governors as well as the governed, then society will likely benefit from better rules, as the governors will feel the same pain or benefits they impose on everyone else. People will also feel more secure in their persons and possessions and thus create more value for society if they know they can rely on rules, like “thou shall not steal” applying to those who rule over them.

The same should be true inside the firm. Although different rules may apply for different job descriptions, the same core rules should apply to everyone, so that those making the rules can personally experience feedback on their burdens or blessings. The result should be good rules for the firm that promote a healthy work environment.

A good example can be found in the in the cafeteria at Koch Industries (Café Koch). A few months ago, Koch changed food vendors. The food had always been pretty good, and many employees speculated that the company was trying to save money and that they were about to lose what had been a benefit. That was until someone said, “Hey, Charles Koch (the CEO) eats down here too, so it’s not like he’s not going to know if the food goes bad.” All of a sudden people stopped worrying about the impending switch in food vendors. If employees know that changes affecting them will also affect those making them, then they are less likely to worry and more likely to “buy in” to the changes made.

Incidentally, more people are eating in Café Koch, which is undoubtedly improving morale and productivity. And if the food ever slips, Charles Koch won’t need a memo, just his lunch.