Market-Based Management®

Markets Fail When You Make Them

Ok, I made a bad prediction in my previous post about gasoline coming to Georgia in the wake of Hurricane Ike. I know it was a bad prediction, because I drove to Atlanta Airport on Sunday and did not see a single gas station with petrol (although news reports say about half do). So why was I wrong, and why has the market appeared to fail? First of all, my prediction was based on the premise that the market would be allowed to work. Gas can be found in the Southeast—just not in Atlanta. Why did every station I saw in rural Mississippi and Alabama earlier this week have gas, while those in Atlanta did not? The answer is that it would be illegal to sell the gas available in the country or suburbs in Atlanta proper. The American gasoline market is not a single unified market, but a deeply fragmented patchwork of markets where federal clean air mandates dictate what types of gasoline (called boutique fuels) can be sold where. Because of its air pollution problems, only a special boutique fuel can be sold in Atlanta. After hurricanes Katrina and Rita, the federal government wisely suspended these fuel mandates and momentarily recreated a national market for gasoline. While this measure did have a temporary effect on air quality, it prevented many of the shortages that we now see today. Unfortunately, the feds did not follow this policy after Ike, but kept the mandates in place, which is the reason that Atlantans wanting to fill up either have to wait for scant fuel deliveries or dive to the suburbs or country.

Another curious going on is that when there is gas in Atlanta, prices do not appear elevated and are roughly on par with those before the hurricane. So why with all this scarcity, are gas stations charging prices close to pre-hurricane levels? The answer probably lies in the overt threats from state and federal officials that they will go after price “gougers” for selling gasoline at high prices. As I mentioned in the previous post, the Georgia price “gouging” law is fairly toothless and not even currently applicable (the governor has to declare a state of emergency for the statute to come into force). I erroneously believed that the benign nature of this law would not impede rises in Georgia gas prices and subsequently encourage conservation and supply. However, most gas station owners are either only vaguely aware of this or think the feds will get them instead. The effect has been a de facto price ceiling on gas prices in the Atlanta area, which gives motorists the incentive to snap up gas when it is available, rather than weighing much higher prices (say $8 a gallon) and buying only a few gallons at a time. This is exactly what I—and everyone else ay my neighborhood station—did when a gasoline shipment arrived. As a result, folks who would otherwise drive around with half or quarter tanks fill them up (and top them off) whenever possible. I am running with a full tank right now but would have left more for my fellow Atlantans had the price been higher. Unfortunately, the situation has unleashed my (and apparently everyone else’s) inner speculator.

Why there will be Gas in Georgia

With the approach of Hurricane Ike, I started to wonder if I should fill my gas tank prior to the inevitable disruption in the nation’s refining network. However, a quick google search revealed that Georgia (where I am) has a very tame anti-price “gouging” statute, which only comes into force when the governor declares a state of emergency (unlikely considering the state of emergency is in Texas). At the same time I noticed that those states neighboring Georgia (primarily Tennessee, South Carolina, and Florida) have more strongly worded statutes, and their public officials have been making noises about enforcing them come the inevitable spike in prices. In a market economy, prices provide the knowledge governing production, distribution, and consumption. If you monkey with this system by implementing a de facto price control in the form of an “anti-gouging” law, then you recreate the foolishness of the price controls of the early and late 70s. Of course, the full impact depends on Ike, but even if some shortages occur in Georgia; we will certainly fair better than our neighbors to the north and south.

Spontaneous Order Revealed

Spontaneous order is a key mental model in Market-Based Management and is loosely defined as the miraculous emergence of order from the seemingly chaotic interaction of billions of human beings. Adam Ferguson famously described it as "the result of human action, but not the execution of any human design." In MBM, spontaneous order represents our mental model of how the world works. That is, the world is made up of billions of self-interested individuals who provide for one another by pursuing their own self interests. If an individual or business fails to provide for others, then it will fail in providing for itself. I was acutely reminded of spontaneous order while viewing this short clip on the BBC. It depicts GPS tracking of ships, planes, and taxis (among other things) traveling in and around the British Isles within a 24 hour period. Not only is the clip amazing, but it serves a reminder that chaos is often not so chaotic.

When No One is Accountable

There is a fantastic post by former Treasury Secretary Larry Summers over at Creative Capitalism (HT: EconLog’s Arnold Kling) on the bubbling problems at Fannie Mae and Freddie Mack. I will let the post speak for itself, but for decades politicians have trumpeted the idea of public-private partnerships, as a sort of “third-way” where the supposed deficiencies of markets and government cancel one another out. Unfortunately, as evidenced by the growing troubles at Fannie and Freddie, this combination of conscience and profit is probably responsible for much of the trouble. What does one of these partnerships tell its private shareholders when there are no profits? It tells them that the company’s social obligations are to blame. What about when the partnership fails in its social obligations? The company explains that it has done so in order to fulfill its obligations to profit its private shareholders. As for the shareholders, should they keep an eye on the company’s books or question its debts and lending practices? Why bother, since the partnership’s debts are guaranteed by the government. In the end, we are left with a perfect storm of unaccountability—be careful of mixing two worlds, you may get the worst of both.

Creative Destruction Threatens Snail Shortage

Where have all the good snail collecting jobs gone? The answer appears to be nowhere—the problem is finding people willing to fill them. Snail gathering is hard work, but someone has to do it—otherwise Europe’s gastropod lovers (the French in particular) will go without escargot. Unfortunately, relatively high wages in France and the extension of protections to some species of snail nudged the French snail industry into slow decline some years ago. Fortunately, the demise of the Berlin Wall brought a flood of slimy molluscans from Eastern Europe, as impoverished villagers in Poland and Bulgaria proved only too happy to perform the dirty work and keep the escargots flowing.

That was until economic development in Eastern Europe brought better things to do, and would-be snail gatherers have moved on to more rewarding occupations. Now there is consternation in France that foreign supplies of snails may dry up and deprive Frenchmen of their beloved escargot. The pending snail crisis is an example of newer and better jobs crowding out the old—a process the great economist Joseph Schumpeter popularized as “creative destruction”. By providing greater opportunities, the rising tide of Eastern European prosperity is simultaneously destroying its snail industry. This is a telling reminder that, while we are bombarded with tales of this or that industry failing or moving oversees, the truth of the matter is this is often a symptom people of a country finding better things to do. At the same time I fear not for the French. I am sure they will get their snails from somewhere, as the nations of Eastern Europe pass the torch of snail gathering to peoples with lower opportunity costs, who will be delighted (and much better off) for receiving it.

The Importance of Vetting Knowledge

MBM talks a lot about collecting and sharing knowledge. However, we sometimes don’t stress the need to understand exactly what that knowledge means. Often what appears a clear connection is really quite meaningless. I was reminded of this by an article in today’s Arizona Republic (HT: Coyoteblog). The article complains that consumers are being “gouged” by faulty gas pumps. Apparently, about 9 percent of Arizona’s inspected gas pumps failed tests by the State’s Department of Weights and Measures. The article is full of innuendo and numbers implying there is something rotten in the state of Denmark (or at least Arizona). Despite the tone of the article, the fourth sentence begs some curiosity:

Half of those [pumps] were malfunctioning to the detriment of customers.

Faulty pumps are not good, and people getting ripped off is not good; but if half of the malfunctions cause detriment to customers, then what about the other half? Are some of the good people of Arizona getting a little free gasoline? Of course, I do not doubt the need for governments to standardize and inspect weights and measures (the practice dates to the Magna Carta (clause 35) in the Anglo-American tradition), but the little nugget on the impact of these inaccuracies tells us that this situation is probably happenstance or, at worst, neglect on the part of the pump owners. Interestingly, the article also mentions that it can cost up to $800 to recalibrate a pump, which considering the thinness of margins in retailing gasoline (only a few pennies on the gallon), is probably incentive enough to recalibrate infrequently—as opposed to deliberately fiddling the pumps. Furthermore, as the fine for a first time offense is only $300, it makes perfect sense for the gas station owners to have the state come out and do the inspections for them (paying the fine and fixing the affected pumps should be much cheaper than constantly re-calibrating of all of them). So, while malfunctions of 1 out of 11 inspected pumps causes us to quickly jump to conclusions, a little vetting of information reveals nothing more than perhaps the nature of pumps, happenstance, poor incentives, or the combination of all three—meaning only a few lines tell the whole story, and they don’t match the rest of it.

Entrepreneurs and Disaster

Last week ago, I was struck by this Wall Street Journal article recommended by Jamie Peterson at INVISTA. The article concerns the sprouting of entrepreneurship in the aftermath of the recent devastating Sichuan Earthquake in China (unfortunately, reading the full article requires a Wall Street Journal subscription).

Interestingly, entrepreneurs are often the first to swing into action following a natural disaster (the first trainloads of lumber for rebuilding arrived the very day after the Great Chicago Fire of 1871). However, sometimes the imposition of price controls and “anti-gouging” statutes quash these efforts by removing the incentives needed to induce the effort. Although price spikes following natural disasters are common, price controls only force the squandering of scarce resources within the affected area, while choking off flows of supplies from outside. If allowed to operate, the price mechanism usually forces prices back down fairly quickly and sometimes even gluts the market.

I wrote about this phenomenon a couple years back in the ABA's Journal of Natural Resources & Environment, and economist Russ Roberts has dedicated his latest work of economics-influenced drama to the topic. However, the overwhelming need for flexible markets following natural disasters is not the purpose of this post: it is that, despite decades of being told to despise entrepreneurship and other “bourgeois” values, in the wake of disaster, many Chinese discovered their inner entrepreneur. A lot of folks make silly comments like “markets are not compatible with _____ culture” (personally, I blame this false mental model on Max Weber’s attributation of capitalism to some vague notion of “Protestant work ethic”).

The Sichuan Earthquake reminds us that people are naturally entrepreneurial. Entrepreneurship is in our blood and no amount of cultural conditioning or even brute force can completely stamp it out (considerer the phenomenon of black markets). Of course, some countries exhibit greater levels of entrepreneurship than others, but this is because some countries do a better job of facilitating the human desire to benefit one’s self through the service of others. True, one’s inner entrepreneur maybe repressed by governmental, cultural, or overly bureaucratic corporate environments, but it is always there; and a little shove from within makes a much better catalyst than an earthquake.

The Heroic Entrepreneur

Most folks tend to think well of entrepreneurs. We cannot help but admire those who work two jobs to scrap together capital, while tinkering away in their garages or basements at night. Of course, the opinions of some tend to diverge after the erstwhile struggling entrepreneur transforms himself into something resembling a captain of industry, technology, or even coffee, but even the critics of free-market capitalism cannot help but offer grudging respect for the energy, effort, and chances taken by the entrepreneur.

While we admire the entrepreneur, we often forget that bygone entrepreneurs used to risk much more than bankruptcy or the other adverse effects of over work—they often put their lives on the line to provide goods or services for others. Nathaniel’s Nutmeg: How One Man’s Courage Changed the Course of History is the story of the first English traders who ventured to the East Indies (present day Indonesia). From rough seas, scurvy, and rotting ships to the literally “cut-throat” competition from the Dutch and native cannibals, Nathaniel’s Nutmeg details how entrepreneurs in search of fantastic profits risked, and often gave, their lives to feed Europe’s demand for spices. Ten pounds of nutmeg that cost less than one English penny in the East Indies would sell for two and a half pounds sterling in London—a markup of 60,000 percent! Of course, the King would take a reasonable cut, but there was little talk of windfall taxes on the lucky few who returned to fortunes and a lifetime of free drinks exchanged for tales of the East Indies.

The story itself centers on the tiny (about two and a half miles long) East Indian island of Run, which, although almost completely forgotten, used to be one of the most famous places in the world. One of the more inaccessible of the Spice Islands, it was here that English traders befriended locals and bought huge cargoes of nutmeg under the noses of the powerful Dutch East India Company. After years of being piqued by the cheeky English, the Dutch eventually attacked and seized Run triggering war between the two countries in the 1660s. At peace negotiations in 1667 (following two years of stalemate), the Dutch and English settled on an exchange of territories each had seized from the other. The Dutch would gain control of Run, while the English received what had been the disappointing colony of New Netherlands, which we now know as New York City and New York State. At the time, most observers thought the Dutch got the better of the bargain.

Property Rights, Spontaneous Order, and Clearing the City

On a recent trip to Chicago, I turned in amidst heavy snowfall.  I awoke to find the sidewalks completely clear and thought that the City of Chicago had indeed done a fine job.  While walking around town, however, I realized that the city’s contribution had only extended to the streets.  Although it was Sunday, all across the city, shop keeps, restaurant and bar owners, doormen, and even construction workers from idle worksites had come out of the woodwork to clear the sidewalks in front of their establishments.  The doormen even went as far as to give the crosswalks a second look and cleared the heavy low walls piled up between the street and crosswalk by the street plows. 

Thanks to the overlapping individual actions of thousands of people there was nary a snow and ice covered sidewalk in all of downtown Chicago.  Why did all these people go to so much trouble?  I would venture because the owners of apartments buildings and businesses saw benefit in clearing their sidewalk for their customers.  Thus, thousands of self-interested actions cleared the paths of downtown Chicago. 

Despite this concerted effort a single stubborn piece of sidewalk remained uncleared.  Let’s just say I would recommend avoiding the pavement edging the post office.

What Affects "Them" Affects You

Although they are necessary, I have yet to find anyone who likes paying taxes. However, there is no shortage of people who like it when others meet their tax bill for them, which is why I love the lottery. Consider the 1990 imposition of luxury taxes on expensive cars, jewelry, furs, private airplanes, and yachts. What is there not to like? As I consume none of these goods, then those who do presumably reduce my tax bill (or lessen the amount of government borrowing that I will have to pay for later).

Unfortunately, these very popular luxury taxes did not quite work according to plan. The $31 million in revenues the taxes were supposed to have raised ended up being only $16.6 million; as those who would have paid the luxury tax just bought their yachts and jewelry in other countries or switched their consumption to other goods they valued not covered by the tax.

At the same time, the drop in demand for luxury goods led to the elimination of an estimated 330 jobs in jewelry making, 1,470 in aircraft manufacture, and 7,600 in the boating industry. These job losses ended up costing the government $24.2 million in lost income tax revenue and unemployment benefits. So the tax on "them" actually produced a $7.6 million hole in the government fisk that had to be made up somehow—presumably by taxing you and me or cutting the government services we receive.

The surprising news is that the government always seems to learn its luxury tax lesson very quickly. Congress repealed most of the 1990 luxury taxes in 1993, and had apparently done the same in 1965 after similar shenanigans.

However, we sometimes observe a very similar (and equally destructive) "let them pay" attitude in large companies. Often large, multi-divisional companies will contain certain services that are available to all groups and businesses within the company. Information technology or facilities management are good examples. One of the most popular ways to pay for these services is for the company to add up all of the expenses and assess them across the different business groups in the form of a tax. Unfortunately, as everyone pays into a common pool and receives communal services, the incentive is for the different businesses to make excessive demands.

For example, a business may demand complicated and costly additional services from IT that may only yield marginal value. The same business may also make excessive use of facilities management—ordering the whimsical movement of walls, painting and repainting, frequent office swapping, and expensive furniture and fixtures. The business groups assume that while they pay for some of the services they receive via the assessment, any expenditure in excess of the tab will be picked up by the contributions of other businesses. This "let them pay" attitude is very quickly adopted by the other businesses, which are quick to drive up their own expenses. As a result, the "tax" needed to cover the communal services has to be raised every year. Expenses quickly spiral out of control and lead to conflict between the businesses, who complain that the support services cost to much, and the support services, who complain that the businesses ask too much of them.

The solution to this all too common problem is the internal market. If business groups pay directly for the support services they receive, then they will tend to consume only those services that produce the most value for the business. Although not unique to MBM, internal markets are very much a part of it. Because, to paraphrase Milton Friedman, when you spend someone else's money on yourself, then you are really going to have a good lunch!