Author: navin

If free market is so great, why do “companies” exist?

One of the fundamental lessons of economics is that in a free market, prices determine what gets produced and by whom. If onions are in short supply somewhere, the prices of onions rise, then more farmers switch to planting onions and the supply problem is met. And this is one of the most efficient ways of organizing production of the world.

But obviously, this is now how things work within a company. You do what your boss tells you to do. If he wants TPS reports, he doesn’t announce this fact to all the employees and give the job to the one who quotes the lowest prices. He simply tells you to do it because “it is your job”.

So how does economic theory handle this apparent contradiction?

This essay tackles this problem. First the problem definition:

So, one day the boss has this crazy thought. He asks himself a question that has never occurred to him before: Why have any employees at all? Why have a building? Why not just sit home, wearing his jammies and bunny slippers, sipping a nice cup of tea, and outsource everything? He can write contracts to buy parts, he can pay workers to assemble the parts, and he can use shipping companies to box and transport the product.

The boss is elated. He never really liked these people anyway. Always asking questions, constantly looking for direction and expecting him to know the answers. He fires all his employees, effective one month from now, and takes bids on all the design, parts manufacture, assembly, and shipping that those people used to do.

On day 31, after all those wasteful employees are gone and the new contracting efficiency regime is in place, the boss has a nice breakfast, pours his tea, and puts his bunny-slippered feet up on his desk at home.

So what is wrong with this picture? Why aren’t all companies in the world structured this way?

If prices and competition do such a terrific job of directing resources (and they do!), then why are there firms? Why are there hierarchical organizations that are internally directed by command and control, rather than the price system? Why not outsource everything? Why don’t bosses sit home wearing bunny slippers?

The problem is the overheads introduced:

Each step, each break in the production process from one artisan to another, would require negotiations, a transaction, payment, and transportation of the product to the next step.

Obviously, that’s silly: no [company] could work that way. The cost savings from division of labor would be swamped by the increased cost of negotiating and carrying out transactions, and monitoring quality.

But that’s only a partial answer. The real question that needs to be answered is:

The task of the economist, then, is to explain two phenomena with just one theory. First, why are firms more efficient than markets at organizing some transactions? Second, if firms are so efficient, why are there any market transactions at all? What determines the margin where the firm stops organizing additional transactions internally, and buys goods or services instead through the market?

Will this mean the end of free-market theory? Will the author succeed in saving economic theory from imminent doom? For answers to this and all other questions, read the thrilling conslusion in the original essay.

Prediction: Very bad weather in 2008

A great article from the New York Times:

I’d like to wish you a happy New Year, but I’m afraid I have a different sort of prediction.

You’re in for very bad weather. In 2008, your television will bring you image after frightening image of natural havoc linked to global warming. You will be told that such bizarre weather must be a sign of dangerous climate change — and that these images are a mere preview of what’s in store unless we act quickly to cool the planet.

Unfortunately, I can’t be more specific. I don’t know if disaster will come by flood or drought, hurricane or blizzard, fire or ice. Nor do I have any idea how much the planet will warm this year or what that means for your local forecast. Long-term climate models cannot explain short-term weather.

But there’s bound to be some weird weather somewhere, and we will react like the sailors in the Book of Jonah. When a storm hit their ship, they didn’t ascribe it to a seasonal weather pattern. They quickly identified the cause (Jonah’s sinfulness) and agreed to an appropriate policy response (throw Jonah overboard).

[…]When judging risks, we often go wrong by using what’s called the availability heuristic: we gauge a danger according to how many examples of it are readily available in our minds. Thus we overestimate the odds of dying in a terrorist attack or a plane crash because we’ve seen such dramatic deaths so often on television; we underestimate the risks of dying from a stroke because we don’t have so many vivid images readily available.

Slow warming doesn’t make for memorable images on television or in people’s minds, so activists, journalists and scientists have looked to hurricanes, wild fires and starving polar bears instead. They have used these images to start an “availability cascade,” a term coined by Timur Kuran, professor of economics and political science at Duke University, and Cass R. Sunstein, a law professor at the University of Chicago.

The availability cascade is a self-perpetuating process: the more attention a danger gets, the more worried people become, leading to more news coverage and more fear. Once the images of Sept. 11 made terrorism seem a major threat, the press and the police lavished attention on potential new attacks and supposed plots. After Three Mile Island and “The China Syndrome,” minor malfunctions at nuclear power plants suddenly became newsworthy.

See full article. If you want to get confused about global warming, it might be a good idea to see Al Gore’s An Inconvenient Truth, and then go read Michael Crichton’s State of Fear. That should convince you to stop getting involved in weighty issues like this and go back to Rakhi Sawant’s antics.

See also my earlier post on global dimming.

By the way, Al Gore’s movie is an excellent example of how to give a good Powerpoint presentation – as opposed to the bullet-point ridden junk that you usually turn out. (Essentially the entire movie is a Nobel-prize winning slide show presented by Al Gore.)