Stumbling and Mumbling

The cost of ambition

Sammy Lee’s sacking by Bolton Wanderers raises a general point - that ambition can be economically damaging as it can lead to a misallocation of resources.
It’s widely agreed that Lee was an excellent assistant manager, but a poor boss, partly - it seems - because his efforts to assert his authority backfired.
Lee’s ambition to be boss has been bad for Bolton and perhaps for him too. Both parties might have been better off if Lee had shown less ambition and more self-awareness - if he‘d known that he was a fine number two but not a boss, as Portsmouth‘s Joe Jordan seemed to realize.
I suspect the Stupid Party and William Hague made a similar error in 1997. If Hague had figured in 1997 “I’d be a poor leader as I’m insufficiently telegenic and too young; my considerable skills would be better used in other roles” the Stupid Party might have been stronger.
And of course there are countless companies which have illustrated the Peter principle, by promoting people beyond their competence.
So, why does this happen? I reckon there are at least three problems:
1. Directors (and voters?) are bad at spotting talent. A man’s over-ambition would be no problem if the people hiring the boss could spot that he wasn’t cut out for the job. But they can’t - especially, but not only, if they are football chairmen.
2. Wage differentials between top bosses and their juniors are huge.  It pays better to be a bad boss (subject to keeping your job) than an excellent worker. So people go for the boss’s job simply for the money, not because they’d be good at it.
3. Autonomy is limited. People often want to be boss simply because it’s the only way to get freedom over one’s job, to make the difference to an organization they think you can make.
It’s natural enough for people to be ambitious, and to be over-confident about their abilities. But is it really rational to have organizational structures that increase vulnerability to over-ambition?

Skype's lessons

Ebay has admitted what equity analysts have long known - that it paid over the odds for Skype. I reckon there are three general lessons to be learned here:
1. Innovative companies don't often make money. As William Nordhaus showed (pdf), the benefits of innovation flow to consumers, not shareholders. Instead, firms make money by having the power to exclude rivals and kill competition. And Skype can't do this. Not only are there lots of competing Voip systems, but it's also hard to compete against cheap call charges in the US.
2. Synergies are over-rated, diseconomies of scale are under-rated. Ebay hoped that Skype would somehow drive traffic to its auction business. This never happened.
This corroborates one of the messages of this paper (pdf) - that mergers work best when they aim to cut costs, rather than raise revenues through synergies; remember AOL-Time Warner?
3. The price elasticity of demand is very high between a free service and a paid-for one.  If you try charging customers for something they can get for free, they'll often leave. Just ask the FT or New York Times. This is entirely consistent with this; once you  charge for something, you break the norm of reciprocity, and signal to customers that we're in the realm of homo economicus, so they act accordingly.

The Met sees opportunity cost

Congratulations to the Metropolitan Police. Sure, they waste time and money. But at least they account for that waste properly:

A Scotland Yard report delivered to the Metropolitan Police Authority (MPA) stressed "a large proportion of costs quoted [of policing Brian Haw's demonstration] do not represent additional costs to the MPS.
"Rather, the officers and other staff assigned to a given operation would be assigned to other policing duties or operations," the document added.

So, the Met knows about opportunity costs. In this respect, it's more advanced than most companies.
You'll not read about opportunity costs in the average company's accounts. Few firms say explicitly: "we made £x million on this project, but that's a loss of £y million compared to putting the money in the All-share." Even fewer regard a potentially profitable venture that they failed to pursue as a cost of funds.
One exception here is Koch Industries, the private firm run on market-based management principles. In The Science of Success, Charles Koch writes:

To encourage entrepreneurship among our employees, including appropriate risk-taking, we began to consider the profit foregone from an opportunity missed to be equivalent to a book loss.

But you don't often find this idea used in publicly-quoted hierarchical companies.
Is there a more damning indictment of these that there are not even as economically literate as the Dibble?

Groupthink in companies

This survey of executives in the McKinsey Quarterly suggests that groupthink contributes to  bad decision-making: 

Only about a third of respondents, for instance, say executives frequently disagree about the attractiveness of future growth opportunities—hardly a topic that would seem to lend itself to unanimity. What’s more, a majority of respondents say it’s at least “somewhat” important to avoid contradicting superiors.

This can be expensive. Executives think that 19% of their firm's capital investments should never have been made.  That suggests that firms waste around £25bn a year in the UK alone.
And this could be an understatement:

Roughly 40 percent...don’t have a point of view on how many investments should be terminated. This figure could be a warning sign that postmortem analysis is infrequent at many companies.

This might be the disconfirmation bias at work; people don't like to look for evidence that might prove them wrong.
All this is striking because the survey contains a selection bias in favour of finding executives who approve of their firm's behaviour. An executive who thought his colleagues were all ignorant toadies who wasted millions of pounds on crack-brained investments would probably not stay with his firm for long.
So, perhaps this shows that traditionally-organized firms are a poor way of making decisions.
Or am I  guilty of the confirmation bias?

How to manage talent

The Times has a supplement advising bosses on how to manage talent. It doesn't give the most important advice of all - the best way to manage talent is to find ways to do without it.
The fact is that money flows to power. If your business is dependent upon talented performers, they've got you by the Davinas. They'll make money and you won't. This is why football clubs have for long been bad businesses. They suffer what Alan Sugar called the prune juice effect - money comes in and goes straight out to players.
The question of who has what power is, therefore, central to thinking about companies, as the marvellous Luigi Zingales discusses here (pdf). The question for bosses, then, is: how to increase their power (and hence profits) by reducing reliance on talent.
Ways in which this is done include:
1. TV. Find formats that work without stars. If you make the Paul Daniels Show (God forbid) you need Paul Daniels and he'll hold you to ransom. If you make Big Brother or the X Factor, you can exploit wannabees.
2. Film. Use CGI and special effects rather than rely on stars. Shrek won't demand $50 million for a sequel, join the scientologists, lose his looks or get drunk and insult jews. CGI's expensive, but reliable.
3. Media. Dumb down. Any idiot can root in Kate Moss's dustbin or write for CiF, so these journalists come cheap.  Genuinely talented writers with  specialist knowledge are more expensive (so I'm told.)
4.  Fund management. Use quant finance and trading rules, rather than "star" managers who use "judgment." Quant guys are usually (with exceptions) more fungible and less egotistic than stars.

Jag for sale: three questions

Reports that Ford is planning to sell its Premier Automotive Group, which includes Jaguar, Volvo and Land Rover, raise three questions for orthodox neoclassical economics:
1. Are economies of scale, or synergies, over-rated? You'd imagine that Ford could find synergies with Jaguar: they could use common components, marketing or adminstrative functions. Such synergies should make Jaguar more valuable to Ford than to others. But this seems not to be the case; one reason for the X-type's poor sales was the perception that it was just an over-priced Mondeo.
As Robert Peston says, the marriage failed. Doesn't this show that diseconomies of scale often bind, whilst economies are surprisingly elusive?
2. In the absence of asset complementarities, does ownership matter? Bog-standard neoclassical economics says it doesn't. There's only one way to maximize profits - make marginal cost = marginal revenue. Both are largely exogenous. It's just a matter of computing to determine them. And, everyone being rational, this computation can be done by anyone.
On this view, it doesn't matter who owns Jaguar, as profits will be maximized regardless. But meeja talk suggests ownership does matter. So why exactly is the neoclassical view wrong, if it is?
3. Whatever happened to liquidity constraints? We used to think that one advantage of big, incumbent firms was that they had easier access to cheap finance; they have collateral, internal funds and reputation.
But this is no longer true. Ford is potless, because its incumbency - once an advantage - has left it with huge legacy costs. The best hope for recapitalizing Jaguar, Land Rover and Volvo -  new cars are horribly expensive to design - is if they are bought by a venture capital firm with high leverage.
This raises the question: if the advantages of age and incumbency are waning, shouldn't we expect to see much more creative destruction in future?

Email and productivity

All those internal emails you get at work aren't just a mindless distraction - they might help raise productivity.
This new paper (pdf) by Neil Gandal and colleagues shows that the size of an individual's internal email network and his betweenness within that network are strongly positively correlated with his productivity. The results are based upon a management   recruitment firm.
Amazingly, email use is more closely related to productivity than age, education and experience put together.
There is a caveat here, though. Do email networks raise productivity directly, by reducing search costs within the firm, and by allowing better matches between individuals and projects? Or are they just measuring the fact that individuals who are good at building internal networks make better management recruiters, because they're also good at building external networks?
If it's the former, then this has implications not just for IT use, but for corporate structure generally. Traditionally, one justification for the existence of hierarchy within a firm - expressed classically by Oliver Williamson in Markets and Hierarchies - has been that it saves upon information costs. This is because within a hierarchy, information flows only up and down, whereas in an egalitarian network it goes all over the place.
But if bigger networks actually raise individual productivity, this argument for hierarchy disappears.

Barclays and the base rate fallacy

A common cognitive bias is the base rate fallacy - in judging probabilities, we focus too much on individual cases, and not enough upon background probabilities.
Much discussion of Barclays possible merger with ABN Amro seems to be committing just this error. People are focusing on the merits (or not) of the deal, and are not asking the question: what's the general success rate of cross-border banking mergers?
This paper by Dirk Schmautzer fills in the gap. It suggests Barclays is onto a loser. He says:

Transactions are found to be value-creating, albeit only on a net basis with target gains more than compensating for bidder losses.

In other words, the gains of the merger have already been reaped - by ABN Amro's shareholders.
There's worse. Schmautzer says:

Bidders create most value when they take over targets that lack stand-alone growth prospects but are already relatively cost efficient ex-ante.

But ABN Amro is thought to have too high costs.
Worse still, Barclays has bad form here. Its takeover of the Woolwich is regarded as a failure.
So why is it repeating the trick? Maybe it's not just the base rate fallacy at work. 20 years ago, Richard Roll suggested that takeovers were motivated partly by hubris (unfriendly pdf); bosses over-rate their abilities. Maybe little has changed in 20 years.

Private equity: what it does

Congratulations to Michele Hanson. She's written what might be the worst article ever to appear on Comment is Free - and there's some stiff competition. Here's the gist:

But whatever is private equity? I've looked it up and I still can't quite make it out. It's in another language: angel investing, mezzanine capital, passive limited partners and hurdle rates. What? I asked my friend Rosemary and she couldn't even be fagged to think about it.

Here's the Wikipedia entry.

Luckily, my friend Fielding saw a programme on it, and he explained. "They can just do what they want," says he. "It's a new game called I Want It So I'll Have It. To play, you borrow squillions, buy a company, keep it for a bit, strip it of its assets, sack loads of workers, tell everyone that you've made it more efficient, then sell it again at a gigantic profit, making billions in 'performance fees.'

More rigorous research says it's not like this. Here's a short paper (pdf) from Nottingham University's Centre for Management Buyout Research:

Evidence from 1350 UK buyouts observed over the period 1993-2004 shows that employment in the MBOs dips initially after the buyout but then begind to rise aboue pre-buyout levels, being 21.4% higher on average by the fourth year after the buyout.

What Hanson is doing here is blurting out the sheer crassness of the lame-brained soft left. She gets her opinions from her addle-headed friends, rather than research and thinking. She's hostile to anything she finds unfamiliar or too complex for her tiny mind.
And worst of all, she misses the big point. Private equity firms succeed largely because publicly-quoted  firms are inefficient; their profits come partly from  eliminating such inefficiencies.
Which raises the question. If conventional shareholder ownership is inefficient, what business structures are efficient? Mightn't one form be worker ownership?
Asking this question, however, might empower ordinary people. And that's something the Guardianistas wouldn't want.  

Hierarchy, markets and innovation

D2 has asked a question that deserves an answer: why, if hierarchy is as bad as I claim, has the west’s economic performance and innovation been so good? There are (at least) three answers.
1. The costs of hierarchy have been mitigated by intensified competition among them. General Motors has for years been a dysfunctional organization. But competition from other car producers - especially Japanese ones - has forced it to mitigate its dysfunctionality.
2. Many successful firms have begun to de-layer hierarchies. In the 1960s, IBM had 23 layers of hierarchy. Today it has just six. Sir Terry Leahy, boss of Tesco, has said: “There are only six layers between the person who works on the checkout counter and me.”
3. Much innovation comes not from old hierarchical firms, but from new firms which spring up to exploit the opportunities created by the inefficiency and slowness of those old firms. Dell became a multi-billion pound business because IBM was slow to sell personal computers direct to households. Bloomberg’s success was facilitated by Reuters’ slowness and lack of innovation. Countless biotech firms are doing research which Glaxosmithkline and Astrazeneca are too inflexible to do. And in recent years hedge funds - most of which are partnerships - have grown at the expense of traditional hierarchically-organized fund managers who use out-dated and discredited investment techniques.
Even Oliver Williamson, an economist who generally stressed the benefits of hierarchy, conceded this point. In Markets and Hierarchies, he said: “Major new developments have historically come preponderantly from sources outside the large corporation”.
Here's some great empirical evidence for all this. Bart Hobijn and Boyan Jovanovic estimate (pdf) that the stock market value of US firms that existed in 1972 fell relative to GDP in the three subsequent decades. And yet the value of the overall market more than doubled relative to GDP. This means that more than all the rise in the value of shares relative to GDP came from new firms. Growth - as perceived by investors - therefore comes from new firms much more than incumbent ones.
This suggests that old hierarchic firms don't grow quickly. Rather than being a source of innovation, big hierarchical firms exist to exploit innovations that have occurred outside the firm, as this paper (pdf) shows.
Now, I'm not saying here that co-operatives would be a better source of innovations; as workers want to cling onto their jobs, labour-saving innovation would be less. All I'm saying is that whatever the benefits of hierarchies are, they don't include an ability to innovate. It's markets that give us innovations, not hierarchies.
Casual, but strong, evidence for this comes from the performance of government relative to the private sector. Most would agree that productivity growth and innovation has been better in the latter. Is it really a coincidence that its' the private sector where hierarchy is mitigated by competition?