Because most philosophies that frown on reproduction don't survive.

Wednesday, December 10, 2008

Does a Profit Driven Business Model Corrupt?

One of the big criticisms of free market economics is that markets are driven by greed. "Why would you want to allow markets to set the price of [health care, wages, basic housing, food, education, etc.]," the argument goes, "when that means subjecting a basic humanitarian necessity of the dictates of unfettered greed?" I think this represents a basic misunderstanding of how markets work, and I'm going to try to address that in this post -- though I approach the attempt with some trepidation given the difficulties of the subject matter and the limits of the medium.

I'm going to start by conceding a point which those making the assertion I describe above may consider to prove their case: The economic view of market dynamics tends to view individual actors within a market as value maximizing agents. In other words, a market consists of a number of actors each trying to get the most possible value for the least possible expense.

Doesn't this mean that markets are driven by greed? Don't we need to encourage people to be something other than value maximizing agents?

Well, certainly, there is much more to life than what you can buy and sell, so people should never reduce themselves to nothing but value maximizing agents. However I'm going to attempt to argue that markets based on individual value maximization are not necessarily merely exercises in greed.

There are two things which must, I think, be kept in mind here. First of all, we do not all value things equally. And secondly, a market involves all sides of every transaction trying to maximize value.

The first of these points is key because the different values which we place on things result in the motivation for trade. Say that I enjoy doing carpentry while a buddy of mine enjoys doing car work. It would make sense for me to help my buddy with building book shelves and installing wood floors, while he would help me when my car needs work, because the work of doing carpentry has a higher "cost" to him than it does to me. (I enjoy it, and he doesn't. Plus I perhaps have more skills than he does, so I get it done faster and better as well.)

Since I get enjoyment from doing carpentry (and find it easy) I would not be willing to pay someone much to do it for me. But since my friend doesn't enjoy it, he would pay significantly more in order to avoid having to do the work himself. When we specialize and exchange, we both get increased value from the transaction. In essence, by exchanging what we don't want for what we do want, we create value. Is either one of us being greedy in this exchange? No. Indeed, you could argue that we're both helping each other, even though we are also both maximizing value for ourselves.

Let's try this with an example which is more often seen as showing greed. I bought a coat yesterday for $69 (50% off) which was, according to its tag, made in Vietnam. I'd long delayed buying a coat, even though the last one I bought (nine years ago) was pretty seriously worn out, because I was put off by the expense of the coats I was seeing. If you grit your teeth and jog fast from your car to the building you're headed for, you can get by a long time in Central Texas without a coat, and the thought that the $150-$250 that many of the coats I was seeing cost would feed our family for a week or two, or buy winter clothes for all the kids, or cover car repairs, or any of another of other items on the list of household expenses. Now, if the wages for coat makers in Vietnam were such that it was impossible to buy a coat for less than $300, I certainly would not begrudge them a better lifestyle, however I almost certainly would have continued wearing my shabby old coat and dashing about in shirtsleeves and put off buying the coat for another year. And that decision of mine (and of others like me) would mean that there would be a reduction in the demand for coats. Which in turn would impact those who make coats.

The current cost of coats thus represents a balance. I want to cover other household expenses before my own needs. Coat sellers want to sell more coats and grow their business. Coat makers want higher wages. Unemployed Vietnamese workers living near coat factories want jobs, and are willing to get them by offering to work for slightly less than others who are already skilled in coat making. All of these demands are weighed and balanced through millions of individual transactions in the coat market. And everyone gets as much of what they value as possible given the demands of everyone else.

Some of the people involved in this complex interweave of desires may indeed be profoundly greedy, but in a sense, it doesn't matter. Whether they are greedy or simply trying to take care of their families by balancing the many demands upon them, the result is a balance between the demands of everyone involved.

The idea behind markets is that given that hundreds, thousands, or millions of people are often involved in a complex economic supply chain, it's far easier and more efficient (and thus in the long run, better for all involved) if to a great extent prices are negotiated through free exchange of goods and labor rather than through seeing prices or wages where they "ought" to be -- because given a sufficiently complex situation the sum of the knowledge of all the individual actors involved is much greater than the understanding of any given regulator could possibly be.

Still, isn't it a problem to have a market full of people thinking only of their own profits? Wouldn't it be better to have community organizations whose whole purpose is to benefit everyone involved?

A couple weeks ago I had an extended conversation with someone over whether credit unions were morally superior to banks. His argument essentially was, "The express purpose of a credit union is to provide value for its members, to whom it is directly accountable. A bank, on the other hand, is accountable to its stockholders, so it is always going to put the interests of its customers second to profit."

If this were the case, it seems to me, then people would invariably keep their money at credit unions, buy their food at co-ops, etc. Because while a credit union and a bank have different business and ownership models, the services they provide are pretty much the same: They loan money in return for interest, and they pay interest out to depositors.

People with savings will naturally want to get the most interest that they can without sacrificing the security of their savings, so they will check around at a couple of different banks and/or credit unions and put their money in the most advantageous place. Similarly, borrowers will shop around for the lowest possible interest rate.

If the community-owned model of credit unions always provided greater value to depositors and borrowers, then they would get all the business and banks be left on the sidelines. And yet, we know that this is not the case. Why not?

I think that more than anything else it boils down to incentive. A bank is constantly incented to stretch itself in order to both win more customers by offering high interest to depositors and low interest to borrowers, and also to make those bets pay off in order to make money for the stock holders and bonuses for the employees. As such, the management and employees at a for-profit bank are strongly incented to take good risks, avoid bad risks, and find new ways to make that extra basis point of profit. (A basis point is 1/100th of a percent, and it's the sort of thing that a lot of work is put into making when you deal with consumer financing.)

The community owned, not-for-profit enterprise, on the other hand, is primarily incented towards stability. At this particular moment in history, when a lot of banks recently made bad bets based on poor forecasting, focusing on stability definitely has its upside. However, because a community owned enterprise is incented towards stability while a for-profit enterprise is incented towards risk and innovation, the result is that a for-profit enterprise will often provide goods and services at similar or lower cost than a not-for-profit, while at the same time paying out a small operating profit to its owners. By providing people with the incentive of additional gain, for-profit enterprises encourage the creation of more value than communally owned enterprises.

One final example: Let us consider two grocery stores in a small neighborhood. One of them is a community owned co-op. As a member, you are a part owner and you help elect the governing board which sets policies and hires employees. Any reductions in costs are handed back to the members in the form of lower prices. The other is a family owned grocery, and that family keeps all the profits which are made.

Both the co-op and the grocery will only have customers if they provide good groceries at low prices. Sure you could label the grocer as being motivated by "greed" in everything he does, because if he find that he can price cereal $0.05 higher per box he gets to keep the money -- or if he's able to buy honey directly from a local bee-keeper he gets to pocket the 5% markup that a distributor would have taken.

And yet, in order to make his family money, he needs to provide customers with good products at low prices. While his business model may be centered around making a profit, if he doesn't do just as good of job of meeting the food co-op's mission of "Provide the community with good food at great prices while maintaining a warm, personal atmosphere" he won't have customers and won't make a profit. So while you could argue that his ultimate incentive is to make a profit, the only way he can achieve that goal is to give himself the personal goal of providing the community with good food at great prices.

Meanwhile, the fact that he directly benefits his family when he finds a way to save $1000 here in cost negotiations and make $500 there where the competitive environment allows him to raise prices incents the grocer to work harder and take more calculated risks than the managers of a community owned food co-op would be. After all, a $2000 increase in monthly profits might mean a great deal to a family grocery store, but in a food co-op that $2000 would be spread out across the monthly food budgets of hundreds of families in small savings on each item until it became impossible to notice.

Because ownership assigns the benefits gained from cost savings, increased efficiency, demand generation and optimal pricing to a small enough number of people for them to have a compelling interest in putting a lot of work into improving those numbers, for-profit enterprises can succeed in producing more value for more people, and have just as much incentive to keep their customers' interests at heart as not-for-profit "community owned" enterprises.


Rick Lugari said...

It's been a long time; you've been slacking. This post is 1908 words and consumes about 20% of the main page, which contains about a month's worth of posts. Apparently you don't have any work to do and have already bought the wife that expensive tennis bracelet she's secretly wishing you would get her.

Nevertheless, good post and a good effort at examining reality.

Anonymous said...

Good post. I'll admit I skimmed, what with keeping finding that I agreed with you, and plus the need to get to work to earn *my* tennis bracelet. Hehe. (Anyone see the Santa Bailout column in today's WSJ?)

It is helpful look at the free market along the same lines as the rest of human life: usually we do pretty well, sometimes we sin big time. We assume the average citizen isn't a would-be murderer, robber or embezzler, but still put some controls in place to deal with the ones who are, and discourage the ones who might tend that way. We use a combination of means to achieve those controls (laws, social pressure, etc.).

The imperative to pay a living wage, or to be environmentally responsible, or name-that-bit-of-social-justice, is best carried out in the context of a free market. Just like all the other moral imperatives are best carried out in an environment of freedom. Not reckless do-whatever-you-like license, but freedom all the same.

Darwin said...

It's been a long time; you've been slacking. This post is 1908 words and consumes about 20% of the main page, which contains about a month's worth of posts. Apparently you don't have any work to do and have already bought the wife that expensive tennis bracelet she's secretly wishing you would get her.

Ha! Well I suppose I've been slacking a bit, but since I'm busy collecting the kudos for all the Black Friday Sale related stuff that had me tied up the previous few weeks I figured I'd indulge myself.

MrsD doesn't play tennis, so I figured instead of some silly bracelet she'd rather a food processor or something useful like that.

Kate said...

As I see it, the problem with current market systems is that there is a whole industry devoted to convincing us to make purchasing choices based on criteria other than need or quality or even price. Instead, we have a market based largely on more ethereal psychological qualities (and the deceptions of advertising) ...which, I fear obscure and distort any mutually beneficial relationship between seller and buyer.

Rick Lugari said...

...but since I'm busy collecting the kudos for all the Black Friday Sale related stuff that had me tied up the previous few weeks..

Ahh, great. Glad to see your extra effort is paying off.

I know what you're thinking, but you should be warned. Food processors really just chop stuff up. If you want to improve the MrsD.'s cooking you'll have to think of something else to get her. Lucky for you though, you have a friend who knows about these things. Get her this series of books by the talented and lovely Sandra Lee. She'll love the wonderful recipes and the various craft and design ideas for making a more lovely home for you. Plus you'll again have something pleasing to look at, seeing as the Mrs. canceled your Victoria's Secret catalog subscription.

I know it might be a gamble sending this to you here, but I'm confident that your wife, like mine, learned to tune me out long ago...

Deuce said...

"Why would you want to allow markets to set the price of [health care, wages, basic housing, food, education, etc.]," the argument goes, "when that means subjecting a basic humanitarian necessity of the dictates of unfettered greed?"

I think the answer to this question is really quite simple, when you get down to it.

Health care, basic housing, food, education, etc don't grow on trees. Somebody who possesses the requisite skills has to make each one of those things in order for them to exist.

Now, there are ultimately only two ways to get them to make those things:

1) You stay out of the way, and allow them to trade the things they make for things they need/want that other people make, so that they have an incentive to continue making those things of their own free will.


2) You coerce them into making those things via some sort of threat of violence, in exchange for nothing, or for things they don't really want that much.

If you choose option #1, you're for the market setting prices. If you're against the market setting prices, you're for option #2. It's not really complicated.

Can the market be abused? Sure, humans can abuse pretty much anything. But option #2 is an abuse in and of itself.