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December 14, 2006

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So Hairston made $500K net income on $971K revenues in 1997? That really boggles the mind.
Marginal Revolution has a quite instructive piece up today about the Goldman Sachs earnings.

Interesting. I quibble with the idea that Hairston ever had 'monopoly power'; he was competing in an underserved market, but to my mind monopoly power implies some additional ability to exclude competitors, which Hairston clearly didn't have. Hopefully he saved some of his profits from the fat years so that his reduced income doesn't cause too many problems for him.

This also reminds me of the chinese tofu manufacturers in California, who deliberately hire hispanic workers because they feel that other chinese are too likely to take the knowledge of tofu manufacture and go into business themselves...

I wonder if Mr. Hairston was originally an 8a (minority, disadvantaged) contractor who made his living off of government contracts and the contracts given out by Redevelopment corporations. The huge amount of ned profits in a single year looks like it could be the rent seeking normally associated with 8a companies.

Given the timeline, his business problems may have to do with his 8a certification expiring and his needing to compete on private projects against companies who never were in the 8a market.

Interesting. Guy shafts workers. Workers leave and start better company. Guy blames illegal immigration.

That's a fine essay on business strategy, but if the mere existence of a barrier to entry means that there is a monopoly then every single business in the U.S. is monopoly.

The only absolute monopolies are those granted by the government and it's no secret that businesses prefer a franchise protected by steep barriers to entry to brutal competition.

To call i-banking a cartel is just plain silly. It's not even an example of an industry with high barriers to entry. By the reasoning above, every industry is a cartel. There's the discount goods cartel, the soft drink cartel, the automotive cartel and if Mr. Hairston had recognized his better workers as potential competition and paid them better I suppose there would also be the South Carolina Stucco cartel.

So then what do we call real cartels like OPEC? And what do we call real monopolies like De Beers, the U.S. Postal service or professional baseball?

Finally we make as well forget about discussing firms like Microsoft, Ebay or Visa and Mastercard that do have very strong barriers to entry.

-Mercy

Here's a site that lists hundreds of investment banking firms. I wonder how many of them are part of the cartel.

-Mercy

http://tinyurl.com/ye7wr7
http://www.vault.com/hubs/channelmain.jsp?chm_page=5&ch_id=240&v=1

Mercy, by "monopoly" I really meant only partial monopoly power, more power than a firm would have if there were a competitive market with minimal barriers to entry.

Mr. Hairston seemed to be part of a geographical oligopoly. Before his workers started competing against him, there seemed to be only one or two other stucco companies in that area of South Carolina.

It's not silly at all to call investment banking a cartel. The industry most certainly increases profits through restrictive practices such as price fixing. Unlike OPEC, they don't call themselves a "cartel" because cartels are illegal in the United States. The difference between OPEC and investment banking is that the former is a formal cartel and the latter is an informal cartel.

You are right that investment banking has few barriers to entry. The primary barrier is that you have to have worked in the industry to know how to compete. But that still means there are lots of people who know how to enter the business. That's the whole point of the essay, which is to demonstrate that invement banks organize the industry to prevent their employees from starting competing businesses.

Major League Baseball: there's a business with massive marketing economies of scale. You can start your own baseball league (the game is too old to be owned by MLB), but does anyone want to see these new teams play each other? Billions of dollars and a hundred years have been invested in MLB's brand name. That's the barrier to entry and the reason why MLB makes so much money.

HS - I think you're wrong on the baseball thing. I'm fairly certain that you actually *can't* legally start your own national baseball league, strange as that sounds. Congress has passed various laws specifically granting MLB special status. Marketing economies of scale are not the only factor.

I think you're wrong on the baseball thing. I'm fairly certain that you actually *can't* legally start your own national baseball league, strange as that sounds. Congress has passed various laws specifically granting MLB special status.

MLB's antitrust exemption allows it to restrict the movement of teams to new cities but does not say anything about the formation of an entirely new league. Here is some information about the exemption.

This is great essay and best explaination I have seen yet. Like you, I can't figure out why MR and Econlog explainations were so lame.

if the mere existence of a barrier to entry means that there is a monopoly then every single business in the U.S. is monopoly.

That's actually a good way of looking at things. Everything has partial monopoly power. It's the only way to make money. The interesting question is how the barriers differ from industry to industry. Also, this perspective discourages people from getting hysterical about monopolies.

HS - You'd be proud. After working three years as an engineer, I'm giving notice on Monday and starting work as an ibanker with a bulge equivalent in a month. I don't think track switching is as hard as you make it out to be if you could have been hired in the first place. Glad I'll be on the inside of the cartel now and collecting obscene rents in the future...

Investment banking and South Carolina stucco are similar to the game theory explanation of oligopoly.

Let's say there's only two firms in a market with the following payoff matrix. Firm A's decisions are on the left and firm B's decisions are on the right. These payoffs assume perfect information on the part of consumers who will automatically all buy the cheaper product.

Charge $50Charge $40
Charge $50:500,5000,750
Charge $40:750,0400,400

It's a prisoner's dilemma where the firms are better off if they cooperate and both charge 50 dollars, but if only one firm charges 40 dollars, that firm will get more money than cooperating with the other firm.

Still under the assumption that both firms and consumers have perfect information, whether or not the firms "cheat" and charge 40 dollars depends on the discount rate of future profits. In other words, both firms will charge 50 dollars into perpetuity if future profits count as much as current profits, but with future profits discounted firms become discounted to undercut the other firm for more profits today.

The economic ramifications of this problem is that firm's are more likely to compete as the number of firms increases. For example, with three different firms in the last problems, the payouts for each firm cooperating is only 333, 333, 333 while "cheating" and charging less than the other two firms still nets a profit of 750. A firm becomes more likely to cut its price when the payoff difference is 750 vs. 333 than when it's 750 vs. 500.

Taking the stucco example, Hairston was myopic in paying a potential competitor in Serrano so little. He made Serrano's potential payout very small in comparison to going out on his own and getting some temporary profits by undercutting his former boss. Hairston had the chance to keep the number of firms in the market small, but he couldn't do it.

However, I don't want to hold to this theory too dogmatically. Just looking at the world around us, most major industries certainly have companies competing and undercutting each other. Wal-Mart, Target, Hyundai, Dell, and Kroger would all be earning much higher profits if they could successfully form such an informal cartel. Kroger would much rather be in an agreement with Publix to charge 6 dollars for a gallon of milk than earning pennies of profit on every purchase.

In my opinion, the stucco market in South Carolina would have had more new firms entering the market. Hairston was really just fortunate to have such a business when the housing boom took off and he would have had to hire more and more Serranos until he could no longer afford to pay each and every one of them the 150,000 or whatever to keep them from going solo.

As for investment banking, it could just be that the market for IPOs, mutual funds or whatever is expanding at such a pace that Goldman Sachs can continue to keep hiring more and more bankers at the price that keeps them from competing. However, this boom won't last forever and either investment bankers will be laid off or Goldman Sachs will have to reduce their pay to stay afloat. Then the payoff difference will become less and more firms will be created to undercut the current competition.

This happens in all markets eventually and I have yet to seen a true permanent cartel that didn't exist without government intervention. That's why I'm still cautious about government control to try and offset these temporary effects.

Matthew -
your point that discounting of future profits prevents a permanent cartel (or monopoly) is a good one. I hadn't thought of that before. It applies also to the example HS mentioned above, of EBay. On the face of it, EBay is in a business which tends to be a natural monopoly. But because it has an obligation to its shareholders to maximize profits in the near-term, EBay is forced to charge high enough commissions that some sellers will jump ship to other competitors. If EBay only wanted to maximize profits for all time, it could suppress competitors much more effectively - but instead it's forced to take on a significant risk of future competition...

"HS - You'd be proud. After working three years as an engineer, I'm giving notice on Monday and starting work as an ibanker with a bulge equivalent in a month. I don't think track switching is as hard as you make it out to be if you could have been hired in the first place."
Could have been hired? Huh?
"Glad I'll be on the inside of the cartel now and collecting obscene rents in the future..."
Most people don't get rich, but you might as well try...

HS,

I mentioned professional baseball because that industry is the only specifically excluded from anti-trust legislation.

Anon,

Congratulations on the new job, although I don't think a monopoly environment is what you're going to find! If you went to S&P or Moody's then perhaps you could kick back and collect your rents, but I-banking is generally brutally competative.

If you wouldn't mind sharing how you made the jump, I think many people on this board would be interested in hearing your story.

-Mercy

The $500,000 profit doesn't seem wildly outlandish to me. I have a friend who does tile work in the region around Jackson, WY and Idaho Falls, ID. He makes a bit under $200,000 per year with with only three people working for him. Unlike the stucco guy, he figured out that keeping his top employee around at a fairly high wage is well worth protecting his business. (He was valedictorian in high school, so he's a fairly bright guy despite not having gone to college.)

I can't believe i'm just getting to this thesis on "foolish business upstarts"...apparently only successful during booms, or so says author, but it was extremely educating nonetheless.

I happen to be one of those doggedly persistent brokers who ply open grannies coffers to make my senior partners rich, by the way.(Venture Capital is my hunt)

I now know how to successfully elbow out possible dissention when I attempt my own business ventures in the future, and I couldn't have succeeded without the rudimentary and biting sarcastic racism brought forth through this business analyst class...

"Time to chuck out the Illegals I suppose" :)

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