Investment banking vs. stucco

On the front page of yesterday's Wall Street Journal, there is an article about how a once successful black entrepreneur saw his stucco business ruined because of competition from Mexican immigrants.

It seems to me more a tale of business strategy and microeconomics than it does about immigration.

By the mid-1990s, stucco jobs increasingly took Mr. Hairston and his predominantly black crew from Atlanta to Hilton Head Island. Mr. Hairston fell in love with the moss-draped oak trees and intercoastal waterways inhabited by snowy egrets. Golf and hotels had turned the area into a resort mecca, and in the mid-1990s, a housing boom in the area allowed Beaufort County to boast the fastest growth and lowest unemployment in the state. "There was tons of work ... and only a couple stucco contractors in the whole area," recalls Mr. Hairston, a tall, strong man who sports a shaved head and a goatee.

According to the article, Mr. Hairston's most profitable year was 1997 when he had $971,000 of revenues and "roughly $500,000" of net income.

Half a million a year is a huge income even for a white Harvard educated professional living in Manhattan. What did he do to actually "earn" that income? He found a market where there was little competition, and we presume that there were barriers to entry which prevented competition. What exactly were the barriers to entry? (1) You have to be smart enough to manage a stucco business, and (2) you need to work in the industry to learn the ropes. Probably, nearly all the people with enough intelligence and ambition to run their own businesses were turned off by the idea of working for low wages as a stucco person, and they got sucked into more prestigious occupations, probably ones that require a college degree.

How much of his big income did he share with his black workers? Probably, like a good capitalist, he kept all the money for himself and paid his workers the lowest wage he could get away with. It's not just the white man keeping the black man down. As soon as a black man makes it big, he also participates in keeping the other blacks down.

But then Mr. Hairston discovered immigrant labor.

Latin American immigrants were just starting to trickle into the area, as word spread that jobs in construction and hospitality were plentiful. Immigrants were increasingly bypassing traditional gateways, like California and Texas, to seek work in the Southeast.

So Mr. Hairston, who until then had mostly relied on black labor, hired a handful of Mexicans. He says they were diligent and eager to learn. They were "prepared to acquire basic knowledge and not afraid to try" new work, says Mr. Hairston. When he needed more hands, his Mexican workers sent for their relatives back home and elsewhere in the U.S. Mr. Hairston says they presented Social Security numbers, and he in turn paid taxes and workers' compensation although he acknowledges some of them had probably entered the U.S. illegally.

It sounds pretty good for Mr. Hairston. Better quality labor for the same low price, or even lower, than before.

I have no doubt that the Mexicans were better workers. The black workers were probably from the bottom half of the black bell curve. Who else would want to do manual labor in the hot humid climate of South Carolina? The Mexicans, on the other hand, took these jobs because barriers to entry (such as being illegal and not speaking English) prevented them from working at higher level jobs. But some of Mr. Hairston's new Mexican workers were smart and ambitious enough to learn the business and then compete against him!

Mr. Serrano began to work in stucco, perfecting his skills as an employee of Mr. Hairston's Pro Plastering & Stucco. He says he earned $8 to $10 an hour during the two-and-a-half years he worked for Mr. Hairston. In the beginning, Mr. Serrano recalls, Mr. Hairston still employed several black workers. But gradually Mr. Hairston came to rely more on Mr. Serrano and other Mexican immigrants. "We showed up for work every day and we were dedicated," Mr. Serrano recalls.

On His Own

Around 2000, Mr. Serrano struck out on his own, working as a subcontractor to Mr. Hairston. He supplied Mr. Hairston with crews for several jobs. "I was able to train the workers," who were all Spanish speakers, he recalls. Mr. Hairston typically paid him about 25% of the value of the contract for the job, he says. Mr. Serrano says that he pays taxes on all his workers, as well as workman's compensation.

Mr. Hairston says that for a while it didn't bother him that some of his Latino workers, like the Serranos, struck out on their own. "I never thought I would be competing against them," he says. But he felt particularly stung when he encountered one of his workers -- who had asked for two weeks off -- working on an $80,000 job on a high-end house that Mr. Hairston's company had bid for.

Mr. Hairston's business gradually began to unravel. Mr. Hairston "would bid and another guy who used to work for him would bid on the same job," recalls Greg Goldberg, another builder, who is currently president of the local home builders' association. Mr. Goldberg himself says he hired some of Mr. Hairston's former workers.

Because of the new competition, "the Hairstons' net income plunged from roughly $500,000 in 1997 to about $70,000 in 2005."

$70,000 isn't a bad salary for a guy doing manual labor. Skilled engineers or computer programmers, jobs which require much more sophisticated knowledge, probably don't make much more than that when they are working in a low wage area of the country such as South Carolina.

Once Mr. Hairston's monopoly power was destroyed, his income sunk to the normal level of a skilled worker.

Yesterday I wrote about investment bankers. I asked, why do investment bankers make so much money? Why doesn't competition lower their income to the level of regular highly specialized workers? We might ask the same of BIGLAW, because similar principles apply. Why do BIGLAW partners make a million dollars a year?

Whenever people are making so much money, it's because there are barriers to entry and lack of real competition. Investment banking and BIGLAW both operate as cartels. A cartel is defined in Wikipedia as "a group of formally independent producers whose goal is to increase their collective profits by means of price fixing, limiting supply, or other restrictive practices.

Let's examine what investment banks and BIGLAW do differently from Mr. Hairston to maintain their market power and high incomes.

What they don't do is hire dumb employees. This is what Mr. Hairston used to do. If he had continued to hire the lousy black workers instead of the smarter and more motivated Mexican workers, he wouldn't have trained the people who ended up competing against him. Investment banks and law firms don't hire dumb people, but in corporate America, it's not uncommon for managers to purposely hire people not as capable as themselves to prevent their employees from eventually displacing them.

So how do investment banks and law firms keep their smart and ambitious employees from competing against them? One of their most important strategies is that they share the profits. This is why professional service firms are set up as partnerhips with large numbers of partners, and why so many people get large chunks of the profits. Goldman Sachs, by paying out billions of dollars in bonuses, demonstrates that it's more profitable for the employees to stay with the firm than it is for them to try to compete against it.

This is one of the things that Mr. Hairston did wrong. He paid Mr. Serrano a lousy $10/hour salary and kept all the profits for himself. If he made Mr. Serrano, and other workers who were identified as being the most likely to be able to successfully compete against him, junior partners, and upped their salary to $100,000 year, Mr. Hairston might still be making $500,000 a year. Instead of a bunch of small stucco firms competing against each other, there would be one big stucco firm with monopoly power and with several partners making big incomes.

The partnership model is used in industries where the primary barrier to entry is knowledge of the industry. In industries where there are other barriers to entry, such as high capital requirements or unique intellectual property protected by law, companies don't have to share the profits with the employees, and they don't. (Except for the CEO, but the reason for crazily high CEO salaries is beyond the scope of this essay.)

To further prevent competition within the industry, firms work towards creating group loyalty. Why do new investment bankers have to work 90 or 100 hour weeks? One reason is limit the number of people in the industry who have the knowledge of how to compete. But another very important reason is because this hazing experience actually creates group loyalty. As copied from Wikipedia:

Hazing is often used as a method to promote group loyalty and camaraderie through shared suffering, either with fellow participants, past participants, or both.

A tentative explanation from evolutionary psychology is that grave hazing can activate the capture-bonding psychological trait also known as Stockholm syndrome.

The group loyalty and camaraderie created by the grueling 100 hour work weeks and brutal treatment of investment banking associates discourages them from later competing against other investment bankers in a manner which would ruin the profits for the entire indusry.

The following description of the bidding process for stucco jobs demonstrates the lack of market power held by the stucco companies:

Mr. Hairston says that he never knew by how much he was undercut because the bidding process in construction isn't open. Builders often approach two or three subcontractors and invite them to make an estimate for a project. The builders rarely reveal the value of the winning bid to the losing parties.

What would happen if a company asked a bunch of investment banking firms, or law firms, to submit sealed bids in this manner? I'm pretty sure that the lawyers or investment bankers would say "sorry, that's not the way we do business." They know that as soon as one firm submits to this indignity, the profitability of the entire industry would unravel.

Furthermore, in investment banking, the amount paid to the bankers can't be hidden. The financial disclosure requirements, required by law, ensure that everyone knows how much the investment bankers made from the deal. How convenient that the law, which supposedly protects investors by disclosing financial details to them, has the parallel effect of making the industry less competitive and helps the investment bankers rip off the investors.

Law firms, of course, also take advantage of the law to limit their competition. All lawyers must pass the bar exam of the state in which they practice. Although passing a bar exam isn't the most difficult thing to do, the fact that each state has its own bar exam prevents lawyers from competing with lawyers from other states. So instead of one big national legal market with a large number of law firms, there are 50 legal markets each with a much smaller number of firms. The fewer the number of members, the more powerful the cartel.

Lawyers also have Model Rule 5.4 which ensures that lawyers get to keep their profits.

Mr. Hairston has learned the lessons of the lawyers and, with the help of his wife, is now trying to get the government to make his competition go away so he can once again make big profits:

In September, Mrs. Hairston presented a draft of an "illegal immigration relief ordinance" to the County Council. Under the ordinance, companies that knowingly hire undocumented laborers could have their business licenses revoked. The ordinance would require that all businesses volunteer to participate in a federal government pilot program that verifies whether a Social Security number matches an individual's name. It would bar illegal immigrants from getting a business license.

Comments

[Peter]

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.

[bbartlog]

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...

[superdestroyer]

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.

[JewishAtheist]

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

[Mr. Mercy Vetsel]

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

[Mr. Mercy Vetsel]

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

[Half Sigma]

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.

[bbartlog]

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.

[Peter]

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.

[Butter]

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.

[Douglas Knight]

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.

[anon4now]

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...

[Matthew]

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.

[bbartlog]

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...

[SFG]

"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...

[Mr. Mercy Vetsel]

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

[mobiusnu]

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.)

[frnnkdlxx]

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" :)