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May 17, 2011

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Industrial Organization is a very important part of economics, but it does require a little more math and understanding of the basic concepts than most Intro or Priciples students have.

"What people don’t get is that, if a market is a natural winner-take-all market, then some participant has to win, regardless of whether or not that participant has done anything to deserve winning."

Not really. In some third world countries, there are lots merchants, restaurateurs, etc., without one dominant player in those markets. There's no law of nature that markets can't remain fragmented and local. Building a dominant business isn't like dropping a pencil on the floor. It isn't just luck.

I have heard that Moore's Law will come to an end around 2020 due to some constraints imposed by the size of the silicon atom. This could lead to some major shakeups in the electronics and IT industries.

I don't know, Half. I don't like Microsoft, but since they took over the world, computers can talk to each other easily. I don't need conversion software for ten operating systems and ten word processors. There has to be some value creation, there.

[HS: That's an example of why software is a natural monopoly, not why Microsoft created any value. There wouldn't have been 20 different operating systems for long, one OS would have to win the race because as you point out, a single OS makes a lot more sense.]

Regarding economies of scale for accounting firms, from the audit perspective of my experience as a CPA, there are some economies of scale from having specific employees to do standards research, audit program updates, manage technology, acquire new clients, etc., but this can be accomplished within a moderate-sized regional firm so you don't necessarily need a Big Four. The small or one-person shops generally have a worse product just because managing all the necessary functions is more work than any one person could handle well, especially if they want to have a life, but on the other hand, I don't think their client base really cares how detailed the audit is.

The argument against big companies hiring mid-size firms to do their audits has traditionally been that they would represent too big of a revenue stream for the firm to be truly independent, but I sometimes wonder if the Big Four could truly be said to be independent.

"In comments, some have insisted that it’s necessary for such vast rewards to exist because otherwise people won’t take 'risks' and there won’t be any technological progress or innovation."

It's not necessary for there to be vast rewards, but there needs to be rewards which are reasonably big. Without "value transference," there would be no rewards at all. It would be impossible to make even $1000 from an important invention or discovery.

"Most real invention takes at big companies and is done by salaried employees who don’t retain any of the profits from their labor."

Sure, but if the employer was not able to hit it big from those employees' inventions, then those employees would not be paid to invent stuff. i.e. without value transference, those men are unemployed.

[HS: You're attacking a straw man, I never said someone shouldn't be able to make $1000 from an invention. Although many people do make less than that from their inventions, they are called employees.]

Globalization is an important factor to consider. In the period from 1880 to 1940 it was logical to break up monopolies into smaller competing companies. These breakups encouraged competition and innovation. But what happens to a country that breaks up a world dominating company like Microsoft or Siemens. It might be in the interest of a country to tolerate some monopolies and the value transferance that they engage in if the result of breaking up those monopolies was the loss of a key industry to less scupulous foreign competitors.


Another fun concept to consider is that profit is maximized when marginal revenue = marginal cost. At the peon level this law is ruthless. The change in revenue that comes by adding one additional employee had better exceed the change in cost or that peon is not hired. This drove the downsizing trend in the early nineties. Lay off employees and cut production--revenue may fall, but if cost falls more you win. At the executive level things get murky and the MR=MC law is no longer universal. An executive who is compensated with 80 million USD had better be worth at least 30 million USD more of revenue to his compnay than an exec. willing to do the same job for a mere 50 million per year. Are individual managers that far apart in talent? Some may be and perhaps big exec. compensation packages are justified, but Japanese companies dont' think so...

"There wouldn't have been 20 different operating systems for long, one OS would have to win the race because as you point out, a single OS makes a lot more sense."

Just because something seems like it makes sense (with the benefit of hindsight) doesn't mean it will happen. In hindsight, it made sense to automate and centralize restaurant reservations for years, but it didn't happen until Chuck Templeton founded Open Table in 1998.

When Bill Gates and Paul Allen founded Microsoft in the late '70s, it was in no way obvious that there ought to be one operating system for computers. For that matter, it wasn't even obvious that software should be a consumer business. At the time, it was the province of hobbyists. Bill Gates is mostly responsible for turning it into an industry.

Gates and Paul Allen are mostly responsible for the current ubiquity of personal computers today. You forget how radical their idea of "a computer on every desk" was when Microsoft was founded. Sure, Xerox PARC invented the graphical user interface, but they did nothing with it (talk about suppressing value creation!). It was Microsoft and Apple, for the most part, that ran with it.

Do you know how ignorant you sound? How did Wal Mart grow from a single store to the largest retailer against Sears, Kmart etc... lol.

Your argument assumes all is relatively equal. Wal Mart has the most efficient supply chain in the world.

My families business competes against large companies and has since 1989. How? Because we offer service or product the big boys cannot. We differentiate oruselves. We plan for hard times thus during economic down turns our competitors go by the way side while we survive.


You have no practical experience in business and thus it all looks like luck.

As someone who does understand probability, I have to argue with the point about never buying lottery tickets. If you buy zero lottery tickets, your chances of winning the lottery are (obviously) zero. If you buy just one ticket your odds of winning go up tremendously (an infinite percentage increase). I am being a bit facetious I guess, but buying one ticket gives you a pretty big bang for the buck.

1000 tickets, not so much.

-M

"HS: You're attacking a straw man, I never said someone shouldn't be able to make $1000 from an invention."

You said that value transference should be discouraged. It's impossible to make even $1000 from an invention with value transference.

You need to concede that some kinds and degrees of value transference are good and necessary and I will concede that in a free market system, some people are compensated far in excess of the value which was created but for their efforts and far in excess of what is necessary to adequately incentivize them.

Oops, that should be "it's impossible to make even $1000 from an invention WITHOUT value transference."

I agree with the overall premise, with two points:

"If people truly understood the odds, no one would ever buy lottery tickets."

People do understand the odds of the lottery, but buy tickets anyway. Winning is life altering. Losing, assuming you are only buying one ticket every once in awhile, doesn't change your lifestyle at all. So people are buying a dream.

"Most real invention takes at big companies and is done by salaried employees who don’t retain any of the profits from their labor. There would be no basis for Microsoft, Dell, Apple, Google or Facebook existing were it not for the fact that there are thousands of engineers toiling anonymously at companies like Intel and Motorola making Moore’s Law a reality. "

Actually, most invention takes place at start ups that get bought out by those companies. Largely they exist because they were once start ups who had one good idea and are in various stages of "maturity" (lack of internal innovative capacity) at this point.

Employees get paid whether they are particularly value creating or not. Within many organizations a large swath of the employees receive more in value then they create. But companies can't tell who the super stars are and who the mediocre are, so they have to hire a bunch of people. If they hit on a few superstars they capture most of the excess value they create.

Start ups are a way for super stars to capture more of the value for themselves, but its inherently risky. Working for megacorp means health insurance and a nice apartment. Working for a start up may mean billions, but more likely it means ramen noodles in an apartment you share with three dudes for five years with no payoff.

Consider that the presence of a dominant player in an industry might actually *help* other companies.

I'll give an example from my own industry: my company, ABC Insurance, sells a few types of consumer policies that are relatively unusual, in other words not the types of insurance (car, homeowner's, life, etc.) that most people know about. A large, well-known company dominates the market for this type of insurance and spends a great deal of money on advertising. When I and other ABC Insurance agents approach potential customers to speak about what we offer, they sometimes don't understand ... and in that case, we say "we sell what [the large, well-known company] sells, but our rates often are better."

In other words, my company piggybacks off the advertisements this other company runs, using them as a means of creating awareness of the products we offer. They pay for the ads and create the product awareness, and we benefit from their efforts.

The idea of casinos as "economic development" (while closing factories) coincided with the rise of the term "value creation."

Note that casinos merely transfer wealth around, while factories create value.

@sabril: you really don't understand the distinction between value creation and value transference (which you seem to think is synonymous with "voluntary economic activity").

Charles Martin Hall's discovery of an inexpensive way to make aluminum changed the world (the French kings had crowns made of aluminum and now we use it for beverage cans: can you imagine what a 747 would cost if it were made of platinum?); he was a truly value creating hero. The Beatles created value. The people who kept Howard Snitzer alive for 96 minutes without a pulse (and the researchers who created the technology and protocols to make it happen) created value. A good chef creates value.

Getting $80 million a year as a rent-seeking health insurance CEO or through rigged government bids is a far different matter. Those are the people who use "create value" a lot to cover up the fact that they are actually just transferring value.

HS,

For your argument to be taken a little seriously you should include the most important actor.

"That factor might be that the participant has a slightly better product, but it’s just as likely if not more likely to be better marketing, better salesmen, the willingness to behave unethically, better at schmoozing those who can supply the business with capital and better at knowing the right people, or just sheer luck."

Government. The biggest actor in deciding who gets rich through:

1)Bailouts of preferred financial institutions
2)Legislation deciding which technology becomes mandated (say... the G.M. produced catalytic converter.)
3)Direct payments to preferred contractors (Blackwater.)
4)Legislation which raises barriers to entry which helps instead of hinders current industry leaders.
5)Legislation which is specifically designed as tax carve outs for preferred businesses.

You have a point that it's hard to know whether a given rich person became so because he was the "best" in a given area, but your idea that the same government that provides the above laundry list of crimes should then decide to tax massively and send yet more "largesse" out to favored constituents is amazing. We don't need a bigger one of these:

http://practicepuritycontrol.net/pictures/favoritetat.jpg

DeepThought, I have been running a business for 12 years and H.S. makes plenty of sense.

The incentive for large monetary rewards is not necessary for invention to take place. There are plenty of creative people that enjoy inventing things and are thrilled that they can get paid a salary to do it.

"@sabril: you really don't understand the distinction between value creation and value transference (which you seem to think is synonymous with 'voluntary economic activity')."

I'm simply going by HS's definition. His definition of value transference includes a situation where an inventor gets rich off of his invention.

There is no problem with my understanding; the problem is that you object to his definition.

D.H.

"There are plenty of creative people that enjoy inventing things and are thrilled that they can get paid a salary to do it."

Sure, there are many people willing to do creative work if other people are willing to risk their own money to pay them and buy the equipment and space that they need.

http://en.wikipedia.org/wiki/Angel_investor

How do you get investors to fund these nerds, their habits, and their need for capital... without the investor being able sometimes strike it big to pay for the failures, the guaranteed return that they eschew, and the costs of arranging the nerds and their stuff?

Without the government seizing the means of production, some investors are bound to make huge strikes sometimes.

Posted by: Peter
"I have heard that Moore's Law will come to an end around 2020 due to some constraints imposed by the size of the silicon atom. This could lead to some major shakeups in the electronics and IT industries."

From the year 1980 to 1990 CPU speeds for personal computers have increased by 20 fold. From 1990 to 2000 the increase was only 10 fold. From 2000 to 2010 it was only 5. Okay so maybe those aren't hard numbers but you get the point. CPU speeds have been increasing ever since the advent of PC's but the rate of increase is going downhill. If the trend continues 5GHz CPU's will be the brick wall that will never be breached.

That's not to say that all innovation in IT will stop. On the contrary there are plenty of exciting and strange ideas for example organic based machines. Imagine the possibility of encoding the schematics for a computer into the DNA of a plant. In the future we may grow computer similar to how farmers grow food today. Your grandkids might live in a world where a computer costs less than a burrito at a Mexican restaurant. Granted it will perform no better than 5GHz but hey, at prices like that who's complaining?

[HS: There's a clock-speed limit base on the physical properties of silicon which we have reached, but there are other ways to make the chips more powerful other than increasing the clock speed.]

"In most industries, a competitive market in which no one buyer or seller becomes dominant is an unstable system."

Yes, that´s why most industries and market consist of one dominant player.

Oh wait, that´s not even remotely true.


"Most real invention takes at big companies and is done by salaried employees who don’t retain any of the profits from their labor."

Yes indeed, they are unpaid slaves toiling away in the sugar caves. Oh wait, they actually get paid pretty well.

And so on.

Also, if you are browsing econ textbooks, the term for what you are discussing is "rent" (not "value transference"). The topic of this post is usually discussed more at length in Industrial Organization textbooks, not in introductory economics textbooks that are trying to make 18-year olds grasp concepts like "demand" and "supply".

In short: less ignorance would make your posts more worthwhile.

"There are plenty of creative people that enjoy inventing things and are thrilled that they can get paid a salary to do it"

I agree with NAM on this point . . . the person who is paying the inventor's salary is hoping to hit it big. So your low-paid researcher would be out of a job without value transference.

People would still invent stuff in their spare time, but the amount of resources put into innovation would be far less without value transference (as that term is defined by HS).

When rewards are distributed by windfall to those in possession of "land" -- economic rent -- then the incentive is to acquire property and prevent the creation of alternative "land". This is essentially what prematurely terminated the opening of frontiers like the ocean and space.

Actual land, physical territory is the prime example, but in modern economies "land" can be extended to encompass other things that can be monopolized (especially those whose supply is greatly inelastic) and whose economic rent - value - goes entirely to its owner as a windfall.

"This is essentially what prematurely terminated the opening of frontiers like the ocean and space."

So if Western policies were different, people would be living off of the Earth now? If you think so, what would those different policies be?

"but in modern economies 'land' can be extended to encompass other things that can be monopolized "

Can you give a specific example please?

Turns out that the same analysis of Microsoft applies to UNIX as well, to some extent. See forward/preface and first couple sections in http://simson.net/ref/ugh.pdf .

This comment from Charles Hugh Smith seems relevant:

As I have often observed, the majority of America's household income flows to a handful of corporate cartels protected by the Central State. Most of the mortgage payments flow to the "too big to fail" banks. Most of the telecom payments flow to the few companies in the telecom cartel. Most of the energy money flow to the energy cartel. Most of the food budget go to the Big Ag cartel and the retail cartel. Most of the money spent on "entertainment" flows to the corporate media cartel, and so on.

Most of the global media is owned by 5 or 6 corporations. Most of the radio stations in the U.S. are owned by two corporations. This tremendous concentration of ownership of the nation's assets gives these cartels immense political power, and so the Central State acts as "partner" to Corporate America, protecting the cartels from competition by insuring that regulations are used to stamp out or limit competitors. Corporate losses are shifted to the backs of the taxpayers, all in the name of the "common good." Profits are private but losses are public--a peculiar definition of "common good."

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