microeconomics

Family Affair — Part III — Private Monopsony, Monopoly, and the Disaccumulation of Capital

It’s always good to be ahead of the power curve.  I see that the eminent Paul Krugman had an editorial in the New York Times about the very issues that I’ve dealt with in this blog, his example in this case being Amazon.  This is just one of many articles that have been raised about the monopsony power as a result of the Hatchette controversy.  In The New Republic Franklin Foer also addresses this issue at length in the article “Amazon Must Be Stopped.”  In my last post on this topic I discussed public monopsony, an area in which I have a great deal of expertise.  But those of us in the information world that are not Microsoft, Oracle, Google, or one of the other giants also live in the world of private monopsony.

For those or you late to these musings (or skipped the last ones), this line of inquiry when my colleague Mark Phillips made the statement at a recent conference that, while economic prospects for the average citizen are bad, that the best system that can be devised is one based on free market competition, misquoting Churchill.  The underlying premise of the statement, of course, is that this is the system that we currently inhabit, and that it is the most efficient way to distribute resources.  There also is usually an ideological component involved regarding some variation of free market fundamentalism and the concept that the free market is somehow separate from and superior to the government issuing the currency under which the system operates.

My counter to the assertions found in that compound statement is to prove that the economic system that we inhabit is not a perfectly competitive one, that there are large swaths of the market that are dysfunctional and that have given rise to monopoly, oligopoly, and monopsony power.  In addition, the ideological belief–which is very recent–that the roots of private economic activity is one that had arisen almost spontaneously with government being a separate component that can only be an imposition, is also false, given that nation-states and unions of nation states (as in the case of the European Union) are the issuers of sovereign currency, and so choose through their institutions the amount of freedom, regulation, and competition that their economies foster.  Thus, the economic system that we inhabit is the result of political action and public policy.

The effects of the distortions of monopoly and oligopoly power in the so-called private sector is all around us.  But when one peels back the onion we can see clearly the interrelationships between the private and public sectors.

For example, patent monopolies in the pharmaceutical industry allow for prices to be set, not based on the marginal value of the drug that would be set by a competitive market, but based on the impulse for profit maximization.  A recent example in the press lately–and critiqued by economist Dean Baker–has concerned the hepatitis-C drug Sovaldi, which goes for $84,000 a treatment, compared to markets in which the drug has not been granted a patent monopoly, where the price is about $900 a treatment.  Monopoly power, in the words of Baker, impose 10,000 percent tariff on those who must live under that system.  This was one of the defects in a system that I wrote about in my blog posts regarding tournaments and games of failure, though in pharmaceuticals the comparison seems to be more in line with gambling and lotteries.  The financial risks of investors, who often provide funds based on the slimmest thread of a good idea and talent, are willing to put great sums of money at risk in order to strike it rich and realize many times their initial investment.  The distorting incentives on this system are well documented: companies tend to focus on those medications and drugs with the greatest potential financial rate of return guaranteed by the patent monopoly system*, drug trials that downplay the risks and side-effects of the medications, and the price of medications is placed at so high a level as to eliminate them from all but the richest members of society since few private drug insurance plans will authorize such treatments given the cost–at least not without a Herculean effort on the part of individual patients.

We can also see the monopoly power at work first hand with the present lawsuits between Apple and Samsung regarding the smartphone market.  For many years (until very recently) the U.S. patent office took a permissive stand in allowing technology firms to essentially patent the look and feel of a technology, as well as features that could be developed and delivered by any number of means.  The legal system, probably more technologically challenged than other areas of society, has been inconsistent in determining how to deal with these claims.  The fact finder in many cases has been juries, who are not familiar with the nuances of the technology.  One need not make a stretch to pick out practical analogies of these decisions.  If applied to automobiles, for example, the many cases that have enforced these patent monopolies would have restricted windshield wipers to the first company that delivered the feature.  Oil filters, fuel filters, fuel injection, etc. would all have been restricted to one maker.

The stakes are high not only for these two giant technology companies but also for consumers.  They have already used their respective monopoly power established by their sovereign governments to pretty effectively ensure that the barriers to entry in the smartphone market are quite high.  Now they are unleashing these same forces on one another.  In the end, the manufacturing costs of the iPhone 6–which is produced by slave labor under the capitalist variant of Leninist China–are certainly much lower than the $500 and more that they demand (along with the anti-competitive practice of requiring a cellular agreement with one of their approved partners).  The tariff that consumers pay for the actual cost of production and maintenance on smartphones is significant.  This is not remedied by the oft-heard response to “simply not buy a smartphone,” since it shifts responsibility for the establishment of the public policy that allows this practice to flourish, to individuals who are comparatively powerless against the organized power of lobbyists who influenced public representatives to make these laws and institute the policy.

The fight over IP and patent (as well as net neutrality) are important for the future of technological innovation.  Given the monopsony power of companies that also exert monopoly power in particular industries, manufacturers are at risk of being squeezed in cases where prices are artificially reduced through the asymmetrical relationship between large buyers and relatively small sellers.  Central planning, regardless of whether it is exerted by a government or a large corporation, is dysfunctional.  When those same corporations seek to not only exert monopoly and monopsony power, but also to control information and technology, they seek to control all aspects of an economic activity not unlike the trusts of the time of the Robber Barons.  Amazon and Walmart are but two of the poster children of this situation.

The saving grace of late has been technological “disruption,” but this term has been misused to also apply to rent-seeking behavior.  I am not referring only to the kind of public policy rent-seeking that Amazon achieves when it avoids paying local taxes that apply to its competitors, or that Walmart achieves when it shifts its substandard pay and abusive employee policies to local, state, and federal public assistance agencies.  I am also referring to the latest controversies regarding AirBnB, Lyft, and Uber, which use loopholes in dealing with technology to sidestep health and safety laws in order to gain entry into a market.

Technological disruption, instead, is a specific phenomenon, based on the principle that the organic barriers to entry in a market are significantly reduced due to the introduction of technology.  The issue over the control of and access to information and innovation is specifically targeted at this phenomenon.  Large companies aggressively work to keep out new entries and to hinder innovations except those that they can control, conspiring against the public good.

The reason for why these battles are lining up resides in the modern phenomena known as disaccumulation of capital, which was first identified by social scientist Martin J. Sklar.  What this means is that the accumulation of capital, which is the time it takes to reproduce the existing material conditions of civilization, began declining in the 1920s.  As James Livingston points out in the same linked article in The Nation, “economic growth no longer required net additions either to the capital stock or the labor force….for the first time in history, human beings could increase the output of goods without increasing the essential inputs of capital and labor—they were released from the iron grip of economic necessity.”

For most of the history of civilization, the initial struggle of economics has been the ability for social organization to provide sufficient food, clothing, shelter, and medical care to people.  The conflicts between competing systems has been centered on their ability to most efficiently achieve these purposes without sacrificing individual liberty, autonomy, and dignity.  The technical solution for these goals has largely been achieved, but the efficient distribution of these essential elements of human existence has not been solved.  With the introduction of more efficient methods of information processing as well as production (digital printing is just the start), we are at the point where the process of less capital in the aggregate being required to produce the necessities and other artifacts of civilization is accelerating exponentially.

Concepts like full employment will increasingly become meaningless, because the same relationship of labor input to production that we came to expect in the recent past has changed within our own lifetimes.  Very small companies, particularly in technology, can have and have had a large impact.  In more than one market, even technology companies are re-learning the lesson of the “mythical man-month.”  Thus, the challenge in our time is to rethink the choices we have made and are making in terms of incentives and distribution that maximizes human flourishing.  But I will leave that larger question to another blog post.

For the purposes of this post focused on technology and project management, these developments call for a new microeconomics.  The seminal paper that identified this need early on was by Brad DeLong and Michael Froomkin in 1997 entitled “The Next Economy.”  While some of the real life examples they give from our perspective today provides a stroll down the digital memory-lane,  their main conclusions are relevant in how information differs from physical goods.  These are:

a.  Information is non-rivalrous.  That is, one person consuming information does not preclude someone else from consuming that information.  That is, information that is produced can be economically reproduced to operate in other environments at little to no marginal cost.  What they are talking about here is application software and the labor involved in producing a version of it.

b.  Information without exterior barriers is non-exclusive.  That is, if information is known it is almost impossible for others to know it.  For example, Einstein was the first to observe the mathematics of relativity but now every undergraduate physics student is expected to fully understand the theory.

c.  Information is not transparent.  That is, oftentimes in order to determine whether a piece of software will achieve its intended purpose, effort and resources must be invested to learn it and, oftentimes, apply it if initially only in a pilot program.

The attack coming from monopsony power is directed at the first characteristic of information.  The attack coming from monopoly power is currently directed at the second.    Doing so undermines both competition and innovation.  The first by denying the ability of small technology companies to capitalize sufficiently to develop the infrastructure necessary to become sustainable.  Oftentimes this reduces a market to one dominant supplier.  The second by restricting the application of new technologies and lessons learned based on the past.  The nature of information asymmetry is a problem for the third aspect of information, since oftentimes bad actors are economically rewarded at the expense of high quality performers as first identified in the automobile industry in George Akerlof’s paper “The Market for Lemons” (paywall).

The strategy of some entrepreneurs in small companies in reaction to these pressures has been to either sell out and be absorbed by the giants, or to sell out to private equity firms that “add value” by combining companies in lieu of organic growth, loading them down with debt from non-sustainable structuring, and selling off the new entity or its parts.  The track record for the sustainability of the applications involved in these transactions (and the satisfaction of customers) is a poor one.

One of the few places where competition still survives is among small to medium sized technology companies.  In order for these companies (and the project managers in them) to survive independently requires not only an understanding of the principles elucidated by DeLong and Froomkin.  Information also shares several tendencies with other technological innovation, but in ways that are unique to it, in improving efficiency and productivity; and in reducing the input of labor and capital.

The key is in understanding how to articulate value, how to identify opportunities for disruption, and to understand the nature of the markets in which one operates.  One’s behavior will be different if the market is diverse and vibrant, with many prospective buyers and diverse needs, as opposed to one dominated by one or a few buyers.  In the end it comes down to understanding the pain of the customer and having the agility and flexibility to solve that pain in areas where larger companies are weak or complacent.

 

*Where is that Ebola vaccine–which mainly would have benefited the citizens of poor African countries and our own members of the health services and armed forces–that would have averted public panic today?

Family Affair — Part II — The Micro and Managerial Economics of Projects under Public Monopsony

In my last post I summarized by the macroeconomic environment in which we operate and delved into some discussion of microeconomic foundations.  The response was positive if lukewarm overall, but ego-boosting is not why I started a blog.  One of my readers once asked why I don’t take on some hot button issues.  Well that’s not my role or area of expertise.  I’m not a politician or a social commentator.  The community I inhabit has a large impact but is relatively small and mostly consists of engineers, scientists, mathematicians, some policy-makers, thought leaders, and other technically-focused professionals.  I’m not trying to stir up emotions.  I’m out to stimulate discussion and thought.  I’m relieved that I don’t get trolls when posting factual information that goes against popular misconceptions.  They are a waste of time.

So for me this blog serves two purposes.  First, it is a public discussion of sorts on topics both familiar and unfamiliar, but which I consider interesting.  I do a lot of background research for each post and usually learn something new.  That’s why I don’t post every day.  I give things some thought and research what I write about.  I think it useful to share these discoveries and insights.  The ones that relate to my professional development and expertise in software and project management get posted to my company’s website.

Secondly, I think we live in interesting times.  This is meant both positively and ironically.  I think it useful to record the human condition as we find it in our daily lives during the period of human history we inhabit, and to record many of the intellectual and cultural issues that are topical.  I always find it interesting to return to a subject years later through the writings of others as well as my own to see how they stack up against the perspective of time.  Dr. Roger Spiller of the Army’s Combat Studies Institute, one of my mentors for my graduate degree in history, once told me that if I can look back at anything I’ve written and not be embarrassed by something in those writings would make me a very lucky man.  I’m not that lucky.  But taking the chance to be wrong is part of the price of intellectual curiosity.  Recognizing and admitting one’s wrongness is part of intellectual honesty and maturity–and we are nothing if not thinking.  Our intellect is the most significant feature that we possess that distinguishes us from the other animals.  It is in the cliche’, the ideology, the spin, the doctrine–types of non-thought–where evil finds comfort.

So in continuing from my last post; in understanding the basis of the macroeconomic environment in which we operate, how these systems behave, and how the microeconomics under the macroeconomic environment are affected by the framing of the macro rules of behavior allow us to then flesh out the microeconomics and managerial economics of project management.

As I stated in my last post on the topic, markets are really good at establishing price and pretty bad mechanism for anything else.  Everyone who has taken basic economics understands the basic supply and demand curve.  Here is an example for housing*:

 

So when we make decisions for projects within an organization or firm regarding price, which then allows us to determine the resources we will have to do business given a set of assumptions on possible sales volume, it is useful to understand the nature of the market in which it inhabits, and the competitive environment of that market.  Some examples follow.

Public Monopsony

I have a great deal of experience in operating in this type of market from my perspectives as a business operator and owner and, previously, as a government Contracting Officer and acquisition professional.  Monopsony exists where there is one dominant buyer of the supplies and services from that market.  There are both public and private monopsony (and some are forced by unfair competitive practices such as exclusivity agreements by dominant market entities due to their monopolistic or oligopolistic ambitions or position in a market as sellers).

The traditional supply and demand curve does not apply in the way that classical economics recognizes it under these conditions.

In government monopsony, such as the market for items for the Department of Defense and other specialized government agencies, the chances are that only a portion of the available commercial products in the market can be adapted to the requirement.  Very few commercial products need to survive missile impacts, evade guidance and radar systems, or survive through high G escape velocities and then perform in the vacuum of space, to name only some capabilities often desired.  Oftentimes commercial technologies that can be applied must be modified or “hardened” in order survive in the expected environments.

Governmental or public monopsony power cuts both ways.  As it is practiced in the United States under republican institutions, it behaves mostly in a benevolent manner.  The companies that inhabit this space in large part would not exist and achieve profitability if not for the specialized skills and products required.  They are, for all intents and purposes, semi-public institutions.  It is the irony of our times that free market fundamentalists will simultaneously criticize this type of governmental power while acknowledging the need for the end items that are only possible under this arrangement, especially in regard to national defense, but also for any measure of infrastructural, health, and other items required by a functioning nation.

In terms of microeconomics, there are a number of mechanisms that exist to balance out the asymmetrical relationship between the parties, while at the same time certain peculiarities in which the sovereign (the government) maintains its position.  For example, in contracting, the government invites an offer.  The methods of acquisition are requests for quote, requests for proposals, requests for information, etc.  The private or semi-private entity is always the offeror and, therefore, it is assumes freely engages in the activity being contracted.  In addition, only those offerors deemed both responsible and responsive can enter into a contract.  Responsibility includes a host of technical measures but, simply, it means that the firm offering the supplies and services has both the means and ability to perform the work.

The balancing mechanisms that apply in this market are many of the same institutions that provide checks and balances in competition with the Executive Branch: the Courts and the Congress.  The press operating as the Fourth Estate also provides a check in this area.  In addition, economic organizations from industry can petition the government through both direct lobbying and lobbying organizations, and influence the development of policy and standards through membership in professional organizations where certain competencies are shared.

Thus, because of these interrelationships and the nature of the market, competition is oftentimes limited to a few firms possessing expertise that is highly specialized.  Price competition, when it does occur, is oftentimes marginal (or should be) and employs a number of strategies summarized by the phrase “priced to win.”  These strategies can result in market distortions known as “buying-in” to a contractual arrangement.  There may be compelling reasons on the part of the producer/supplier to “buy-in”–denying market share to a competitor, to protect an area of expertise or a skillset or, alternatively, to develop one;  to ensure employment of internal competencies that would otherwise drive up overhead costs due to unutilized labor, apart from the motivation to win business.  For example, on the issue unutilized labor, one can reasonably ask how much it costs to develop an engineer familiar with the airframe of, say, an F-16 and, if lost, how can this expertise ever be reacquired so as to be available when it is needed?  Thus, in government acquisition, it falls upon the Contracting Officer to weigh these issues and prevent outright buying-in, though their expertise and skill in identifying and preventing this type of behavior is certainly not uniform.

Where there is an overlap for supplies ands services across both private and public sectors, there is an opportunity for some competition among firms that provide items based on commercial-off-the-shelf-pricing that responds to a certain extent to the supply and demand pricing mechanism.  For example, in project management, these are usually firms devoted to consulting and to software companies with sharply targeted functionality.  But even here, the expertise required to fulfill some of the needs of the market are unique and, as a result, prices tend to be sticky or inelastic; resisting wholesale competition that would drive a race to the bottom based solely on price.

Furthermore, since acquisition is an Executive Branch responsibility subject to acquisition law, rules, and regulations, their interpretation and implementation is oftentimes influenced not only by operational, but also political considerations.  Since the imposition of sequestration, for example, project managers and contracting officers have been under a great deal of pressure to reduce both costs and prices.  This can often result in government agencies acquiring an inferior or deficient product–or fewer units than needed based on operational requirements–where cost and price pressure is the overriding consideration.  The tenor of looking for cost reduction has been a constant since the early 1980s.  Thus, over the years, a number of “acquisition reform” methods have been employed to counteract the perceived and real inefficiencies in acquiring the latest technology at the most reasonable cost.

Where cost and price pressure is seen to undermine quality, the supply and demand curve in setting price is modified by agencies to require that an assessment of value be determined, and that the item providing the best value, even if not the lowest cost, be selected.  Even in an expansive open market with many competitors there will be a range of similar products offered under range of prices, where the consumer will view several of the products as falling within an acceptable range of value.  This perception of value can be influenced by the asymmetrical relationship between the parties regarding information, or influenced by other psychological factors such as fashion and marketing.  Government monopsony counteracts the asymmetrical relationship of information and psychological factors that tend to distort good market decisions through specialized requirements on offerors–Truth in Negotiations (TINA), representations and certifications of full disclosure, socio-economic and non-discriminatory status, in sensitive areas restrictions on the use of foreign nationals and foreign influence, adherence to U.S. federal labor laws, among other requirements.  For highly complex cost-reimbursable efforts, the offeror must provide cost accounting data and procedures, and ensure that business systems adhere to certain minimum standards prior to award.  Contracting officers can also open discussions and negotiations at will to determine the true cost or value of the supplies and services being acquired–compelling the offeror to provide the necessary information.

Value analysis also acts as a break to downward price pressure.  For example, in my own area of software technology, while it is true that general expertise in areas of programming that 10 years ago were fairly rare–and commanded high salaries–is no longer the case due to policies that promoted globalization, there are some very highly specialized skillsets that cannot be outsourced, at least not yet.  Finding someone who understands not only how to code, but how that code needs to operate in the environment for which it is designed, is a skill that is highly influenced by culture.  The culture can be one of a nation, a people, a market, or a specialty.  In the area of public project management in the United States, it may not be sufficient for someone to come forward with general programming skills without an understanding of the managerial economics that influence the environment.  Instead, they may be called upon to know or be able to learn very quickly the security protocol required for the data being processed, the structure of the organizations in the market, and the manner in which information is consumed and analyzed, as well as issues of cost management, schedule management, risk management, and technical achievement.  Individuals with these skillsets exist but they are few and far between, and command salaries commensurate with their talents and expertise.  From the microeconomic perspective, when there is no longer a demand for this expertise the value will no longer be there to sustain the price established, but there isn’t going to be a lot of price competition while there is demand, so pricing tends to be inelastic.

In public monopsony, the government is the consumer.  As such, this differs from private monopsony such as that recently described by The New Republic regarding Amazon’s impact on the publishing industry, where the dominant market entities are part of the supply chain between producers and consumers.

The management economics of project management under public monopsony, then, leaves no room for pricing adjustments other than what is provided by the contracts that govern the acquisition of the products and services.  Where commercial products can be utilized, pricing is flexible enough in making a difference in terms of project cost reduction for those niches, assuming that they do not require a great deal of specialization or configuration to meet the special needs of the public marketplace.  This creates an environment of both certainty (and hence stability until, at least, instability is introduced by the political system) and a series of constraints on both managerial action and economic flexibility.

As such, there is no room for lack of estimating, scheduling, risk assessments, or performance management as has been pointed out numerous times, but most recently by Glen Alleman in his excellent “Herding Cats” blog.  There is no room for “exploring” because “we don’t know what we need until we build it.”  Recently I attended a meeting with both public and private industry officials discussing how Agile methods can be reconciled with the more structured environment of public project management.  Well, I guess if we forget about budgets and contracts we can all get to that day when developers don’t have to be accountable and we all can pursue imaginary cost avoidance in providing unmeasurable value under the rubric of cults built on catchphrases.  (And a sad day that would be).

In the meantime, for a firm to survive and its products to be sustainable so that it continues to win a share in this market, inelastic pricing that must be established by strong estimating skills in determining what the market entities will accept, an active regulatory regime, and a structured contracting environment–which provide both advantages and constraints–are the overriding factors in managerial economics as they apply to project management under public monopsony.

I will be dealing with private monopsony in a post next week.

*From “Comparative Statics: Changes in the Price of Housing”, section 19.2 from the book Theory and Applications of Economics (v. 1.0).  The chart can also be found here.