Chapter 4 Government Controls: How Management Incentives Are Affected 24 24 Government power can also be used to eliminate externalities or reduce monopoly power. Whether the use of such controls is considered good or bad depends to a significant extent on one’s personal values and circumstances. In a free market system, price controls and consumer protection will always be controversial. In the case of minimum wage hikes, it appears that policy makers and economists alike have failed to grasp an important lesson: The hikes do not destroy competition, only redirect its force. They also give managers an incentives to find ways of reducing their impact on employment – and the net benefits of the hikes to the workers. Review Questions 1. Is a tax on margarine efficient in the economic sense of the term? Why would margarine producers prefer to have an excise tax imposed on both butter and margarine? Would such a tax be more or less efficient than a tax on margarine alone? 2. If punishment for crime is a kind of tax on those who engage in illegal activity, what effect would the legalization of marijuana have on its supply and demand? What would happen to the market price? The quantity sold? Illustrate with supply and demand curves. 3. If in a competitive market, prices are held below market equilibrium by government controls, what will be the effect on output? How might managers be expected to react to the laws? 4. Why might some managers want price controls? Why don’t they get together and control prices themselves (if it were legal)? 5. How would price controls affect a firm’s incentive to innovate? Explain. 6. “If prices are controlled in only one competitive industry, the resulting shortage will be greater than if prices were controlled in all industries.” Do you agree? Explain. 7. “Price controls can be more effective in the short run than in the long run.” Explain. 8. Why would some firms want the minimum wage to be increased? Why would some managers who believe that workers “deserve” higher wages cut fringe benefits or increase worker demands in response to a hike in the minimum wage? READING: Water Rights and Water Markets Terry L. Anderson, Montana State University Mark Twain wrote, “Whiskey is for drinkin’—water is for fightin’.” In the American West, water has always been a matter of survival. It was the cause of many frontier skirmishes, and it may provoke conflict again. Newsweek warned recently that “drought, waste, and pollution threaten a water shortage whose impact may rival the energy crisis.” And former Secretary of the Interior James Watt said, “The energy crisis will seem like a Sunday picnic when compared to the water crisis.” Unless Americans change their ways, a water crisis is inevitable. In economic terms, the quantity of water demanded is greater than the quantity available, and there is little time to adjust either amount. The Chapter 4 Government Controls: How Management Incentives Are Affected 25 25 reason for the imbalance is that the government has been keeping prices below market-clearing levels. In most places in the United States, water is cheaper than dirt. Nowhere in the nation do water prices reflect the true scarcity of the resource. In Southern California, for example, water is in short supply. Yet Los Angeles residents pay only 0.60 per thousand gallons—a quantity that costs the residents of Frankfurt, Germany, $2.80. It is not surprising, therefore, that each person in the United States consumers an average of 180 gallons a day, compared with 37 gallons in Germany. Water prices are actually lowest in the arid Southwest, where residents of El Paso and Albuquerque pay $0.53 and $0.59, respectively, per thousand gallons, compared with $1.78 in Philadelphia. In many U.S. cities the real price of water has fallen in recent decades, despite the threat of shortages. Agricultural users, who consume over 80 percent of the water in western states, enjoy extremely low prices. Throughout the nation the price of irrigation water ranges from about $0.009 to $0.09 per thousand gallons. In 1981, the average price of covering one acre of land in California’s Central Valley with one foot of water was $5.00, or less than $0.02 per thousand gallons. Supplying that amount of water cost the government as much as $325. According to a 1980 study by the Department of the Interior, government subsidies covered between 57 and 97 percent of the cost of water projects. Pricing water at market rates could help to solve the water crisis. Water consumption—whether for industrial, municipal, or agricultural use—is highly responsive to price changes. For example, the quantity of water used in industrial processes varies considerably around the world, depending on prices. Where water is expensive, electric power is produced using as little 1.32 gallons per kilowatt-hour. Where water is cheap, production requires as many as 170 gallons per kilowatt-hour. One study of urban water consumption showed that a 10 percent increase in the price of water decreased the quantity of water demanded about 4 to 13 percent. Pricing water more realistically will require changes in the laws governing water use, as well as the creation of an effective water market. Like any market, a water market will depend on well-defined, well-enforced property rights. If water rights are secure and people can trace them, prices will quickly come to reflect the true scarcity of the resource. During the late nineteenth century, such a system evolved in the American West. Rights were defined on a first-come, first served basis, and institutions arose through which owners of rights could seek out the highest and best use of the resource. The system offered incentives that encouraged some people to deliver water wherever it was demanded. Thousands of miles of ditches were constructed, and millions of acres blossomed, as a result of entrepreneurial efforts to deliver water. Over time, however, legislators, bureaucrats, and judges have tinkered with the system. Legal restrictions now limit the transfer of water, and its use is determined by politicians, not by the market. One place where a water market might encourage more efficient water use is the Imperial Irrigation District (IID) in Southern California. The IID receives its water from the U.S. Bureau of Reclamation, at subsidized rates. Its water could be conserved if ditches were lined, wastewater recovered, and the timing of irrigation changed. All those measures would be costly to farmers, however. And at present low prices, farmers have little incentive to invest in conservation. Recently, the Municipal Water District (MWD) of Southern California, thwarted in its effort to obtain water from Northern California, has begun negotiating for water from the IID. The MWD is willing to fund improvements in farmers’ irrigation systems in return for the water those improvements would save. If such a trade could be accomplished, everyone would be better off. CHAPTER 5 The Logic of Group Behavior In Business and Elsewhere Men journey together with a view to particular advantage and by way of providing some particular thing needed for the purpose of life, and similarly the political association seems to have come together originally. . . for the sake of the general advantage it brings. Aristotle 1 Unless the number of individuals in a group is quite small, or unless there is coercion, . . .rational, self-interested individuals will not act to achieve their common or group interest. In other words, even if all. . . would gain if, as a group, they acted to achieve their common interest or objective, they will still not voluntarily act to achieve that common or group interest. Mancur Olson 2 n earlier chapters, we introduced the usefulness of markets. However, as is evident inside firms, not all human interactions are through “markets.” People often act cooperatively in groups or, as the case may be, in “firms.” In this chapter our central purpose is to explore how and under what conditions people can organize their behavior into voluntary cooperative associations (groups and firms) in which all work together for the attainment of some common objective, say, greater environmental cleanliness, the development of a “club atmosphere,” or the maximization of firm profits. The focus of our attention is on the viability of groups like families, cliques, communes, clubs, unions, and professional associations and societies, as well as firms, in which individual participation is voluntary to cohere and pursue the common interests of the members. We consider two dominant and conflicting theories of group behavior. They are “the common interest theory” and “the economic theory” of group behavior. The former is based on the proposition that a group is an organic whole” identified by the “common interest” shared by its individual members. Its basic thesis is that all groups, even very large ones, are organized to pursue the common interest of the group members. Taking this theory one step further, it implies that if people share a common interest, they will organize themselves into a group and voluntarily pursue their shared interest. According to the economic theory of group behavior, the group is a collection of independently motivated individuals who organize voluntarily to pursue their common interest only in small groups, like families or clubs. In large groups the common interest 1 Aristotle, Ethics, vol. 8, no. 9, p. 1160a. 2 Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1971), p. 2 I Chapter 5 The Logic of Group Behavior In Business and Elsewhere 2 is very often ineffective in motivating group behavior. The logic of this theory seems perverse; but, as we will see in later chapters, it is the basis for almost all economic discussion of markets and explains why many policy proponents argue governments must be delegated coercive powers to collect taxes and to pursue the “public interest.” It also helps explain why firms are organized the way they are and why managers manage the way they do. This is, therefore, one of the pivotal chapters in this book. However, keep in mind that groups are not the only means by which people’s interpersonal or social behavior is organized in society. Economics is basically a study of comparative social systems, an examination of how the different ways of organizing interpersonal behavior can be fitted together in different combinations. We call these means of organizing people’s behavior “social organizers” and mention four of them here: markets which involve exchanges of goods and services, government coercion, violence, and voluntary groups. On the surface, violence may not appear to be a bona fide alternative, but we are forced to mention it because of the use made of it throughout the world. The behavior of street-gang members, for example, with respect to people totally unassociated with them, is largely based upon either the existence or the threat of violence. The Cold War was a tenuous truce founded to a sizable degree on the threat of a nuclear holocaust. The persistent violence in the streets of Northern Ireland during the 1960s and 1970s will for many years have a profound influence on what the people of that country can hope to accomplish. Many examples can be cited which illustrate the spread of terrorist activities and the threat they represent to the fabric of social order which has been built on the basis of other social organizers. Aside from what we have already said with regard to anarchy, we will have little to say about violence as a social organizer. This does not lessen the importance, which we attribute to violence; it simply reflects the fact that economists have only recently turned their attention to the subject and much remains to be done in the way of theory construction. 3 The question of how you appraise the roles the various social organizers should play in social order appears to be wrapped in one’s personal ideology or value system—that is, there appears to be no room for positive analysis. Indeed, what we as individuals want the system to accomplish is surely a factor in how each of us evaluates potential social organizers. Personal values will affect our attitude as to whether or not a given social organizer should be used and, if used, how extensively. The avowed Marxist has very harsh opinions of the market system. But perhaps just as important in our appraisal is what we know about the relative effectiveness—the advantages and limitations—of the potential means for ordering behavior. If, for example, we have only a rudimentary understanding of how the market works and fail to appreciate with sufficient clarity the limitations of cooperative efforts, we may naturally place greater reliance on voluntary 3 For example of economists’ initial probes into the area of malevolence and violence, see Kenneth E. Boulding, The Economy of Love and Fear (Belmont, Calif.: Wadsworth Publishing Company, Inc., 1973), and Gordon Tullock, The Social Dilemma: The Economics of War and Revolution (Blacksburg, Va.: University Publications, 1974). Only those who wish to be challenged will find these books useful. Chapter 5 The Logic of Group Behavior In Business and Elsewhere 3 cooperation than we would otherwise. We, therefore, in this chapter highlight the limitations of voluntary groups as a social organizer in order that we may appreciate why markets are not only beneficial but also necessary in organizing a society of heterogeneous individuals. Common Interest Theory of Group Behavior There are almost as many theories of group behavior as there are group theorists. However, categorizing theories according to dominant themes or characteristics is sensible in light of our limited space. All theories of group behavior begin by recognizing the multiplicity of forces, which affect group members and, therefore, groups. This is especially true of what we term the common interest theory. Many present-day sociologists, political scientists, and psychologists generally share this point of view, which has been prominent at least since Aristotle. The determinants of group behavior most often singled out are the “leadership quality” of specific group members and the need felt among group members for “affiliation,” “security,” “recognition,” “social status,” or money. Groups like clubs or unions form so that members can achieve or satisfy a want that they could not satisfy as efficiently through individual action. All these considerations are instrumental in affecting “group cohesion,” which, in turn, affects the “strength” of the group and its ability to compete with other groups for the same objectives. From the perspective of this theory, when people join firms, they accept the firm’s objective and pursue it because everyone else wants the same thing, leading to self-enforcing group cohesion. The common interest theory views the “group” as an organic whole, much like an individual, as opposed to a collection of individuals whose separate actions appear to be “group action.” According to the theory, the group has a life of its own which is to a degree independent of the individuals who comprise it. Herbert Spencer, a nineteenth- century sociologist, often described the group as a “social organism” or as a “superorganic” entity. 4 Karl Marx wrote of the “class struggle” which will bring down “bourgeois capitalism” and of the proletariat” which will, in its place, erect the communist society. And it was probably the social-organism view of groups that Aristotle had in mind when he wrote, “Man is by nature a political animal.” 5 Two major reasons are given for viewing groups as a social organism. First, a group consists of a mass of interdependencies, which connect the individuals in the group. Without the interdependencies, there would be only isolated individuals, and the term group would have no meaning. Individuals are like the nodes of a spider web. The 4 Spencer was actually somewhat ambivalent on the subject; at times he also wrote of groups as a composite of individuals. This aspect of his writing reflected the influence David Hume and Adam Smith had on his thinking. See Herbert Spencer, Principles of Sociology (London: Williams and Norgate, Ltd., 1896). 5 Aristotle, Politics, Book II. Chapter 5 The Logic of Group Behavior In Business and Elsewhere 4 spider web is constructed on these nodes, and the movements in one part of the web can be transmitted to all other parts. Much like the process of synergism in biology, 6 the actions of individuals within a group combine to form a force that is greater than the sum of the forces generated by individuals isolated from one another. The group must, so the argument goes, be thought of as more than the sum total of individuals. This argument is often used to arouse support for a labor union. Union leaders argue that the union can get higher wage increases for all workers can obtain acting independently of one another. The reason is that union leaders efficiently coordinate the efforts of all. Environmental groups make essentially the same argument: With well-placed lobbyists, the environmental group can have a greater political impact than can all the individuals they represent writing independent letters to their representatives at different times. Second, groups tend to emerge because they satisfy some interest shared by all the group’s members. Because all share this “common interest,” individuals have an incentive to work with others to pursue that interest, sharing the costs as they work together. Aristotle wrote, “Men journey together with a view to particular advantage,” 7 and Arthur Bentley said, “There is no group without its interest . .The group and the interest are not separate. . . . If we try to take the group without the interest, we simply have nothing at all.” 8 Having observed that a common interest can be shared by all of a group’s member, the adherents of this theory of group behavior argue that a group can with slight modification, be treated as an individual. The primary modification is the relative tightness or looseness of the ties that bind the group members together. This usually makes group action and reaction less decisive and precise than that of individuals, but the difference between a group and an individual is still a matter of degree, not kind. For instance, the difficulty of passing information about group goals from person to person can make the group’s response to new information somewhat sluggish. Nevertheless, a group can be assumed to maximize the attainment of its common objective. Furthermore, the implicit assumption is made that this will be true of large as well as small groups. It is on this deduction that Mancur Olson and many economists take issue with this analysis of group behavior. The Economic Theory of Group Behavior Mancur Olson, on whose work this section rests, agrees that the “common interest” can be influential and is very important in motivating the behavior of members of small groups. However, he, like so many other economists, insists that a group must be looked upon as a composite of individuals as opposed to an anthropomorphic whole, that the common interest, which can be so effective in motivating members of small groups, can be impotent in motivating members of large groups: “Unless there is coercion in large 6 This is the process whereby two or more substances (gases or pollutants) come together, and combined can have a greater effect than the sum of the effects of each individual taken separately. 7 Aristotle, Ethics, vol. 8, no. 1, p. 1160a. 8 Bentley, in Peter Odegard (ed.) Process of Government (Cambridge: The Belknap Press, Harvard University Press, 1967), pp. 211-213. Chapter 5 The Logic of Group Behavior In Business and Elsewhere 5 groups. . . ., rational self-interested individuals will not act to achieve their common or group interest.” Furthermore, he contends, “These points hold true when there is unanimous agreement in a group about the common goal and the methods of achieving it.” 9 To understand this theory, we will first examine the propositions upon which it is founded and then analyze some qualifications. Basic Propositions Using economic analysis, people are assumed to be as rational in their decision to join a group as they are toward doing anything else; they will join a group if the benefits of doing so are greater than the costs they must bear. As explained earlier, these costs and benefits, like all others relevant to any other act, must be discounted by the probability that the costs and benefits will be realized. 10 There are several direct, private benefits to belonging to groups, such as companionship, security, recognition, and social status. A person may also belong to a group for no other reason than to receive mail from it and, in that small way, to feel important. A group may serve as an outlet for our altruistic or charitable feelings. If by “common interest” we mean a collection of these types of private benefits, it is easy to see how they can motivate group behavior. Entrepreneurs can emerge to “sell” these types of private benefits as they do in the case of private golf clubs or Weight-watchers. The group action will be then, essentially, a market phenomenon—that is, a problem in simple exchange. However, the central concern of this theory is a “common interest” which is separate and detached from these types of private benefits. The concern is with public benefits that transcend the entire group, which cannot be provided by the market, and which may be obtained only by some form of collective action. That is, a group of people must band together to change things from what they otherwise would be. Examples include the common interest of consumers in general to obtain better, safer products than the market would provide without collective action; the interest of labor unions is to secure higher wages and better fringe benefits than could be obtained by the independent actions of laborers; the interest of students is to have better instruction; the interest of faculties is to educate quality graduates. These are examples of the common interest being a public good. (As you will recall, a public good was defined as a good— or service—the benefits of which are shared by all members of the relevant group if the good is provided or consumed by anyone.) 9 Olson, Logic of Collective Action, p. 2. A number of economists were moving toward the development of Olson’s line of analysis, but the force and clarity of Olson’s presentation of his view of group behavior make his book an important reference work. 10 This type of cost and benefit analysis has been explicit, if not implicit, in much of the writing of those in support of the “common interest theory of groups” explained above. There would be little reason for talking about a “common interest” if it did not have something to do with benefits of group participation. See, for example, Dorwin Cartwright, “The Nature of Group Cohesiveness,” in Dorwin Cartwright and Alvin Zander, eds., Group Dynamics: Research and Theory, 3d ed. (New York: Harper & Row, Publishers, 1968), pp. 91-109. Chapter 5 The Logic of Group Behavior In Business and Elsewhere 6 Small Groups Small groups are not without their problems in pursuing the “common interest” of their members. They have a problem of becoming organized, holding together, and ensuring that everyone contributes his part to the group’s common interest. This point was illustrated earlier in terms of Fred and Harry’s problems of setting up a social contract, and it can be understood in terms of all those little things which we can do with friends and neighbors but which will go undone because of the problems associated with having two or three people come together for the “common good.” For example, it may be in the common interest of three neighbors for all to rid their yards of dandelions. If one person does it, and the other two do not, the person who removes the dandelions may find his yard full of them the next year because of seeds doing from the other two yards. Why do we so often find such a small number of neighbors failing to join together to do something like eradicating dandelions? We can address this question with the use of the public goods demand curve developed earlier. The common interest is dandelion eradication; and two neighbors, Fred and Harry, again, have a demand for this public good. 11 There is no particular reason for us to assume that Fred and Harry have identical demands for this particular public good; consequently, we have drawn Harry’s demand for eliminating dandelions in Figure 5.1 greater than Fred’s demand. _________________________________________ Figure 5.1 The Problem of Getting Collective Action If the marginal cost curve is MC 2 , the marginal cost of eliminating even the first dandelion will be too high to take any action at dandelion eradication. However, if the cost were lower, MC 1 instead of MC 2 , Harry would be willing to eliminate as many as Q 1 dandelions. Fred would still do nothing. 11 We realize the imperfections of this example of a public good; much of the benefit of each person’s action is private. Only a portion of one neighbor’s dandelions may actually affect other people’s yards. The example, however, is a reasonably good one for our purpose. Chapter 5 The Logic of Group Behavior In Business and Elsewhere 7 If we assume, for simplicity only, that the marginal cost of eliminating dandelions is constant, the marginal cost curve will be horizontal. Whether or not either Fred or Harry will individually do anything about his dandelions depends, given their demands, upon the position of the marginal cost curve. If, for example, it is positioned as MC 2 in Figure 5.1, neither Fred nor Harry will be motivated individually to do any thing about the problem. The marginal cost of eliminating the first dandelion is greater than the benefits that even Harry, who has the greater demand, received from it. Notice that the marginal cost curve (MC 2 ) does not intersect either of the demand curves in the graph, meaning that the optimum level of activity for both, on an individual basis, is zero. On the other hand, if the marginal cost curve is at MC 1, Fred will still be unwilling to do anything, but Harry will be willing to eliminate, on his own, up to Q 1 dandelions. Fred, however, will benefit from Harry’s actions; he will have fewer dandelions in his own yard; he can “free-ride” because of Harry’s high demand for dandelion eradication. Still, the quantity of dandelions eradicated may not be what is socially optimal. Consider Figure 5.2. In that figure we have constructed Fred and Harry’s joint, or public good, demand curve. Their collective demand curve is obtained by vertically summing the demands of the individuals. Under individual action, Q 1 dandelions are eradicated by Harry. However, the value which Fred and Harry collectively place on the elimination of additional dandelions is greater than the marginal cost. For example, the marginal value of the Q 1 th unit to both Fred and Harry combined is MB 1 ; the marginal cost, MC 1 . They can gain by eliminating that dandelion and all others up to Q 3 . This is the point where the marginal cost curve and the public good demand curve intersect. By sharing the cost of eliminating the weeds, they can move to Q 3. Harry will not move to that point if he has to pay the full cost for each unit, MC 1 , but he will move beyond Q 1 if he can get Fred to take over part of the cost. How they share the cost must, because of the complications involved, be reserved for a later discussion; we need only point out here that there is no reason to believe that an equal sharing of the cost will be the outcome. __________________________________________ Figure 5.2 Efficient Provision of Collective Goods The public goods demand curve, which is the darker curve in the figure, is derived by vertically adding the demands of Fred and Harry. Given a marginal cost represented by MC1, the optimum quantity of dandelions removed is Q3. _________________________________________________________________ __________________________ _________________________ Chapter 5 The Logic of Group Behavior In Business and Elsewhere 8 Even though Fred and Harry may not ever agree to work out their common problem (or interest) cooperatively, there are several conditions that may lead them to do so. In a small group there is personal contact. Everyone knows everyone else. What benefits or costs there may be from an individual’s action are spread over just a few people and, therefore, the effect felt by any one person can be significant. (Fred knows there is a reasonably high probability that what he does to eliminate dandelions from the border of his property affects Harry’s welfare.) If the individual providing the public good is concerned about the welfare of those within his group and receives personal satisfaction from knowing that he has in some way helped them, he has an incentive to contribute to the common good; and we emphasize that before the common good can be realized, individuals must have some motivation for contributing toward it. Furthermore, “free-riders” are easily detected in a small group. (Harry can tell with relative ease when Fred is not working on, or has not worked on, the dandelions in his yard.) If one person tries to let the others shoulder his share, the absence of his contribution will probably be detected. Others can then bring social pressure to bear to force him to live up to his end of the bargain. The enforcement costs are low because the group is small. There are many ways to let a neighbor know you are displeased with some aspect of his behavior. Finally, in small groups an individual shirking responsibilities can be excluded from the group if he does not contribute to the common interest and joins the group merely to free ride on the efforts of others. In larger groups, like nations, exclusion is more difficult and, therefore, more unlikely. The problem of organizing “group behavior” to serve the common interest has been a problem for almost all groups, even the utopian communities that sprang up during the nineteenth century and in the 1960s. Rosebeth Kanter, in her study of successful nineteenth-century utopian communities concluded: The primary issue with which a utopian community must cope in order to have the strength and solidarity to endure is its human organization: how people arrange to do the work that the community needs to survive as a group, and how the group in turn manages to satisfy and involve its members over a long period of time. The idealized version of communal life must be meshed with the reality of the work to be done in the community, involving difficult problems of social organization. In utopia, for instance, who takes out the garbage? 12 Kanter found that the most successful communities minimized the free-rider problems by restricting entry into the community. They restricted entry by requiring potential members to make commitments to the group. A six “commitment mechanism” distinguished the successful from the unsuccessful utopias: (1) sacrifice of habits common to the outside world, such as abstinence from alcohol and tobacco or, in some cases, celibacy; (2) assignment of all worldly goods to the community; (3) adoption of rules which would minimize the disruptive effects of relationships between members and 12 Rosebeth M. Kanter, Commitment and Community: Communes and Utopias in Sociological Perspective (Cambridge, Mass.: Harvard University Press, 1973), p. 64. . District (MWD) of Southern California, thwarted in its effort to obtain water from Northern California, has begun negotiating for water from the IID. The. the actions of individuals within a group combine to form a force that is greater than the sum of the forces generated by individuals isolated from one another.