Chapter 6. Reasons for Firm Incentives 29 and rents it to the supplier can benefit from the fact that less threatened suppliers will charge lower prices. This consideration may also be a motivation for auto manufacturers to own the equipment that some of their suppliers use. It also provides a very good incentive-based explanation, and justification, for a business arrangement that has been widely criticized. An arrangement that reduced the threat of opportunistic behavior on the part of firms against workers was the much-criticized “company town.” In the past it was common for companies (typically mining companies) to set up operations in, what were at the time, very remote locations. In the company towns, the company owned the stores where employees shopped and the houses where they lived. The popular view of these company stores and houses is that they allowed the companies to exploit their workers with outrageous prices and rents, often charging them more for basic necessities than they earned from backbreaking work in the mines. The late Tennessee Ernie Ford captured this popular view in his famous song “Sixteen Tons.” 44 Without denying that the lives of nineteenth-century miners were tough, company stores and houses can be seen as a way for the companies to reduce (but not totally eliminate) their ability to exploit their workers by behaving opportunistically. Certainly workers would be reluctant to purchase a house in a remote location with only one employer. The worker who committed to such an investment would be far more vulnerable to opportunistic wage reductions by the employer than would the worker who rented company housing. Similarly, few merchants would be willing to establish a store in such a location, knowing that once the investment was made they would be vulnerable to opportunistic demands for price reductions that just covered their variable costs, leaving no return on their capital cost. Again, in an ideal world without transaction costs – and without opportunistic behavior -- mining companies would have specialized in extracting ore and would have let suppliers of labor buy their housing and other provisions through other specialists. But in the real world of transaction costs, it was better for mining companies to also provide basic services for their employees. This is not to say that there was no exploitation. But the exploitation was surely less under the company town arrangement than if, for example, workers had bought their own houses. 45 The threat to one party of a transaction from opportunistic behavior on the part of the other party explains other business and social practices. Consider the fact that despite valiant efforts, the vast majority of farm workers have never been able to effectively unionize in the United States. No doubt many reasons explain this failure, but one reason is that a union of farm workers would be in a position to harm farmers through opportunistic behavior. A crop is a highly specialized and, before harvested, immobile investment, and one whose value is easy to 44 The lyrics of which went, “Sixteen tons and what do you get? Another day older and deeper in debt. Saint Peter don’t you call me cause I can’t go. I owe my soul to the company store.” 45 For a relevant discussion of company towns set up by coal mining firms, see Price V. Fishback, Soft Coal, Hard Choices: The Economic Welfare of Bituminous Coal Miners, 1890-1930 (New York: Oxford University Press, 1992); especially chapters 8 and 9. Chapter 6. Reasons for Firm Incentives 30 expropriate at harvest time. In most cases, if a crop is not harvested within a short window of opportunity, its value perishes. Therefore, a labor union could use its control over supply of farm workers to capture most of a crop’s value in higher wages by threatening to strike right before the harvest. While this threat would not necessarily be carried out in every case, it is too serious for those who have made large commitments of capital to agricultural crops to ignore. Not surprisingly, farm owners have strongly resisted the unionization of farm workers. The threat of opportunistic behavior is surely an important consideration in another important exchange relationship, that of marriage. Although there clearly are exceptions, rich people seldom marry poor people. The story of the wealthy prince marrying poor, but beautiful, Cinderella, is, after all, a fairy tale. Rich people generally marry other rich people. As with all activities, there are many explanations for marital sorting, including the obvious fact that the rich tend to hang around others who are rich. But an important explanation is that marriage is effectively a specialized investment that, once made, commits and creates value not easily shifted to another enterprise, or object of affection. The rich person who marries a poor person is making an investment that is subject to hold-up. This is a hold-up possibility that is not ignored, as evidenced by the fact that pre-nuptial agreements are common in the case of large wealth differences between the two parties to a marriage. But because of the difficulty of anticipating all possible contingencies relevant to distributing wealth upon the termination of a marriage, such agreements still leave lots of room for opportunistic behavior. Marriage between people of roughly equal wealth reduces, though hardly eliminates, the ability of one party to capture most of the value committed by the other party. A good general rule for a manager is to buy the productive inputs the firm needs rather than make them. When inputs are produced in-house, some of the efficiency advantages of specialization provided through market exchange are lost. But as with most general rules, there are lots of exceptions to that of buying rather than making. In many cases the loss from making rather than buying will be more than offset by the savings in transaction costs. Typically, firms should favor making those things that require capital that will be used for specific purposes and, therefore, will not have a ready resale market. The Decision to Franchise The decision a firm faces over whether to expand through additional outlets that are owned by the firm or that are franchised to outside investors has many of the features of decisions to make or buy inputs. Franchising is simply a type of firm expansion – with special contractual features and with all the attendant problems. Franchise contracts between the “franchiser” (franchise seller) and the “franchisee” (franchise buyer) typically have several key features: • The franchisee generally makes some up-front payment, plus some royalty that is a percentage of monthly sales, for the right to use a brand name and/or trademark -- for example, the name “McDonalds” along with the “golden arches.” Chapter 6. Reasons for Firm Incentives 31 • The franchisee also agrees to conduct business along the lines specified by the franchise, including the nature and quality of the good or service, operating hours, sources of purchases of key resources in the production process, and the prices that will be charged. • The franchiser, on the other hand, agrees to provide managerial advice and to undertake advertising, to provide training, and to ensure that quality standards are maintained across all franchisees. • The franchiser typically retains the right to terminate a franchise agreement for specified reasons, if not at will. The own-or-franchise decision is similar to the make-or-buy decision because both types of decisions involve problems of monitoring, risk sharing, and opportunistic behavior. At one time, scholars believed that firms expanded by way of franchising only as a means of raising additional capital through tapping the franchisee’s credit worthiness. If the firm owned the additional outlet, it would have to bring in more investors or lenders at higher capital costs. Supposedly, franchisees could raise the money more cheaply than the franchiser. 46 However, Emory University economist Paul Rubin has argued with force that franchising, per se, doesn’t, and can’t, reduce the overall cost of capital – at least not as directly as previously argued. 47 A firm in the restaurant business, for example, can only contemplate expanding through franchising if it has a successful anchor store. It can establish another outlet through the sale of its own securities, equities or bonds, in which case the investors will have an interest in both the successful anchor restaurant and the new one. That investment in a combination of the proven and new restaurant is likely to be less risky than any single investment in just the new restaurant, which, because it has the same menu as the anchor restaurant, has a good chance of success, but is still unproved. Hence, the cost of capital for the franchisee, everything else held constant, is likely to be higher than for the central restaurant firm. Why franchise ever? Rubin argues that in business there are unavoidable agency costs, or costs associated with the fact that the owners (or principals) of a firm must hire managers and workers (agents) who have discretion in the use of firm resources but who do not necessarily have the right incentives to use the firm’s resources in the most effective manner to pursue the owners’ goals, as opposed to the private goals of the managers and workers. Rubin believes the reason for franchising is that the agency cost is lowered (but not totally eliminated) by expanding through franchising. The manager of the company-owned restaurant will likely be paid a salary plus some commission on (or bonus related to) the amount of business. The manager’s incentive will be weakly related to the interests of the owners. Hence, 46 This argument is evident in Donald N. Thompson, Franchise Operations and Antitrust (Lexington, Mass.: D.C. Heath, 1971). 47 Paul H. Rubin, “The Theory of the Firm and the Structure of the Franchise Contract,” Journal of Law and Economics, vol. 21 (1978), pp. 223-233. Chapter 6. Reasons for Firm Incentives 32 the manager will have to be closely monitored. The franchisee, on the other hand, becomes the residual claimant on the new restaurant business and, accordingly, has a stronger incentive to reduce shirking and other forms of opportunistic behavior by the employees. We note above that monitoring costs (or the costs associated with keeping track of manager and worker performance) are not eliminated through franchising. This is the case because the franchisees have some reason to shirk (albeit that the incentive to shirk is impaired by the franchise agreement that leaves the franchisee an important residual claimant). Customers often go to franchised outlets because they have high confidence in the nature and quality of the goods and services offered. McDonalds customers know that they may not get the best burger in town when they go to a McDonalds, but they do have strong expectations on the size and taste of the burgers and the cleanliness of the restaurant. McDonalds has a strong incentive to build and maintain a desired reputation for its stores, and therein lies the monitoring catch. Each franchisee, especially those that have limited repeat business, can “cheat” (or free ride on McDonalds overall reputation) by cutting the size of the burgers or letting their restaurants deteriorate. The cost savings for the individual cheating store can translate into a reduced demand for other McDonalds restaurants. This is a prisoner’s dilemma in which all stores can be worse off if noncooperative behavior becomes a widespread problem. So, McDonalds must set (and has strong incentives to do so) production and cleanliness standards and then back up the standards with inspections and fines, if not outright termination of the franchise contract. McDonalds (and any other franchiser) also controls quality by requiring the individual restaurants to buy their ingredients -- for example, burger patties and buns -- from McDonalds itself or from approved suppliers. McDonalds has good reason to want its franchisees to buy the ingredients from McDonalds, not because (contrary to legal opinion) it gives McDonalds some sort of monopoly control, but because McDonalds has a problem in monitoring outside suppliers. 48 Outside suppliers have an incentive to shirk on the quality standards with the consent of the franchisees that, individually, have an interest in cutting their individual costs. Moreover, by selling key ingredients, the franchiser has an indirect way of determining if its royalties are being accurately computed. So-called “tie-in sales” are simply a means of reducing monitoring costs. Of course, the franchises also have an interest in their franchiser having the lowest possible monitoring cost: it minimizes the chances of free riding by the franchisees and maintains the value of the franchise. Similarly, a franchiser like McDonalds (as do the franchisees) has an interest in holding all franchisees to uniform prices that are higher than individual McDonalds might want to choose. By maintaining uniform retail prices, McDonalds encourages its franchisees to incur the costs that must be incurred to maintain desired quality standards. 48 Rubin, “The Theory of the Firm and the Structure of the Franchise Contract,” p. 254. For a review of legal opinion on the so-called “tie-in sales” of franchise relationships, see Benjamin Klein and Lester F. Saft, “The Law and Economics of Franchise Tying Contracts,” Journal of Law and Economics, vol. 28 (May 1985), pp. 345-361. Chapter 6. Reasons for Firm Incentives 33 The chances for opportunistic behavior can be lowered through franchising, but hardly eliminated. 49 If the franchisee buys the rights to the franchise and then invests in the store that has limited resale value, the franchiser can appropriate the rents simply by demanding higher franchise payments or failing to enforce production and quality standards with the franchisees, increasing the take of the franchiser but curbing the resale value of the franchise. On the other hand, if the franchisee pays for the building that has a limited resale value, the franchisee can, after the fact, demand lower franchise fees and special treatment (to the extent the franchiser must incur a cost in locating another franchisee). These points help explain up-front payment and royalty provisions in franchise contracts. The value of the franchise to the franchisee – and what the franchisee will pay, at a maximum, for the franchise – is equal to the present value of the difference between two income streams, the income that could be earned with and without the franchise. The greater the difference, the greater the up-front payment the franchisee is willing to make. However, the franchisee is not likely to want to pay the full difference up-front. This is because the franchiser would then have little incentive to live up to the contract (to maintain the flow of business and to police all franchisees). The franchiser could run off with all the gains and no costs. As a consequence, both the franchiser and franchisee will likely agree to an up-front payment that is less than the difference in the two income streams identified above and to add a royalty payment. The royalty payment is something the franchisee, not just the franchiser, will want to include in the contract simply because the franchiser will then have a stake in maintaining the franchisee’s business. A combination of some up-front payment and royalty is likely to maximize the gains to both franchisee and franchiser. Franchising also has risk problems no matter how carefully the contract may be drawn. Typically, franchisees invest heavily in their franchise, which means the franchisee has a risky investment portfolio because it is not highly diversified. This can mean that the franchisee will be reluctant to engage in additional capital investment that could be viewed as risky only because of the lack of spread of the investment. As a consequence, franchisers will tend to favor franchisees that own multiple outlets. A franchisee with multiple outlets can spread the risk of its investments and can more likely internalize the benefits of its investments in maintaining store quality (customers are more likely to patronize, or fail to do so, at another of the owner’s outlets). Obviously, both ownership and franchise methods of expansion have costs and benefits for investors. We can’t here settle the issue of how a firm like McDonalds should expand, by ownership of additional outlets or by franchising them. All we can do is point out that franchising should not be as important when markets are “local.” It should not, therefore, be a surprise that franchising grew rapidly in the 1950s with the spread of television that greatly expanded the market potential for many goods and services and when transportation costs 49 See James A. Brickley and Frederick H. Dark, “The Choice of Organizational Forms: The Case of Franchising,” Journal of Financial Economics, vol. 18 (1987), pp. 401-420. Chapter 6. Reasons for Firm Incentives 34 began declining rapidly, which allowed people to move among local markets. 50 Franchising will tend to be favored when there is a low investment risk for the franchisee and when there are few incentives for free riding by both franchisee and franchisers. We should expect that franchises should be favored the greater the monitoring costs (implying the farther the store location is from the franchiser, the more likely the expansion will be through franchising, a conclusion that has been supported by empirical studies 51 ). Also, we would expect stores at locations with relatively few repeat customers to be company owned. A better way of putting that point is the fewer the repeat customers in a given location, the greater the store will be company owned. When a store has few repeat customers, the incentive to cheat is strong, which means that the franchiser will have to maintain close monitoring to suppress the incentive for the franchisee to cheat or free ride – which implies there may be fewer cost advantages to franchising the location. 52 If monitoring costs go down, we should expect firms to increase their ownership of their outlets. Much of what we have written in this chapter is based on the presumption that people will behave opportunistically. We see the presumption as well grounded, given the extent to which people do behave that way in their daily dealings (and most managers have no trouble identifying instances of opportunistic behavior in workers, suppliers, and investors). We may, however, have given the impression that we believe that all people are always willing to behave opportunistically, which is simply contradicted by everyday experience. The business world is full of saints and sinners, and most people are some combination of both. We simply base our discussion here and in later chapters on a presumption that people will behave opportunistically not because such an assumption is fully descriptive of everyone in business, but because that is the threat managers want to protect themselves against. Business people don’t have to worry about the Mother Teresa’s of the world. They do have to worry about less-than-perfect people. (And they do have to worry about people who pretend to be like Mother Teresa before any deal is consummated.) They need to understand the consequences of opportunistic behavior in order that they can appropriately structure contracts and embedded incentives. 50 G. Frank Mathewson and Ralph A. Winter, “The Economics of Franchise Contracts,” Journal of Law and Economics, vol. 28 (October 1985), p. 504. 51 Brickley and Dark, “The Choice of Organizational Forms: The Case of Franchising,” pp. 411-416. 52 Unfortunately, the only available study on the relationship between the extent of repeat business and the likelihood of franchising (Brickley and Dark, “The Choice of Organizational Forms: The Case of Franchising,”) does not confirm the theory. These researchers investigated how the location of outlets near freeways affected the likelihood that they would be franchised. They assumed that locations near freeways would have limited repeat business. Hence, they expected that locations near freeways would tend to be company owned, but they found the exact opposite: outlets near freeways tended to be franchised. The inconsistency between the findings and the prediction could be explained by the fact that the theory is missing something. However, it could also be, as the researchers speculate, that the problem is their measure of repeat business; locations near freeways may not be a good measure of repeat business. Such locations might get more repeat business than was assumed when it was selected as a proxy. Chapter 6. Reasons for Firm Incentives 35 Here, we have shown how opportunistic behavior can arise in the most basic of management decisions, whether to “make or buy.” An important task of a good manager is being constantly attentive to the trade-off between the advantages of buying and those of making, and one of the major worries is the extent of opportunistic behavior in that decision. In assessing this trade-off managers need to be aware that the decision is dependent upon the nature of what is to be bought or produced and that bureaucratic tendencies within a firm can distort decisions in favor of producing in-house even though buying would be more efficient. The firm that loses sight of this tendency may soon be out-competed by smaller firms that rely less on internal allocation and more on specialization and market transactions to produce at lower cost. This suggests that the size and specialization of firms will change over time in response to technological advances that alter the relative costs of market transactions and the costs (as well as the efficiency) of managerial control. In other chapters we discuss the effects that improvements in communication, transportation, and management information systems are having on the size and focus of firms. The trend for firms to downsize and to refocus on their “core competencies” can be explained, at least in part, by the reduced cost of smaller, more specialized firms dealing with each other through market exchange in collaborative productive efforts. But no matter how specialized firms become, resources will continue to be allocated differently within firms than they are across markets. The reason firms will continue to exist is that over some range of productive activity, it is more efficient for resources to be directed by managerial control than by market exchange. 53 MANAGER’S CORNER: Fringes, Incentives, and Profits Varying the form of pay is one important way firms seek to motivate workers – and overcome the prisoners’ dilemma/principal-agency problems that have been at the heart of this chapter. And worker pay can take many forms, from cold cash to an assortment of fringe benefits. However, it needs to be noted that workers tend to think and talk about their fringe benefits in remarkably different terms than they do about their wages. Workers who profess that they “earn” their wages will describe their fringes with reference to what their employers “give” them. “Gee, our bosses give us three weeks of vacation, thirty minutes of coffee breaks a day, the right to flexible schedules, and discounts on purchases of company goods. They also provide us with medical and dental insurance and cover 80 percent of the cost. Would you believe we only have to pay 20 percent!” 53 It should be pointed out that even when managers within the firm control resources, this control couldn’t be exercised independently of market forces, at least not for long. Unless the firm is using its productive resources to produce goods and services that pass the market test, it will soon be forced through bankruptcy and have to relinquish those resources to more efficient firms. Chapter 6. Reasons for Firm Incentives 36 Wages are the result of hard work, but fringes, it seems, are a matter of employer generosity. Fringes are assumed to come from a substantially different source, such as out of the pockets of the stockholders, than wages, which come out of the revenues workers add to the bottom line. Employers use some of the same language, and their answers to any question of why fringes are provided are typically equally misleading, though probably more gratuitous. The main difference is that employers inevitably talk in terms of the cost of their fringes. “Would you believe that the cost of health insurance to our firm is $4,486 per employee? That means that we spend millions, if not tens of millions, each year on all of our employees’ health insurance. Our total fringe-benefit package costs us an amount equal to 36.4 percent of our total wage bill!” The point that is intended, though often left unstated is “Aren’t we nice?” If either the workers or the employers who make such comments are in fact telling the truth, then the company should be a prime candidate for a hostile takeover. Someone -- a more pragmatic and resourceful businessperson -- should buy the owners out, and the workers should want that someone to buy the company because they could then share in the gains to be had from the improved efficiency of the company. Our arguments here will be a challenge to many readers since it will develop a radically different way of thinking about fringe benefits. It will require readers to set aside any preconceived view that fringes are a gift or that fringes are either provided or they are not. The approached used here employs what we call marginal analysis, or the evaluation of fringes in terms of their marginal cost and marginal value. It is grounded in the principle that profits can be increased so long as the marginal value of doing anything in business is greater than the marginal cost. This principle implies that a firm should extend its output for as long as the marginal value of doing so (in terms of additional revenue) exceeds the marginal cost of each successive extension. It should do the same with a fringe: provide it so long as it “pays,” meaning so long as the marginal cost of the fringe is less than its marginal value (in terms of wages workers are willing to forgo and greater production) for the firm. This way of looking at firm decision- making means that changes in the cost of fringes can have predictable consequences. An increase in the cost of any fringe can give rise to a cut in the amount of the fringe that is provided. An increase in the value of the fringe to workers can lead to more of the fringe being provided. Workers As Profit Centers We don’t want to be overly crass in our view of business (although that may appear to be our intention from the words we have to use within the limited space we have to develop our arguments). We only want to be realistic when we surmise that from our economic perspective (the one that is likely to dominate in competitive business environments), the overwhelming Chapter 6. Reasons for Firm Incentives 37 majority of firms that provide their workers with fringes do so for the very same reason that they hire their workers in the first place: To add more to their profits than they could if they did something else. Like it or not, most firms are in the business of making money off their employees -- in all kinds of ways. The reason many firms don’t provide their workers with fringe benefits -- with health insurance being the most common missing fringe in small businesses especially -- is that they can’t make any money by doing so. The critical difference between those employers who do provide fringes and those who don’t is not likely to have anything to do with how nice each group wants to be to its employees. We suspect that both groups are equally nice, or equally crass. There is really no reason to believe that people who do not provide some form of fringes (or provide less of some form) are, on average, any more derelict in their duty to serve mankind than are the people who do. When making decisions on fringe benefits employers face two unavoidable economic catches: First, fringes are costly, and some fringes, like health and dental insurance, are extraordinarily costly. Second, there are limits to the value workers place on fringes. The reason is simply that workers value a lot of things, and what they buy, directly from vendors or indirectly via their employers, is largely dependent on who is the lowest cost provider. Yes, workers buy fringe benefits from employers. They do so when the value the workers place on the fringes exceeds the cost of the fringes to the firms. When that condition holds, firms can make money by, effectively, “selling” fringes -- for example, health insurance -- to their workers. How? Most firms don’t send sales people around the office and plant selling health insurance or weeks of vacation to their employees like they sell fruit in the company cafeteria, but they nevertheless make the sales. They do it somewhat on the sly, indirectly, by offering the fringes and letting their particular labor market conditions adjust. If workers truly value a particular fringe, then the firms that provide the fringe will see an increase in the supply of labor available to them. They will be able to hire more workers at a lower wage and/or be able to increase the “quality” (productivity) of the workers that they do hire. Firms are paid for the cost of providing fringe benefits primarily in two ways: One, their real wage bill goes down with the increased competition for the available jobs that results from the greater number of job seekers (who are attracted by the fringe). This reflects the willingness of workers to pay employers for the fringe benefits. Two, employers gain by being more discriminatory in whom they hire, employing more productive workers for the wages paid and increasing sales. No matter what happens in particular markets, we know several things about the pattern that will emerge in the fringe-benefit market: • Many firms (but not all) can make money by “selling” fringes to their workers. • Firms won’t provide the fringes if the combined gains from lower wages and better workers are not greater than the cost of the fringes. Chapter 6. Reasons for Firm Incentives 38 • Workers, who may suffer a decline in their wages because of their fringes, will still be better off because of the fringes that they buy. Otherwise, the fringes would not be made available by the firm or the number of job seekers would not increase, and the firms could not justify providing the fringe. • If providing a given fringe is profitable for firms, there will be competitive pressures to provide it. Otherwise, firms that do not provide the fringe will have a higher cost structure (because their total wage bill will be higher by more than the cost of the fringe) and will be in a less competitive position. To see these points with greater clarity, we must look to a graph, albeit a simple one, using only the supply and demand curves with which you must now be familiar. We have drawn in Figure 6.2 normal labor supply and demand curves. The downward sloping labor demand curve, D 1 , shows that more workers will be demanded by firms at lower wage rates than higher wage rates and reflects the circumstance in which no fringe benefit is provided. The upward sloping curve, S 1 , shows that more workers will come on the markets at higher wage rates than at lower ones and reflects an initial circumstance in which a given fringe benefit (such as health insurance) is not provided. These embedded assumptions regarding the slopes of the curves are totally reasonable and widely accepted as reflecting market conditions. At any rate, without the fringe the workers will receive a wage rate of W 1 , where the market clears. _______________________________________ __ Figure 6.2 Fringes and the Labor Market If fringes are more valuable to workers and they impose a cost on the employers, the supply of labor will increase from S1 to S2 while the demand curve falls from D 1 to D 2 . The wage rate falls from W1 to W 2 , but the workers get fringes that have a value of ac, which means that their overall payment goes up from W 1 to W 3 . _______________________________________ __ Consider the simplest of cases, the one in which the firm’s cost in providing a fringe benefit is a uniform amount for each worker and in which the provision of the fringe has no impact on worker productivity, but increases the value of work and increases the supply of . sales, for the right to use a brand name and/or trademark -- for example, the name “McDonalds” along with the “golden arches.” Chapter 6. Reasons for Firm. the real world of transaction costs, it was better for mining companies to also provide basic services for their employees. This is not to say that there