Or Why We Need More Inframarginalism
Todd Henderson and Steven Kaplan commit one of the more basic economic mistakes I have encountered, one all the more embarrassing because they are Chicago lawyers and economists.
They write that the private equity industry should not be judged based on its low returns net of fees because “[w]hile this is the appropriate metric for the decision about whether an individual should invest, what matters for society is how much wealth they create above the next-best alternative.” If you don’t net out the fees, they argue, then private equity shows large returns, and those returns reflect the creation of social value.
What Henderson and Kaplan have done here, in case you missed it just now, is to argue that an industry is productive by redefining a cost—and not just any cost, but that sacredest of sacreds, the fund fee—as social value.
But if they really mean to do that, which I doubt, then they’re actually making the case that private equity earns excess—read unnecessary—profits. Profits that represent a redistribution of wealth from consumers to private equity firms.
Unfortunately, Costs Are Costs
Let’s say that you decide to build a fence, but you’re terrible at it. You nail in all the slats askew and some of them fall off on the way to market. The cost to you was $50 in materials and $30 in labor, judged by the wage in your next best alternative line of employment.
Because your fence is a disaster, however, you are only able to sell the thing for $70, resulting in a loss of $10. Economics teaches that your fence business is a waste of economic resources. You expended $80 in combined value of resources to generate a product that created only $70 of value for consumers.
But Henderson and Kaplan say no. You have created $20 in value, the difference between the price of $70 paid by consumers and your materials costs of $50, because, well, if we ignore your $30 in labor costs, then you did!
What they don’t seem to realize is that the only way you can actually make that $30 in labor costs evaporate is if you don’t actually have an opportunity cost there for your labor; no one would have paid you a dime at any alternative employment. But if that’s true, and your costs really are just $50, then you didn’t need to charge $70 for the fence in order to have an incentive to build it. You just needed to charge $50, and so your $20 in profits are pure and unnecessary appropriation of surplus.
Which means that Henderson and Kaplan are inadvertently arguing that private equity is overpaid.
The Distinction between Value and Cost
But I really don’t think that’s what Henderson and Kaplan mean to argue. I think they are just confused about the relationship between value and cost, a confusion that is, alas, all too common in debates regarding law and economics, as I outline in a recent law review article.
The distinction between value and cost turns in fact on another distinction, that between utility and value.
The fence, even a badly constructed fence, has some utility for consumers, and that utility is measured by the maximum price that consumers are willing to pay for the fence: $70. In trying to avoid netting out costs and focusing instead on gross magnitudes, Henderson and Kaplan seem to be trying to say that utility and social value are one and the same.
But that $70 doesn’t represent value for society, because it does not account for the costs—the disutility—associated with generating it. If society must give up $80 in order to make a $70 fence, then society loses. Utility and social value just aren’t the same thing, as any careful undergraduate economics student should know.
To figure out how much value a business creates, you have to compare the utility the firm generates for those who use its products with the disutility—the costs!—the firm must create in order to produce those products. That is, value is a net quantity, it’s the difference between the maximum that consumers are willing to pay for the product and the cost of producing it. So the social value of private equity isn’t measured just by the gross returns that it generates, but by the returns it brings in net of costs.
Fund Fees Are Costs
Including fund fees.
Costs in the economic sense are all harms that must be suffered in order for production to take place. The lost fees associated with not engaging in their next best alternative mode of employment outside of the private equity industry represent a cost, a harm, incurred by private equity funds in pursuing their work of privately acquiring and running firms. The fees that private equity firms charge must therefore be high enough fully to compensate them for this harm, otherwise they would not do private equity.
Henderson and Kaplan simply cannot ignore those fees in calculating the social value of private equity. They measure the harm of opportunities foregone to engage in private equity, the very harm of not sending physicists and engineers into physics and engineering, but instead allocating them to private equity funds, that critics of private equity decry.
If private equity can’t generate a decent return after netting out those costs, then private equity is social waste.
Unless They Represent Redistribution
The only way private equity fees don’t count as costs is if they not only fully compensate private equity firms for not engaging in some other line of business, but go beyond that to provide additional compensation. In which case some portion of the private equity fee can only represent one thing: an appropriation by private equity of the social value that private equity generates.
That is, private equity fees can only be ignored in the calculation of social value, as Henderson and Kaplan argue that they should be, if they represent an appropriation, by the private equity industry, of social value, defined as the value generated by their activities in excess of costs. And because Henderson and Kaplan appear to argue that we can count all private equity fees as social value, they are arguing that all private equity fees represent pure redistribution of social value from consumers to firms.
But precisely because social value is value in excess of cost, defined as the minimum necessary to compensate for all harms, it is value that does not need to be paid to firms in order to induce them to create social value. (Okay, it is necessary to pay private equity a penny more than cost, so that doing private equity makes firms strictly better off than they would be in their next-best alternative employments. Or just a ha’penny. Or a mill. But you get my point.) So what Henderson and Kaplan are arguing, in effect, is that private equity is taking more out of markets than is necessary to induce them to do private equity.
Government could, if Henderson and Kaplan are right, therefore dictate lower private equity fund fees without reducing social value one bit. Which sounds like a great idea to me.
Inframarginalists Don’t Make This Mistake
What really seems to have gotten Henderson and Kaplan into hot water is a lack of attention to the distribution of wealth between buyers and sellers in individual markets, what Michael Guttentag once described to me in conversation as “inframarginalism,” in contrast to the “marginalism” of a microeconomics that focuses on problems of efficiency.
What matters for efficiency-oriented lawyers and economists is that all units of output for which buyers are willing to pay marginal cost actually get produced. Which means that marginalists are interested in the cost-benefit analysis of the marginal unit of production.
Inframarginalists, by contrast, are interested in how the aggregate social value created over all of the other units produced by the firm—the inframarginal units—is distributed between buyers and sellers.
So social value is a bread and butter concept for inframarginalists. If they can’t define it properly—by netting costs out of willingness to pay—they can’t do their work.
And because inframarginalists know where social value begins and ends, they are unlikely to make the same mistake as Henderson and Kaplan.