Author: Ramsi Woodcock

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Meta

Is the Law Still Enchanted?

[A]ll fields of specialized knowledge or practice like law . . . depend on their internal perspective. The internal discourse of a field represents the language in which the insiders to the field explain or persuade other insiders. In law, the internal perspective may use concepts like precedent, analogy, or doctrine to explain or justify an outcome that a historian might ascribe, for example, to the power of the groups being represented by the parties. So one should not have been surprised to realize that the externalist perspective of [Horwitz’s The] Transformation [of American Law 1780-1860] cheered most historians and brought criticism from the lawyers. But the passionate tone of the criticism uncovered another dimension that did come as a surprise–the extent to which many legal scholars were still deeply invested in a picture of law as the expression of neutral principles.

I had supposed that the lessons of legal realism had seeped into the consciousness of the legal academy. Still, it was becoming increasingly apparent to me that so much of the legitimacy of legal discourse continued to depend on assuming a sharp separation between law and politics. Most conceptions of the rule of law have been built on the possibility of identifying a clear line between the two. Thus, much of legal scholarship is perennially threatened by an external perspective that is skeptical of the claimed boundaries between law and politics.

Morton J. Horwitz, 28 Law & Social Inquiry 1157, 1158 (2003).

I know that in many, many quarters the legitimacy of legal discourse still did depend on assuming a sharp separation between law and politics when Horwitz wrote this in 2003.

But does it still today?

Who today defends the notion that the language of the law alone determines outcomes?

Who today would gladly die on Plain Meaning Hill or Laugh-Test Field?

Who would stake it all on the notion that there are some interpretations of the law so obvious to every American as to make them binding?

As with all disillusionments, the sky has not fallen.

Or has it?

Categories
Antitrust Civilization Monopolization Paradise Lost World

Permian-Triassic Extinction Event Antitrust

The Great Dying deconcentrated markets:

The complexity of an ecosystem can be estimated by the relative number of species: if a handful of species dominate, and the rest carve out a marginal existence, then the ecosystem is said to be simple. But if large numbers of species coexist together in similar numbers, then the ecosystem is far more complex, with a much wider web of interactions between species. By totting up the number of species living together at any one time in the fossil record, it’s possible to come up with an “index” of complexity, and the results are somewhat surprising. Rather than a gradual accrual of complexity over time, it seems that there was a sudden gearshift after the great Permian extinction. Before the extinction, for some 300 million years, marine ecosystems had been split roughly fifty-fifty between the simple and complex; afterwards, complex systems outweighed simple ones by three to one, a stable and persistent change that has lasted another 250 million years to this day. So rather than gradual change there was a sudden switch. Why?

According to paleontologist Peter Wagner, at the Field Museum of Natural History in Chicago, the answer is the spread of motile organisms. The shift took the oceans from a world that was largely anchored to the spot — lamp-shells, sea lilies, and so on, filtering food for meager low-energy living — to a new, more active world, dominated by animals that move around, even if as inchingly as snails, urchins and crabs. Plenty of animals moved around before the extinction, of course, but only afterwards did they become dominant. Why this gearshift took place after the Permian mass extinction is unknown, but might perhaps relate to the greater “buffering” against the world that comes with a motile lifestyle. If you move around, you often encounter rapidly changing environments, and so you need greater physical resilience. So it could be that the more motile animals had an edge in surviving the drastic environmental changes that accompanied the apocalypse . . . . The doomed filter feeders had nothing to cushion them against the blow.

Nick Lane, Life Ascending: The Ten Great Inventions of Evolution 145-46 (2009).

There is much food for antitrust thought in evolutionary history if you think of firms as representing methods of extracting value from the consumer environment. That makes them like species, all the members of which tend to use the same methods of extracting value from the natural environment. One species of bird uses long bills to get worms. Another uses short bills. And so on.

The Advantage of Incumbency

The Great Dying teaches a number of lessons. First, like the Cretaceous–Paleogene extinction event about which I have written before, it suggests the advantages of incumbency. The fact that less motile organisms have not reattained their former dominant position in the 250 million years of relative competition that has prevailed since the Great Dying tells you that less motile organisms were not particularly competitive relative to motile organisms. And yet for the 300 million years until the Great Dying they dominated, despite the parallel existence of more motile organisms. Why? Perhaps simply because they evolved first.

Industrial organization economists have long warned about these “first-mover advantages,” but the antitrust laws ignore them. The “conduct requirement” in antitrust holds that simply being dominant is not an offense in itself. There are plenty of good reasons for that rule, because it’s easy to use it to punish justified market success. But one bad reason to support the rule is that the dominant firm is always the better firm. If the history of the Great Dying is any guide, incumbency does sometimes protect uncompetitive firms.

Competition’s Good Side or The Virtue of Theft

The Great Dying’s second lesson for antitrust has to do with motility, for motility means, at least in part, predation and theft. Creatures that move can seek out new environments not yet colonized by stationary organisms feeding off minerals or sunlight. But one of the major things that motile organisms also do is to predate. Motility lets you range across the environment eating the organisms that have done the hard work for you of generating energy from light and inanimate matter.

We think of theft as being a problem in the law. We like to say that theft reduces incentives for innovation and economic growth because it means that innovators can’t fully reap the fruits of their productive labors. The plant that has a leaf torn off by some vicious armored predator has done the environmentally-friendly work of converting light to energy without so much as emitting a single carbon atom, and yet here the fruits of its labors have been stolen from it. Fortunately, we say, in the business context the law is there to stop such theft.

But the fact that the flourishing of motility after the Great Dying was correlated with an increase in ecosystem complexity—a reduction in species dominance—suggests that theft is not necessarily bad, at least if deconcentration of markets is your thing.

This is a familiar point, approached from a different angle. Industrial organization scholars have long pointed out that the strength of intellectual property protection matters. Make the patent term too lengthy and innovation will fall below optimal levels, because inventors won’t be able to build on prior art to create the next generation of inventions. It follows that if patent rights are too strong, then theft of intellectual property could actually lead to more innovation, and richer and more complex markets. Similarly, when a monopolist ties up a source of supply and uses it to suffocate competitors, theft would bring more competition to the market.

Antitrust recognizes the importance of theft for competition, although antitrust—probably wisely—doesn’t say so in quite such stark terms.

Every time antitrust enforcers order a dominant firm to supply an essential input to competitors—and antitrust does do that occasionally, even in the United States—antitrust is, objectively speaking, revising a property right. Which is to say: authorizing disadvantaged firms to steal from the dominant firm.

The nice thing is that when you’re the law you get to define the boundaries of the law, so you can plausibly say it’s not theft that you’re authorizing, but rather that the dominant firm’s ownership rights over the essential input never actually included the right to deny the input to competitors.

Regardless how it’s characterized, antitrust’s forced dealing remedy does allow other firms to take the fruits of the defendant’s labors, and for a price that must be less than their value, otherwise the taking would provide no competitive succor to the beneficiaries. That’s legalized predation in the biological sense. The aftermath of the Great Dying suggests that it’s probably justified, at least if the goal is to deconcentrate markets.

Competition’s Bad Side or The Horror of Predation

But at the same time, one must proceed with caution in celebrating the complexification of ecosystems that followed the Great Dying, because complexity and competition are not ends in themselves.

There’s a reason for which biologists also refer to the great age before any predators had evolved, the Ediacaran period, as the “Garden of the Ediacara.” We can view the rise of motility and predation, and the demise of filter feeder dominance after the Great Dying, as leading to a golden age of competition and complexity. It’s the golden age we live in today (or lived in until we started wiping out large parts of it starting with the end of the last ice age).

Or we can view the rise of motility and predation as destroying a peaceful Eden in which life competed principally on the virtuous project of converting the inanimate into the animate, of extracting energy from the physical environment, rather than from other living things.

From this perspective, if over the first 300 million years of the existence of complex life evolution tended to hit a wall, and for eons life did not get much better at converting the inanimate to the animate, then that says something about the limits of biology. It does not tell us that the motility, predation, and theft that followed represented an improvement.

From this perspective, the rise of motility and predation was instead a symptom of evolution’s defeat. When life could no longer advance by getting better at converting inanimate matter to animate matter, it turned on itself, leading to the hell of predator-prey competition that has characterized the past 250 million years. If only there had been a world government in the Ediacaran capable of enforcing the basic rules of criminal and property law!

Life would have stayed happy.

In general, the antitrust laws today are much more sympathetic to this dark view of predation than to the other. Antitrust enforcers for the most part shy away from revising property rights. And the legal system as a whole, of which antitrust is just a part, gives great priority to property. The natural world is, of course, the state of nature. And if there is one thing that separates civilization from the state of nature, it’s the concept of property, the notion that theft is to be curtailed, and that evolution within civilization is to take place along the old Ediacaran lines, with each attempting to better himself other than at the expense of others.

Over its first 300 million years, complex life does seem to have hit a wall in bettering itself through virtuous, non-predatory competition, at least so far as the biochemistry of energy production out of inanimate matter is concerned. Our inability to generate energy other than by burning fossil fuels shows that for all our own ingenuity we humans haven’t managed to outdo nature either. We live off the productive labors of other creatures, including both living plants and those dead so long as to have been ground into oil. That makes us, and the horror we have meant for the planet, the logical extreme end of the triumph of motility and predation after the Great Dying.

But the fact that civilization’s vision, honored however often in the breach, is fundamentally Ediacaran, suggests to me that there is hope. Climate disaster is effectively forcing us to extend the property laws we enforce within civilization to the life outside of it. With luck, the virtuous, non-predatory competition that results will help us achieve the breakthrough that life could not, and allow us to advance into new methods for generating energy from the inanimate.

Categories
Apocrypha Miscellany World

Of Course They Could Have Carried It

Not quite: “In 1453, Mehmed II conquered Constantinople, and although his troops plundered what they could carry, the building was saved and turned into a mosque,” writes The New York Times, which makes it sound like the building was saved by sheer luck.

In fact, the Turks treated Hagia Sophia with honor. In contrast to other churches that had been seized and converted into mosques, the conquerors refrained from changing its name, merely adapting it to the Turkish spelling. (“Ayasofya” is the way it is written in Turkey today.) Mehmet, says Ilber Ortayli, director of the Topkapi Palace Museum, the former residence of the Ottoman emperors, “was a man of the Renaissance, an intellectual. He was not a fanatic. He recognized Hagia Sophia’s greatness and he saved it.”

Remarkably, the sultan allowed several of the finest Christian mosaics to remain, including the Virgin Mary and images of the seraphs, which he considered to be guardian spirits of the city. Under subsequent regimes, however, more orthodox sultans would be less tolerant. Eventually, all of the figurative mosaics were plastered over. Where Christ’s visage had once gazed out from the dome, Koranic verses in Arabic proclaimed: “In the name of God the merciful and pitiful, God is the light of heaven and earth.”

Fergus M. Bordewich, A Monumental Struggle to Preserve Hagia Sophia, Smithsonian Magazine, Dec. 2018.
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World

Forgetting Why You Won

The New York Times tells us that “China has laid the groundwork to dominate the market for protective and medical supplies for years to come[]” because it has pursued a policy of subsidizing strategically important industries, like PPE, including by protecting them from foreign competition.

History tells us why China does that. It’s the reason for which the victim tends to remember how a fight was won better than the victor. For about a century ending in 1949, China came close to being wiped off the map repeatedly because it couldn’t control access to its own markets and didn’t have dominance in any strategically important industries to use as a bargaining chip. Foreign powers used their control over strategically important industries, not least those relating to defense, to prize open Chinese markets to foreign goods, wiping out local production. It’s not for nothing that one reads in an economic history that “British competition de-industrialized most of Asia . . . .”

That didn’t come about because a large gap in technology or industry existed between China and the rest of the world when China’s fall started in the early 19th century. On the eve of the industrial revolution, China was a wealthy country and could defend its borders. It was a difference of degree that mushroomed into near destruction. The Chinese never forgot their lesson in the foundations of modern power.

But we did. Did we really think that after more than a century of struggle to regain control over their own markets, at the cost of millions upon millions of lives, the Chinese were going to throw their markets back open to the rest of the world, laissez-faire-style, and run the risk that domestic industry would be out-competed once again? Did we think that the Chinese would not sit down and think carefully about how to take advantage of the rest of the world’s fleeting, pie-in-the-sky romance with free trade silently to achieve dominance in strategically important global industries? Did we think the Chinese didn’t learn their lesson?

Whatever you may think of the Chinese government, this is no kakistocracy happily selling its people out for a bit of short-term gain and a life of luxury in future exile, whatever the Times may once have wanted us to believe with its deep dive on Chinese princelings. Whatever it might have been for a spell decades ago now, today China is no North Korea, hobbled by corruption, operated as an extension of a few personalities. It is a government that knows and jealously guards the national interest.

It would be nice if ours did too.

Categories
Inframarginalism Miscellany Monopolization Regulation

Damages as Personalized Pricing in Favor of Wrongdoers

All courts do all day in civil cases in which the remedy is money damages is to engage in personalized pricing in favor of consumers. The plaintiff is the producer, the defendant is the consumer. And the damages amount is the price charged to the defendant for whatever it is that the defendant has taken from the plaintiff in violation of law, whether dignity, reputation, an arm or a leg.

When private enterprise personalizes prices, it chooses the highest possible prices: price equal to the maximum that the consumer is willing to pay. That is, firms strive to engage in perfect price discrimination.

Courts do the opposite. They personalize the prices of legal wrongs to be the lowest possible prices consistent with compensating victims: price equal to the cost to the plaintiff of the violation of law, and not a penny more. That is, courts strive to engage in what I have called perfect cost discrimination.

That’s weird, when you think about it.

All lawbreaking amounts to a forced sale. The defendant who shoots off the plaintiff’s arm forces the plaintiff to sell his arm to the defendant, or at least to sell the defendant the service of having an arm shot off, and whatever attendant satisfaction that provides the defendant, whether in the form of a feeling of security, the pleasures of power and domination, revenge, or what have you.

The law, in prohibiting battery, recognizes in the plaintiff a right to payment for the service. And if the transaction were not forced, and the plaintiff were to have any amount of market power, which we would expect to exist in spades with respect to the subject of many prohibitions–very few people are willing voluntarily to part with their arms, for example–then the plaintiff would almost surely charge a price for the arm above the bare minimum necessary to compensate the plaintiff for the harm. That is, if the exchange were voluntary, the price would in many cases be much in excess of cost, and indeed much closer to the maximum that the defendant would be willing to pay. Indeed, it seems reasonable to suppose that the defendant forces the transaction precisely because the defendant hopes to avoid being charged a price equal to the maximum the defendant is willing to pay.

So you would expect the law to provide the plaintiff with something closer to the bargain that the plaintiff would have struck voluntarily with the defendant. That at least would ensure that the defendant enjoys no gain from breaking the law and forcing a transaction.

But the law doesn’t see it that way.

The “rightful position” principle in remedies teaches that courts should measure damages in order to put the plaintiff in the position that the plaintiff would have occupied if the defendant had not engaged in the bad act. That causes courts to set the lowest possible price for breaking the law, rather than a price that approximates the voluntary price. For the position that the plaintiff would have occupied without the bad act is assumed to be the one in which no transaction takes place at all and the harm of the transaction has therefore not been inflicted. So damages under this measure just equal the amount necessary to compensate for harm. That is, the cost of the transaction to the plaintiff.

Law and economics scholars have made much of this cost-based baseline, arguing that it leads to optimal deterrence. The idea is that it forces the bad actor to internalize the costs of his actions. And so he will only act to break the law if the gains to him exceed the costs, which is to say, only if cost-benefit analysis shows that the action is efficient.

But that ignores something rather important about optimally-deterrent pricing: there isn’t just one optimal price. So long as the price the defendant pays for the forced sale is personalized, which it must be in a legal system in which judges award damages on a case-by-case basis, any price between cost and the maximum the defendant is willing to pay for the harm is optimally deterring.

Only a price above the maximum that the defendant is willing to pay–as opposed to cost–prevents the defendant from forcing the sale when the benefit exceeds the cost. So only such an extraordinarily high price is non-optimal. The maximum the defendant would be willing to pay is a measure of the benefit to the defendant. So only a price above that maximum drives the defendant away. There isn’t one optimally deterring price, but a range, that from cost all the way up to the maximum the defendant is willing to pay.

Where the courts set the price of illicit conduct within that range matters, because price determines the distribution of wealth between the plaintiff and the defendant, the victim and the injurer. By setting the price equal to cost, courts today achieve the perverse outcome of allowing the injurer to retain all of the gains associated with the forced transaction.

To fully appreciate this perversion, imagine that you decide voluntarily to sell your house. You could sell it at cost, including a reasonable return on investment. But that would be disappointing. What you’d like to do is sell it at the highest price anyone is willing to pay for it. If you do, then you extract all of the value created by the transfer. The buyer obviously places a higher value on the house than you do, otherwise he wouldn’t buy and you wouldn’t sell, and because you charge the highest price the buyer is willing to pay, you cause the buyer to pay out all of that excess value over to you.

By contrast, if you sell at a price equal to cost, including a reasonable return on investment, you don’t extract any of the excess value buyers place on the house. What you paid plus a reasonable return is the value you place on the house, the reasonableness of the return being enough to make you sell at that price. So when you sell at that price, the buyer pays you your valuation, and not a penny more.

Selling at a price equal to cost, including a reasonable return on investment, doesn’t therefore enrich you at all. It just lets you break even in a sense: you give up your house in exchange for a price equal to the value you place on the house.

But now suppose that you decide not to sell the house. You don’t like the price the buyer is offering. You believe the buyer is willing to pay more and you want to hold out until he does. And the buyer responds by bursting in your door one morning, holding a gun to your head, and telling you to clear out permanently, which of course you do, before filing a lawsuit. Now the buyer has forced a sale, and the law of trespass allows the court to dictate to the buyer the price that he must pay for your house.

Under current rules on the measurement of damages, the court would award you cost plus a reasonable return on investment, and not a penny more! The buyer could walk away with all of the gains from trade.

(Let’s put aside the fact that almost any court would issue an injunction here allowing you to repossess your house. Perhaps you’re emotionally scarred and don’t want to live there anymore, so all you demand is money damages. And let’s suppose also that your lawyer commits malpractice and fails to request punitives or damages for emotional distress.)

Which means that current damages rules turn over the entirety of the surplus generated by a violation of law to the wrongdoer! They embody the policy that the wealth generated by illegal transactions should be allocated to the scofflaw.

Which, again, is weird.

Now, you might object that courts award damages equal only to costs because the maximum that the wrongdoer would be willing to pay for the privilege of breaking the law is a thing difficult to calculate.

But so too are costs.

For costs are themselves maxima that someone would be willing to pay. The cost of an injury is the maximum that the victim would be willing to pay to avoid the injury. The cost of your house is what you paid for it plus a reasonable return on investment only because that is the maximum that you would be willing to pay to avoid having it destroyed or taken from you. More than that and you could buy a better house. And there is a subjectively element in that cost calculation: the reasonableness of the return is subjective. Current rules in theory should force courts to take that subjective element into account in awarding you compensation for harm equal to cost. And if courts can do that, they should be able to answer the question what the maximum that the wrongdoer would be willing to pay might be, including any subjective element thereof. (Indeed, courts should already do this in restitution cases, of which more below.)

You might also object that the maximum that the wrongdoer would be willing to pay is always less than the cost to the victim, because otherwise the wrongdoer would just be able to enter into a voluntary transaction with the victim to inflict the harm.

But I don’t think that’s right, at least if we want to maintain the fiction of rational decisionmaking that is all of the fun of law and economics and which itself underpins the whole theory of optimal deterrence I wish to complicate here.

The wrongdoer knows that undertaking the bad act will result in liability, and so when the wrongdoer acts, he does so knowing that he will pay a price. If the price is too high, which it will be if he inflicts a harm for which he would not be willing to pay, then he will not act. The courts therefore never can extract damages from wrongdoers in amounts above those which wrongdoers are willing to pay. If they do, wrongdoers simply will not act.

The economic problem for the courts is precisely to find the price that is high enough to ensure that the wrongdoer will not act unless he values the harm more than the victim, but not so high as to prevent the wrongdoer from acting when he does value the harm more than the victim. The trouble is that under current damages rules the courts always choose the lowest possible price.

Now, I don’t mean to suggest that the law is entirely deaf to the problem of gains from trade. One can almost always bring an unjust enrichment action and obtain the remedy of restitution, which does provide the plaintiff with the gains from trade.

But here’s the thing: restitution is an alternative remedy. Either you get restitution, or you get damages, but you don’t get both.

So a plaintiff can receive compensation for the costs to the plaintiff of illegal activity, or the gains enjoyed by the defendant, but not both. Whether the plaintiff opts for one or the other, therefore, the plaintiff will never receive a price for what he gives up equal to the maximum that the defendant is willing to pay, because the maximum that the defendant is willing to pay must equal both the cost to the plaintiff–the value the plaintiff placed on the harm–and the gains to the defendant of inflicting the harm, the excess over plaintiff’s valuation that makes the rational defendant willing to break the law in the first place.

Do punitive damages pick up the slack? It’s true that the pleasure a wrongdoer derives from inflicting harm is in itself probably sufficient to convert an intentional tort into one of malice, and that in turn can lead to punitive damages. But the doctrine of punitive damages suffers from terrible incoherence; we know that it is meant to punish, but does that mean to take some of the ill-gotten gains, or all of them, or to take more than those gains? Unless we are very lucky, punitive damages will either leave some gains with the wrongdoer or charge the wrongdoer a price in excess of willingness to pay, preventing the wrongdoer from engaging in efficient conduct.

Only a reconceptualization of the “rightful position” principle to require that courts measure damages by the maximum the defendant is willing to pay, rather than the cost to the plaintiff, would ensure that defendants do not enjoy gains from the illicit trade that is every offense under the law.

In closing, a word on the relevance of personalized pricing. Why does it matter here that, in engaging in case by case adjudication, judges effectively personalize the price of offenses?

It matters because personalized pricing is efficient whether the price charged is equal to cost or to the maximum the buyer is willing to pay. When prices can’t be personalized, and price is therefore one-size-fits-all for an entire market of buyers and sellers, then there is likely only one price that does not price some buyers or sellers willing to engage in mutually beneficial trades out of the market. That’s the price equal to marginal cost, the competitive price. And that price distributes the gains from trade between all buyers and sellers in the market in a single unique way. Try to change that distribution, by raising or lowering the price, and efficiency suffers: some buyers or sellers will be priced out of the market.

With personalized pricing, however, the court can vary the price charged to one buyer-seller pair–the defendant and plaintiff before the court–without changing the price charged to other pairs, so regardless the price the court chooses in one case, buyers and sellers won’t be priced out of the market in other cases. So the case-by-case character of adjudication opens up a world of distributive options with respect to the market for illegal activity that would not exist if the courts were to engage in one-size-fits-all damages calculations.

It’s a world that the law has failed so far fully to recognize and exploit.

Categories
Miscellany

Another Way to Fight the Virus

Why be different from your parents? . . . . [P]arasites evolve rapidly: they have short lifespans and heaving populations. It doesn’t take them long to adapt to their host at the most intimate molecular scale—protein to protein, gene to gene. Failure to do so costs them their life; success gives them the freedom to grow and replicate. If the host population is genetically identical, then the successful parasite has the run of the entire population and may well obliterate it. If the hosts very among themselves, however, there is a chance, indeed a probability, that some individuals will have a rare genotype that happens to resist the parasite. They will thrive until the parasite is obliged to focus its attention on this new genotype or face extinction itself. And so it goes on, generation after generation, cycling genotype after genotype, forever running and getting nowhere, as the Red Queen herself. So sex exists to keep parasites at bay.

Nick Lane, Life Ascending: The Ten Great Inventions of Evolution 135 (2009).
Categories
Antitrust Inframarginalism Monopolization Regulation

Wherein Henderson and Kaplan Confuse Value and Cost

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.

All 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.

Categories
Philoeconomica

Economics as Cultural Tell

Why do economic explanations feel so much more insightful than humanistic explanations? The answer may be that economists take social types as their axioms, the unsplittable atoms of the economic universe, whereas humanists take mental states to be their atoms. And we have lost the capacity to believe–really, truly believe–in the inner life.

Consider economist A.O. Hirschman’s argument that monopoly may be better for consumers than the sluggish competition of highly concentrated markets if “exit is ineffective as a recuperation mechanism, but does succeed in draining from the firm or organization its more quality-conscious, alert, and potentially activist customer or members.”

One immediately has the experience of insight here. Yes! If the competitors are already so large that most customers can’t abandon an underperforming firm, but there remain enough options that activist consumers can still bail on underperforming behemoths and buy from some scrappy startup on the competitive fringe, then the behemoths won’t be subject to voice–to the pressure campaigns that only activists are likely to bring–and so the big firms may well perform worse than if there were a single monopoly and the activists were to have nowhere to go but into the streets, onto the message boards, and to Congress to compel change.

What’s driving this experience of insight? The answer is the division of the consumer group into types. Hirschman posits the existence of an activist type, and a sleeper type who does not complain about poor quality. This typology does all of the work in his argument, as the sleepers bail out of underperforming firms when competition persists, depriving all consumers of the massive positive externality that is their activism applied to big firms.

Now consider a humanistic explanation of the same phenomenon. The sociologist, for example, might argue that competition is sometimes worse for consumers than monopoly because the absence of alternatives to a monopoly focuses consumers’ minds on using complaints and activism to induce the monopoly to reform. Whereas the existence of competition leads to apathy, because consumers know that they have the option to buy elsewhere in response to bad behavior, even if they do not exercise that option.

This humanistic explanation does not produce the same experience of insight as Hirschman’s account, at least for me. And yet it is saying exactly the same thing.

Hirschman doesn’t actually know that there are activist types, human beings who have fixed personalities that make them prone to activism in ways not true of other people. But Hirschman does know that there is a human tendency toward activism that is expressed more under some conditions than under others. The mechanism of expression is simply unclear to him and to us all. It could be that there are fixed activist types, as Hirschman suggests, but it could also be that people do change, there are no types, and activism is really a contingent mental state, called forth by monopoly buying, as the humanist suggests. Both Hirschman and the humanist are describing the exact same phenomenon, but imposing upon it different preconceptions regarding the causes of social behavior.

The humanist ties the explanation to an intellectual worldview in which mental states are the axioms, the first principles that produce the experience of insight when applied to observed phenomena. Whereas Hirschman ties the explanation to an intellectual worldview in which personality types are first principles.

But why is Hirschman’s type-casting move so intellectually irresistible?

The reason may just be that we feel more comfortable on an intuitive level dealing in human types than in mental states. If Hirschman had said that monopoly makes us complain, or makes us angry, we would have dismissed him as fishing in the soup of introspection, conjuring up emotions to suit his explanatory tastes. We would not hear “the feeling of being trapped” and say: yes! That’s why consumers discipline monopolies!

But when we hear that activist types can’t bail on monopolies, we feel a veil pulling from our eyes because we already think in terms of types informally. We all already know that there are activist types out there in the world. We have seen them with our own eyes marching in the streets. Economics is satisfying because we intuitively accept its axioms.

In other words, our love of economics should teach us that we do not really, truly, fully believe in the inner life. We feel more comfortable, as a cultural matter, with the immutable personality type than with the notion that the human is a vessel the contents of which are constantly changing as circumstances change, as new thoughts and emotions pour in and old ones pour out. Feelings are, to us, arbitrary, untrustworthy, a kind of magic trick or supernatural spirit conjured up by lazy thinkers to gloss a reality that lies elsewhere. We don’t actually believe in feelings despite all the lip service we like to pay to them.

Somehow I’m reminded of an experience watching a couple of movies with foreign friends in graduate school. One of the films was an American romcom. The other was a film by Almodovar: Women on the Edge of A Nervous Breakdown. I’d seen the romcom before and it was one of my favorites; I’d felt that it was all about the human condition, feelings, and so on.

But watching it with this crowd, and back to back with the Almodovar, was, well, embarrassing. I realized that the entire romcom was a vehicle for the expression of a single emotion at one discrete moment in the film, a kind of exhausting, Herculean effort to get in touch with feelings by a culture for which feelings remain distinctly unnatural to this day. My friends were bored out of their minds.

By contrast, the Almodovar, which for me was dizzying and inscrutable in the way that its characters seemed constantly buffeted by unseen forces, was engrossing and deeply insightful for my friends. I realized that unlike my romcom, the Almodovar film didn’t struggle to present a feeling so much as it took feelings for granted, making of them a vast ensemble of principal players in a drama that unfolded almost entirely on the plane of the inner life. With respect to that plane, that film was like the Mona Lisa standing next to the stick figure of my romcom.

All of economics is a tell regarding this type-casting value system of ours. The economist’s basic model of human behavior is the immutable preference function. When economists model individual behavior, they write down a single function, the utility function, which defines the consumer’s preferences, and then they model the consumer as acting always in a manner consistent with those immutable preferences. Thus for economists, people are always just types. The rise of so-called behavioral economics has not changed this one bit; it has just changed the menu of types.

The economist has no defense for the type-casting approach, anymore than Hirschman could possibly have been prepared to defend his attribution of activism to types as opposed to the changing mental states of consumers. It is simply in the nature of economics to approach the world in this way. You are asked to take it or leave it. And we take it, and have taken it, to a far greater extent than we have embraced any other field of social science, because economics creates for us a more visceral experience of insight.

That tells us something ultimately about ourselves.

Categories
Uncategorized

Serpico

Came across this article by the Serpico in Politico in 2014. Makes fascinating reading in light of current events.

[A]n even more serious problem — police violence — has probably grown worse [than it was when Serpico was in the NYPD in the early 1970s], and it’s out of control for the same reason that graft once was: a lack of accountability.

. . .

Today the combination of an excess of deadly force and near-total lack of accountability is more dangerous than ever: Most cops today can pull out their weapons and fire without fear that anything will happen to them, even if they shoot someone wrongfully. All a police officer has to say is that he believes his life was in danger, and he’s typically absolved. What do you think that does to their psychology as they patrol the streets—this sense of invulnerability? The famous old saying still applies: Power corrupts, and absolute power corrupts absolutely.

. . .

And with all due respect to today’s police officers doing their jobs, they don’t need all that stuff anyway. When I was [a] cop I disarmed a man with three guns who had just killed someone. I was off duty and all I had was my snub-nose Smith & Wesson. I fired a warning shot, the guy ran off and I chased him down. Some police forces still maintain a high threshold for violence: I remember talking with a member of the Italian carabinieri, who are known for being very heavily armed. He took out his Beretta and showed me that it didn’t even have a magazine inside. “You know, I got to be careful,” he said. “Before I shoot somebody unjustifiably, I’m better off shooting myself.” They have standards.

Frank Serpico, The Police Are Still Out of Control, POLITICO Magazine, Oct. 2014.

Categories
Antitrust Monopolization Regulation

Getting Big

The realization that a tight monopoly is preferable under certain circumstances to a looser arrangement in which competition is present comes hard to a Western economist. Nonetheless, the preceding argument compels recognition that a no-exit situation will be superior to a situation with some limited exit on two conditions:

(1) if exit is ineffective as a recuperation mechanism, but does succeed in draining from the firm or organization its more quality-conscious, alert, and potentially activist customer members; and

(2) if voice could be made into an effective mechanism once these customers or members are securely locked in.

There are doubtless many situations in which the first condition applies . . . .

Albert O. Hirschman, Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations and States 55 (1970).