Categories
Inframarginalism Monopolization Regulation

Confusing Scarcity with Monopoly: 1803 Edition

Proposed regulations would read New York’s law against price gouging to police gouging by small firms less strictly than gouging by big firms. I’ve argued that this confuses scarcity with monopoly.

Price gouging is the exploitation of natural scarcity to charge higher prices. Monopoly is the creation of artificial scarcity in order to charge higher prices. Big firms have the power to create artificial scarcity. But all firms can equally take advantage of natural scarcity to rip the public off. So there’s no good reason to apply a more lenient price gouging standard to small firms.

It turns out that New York Attorney General Letitia James is not the first person to get the distinction between natural and artificial scarcity wrong.

Hapsburg Austria did too.

According to a book by David J. Gerber, an 1803 statute invalidated cartel agreements “to prevent merchants from profiting from shortages caused by the Napoleonic wars, particularly in necessities such as food” (p. 53).

The law’s authors don’t seem to have reflected that the point of a cartel is to agree on output reductions and thereby to create an artificial shortage. If the Napoleonic wars have created the shortage for you, then you don’t need to form a cartel to create one.

You just raise prices.

An anti-cartel law is therefore not going to be effective at keeping prices down in wartime. Or anytime prices are driven up by natural scarcity.

It is an amazing but true fact that antimonopoly policy won’t solve every economic problem. But it does seem to have the notable property of enabling us to remake every economic mistake.

Categories
Inframarginalism Monopolization Regulation

The Counterproductive Antimonopolism in New York’s Proposed Price Gouging Rules

In the modern age, we have trouble taking ideas seriously. We prefer to think in terms of dumb mechanism. We need oil for energy. It is in limited supply. Therefore we fight over it. Therefore we have conflict in the Middle East, which has a lot of oil. We apply this sort of economic logic to everything.

The view that ideas determine social behavior seems, by contrast, wishy washy. Does anyone need an idea in the way he needs energy and hence oil to live? Why would two groups that are otherwise well fed and well clothed fight over a figment of the mind?

To the extent that we credit ideas with power, we do so only by seeing them as snare and delusion—weapons in our quest for physical resources. Ideas are spin. They are the Viceroy butterfly’s colors, which mimic those of the bitter-tasting Monarch, warding off predators. Ideas are psyops, nothing more.

The ancients didn’t have this problem. Ideas, for them, were quite obviously everything, which is why people got worked up about religious dogma, as when the greens and the blues came to blows over the question whether Jesus was mostly human or mostly god. (We still do occasionally get violent over religion today, but we see that as a shame and a throwback.)

As I have argued before, the irony of our modern disdain for the power of ideas is that one of our greatest modern inventions—the computer—is an object lesson in the importance of ideas relative to physical mechanisms. No one questions the importance of software. No one questions its influence over the behavior of our machines.

And yet we are somehow certain that our own software—ideas—is mere epiphenomenon.

Antimonopolism as Mere Idea

So it is that when I point out to progressives that antimonopolism is bad for the movement because it leads, ultimately, to a vindication of the justice of the free market, I am told not to worry because antimonopolism is just good progressive psyops. Yes, I am told, free markets are themselves engines of inequality, but being an antimonopolist isn’t the same thing as being a free marketer.

Instead, I am told, antimonopolism is a way of affirming that business interests are the enemy. It’s a way of marshaling support for government intervention. And that is all. Once progressives have ridden a wave of antimonopoly sentiment into power, I am told, they will be free to achieve progressive goals however they want, and that may or may not include more markets and more competition.

This view of antimonopoly as psyops has been most on display in progressive calls to use antitrust to fight inflation. So far as I know, a century of progressive economics had never taken the position that inflation is caused by monopolization or that antitrust might be a useful remedy.

Keynes, for example, thought inflation’s flip side—deflation—had little to do with market structure. He thought Roosevelt’s first New Deal, which was about using cartelization of markets to fight deflation, was a mistake. He invented macroeconomics because microeconomics—tinkering with market structure—was a dead end. It stands to reason that, if he thought deflation wasn’t a problem of market structure, he didn’t think inflation was either.

Progressive economists no doubt understand that the link between inflation and monopolization is tenuous at best. And yet here, for example, was Paul Krugman writing a year ago when this debate was flaring:

Give Biden and his people a break on their antitrust crusade. It won’t do any harm. It won’t get in the way of the big stuff, which is mostly outside Biden’s control in any case. At worst, administration officials will be using inflation as an excuse to do things they should be doing in any case. And they might even have a marginal impact on inflation itself.

Paul Krugman, Why Are Progressives Hating on Antitrust?, N.Y. Times (Jan. 18, 2022).

In other words, arguing that inflation is an antitrust problem is good psyops, allowing progressives to leverage concern about inflation to achieve an unrelated agenda.

Well, there are costs to this kind of instrumental use of ideas—costs that arise because, at the end of the day, ideas aren’t just weapons for striking the other side. They are the software that governs the behavior of those who harbor them. If you hold onto ideas when they’re no good, you are going to do the wrong thing.

When you run bad software, the computer does bad things.

The New York Price Gouging Regulations

The peril of harboring bad ideas is reflected in the rather peculiar interpretation of New York’s new price gouging law proposed by New York Attorney General Letitia James.

The law itself is a good one. It prohibits “unconscionably excessive” pricing during any “abnormal disruption” of a market for a good or service that is “vital and necessary for the . . . welfare of consumers”.

The language is capacious enough to allow New York to institute generalized price controls to reign in supply-chain-driven inflation, including today’s inflation. After all, a supply chain disruption is an “abnormal” disruption. And all goods are, by definition, necessary to the “welfare of consumers.”

But only if the Attorney General interprets the law that way. And here is where the power of bad ideas rears its head.

As the Attorney General acknowledges, half a dozen states—including such conservative climes as Georgia, Mississippi, and Louisiana—consider any increase in the price of covered necessities during a time of emergency to be presumptive price gouging. The price of gas can go up by a penny or ten dollars—either way, the burden is on the seller to prove that it is not price gouging.

The New York Attorney General decided, however, to take a different tack. Instead of applying the presumption to any amount of price increase by any firm, the Attorney General decided to apply it only to any amount of price increase by firms having either a 30% market share or competing in a market with five or fewer “significant competitors.” In all other cases, only a price increase in excess of 10% will trigger the presumption of price gouging.

That’s right, New York’s price gouging presumption is actually going to be narrower than Mississippi’s, because it only applies to big firms.

What gives?

Answer: bad software.

Whether they genuinely believe in antimonopolism, or think it is mere psyops, progressives have antimonopolism on the brain. Every economic problem appears to them to be a problem of monopoly. And every solution appears to them again to be a solution to a monopoly problem.

They do not see a statute that prohibits the charging of high prices as an opportunity to redistribute wealth in areas of economic life that antimonopoly policy cannot touch. Instead, they see it as an invitation to extend antimonopoly ideology into new areas.

In their minds, making such a connection actually broadens the statute, by tying it to what they are sure is the root cause of all economic injustice.

Except it isn’t. And they end up narrowing the statute instead.

So they take a statute that could be interpreted presumptively to ban all above-cost pricing attributable to supply chain disruption and use it instead presumptively to ban only above-cost pricing by big firms.

Price Gouging Is about Scarcity, Not Monopoly (and Yes, Those Are Two Different Things)

The pity of using a market concentration requirement to limit a great price gouging law is that price gouging really has zilch do to with monopoly.

Price gouging is, instead, about scarcity. Or one might say that monopoly is about artificial scarcity whereas price gouging is about the exploitation of natural scarcity.

We fear the monopolist because, in the absence of competition, the monopolist can restrict output and raise price without losing market share.

By contrast, we hate price gouging because it involves taking advantage of an involuntary restriction in supply.

When demand for food spikes before a hurricane, the public knows that supermarkets don’t have the inventory to meet demand. But the public also knows that the supermarkets originally expected to sell the inventory that they do have at normal prices. Those eggs were already on the shelves before the impending hurricane was announced. When the supermarkets raise prices, it is therefore obvious to the public that the surcharge is pure profit. That’s what makes the public mad and gives rise to price gouging laws. The manufacturing of a voluntary shortage plays no role here. No one thinks the supermarket is holding back eggs—or choosing not to order more.

Monopoly is famine while grain rots in silos. Price gouging is your neighbor demanding your house in exchange for a slice of bread—after lightning striking the silos.

That’s why price gouging statutes kick into gear only during an emergency—or, as in the case of New York’s law, during a period of “abnormal disruption” of markets. A monopolist’s decision voluntarily to restrict output and jack up prices is plenty evil, but one thing it isn’t is the sort of supply chain disruption that triggers a price gouging statute.

Confusing Scarcity with Monopoly

So what is a market concentration requirement doing in regulations implementing a price gouging statute?

The Attorney General relies on a passage in the price gouging law that identifies “an exercise of unfair leverage” as a factor in determining whether a firms has engaged in price gouging. But the phrase “unfair leverage” could just as easily refer to (natural) scarcity power as it could to monopoly power.

The Attorney General’s comments shed more light on her rationale. They explain that “firms in concentrated markets pose a special risk of price gouging because they can use their pricing power in conjunction with an abnormal market disruption to unfairly raise prices.”

This seems to articulate a category mistake. She has confused scarcity power with monopoly power.

The pricing power upon which price gouging is based is scarcity power. It is the power that arises because an act of god has eliminated part of the supply that would otherwise exist in the market. The pricing power enjoyed by “firms in concentrated markets” is not (natural) scarcity power. It’s monopoly power (artificial scarcity)—the power voluntarily to restrict supply.

A firm in a concentrated market can use its monopoly power whenever it wants, including during an “abnormal market disruption.” But whenever the firm chooses to use it, the firm isn’t using (natural) scarcity power to raise prices. It’s using monopoly power to raise prices.

If, thanks to the abnormal market disruption, the firm is able to raise prices higher than the firm otherwise might, then that extra increment is price gouging due to (natural) scarcity power. But any price increase that the firm would be able to bring about without the aid of the market disruption is due to an artificial restriction in supply and remains an exercise of monopoly power.

So it makes little sense to say that firms with monopoly power pose a “special risk” during periods of market disruption because they can use their monopoly power “in conjunction” with their scarcity power to raise prices. Firms with monopoly power pose the same risk that all firms pose during periods of disruption: the risk that they will use the additional power conferred on them by disruption-triggered scarcity further to raise prices.

If we worry that (natural) scarcity is going to tempt a monopolist to raise prices we should be equally worried that it will tempt a non-monopolist to raise prices: (natural) scarcity gives both firms the exact same kind of power—the power to exploit scarcity to raise prices.

Non-Monopoly Price Gougers Probably Do More Harm

Indeed, one would expect that the harm that a firm that lacks monopoly power can do by exploiting scarcity would generally be greater than the harm that a monopolist can do by exploiting (natural) scarcity because, before the disruption, the monopolist will already have artificially restricted output to try to raise prices to the most profitable extent.

If a monopolist has already artificially restricted supply to the most profitable extent, any additional involuntary restriction caused by the disruption may be unprofitable for the monopolist and the monopolist may, therefore, choose not to exploit it by raising prices further.

As some have long suggested, the first increase in price above costs is always the most harmful to consumers, precisely because when price equals cost, output is at a maximum and consumers reap the greatest benefit from production. They therefore have the most to lose. Subsequent price increases play out over progressively lower sales volumes, inflicting smaller and smaller amounts of harm.

But what kind of firms are induced by an abnormal market disruption to make a first increase in price above costs?

Answer: non-monopolists.

Firms in hypercompetitive markets start out with prices at or near costs before an abnormal market disruption gives them power to price gouge.

Monopolists facing abnormal disruptions have already raised their prices above costs long ago, when they first acquired their monopoly position. To the extent that they increase prices due to a market disruption, that will be far from the first increase in their prices above costs.

Disruptions Operate at the Level of Markets, Not Individual Firms, So Price Gouging Is Not Worse In Concentrated Markets

The Attorney General seems to think that because a monopolist has a large market share relative to a non-monopolist, any price increase by the monopolist will tend to cause more harm because it will apply to a higher volume of sales. She writes that large firms “have an outsized role in price setting.”

This is the sort of mistake that comes from thinking in terms of firms instead of markets.

A market disruption does not enable price gouging by striking a single firm. If a single firm’s output is restricted but no restriction is placed on the market as a whole, other firms in the market will bring more inventory to market to offset the loss of the firm’s output and no firm will have the opportunity to raise prices.

Instead, a market disruption enables price gouging by striking the entire market. If the output of the market as a whole is restricted, then restrictions on the output of some firms won’t be made up by increased sales by other firms. As a result—and this is key—all firms in the market, and not just the firms that have suffered a restriction in output, will be able to raise prices.

That’s because the higher prices are a rationing mechanism: they allocate the restricted market supply to the consumers who have the highest willingness to pay for it.

If any firm in the market doesn’t raise prices, consumers will all try to buy from that one firm. But because there isn’t enough supply in the market to satisfy them all, that one firm won’t have enough to satisfy them all either. The firm will sell the same volume as the firm would have sold at the higher prices. But the firm will earn less profit. So the firm will prefer to just charge the higher prices.

That’s why only market-level disruptions enable price gouging.

What this means is that a supply disruption that is concentrated in a large firm doesn’t affect more consumers than a supply disruption that hits smaller firms instead. Regardless where the disruption is felt, all prices, charged by all firms in the market, rise—so long, that is, as the disruption is a market-level event in the sense that other participants in the market are unable instantaneously to make up for the reduction in the firm’s supply.

And, as I pointed out above, in markets with large numbers of small, hypercompetitive firms, those price increases are likely to be more harmful precisely because prices are likely to start out lower than in concentrated markets.

One must, therefore, scratch one’s head at the Attorney General’s further observation that “the profit maximizing choice for a smaller competitor in an industry with [a larger] seller will often be to match the larger company’s price,” as if that establishes that price gouging is more severe in markets that have larger competitors.

When industry supply is restricted, the profit maximizing choice for a smaller competitor will be to raise price to match smaller competitors’ price increases, as well. All firms, regardless of size, will find it profit-maximizing to raise price in order to ration the industry’s limited output.

The point of a rule against price gouging is to prevent the market from using high prices to ration access to goods in short supply. The rule effectively requires the market to ration based on the principle of first-come-first-served instead.

Price gouging enforcers target only a small subset of firms in any given market for enforcement. But the goal of the a rule against price gouging is not, ultimately, to regulate the conduct of individual firms but rather to get the market price down to cost. Enforcement against individual firms is meant to have a deterrent effect on the pricing behavior of all firms in the market.

While targeting the biggest firms for enforcement might send a stronger warning to the market than targeting a smaller firm, prosecutors do not need a regulation making it easier to bring cases against big firms in order to pursue such a strategy. Indeed, such a regulation makes it harder for them to bring cases in markets in which there are no big firms.

Does Plenty Really Make Firms More Likely to Collude?

The Attorney General’s theory seems to be that market disruptions enhance monopoly power, enabling a monopoly to leverage scarcity to increase prices in response to a market disruption to a greater extent than could a non-monopolist.

The Attorney General seems to have in mind that market disruptions facilitate collusion. “[I]t may be easier for big actors to coordinate price hikes during an inflationary period, even without direct communication,” she writes.

One would, of course, expect that firms in concentrated markets that are prone to tacit collusion would be able to raise prices after a market disruption. The disruption by definition reduces the amount of output in the industry in the short term, as discussed above.

That allows the firms in the market to raise prices. But such price increases are due to the increased scarcity of output, not to the collusion.

In order for the collusion to be responsible for the price increase, output would have to fall further. The firms would need to engage in collusion that enables them voluntarily to restrict supply above and beyond both the involuntary restrictions created by the market disruption and any voluntary restrictions that the firms were capable of impose absent the disruption.

Presumably the argument is that the impetus to raise prices independently that is created by the supply disruption puts firms in the frame of mind required for them further to restrict supply and raise prices in tacit collusion with other firms.

That’s a pretty slim psychological reed upon which to hang a theory of harm. And one can easily imagine alternative psychologies.

Plenty tends to make us self-involved and egomaniacal. Hardship, if not too great, makes us generous and cooperative. It would seem to follow that the profit opportunities created by a market disruption should undermine cooperation between firms, rather than promote it.

I don’t know if this story is any more likely to be true than the one that the Attorney General seems to favor. The point is that psychological arguments of this sort do not provide a strong basis for carving out special treatment for large firms under a price gouging rule.

More Confusion of Scarcity with Monopoly

The only other argument the Attorney General makes for special treatment reprises the Attorney General’s confusion of scarcity and monopoly power.

The Attorney General argues that

the risk of firms taking advantage of an abnormal disruption may be greater where certain market characteristics reduce the likelihood of new entry—for example, where supply chains are disrupted or key inputs are scarce or where high concentration makes investment less attractive in a particular market. . . . Incumbents are insulated from the credible threat of new competition to discipline prices during abnormal market disruptions.

The Attorney General seems not to understand what a “disruption” is. It is, well, a disruption. Supply is destroyed. Or, equivalently, it is insufficient to meet a surging demand. By definition, there can be no entry. If there were entry by other firms into the market, then supply would not be insufficient anymore!

It follows that the extent to which before the disruption the market is already protected against entry due to the deterrent effect created by high concentration is irrelevant.

If such a deterrent existed before the disruption, and firms took advantage of it, then output would already have been artificially restricted in advance of the disruption. The disruption may destroy additional supply, and firms may raise prices in response, but that destruction won’t be due to market concentration but instead to the disruption.

To be sure, if the market were less concentrated and there were no concommitant entry deterrent, then prices in the market would be lower over the period of the disruption. And, moreover, the extent of the price increase created by the disruption might be different—either greater or lesser depending on the shape of the demand curve.

But that increase would still be attributable to scarcity and not to monopoly. And the ability of firms to enter the market to eliminate the scarcity would be controlled by the nature of the disruption and not any deterrent power wielded by incumbent firms.

The disruption destroys production that already existed notwithstanding the incumbents’ monopoly power. It follows that this output could not otherwise have been precluded through incumbent firms’ deterrent power—otherwise it would not have been there to be destroyed by the disruption.

Anyway, Small Amounts of Harm Are Small Amounts of Harm, Whether the Perpetrator Could Do More Harm or Not

But suppose the Attorney General were right that monopolists cause more harm through price gouging. Would it make sense to treat any price increase by a monopolist as presumptively unlawful but only increases by non-monopolists in excess of 10% as presumptively unlawful?

Of course not.

That’s like saying that it should be battery if a semi bends your fender but it should not be battery if a Prius bends your fender.

Harm is harm whether it’s inflicted by someone who could have done you a lot more harm or by someone who could only have done you a little more harm. A 5% increase in price above cost is a harm to consumers, whether that 5% markup is charged by a firm that could have, under some circumstances, charged you $100 more or only a dollar more.

A Lesson in the Perils of Antimonopolism

Antimonopoly framing may appeal to progressives because they are pushing back against two generations of market fetishism in economics. The framing lets progressives assert that markets aren’t free without having to go to the trouble of rejecting markets in the abstract.

That might feel like a powerful move.

First, it’s true: there’s a lot of monopolization in the economy.

Second, it means progressives don’t need to get into theoretical battles about the virtue of markets in the abstract.

But because antimonopolism sidesteps the theoretical problem of the market, it’s a compromise, not a power play. And a bad play at that.

In order to score points on means antimonopolists concede ends. To curry support for government intervention in business they concede that the end of intervention should be (truly) free markets.

But progressives have known for more than a century that the free market is the problem, not just in practice but in its abstract, idealized form. There’s no guarantee that really, truly, perfectly competitive markets will distribute wealth fairly. Instead, they arbitrarily distribute wealth to those who happen to own relatively productive resources or who happen to place a relatively high value on what they consume.

As David Ricardo pointed out, if you happen to own land having relatively good soil, you will earn a profit, because the price of agricultural produce needs to be high enough to cover the higher cost of tilling less fertile land. Your costs—including any reward needed to induce you to make your land more fertile—are lower, so you will generate revenues in excess of costs. That excess isn’t necessary to keep you in the market or to fertilize your soil. It’s a pure distribution of wealth based on the arbitrary fact that someone else in the market doesn’t have costs as low as your own.

Indeed, as Thomas Piketty has pointed out, the source of the explosion of inequality in recent decades has nothing to do with “market imperfection[s]” like monopolization. It has to do with markets.

There’s no way to divorce the gains progressives make on the means from the losses they suffer on the ends. If you succeed at convincing Americans that every market is monopolized, then Americans’ response is going to be: deconcentrate markets.

It’s not going to be to use every means available, including tax and transfer and price regulation, to redistribute wealth.

But, more importantly in the context of the New York price gouging law, the habit of proving market concentration in order to appease conservative priors regarding the benefits of markets can take on a life of its own.

It makes progressives forget that market concentration is far from the only source of inequality. And they end up casting aside or hamstringing policies aimed at those other sources.

That’s what may have happened here.

Categories
Antitrust Inframarginalism Monopolization Regulation

Competition Trumps Information

Scholarly interest in personalized pricing is growing, and with it confusion about what, exactly, empowers a firm to personalize prices to its customers. You might think that the key is information. So long as you know enough about your customers, you can tailor prices to each. That is, however, incorrect.

No matter how much you happen to know about your customers—indeed, even were you to have a god’s total information awareness regarding each of them—you would not be able to charge personalized prices if you were to operate in a perfectly competitive market. Competition trumps information.

That is because in a perfectly competitive market there are always other sellers available who are willing to charge a price just sufficient to make the marginal buyer in the market willing to stay in the market and make a purchase. If there weren’t, then there would be a chance that the marginal buyer would not be able to find a price that he is willing to pay, and so would not buy, and then the market would no longer be perfectly competitive. For the perfectly competitive market is one in which competition leads to a price at which the marginal buyer and seller are willing to transact.

And so any attempt you may make to personalize a higher price to your inframarginal customers—the ones who are in principle willing to pay a higher price than the marginal buyer—will be met with scorn. Your customers will find those other sellers offering prices keyed to the willingness to pay of the marginal buyer and will purchase from those sellers instead at that marginal-buyer-tailored price.

Thanks to this effect, all buyers will transact at the same, marginal-buyer-tailored price, and so we can conclude that in a perfectly competitive market, price will always be uniform—and uniformly equal to the price at which the marginal buyer and seller transact. (More here.)

It follows that while information is a necessary condition for the personalizing of prices, it is not a sufficient condition.

You also need a departure from perfect competition, which is to say, you need: monopoly. Or at least a hint thereof.

I have argued that personalized pricing is one way to break the iron link between redistribution and inefficiency. When you personalize prices, you can personalize one price to the marginal buyer, ensuring that he stays in the market and the market is efficient, and whatever other prices you wish (within limits) to inframarginal buyers, enabling the redistribution of wealth. But it is important to remember that information on buyers is not alone enough to make this possible. The seller must be a monopolist, too.

Thus the use of personalized pricing as a tool of social justice directly conflicts with the mindless “big is bad” rhetoric that one finds today in certain corners of the progressive movement.

To redistribute wealth at the market level you need to start with big.

And then discipline big’s pricing behavior.

Categories
Inframarginalism Miscellany Monopolization

Notes on the Frysian Theory of the NFT

My colleague Brian Frye has been busy reducing the non-fungible token to theory. Herein some thoughts inspired by Brian’s work.

But first, a definition. An NFT is a ledger entry in a blockchain that (1) indicates a purchase and (2) describes the subject of the purchase, often just with a url link to a picture of the subject. As an approximate matter, when someone posts a digital photo on the Internet and you purchase the NFT to that photo, you obtain a ledger entry in a blockchain that indicates that you made a purchase and describes that purchase using a url link to the photo.

Now for those thoughts.

  1. As a legal matter, the NFT is nothing special. It can be one of two things. It can either be a legally-valid transfer of title to the underlying subject. Or it can be a legally-valid purchase of the service of updating the blockchain ledger to reflect a “purchase” of the underlying subject (without that purchase being legally valid in any way with respect to the underlying subject).

    In other words, the buyer of an NFT clearly pays for the service of having the blockchain ledger updated to reflect a purchase. If the seller’s act of indicating a purchase can be considered a legally-valid expression of intention to transfer title to the subject, then the NFT buyer also gets title to the subject. Otherwise, the NFT buyer just gets a hollow incantation on the blockchain, and nothing more.

    The NFT is a digital version of Berry taking a piece of paper, going up to Apple, and saying to him: “I’ll indicate on this piece of paper that I’ve sold you my Y, if you pay me X”. Apple pays the money. Berry writes on the paper: “sold to you one Y.” Has Apple purchased Berry’s service of writing “sold to you one Y” on the piece of paper or has Apple purchased Y?

    As a general matter, a manifestation of a present intention to transfer title will transfer that title (which is why when someone says, “it’s for you,” you can legally keep the gift). But the law imposes all sorts of qualifications on this rule that are designed to make sure that the intention really was there.

    Does the blockchain-equivalent of shouting “sold” and tendering a url link manifest a present intention to transfer title to the link alone (which is generally not owned by the NFT seller, but rather the platform upon which the NFT is sold, in which case there can be no sale)? If the link leads to a digital photo, does shouting “sold” and tendering the link manifest a present intention to transfer title to the thing depicted in the photo? Or does it manifest a present intention to transfer the seller’s intellectual property rights in the photo itself? If so, which rights? Does the buyer get the right to make a copy of the photo, or does the buyer get the entire copyright?

    Judges will decide these questions.

    If the answer is “no” to all of them, then all that we can say is that purchase of an NFT gets you the service of having a ledger entry placed in the blockchain indicating that you have made a purchase and describing the subject of that purchase. But not title to the subject itself, whatever that may be.

    (Technical note: The foregoing considers the simplest possible form of an NFT transaction, one that is not complicated by any advance written agreement between the parties providing further detail about the character of the transaction. The seller simply makes a promise, expressly or implicitly, to indicate, on a blockchain, sale of some description of a subject if the buyer pays a certain price. This is a unilateral contract offer. The buyer then pays the price and the seller is legally bound to carry out his promise to make the ledger entry in the blockchain. The key question is whether the carrying out of that promise manifests a present intention to transfer title to something, or not.)
  2. If it turns out that the NFT does not transfer title to anything, and instead represents the purchase of the mere service of indicating a sale on a digital ledger, then the NFT is rather interesting as a social matter. Because in that case the market for these things—tens of millions have changed hands for individual NFTs—is a market to buy and sell ledger entries, nothing more. It is for this reason that Brian calls the NFT “the ownership of ownership.”

    In this case, we have in the NFT a further step in the familiar human chain by which a practice that starts out as necessary for survival is progressively abstracted until it persists only as ritual or play. First, men hunted to survive. Then they hunted for fun, though they did not need the meat. Then they played paintball, and took home no meat. First men bought and sold things they needed to survive. Then they bought and sold things that served no practical or spiritual purpose (contemporary art). Then they bought and sold NFTs.

    Nietzsche saw this coming, in a way:

Commerce and Nobility.—Buying and selling is now regarded as something ordinary, like the art of reading and writing; everyone is now trained to it even when he is not a tradesman exercising himself daily in the art; precisely as formerly in the period of uncivilised humanity, everyone was a hunter and exercised himself day by day in the art of hunting. Hunting was then something common: but just as this finally became a privilege of the powerful and noble, and thereby lost the character of the commonplace and the ordinary—by ceasing to be necessary and by becoming an affair of fancy and luxury,—so it might become the same some day with buying and selling. Conditions of society are imaginable in which there will be no selling and buying, and in which the necessity for this art will become quite lost; perhaps it may then happen that individuals who are less subjected to the law of the prevailing condition of things will indulge in buying and selling as a luxury of sentiment. It is then only that commerce would acquire nobility, and the noble would then perhaps occupy themselves just as readily with commerce as they have done hitherto with war and politics . . . .

Friedrich Nietzsche, The Gay Science: With a Prelude in Rhymes and an Appendix of Songs (Walter Kaufmann trans., 2010).

The same information age powers that have given rise to the NFT—making possible a publicly-accessible and (mostly) immutable global ledger system—are also swiftly rendering markets—buying and selling—obsolete.

One day, perhaps sooner than we think, firms and governments will know enough about what we want in order for firms and governments to be able to make allocation decisions for us that are better than we could obtain by bidding for products in markets. And when that happens, we will enthusiastically embrace central planning and forsake markets.

Where today that last seat on the flight is allocated based on ability to pay—a very imperfect method of determining who places the highest value on the seat—tomorrow the airline (or the government agency regulating the airline) will know, based on reams of data about all those who want the seat and that for which they want to use it, that you (yes, you) actually value the seat the most, even though you wouldn’t be able to bid the highest price for it. And so you will get the seat.

In such a world, most of us will cease to buy and sell as a matter of daily life. But perhaps we will continue to play the buying and selling game, just as some of us continue to hunt.

The NFT will be that game.

(Nietzsche didn’t foresee that America would succeed at democratizing and commercializing all things noble, including the hunt, and so he didn’t foresee, either, that the NFT could be more than just the pastime of an aristocracy.)

  1. Brian argues that the NFT could be a solution to the inefficiency of copyright. It is not completely clear to me how this might be so. But there are some possibilities.

    The problem with copyright is that the only efficient way to sell intellectual property is through personalized pricing. That’s because the marginal cost of copying intellectual property is zero—it costs nothing to make a digital copy of an image, for example—and so there are gains from trade to be realized from distributing copies to everyone who places a non-zero value on the work. If you think it’s worth something, you should get access to it. That doesn’t mean that you should not have to pay for the work, or that the work has no cost of production. It means only that those costs are “overhead costs”—they’re the costs of making the work, not of distributing it—and each purchaser should be charged a price no higher than the purchaser’s willingness to pay, for a higher price would prevent the sale and so destroy potential gains from trade.

    Thus the pricing of intellectual property should always be personalized to ensure that it prices no one out of the market. Everyone who cares should be able to buy Steal This Book, but only those who can afford to pay should be charged a price for it, and that price should be no higher, for each, than what he can afford. But those who actually steal it should go to jail, for otherwise there would be no book to steal.

    The problem with copyright is that copyright holders often do not know what their customers are willing to pay and so they do not personalize the prices they charge to licensees. Instead, they impose one-size-fits all prices that prevent some people who place a non-zero value on the work from getting access to it. The price of the paperback is written on the cover. If you can’t afford it, you go home empty handed. Both you and the copyrightholder would be better off if the holder gave you a discount. But the holder thinks (mistakenly) that you’re lying when you claim you can’t afford the official price, so no deal gets done.

    How can NFTs solve this problem?

    Suppose that purchase of an NFT buys only the right to a ledger entry. The buyer does not obtain a general right to the work, or even a license to use a copy of it. If buyers nevertheless continue to love playing the buying and selling game, they may direct sufficient cash to artists to cover the overhead cost of production of their works, and in so doing eliminate the need for copyright protection. That is, if the NFT craze proves long-lived, and spreads enough cash across the creative industries, then we may no longer need to use copyright to fund the arts. Artists could give copies of their works away for free to anyone who wants them, and make a living selling NFTs to fans of the buying game.

    Of course, it might be the case that NFT buyers have less taste than copyright licensees, in which case this new approach to funding would push the arts in unfortunate directions. But the reverse might be equally true, and we might end up with better art. Or, most likely, there would be no change in quality.

    Suppose instead that the purchase of an NFT buys a license to a particular copy of the work. It buys you access to a copy of the Kaufman translation of Nietzsche’s The Gay Science, for example, though not the full copyright to that work. In this case, the NFT format of the sale doesn’t do anything special relative to any other form of digital sale of a copy of a work.

    But the fact that NFT sales are often structured as auctions—buyers bid for the NFT—pushes the pricing of copies in the right direction from the perspective of efficiency. For auction pricing means personalized pricing. If you require no minimum price in your auctions, and keep selling copies ad infinitum, then you will price no buyers out of the market and will end up selling copies at a range of prices personalized to the willingness to pay of buyers.

    Of course, savvy buyers will take advantage of this format to pay you little or nothing (if you know an infinite number of copies are going to be sold, why bid more than zero for any copy?), but we are at least on the right track. (Or not, if you end up getting paid so little that you give up on producing art in future.) The next step would be to use more complex auction structures designed to force buyers to reveal their willingness to pay, or to acquire data on buyers that would enable accurate dictation of personalized prices to them. But none of this, again, requires NFTs. Indeed, one can expect that, regardless whether NFTs persist or not, the information age is going to make it easier for copyright holders to personalize their prices and so much of the inefficiency of copyright will eventually disappear.

    Personalized pricing won’t solve all problems associated with copyright, however, for copyright also creates a distributive problem associated with excessive pricing, and personalized pricing enables owners to extract the maximum possible value from buyers—value that may be far in excess of the cost of producing art. In that case personalized pricing would exacerbate the wealth distributive problem associated with copyright even as it eliminates the efficiency problem. NFTs, in either their fee-for-service guise or their fee-for-license guise can’t solve the distributive problem of copyright, because there’s always a chance that buyers will pay prices for their NFTs that more than cover the cost of producing the arts.

    But that’s a story for another day.
Categories
Inframarginalism Miscellany Monopolization Philoeconomica

Was Personalized Pricing the Epstein Grift?

The Times reports that pedophile Jeffrey Epstein earned more than $100 million from private equity magnate Leon Black in exchange for providing some “idea-generator”-type tax advice on a handful of Black’s family trusts, advice that Black still had to pay his own tax lawyers to implement.

Does that mean that Epstein, who was a college dropout, was a self-taught tax genius? Not likely.

But it does suggest that Epstein knew the value of personalized pricing. Here’s the key passage from the article:

Jack Blum, a Washington lawyer who has led corruption investigations for several Senate committees, said he was surprised by the size of the fees Mr. Epstein’s work commanded. “You could be the best lawyer in Manhattan working on the most complicated trusts and estates and it would never come anywhere close to that kind of money,” he said.

Matthew Goldstein & Steve Eder, What Jeffrey Epstein Did to Earn $158 Million From Leon Black, N.Y. Times (Jan. 26, 2021).

So what gives?

The answer is that tax lawyers price for the marginal consumer: the marginal client using their services. They not only serve magnates like Leon Black, but also the merely rich, like an executive mentioned in the Times article whom Epstein initially refused to take on as a client for being insufficiently wealthy.

The merely rich can’t afford $100 million, so, to get their business, tax lawyers must charge them lower fees. When the truly rich, like Leon Black, go looking for tax advice, they knock on these lawyers’ doors, and the lawyers charge them about the same price they charge everyone else.

They don’t try to charge higher fees to their wealthiest clients because tax law is a reasonably competitive industry. You need to be smart to work at the high end of the field, but tax is not a field in which “the best are easily ten times better than the average.”

And for the many who do have what it takes, the cost of entry into the market is relative low; all you need is a JD and an LLM, which cost a few hundred thousand dollars to obtain, about the amount needed to open a cleaners or a pizzeria (okay, there’s also the opportunity cost of time spent in school, but we are still probably only talking about the high six figures).

So if you start raising your fees above what the marginal client is willing to pay, your super-rich inframarginal clients will take their business to another tax lawyer who is still pricing for the marginal client. So you, too, continue to price for the marginal client.

But what if you could find a way to charge your richest clients prices personalized to them, and not have them jump ship to your competitor?

It looks like Epstein’s grift was figuring out how to do that.

The answer, as in so many other lines of business, was to make tax advice into a luxury product: to make the product exclusive.

The Times tells us that Epstein sold himself to clients as a genius who would only give tax advice to the richest of the rich. He cultivated the image of being, not some pathetic, overworked, upwardly-mobile professional, but one of them, a fellow member of the super-rich who was willing to cut other members in on secrets that only they could access because of who they were.

Exclusivity creates brand loyalty, and brand loyalty means that you stop shopping around; you are willing to pay a price determined by what you can afford, rather then what competitors are offering. You are willing to pay, in other words, a personalized price.

Graphically, the tax market may have looked like this:

Gerrit De Geest observes in Rents: How Marketing Causes Inequality, that in today’s economy, it’s not those who make who earn all the profits, or those who distribute who earn all the profits; it’s those who do the marketing. That’s where all the rents live. Competition drives profits to zero for all save those who beguile.

It seems somehow fitting that this economy would spawn a figure like Epstein, who sold tax advice but didn’t even bother to do his legal work in house. He didn’t really sell tax advice; he marketed it.

As the Times recounts, Epstein referred one acquaintance to outside tax lawyers, whom the acquaintance then paid for tax advice, and then Epstein, having never mentioned a fee to this acquaintance, sent him a bill for 10% of the purported tax savings that the lawyers, and not Epstein, had created.

That 10% was the price of enchantment, nothing more.

But you still have to wonder how a private equity guy like Black, whose business revolves around deals hammered out by armies of lawyers and shaped by tax considerations, could have thought he was getting something special from Epstein.

Did he really think tax was like music, and it was worth paying his Mozart to dream up a tune, even if Black still had to pay someone else to write all the notes down for him?

Maybe he didn’t, and there’s more left to tell in this story.

Or maybe we need a new razor: Never attribute to conspiracy what can otherwise be attributed to marketing.

Categories
Inframarginalism Miscellany Monopolization

Dynamic Pricing Meets Music Licensing?

Just when you thought the most toxic of information age innovations had already spread as widely as possible:

The big publishers — which are all divisions of the major record conglomerates — own far too much material to exploit it all properly, he says. Sony/ATV, for example, has nearly five million songs in its portfolio. . . . In its place, he posits a bold but somewhat vague plan called “song management,” in which leaner companies look after smaller collections of high-value hits, and each track is held to a profit-and-loss analysis to ensure its value is maximized.

Ben Sisario, This Man Is Betting $1.7 Billion on the Rights to Your Favorite Songs, N.Y. Times (Dec. 18, 2020).

The big publishers block-license their songs, which means that they don’t adjust the prices of individual songs based on shifts in the willingness of licensees to pay for them. It sounds like Mercuriadis wants to capture additional profits by pricing songs dynamically–jacking prices up during periods when buyers are willing to pay more–which is why he can afford to pay more for song rights himself. “Song management” is the tell: In hospitality, which pioneered the practice in the context of hotel rooms and airline tickets, they call it revenue management.

Categories
Antitrust Inframarginalism Monopolization

The Smallness of the Bigness Problem

The tendency to ascribe the problem of inequality that ails us to the bigness of firms is the great embarrassment of contemporary American progressivism. The notion that the solution to poverty is cartels for small business and the hammer for big business is so pre-modern, so mercantilist, that one wonders what poverty of intellect could have led American progressives into it.

Indeed, the contemporary progressive’s shame is all the greater because the original American progressives a century ago, whose name the contemporary progressive so freely appropriates, did not make the same mistake. The original progressives were more modern than progressives today, perhaps because the pre-modern age was not quite so distant from them. Robert Hale, the greatest lawyer-economist of the period, wrote that

[e]ven the classical economists realized . . . competition would not keep the price at a level with the cost of all the output, but would result in a price equal to the cost of the marginal portion of the output. Those who produce at lower costs because they own superior [capital] would reap a differential advantage which Ricardo, in his well-known analysis, designated “economic rent.”

Robert L. Hale, Freedom Through Law: Public Control of Private Governing Power 25-26 (1952).

I suspect that this is absolute Greek to the contemporary progressive. I will kindly explain it below.

But first, it should be noted that the American progressive’s failure to appreciate the smallness of the bigness problem is not shared by Piketty, whom American progressives celebrate without actually reading:

Yet pure and perfect competition cannot alter the inequality r > g, which is not the consequence of any market “imperfection.”

Thomas Piketty, Capital in the Twenty-First Century 573 (Arthur Goldhammer trans., 2017). (Italics mine.)

What does Piketty mean here?

He means what Hale meant, which is that the heart of inequality does not come from monopolists charging supracompetitive prices, however obnoxious we may feel that to be, but rather from the fact that the rich own assets that are more productive than the assets owned by the poor, and so they profit more than the poor even at efficient, competitive prices.

In other words, the rich get richer because their costs are lower and their costs are lower because they own all the best stuff.

No matter how competitive the market, prices will never be driven down to the lower costs faced by the rich, because other people own less-productive assets than do the rich and competition drives prices down to the level of the higher costs associated with producing things with less-productive assets.

(Why can’t price just keep going down, and simply drive the more expensive producers out of the market to the end of dissipating the profits of the less expensive producers? Because there is always a less expensive producer! Price can therefore never dissipate the profits of them all, and anyway demand puts a floor on price: consumers are always bidding prices up until supply satisfies demand.)

Graphically, American progressives have been sweating the “monopoly profit” box without seeming to realize that it’s tiny compared to what remains once you eliminate it, which is the “economic rent” box.

Picketty, the original American progressives, and kindergartners know the difference between big and small. Why don’t we?

Categories
Inframarginalism Miscellany

Ruskin on Personalized Pricing

There are few bargains in which the buyer can ascertain with anything like precision that the seller would have taken no less; — or the seller acquire more than a comfortable faith that the purchaser would have given no more. This impossibility of precise knowledge prevents neither from striving to attain the desired point of greatest vexation and injury to the other, nor from accepting it for a scientific principle that he is to buy for the least and sell for the most possible, though what the real least or most may be he cannot tell.

John Ruskin, Unto this Last, and Other Writings 197 (Clive Wilmer, ed. Penguin Classics 2005) (1862).
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
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.