Category: Building blocks

A new way of looking at the firm

The Escondido Framework starts from the assumption that the company (in common with many other forms of organisation) is defined by its interfaces with the various market places in which it operates, in the simplest form the markets for labour, raw materials, capital and finished goods or services. These are, in effect, its boundaries.  And while there are differences between markets, in essence they all reflect an exchange between two parties for mutual benefit – the employee receives payment and other non-financial rewards for his labour; the supplier of raw materials payment for the goods provided; the supplier of funds either interest or dividends and the prospect of capital growth for forgoing use of those funds for his own short term benefit; and the customer goods or services in exchange for payment.  The Framework also reflects the view that being a party to the exchange does not of itself mean that the other party has a “stake” in the company or “own” it in any absolute sense.  There may be a contractual relationship between the party and the company which reflects the terms of the exchange and provides structure for enforcement but essentially this is a mutually beneficial relationship in which both parties have duties to deliver their side of the bargain.

Within the Framework, there is no assumption that any of the providers to the company – of labour, raw materials, capital or revenue – any superior rights or claims over the company, in traditional parlance, “ownership”. Legal devices may be put in place by the state, or may exist in the form of contractual agreements that provide these other parties with rights, for example: in the form of wages and employment rights; to payment for goods at a particular point in time; to payment of interest or dividends; and to return of capital under prescribed terms and with differing degrees of confidence. The contracts and legal frameworks may also define mechanisms under which these other parties may enforce these rights, but enforcement is also be a function of other considerations that reflect market conditions rather than the law, for example: what alternatives are available to a workforce with a specific set of skills and ties to a particular geography; what other customers are available for the raw materials, and how much  are they willing to pay; what will other prospective providers of capital pay for these shares or bonds, and how easily can we replace the existing board and executive team; and how often do customers in consumer markets consider, let alone read terms and conditions.

The Framework suggests that the company can be considered as a “virtual space”, existing between these market interfaces.  The location and shape of each of the market interfaces reflects what economists think of as the demand function and marketing academics describe as indifference curves, i.e. how customers make trade-offs between the various attributes of a product. These are also shaped by the competition that the company faces: when recruiting from a limited pool of skilled employees; for sourcing scarce raw materials; seeking funding from a limited capital market, or seeking the custom of consumers who can buy from other companies or who may be able to substitute one item for other goods. Remove the competition and the market interface or boundary moves outwards, increasing the volume of the “virtual space” available to the company. Improve the operating efficiency within the company or secure a competitive advantage over other participants in one of the markets concerned and the volume of the “virtual space” will also increase.

At any particular point in time, for any particular product or service it sells, these interfaces will be brought together, or resolved, at a single virtual point at which of each of the providers is rewarded at prices that are, all things considered, satisfactory to them. In perfect market equilibrium, all prices would be at market clearing levels, no-one would realise economic rents, and there would one point at which the interfaces would be resolved.  No self-respecting economist has ever viewed the perfect market paradigm as anything other than a useful benchmark for understanding a world which is dynamic and virtually always distant from the paradigm, and in this the Escondido Framework is no different. In reality, the “virtual space” is just that, an available set of points at which the price levels may be resolved. Depending on the scale of the external market failures that allow for the internal organisation of economic activity to generate greater efficiency, there is potential for the management of the company to elect where to set prices and where on the indifference curves to locate the marketing proposition to each of the other parties (suppliers or labour, raw material, capital and custom), and how to allocate the economic surplus that the absolute volume of the “virtual space” represents.

The allocation of income and wealth: power versus marginal productivity

John Kay has written a fine account of the distribution of the rewards created within an economic enterprise in his FT column today.  Reflecting on the rewards of looters in the London riots, and allocation of resources in professional services (“eat what you kill”), he comments:

“Two broad economic theories describe the allocation of income and wealth. The power theory states, broadly, that people get what they grab: from the forest, the markets, or the shop window. The distribution of income reflects the distribution of power. For most of history, this was plainly true – the landlord took what he could from the tenant, the baron what he could from the landlord, and the king what he could from everyone. The sixth Duke of Muck was rich because the first Duke of Muck had been an especially successful gang leader. The alternative theory is that what people earn reflects their marginal productivity – how much they personally add to the value of goods and services. The marginal productivity theory has many attractions, especially to those who are well paid: if what they receive is a product of their own efforts, their rewards are surely well deserved.

“Collaborative organisation was only occasionally necessary in an agricultural society in which there were no asset-backed securities and no electrical goods in the shops. But in a complex modern economy, as in the deer forest, production requires the involvement of many. Adam Smith marvelled at the resulting efficiency in his description of a pin factory. But if, as Smith described, one man wrought the iron and another stretched it, who could say what was the marginal productivity of each? And what was the marginal product of the chief executive of the pin factory, or the person who hedged the foreign exchange exposure on the unfinished pins, whose contributions the Scots savant unaccountably failed to mention?

“If the pin factory really did increase the productivity of the factory by a factor of at least 240, as Smith claimed, there was likely to be a surplus when the wage earners had received whatever their marginal product was. And when it came to dividing that surplus, the distribution of authority within that pin factory would be crucial. That distribution would surely favour the CEO. Since the CEO wrote – or at least commissioned – the pin factory’s annual report, the moral and economic argument could be turned on its head. If you were paid a lot, that showed that you contributed a lot. What the recipient earned was, by that fact alone, justified. So the ethic of just reward through effort gave way to the culture of present entitlement from possession.”

So how does this relate to the Escondido Framework?  After all, the Escondido Framework is about organisations and is underpinned by the idea that organisations are defined by their external market interfaces.

The market defined the minimum reward that must accrue to the wage earner, or the CEO for that matter, since if the rewards are insufficient the wage earner will move to alternative employment (after due allowance for the frictional expense of changing jobs, issues surrounding risk and uncertainty about joining an unknown organisation).  But given that the Escondido Framework recognises that most markets are imperfect, the firm that operates more efficiently than competition (so that Adam Smith’s pin factory enjoys at the very least an experience curve advantage over competitor pin factories) for whatever reason may be able to generate returns above and beyond those required to pay the market clearing prices in its markets.  Who gets the additional return: investor (only if he remains sufficiently engaged to address the agency problem of relying on a manager), the manager (whose position mirrors that of the investor), a monopolist supplier exploiting the leverage from his control over scarce resources, the wage-earners (particularly if their skills are in short supply or they organise into a union), or perhaps the customers if the pin factory if has high fixed costs, spare capacity and no alternative markets to serve, or if the company’s strategy is to defend market share by keeping prices low to discourage competition?

John Kay’s observations about the privileged position and likely hold on power of the “CEO” of the pin factory are characteristically perceptive.  All that is needed to reinforce the upwards pressure on rewards arising from the circular argument that high pay must indicate greater contribution is a remuneration committee displaying the Lake Wobegon effect and setting out to pay top quartile in the believe that those with the highest pay deliver more than those of their peers on lower salaries.

 

The dumbest idea in the world?

In an article in today’s FT Michael Skapinker describes how the debate around shareholder value is turning. He notes that Richard Lambert, his former boss now at the CBI, has suggested that the era “Jack Welch capitalism” – the elevation of shareholder value – was drawing to a close, but that the celebrated Jack had marked this himself last year when described shareholder value as “the dumbest idea in the world”, adding that “Shareholder value is a result, not a strategy … Your main constituencies are your employees, your customers and your products.”

Skapinker notes that Unilever’s chief executive, Paul Polman, has recently said the said same to the FT: “I do not work for the shareholder, to be honest; I work for the consumer, the customer. I discovered a long time ago that if I focus on … the long term to improve the lives of consumers and customers all over the world, the business results will come.”

Skapinker’s own observation on these comments, and what has been going wrong, are worth repeating in full:

“I am sure these leaders did not mean shareholders did not matter; rather that they were best served by businesses that performed well over the years. That meant selling goods and services to customers who were happy to come back, and employing staff committed enough to encourage them to do so. Doing that, and doing it profitably, would, over the years, be reflected in the share price.

“The problem has been the rise of shareholders who are not prepared to wait years, but who want a return now, so that they can sell their shares and repeat the trick elsewhere.”

He observes that the focus on shareholder value has resulted in the design of the executive remuneration packages that were designed to address the “agency problem” and to encourage them to do what was best for shareholders. However, any scheme designed to reward a manager will reflect the relatively short time horizon of the individual – unlikely to be in post for more than ten years and probably a great deal less, so in due course retired and on their way to satisfying Keynes’s “long-run” condition. In contrast, companies or, for that matter, their investors, particularly institutions like pension funds and life insurance companies have very long term, even unbounded, time horizons. It is also worth reflecting on the time that it can take to create a great corporation – building a Unilever, a GE, a McKinsey or BCG, one of the great universities, or even one of the sustainable technology companies (Microsoft is now 45 years old and Apple 44 years old), is a matter of generations.

The second issue that Skapinker refers to is interesting.  It is hard to see a moral argument for the promiscuous shareholder who trades shares on short term price movements having pre-eminence over the other constituencies (to use Jack Welch’s terminology). With well-developed equity markets, the investor has a far more fungible stake in the company than most employees, suppliers or customers. However, there are parallel issues to executive pay in the rewards in the fund management industry. Many fund management remuneration packages encourage short term trading rather than long term active engagement with investee companies. This is despite mounting evidence (probably best illustrated by the success of an even more iconic figure than Jack Welch – one Warren Buffet, sage of Omaha) for the superiority of long term investment strategies over playing short term market movements.

Skapinker completes his challenge to the primacy of shareholders by observing that “it is the customers who provide the revenue, the employees who produce the goods and services and society that tolerates the company’s presence. It is hard to reward one when the others suffer.”