Thursday, January 21, 2010

What era are our intuitions about elites and business adapted to?   posted by agnostic @ 1/21/2010 01:36:00 AM

Well, just the way I asked it, our gut feelings about the economically powerful are obviously not a product of hunter-gatherer life, given that such societies have minimal hierarchy, and so minimal disparities in power, material wealth, privileges of all kinds, etc. Hunter-gatherers don't even tolerate would-be elite-strivers, so beyond a blanket condemnation of trying to be a big-shot, they don't have the subtler attitudes that agricultural and industrial people do -- these latter groups tolerate and somewhat respect elites but resent and envy them at the same time.

So that leaves two major eras -- agricultural and industrial societies. I'm going to refer to these instead by terms that North, Wallis, & Weingast use in their excellent book Violence and Social Orders. Their framework for categorizing societies is based on how violence is controlled. In the primitive social order -- hunter-gatherer life -- there are no organizations that prevent violence, so homicide rates are the highest of all societies. At the next step up, limited-access social orders -- or "natural states" that sprung up with agriculture -- substantially reduce the level of violence by giving the violence specialists (strongmen, mafia dons, etc.) an incentive to not go to war all the time. Each strongman and his circle of cronies has a tacit agreement with the other strongmen -- who all make up a dominant coalition -- that I'll leave you to exploit the peasants living on your land if you leave me to exploit the peasants on my land.

This way, the strongman doesn't have to work very much to live a comfortable life -- just steal what he wants from the peasants on his land, and protect them should violence break out. Why won't one strongman just raid another to get his land, peasants, food, and women? Because if this type of civil war breaks out, everyone's land gets ravaged, everyone's peasants can't produce much food, and so every strongman will lose their easy source of free goodies (rents).

The members of the dominant coalition also agree to limit access to their circle, to limit people's ability to form organizations, etc. If they let anybody join their group, or form a rival coalition, their slice of the pie would shrink. And this is a Malthusian economy, so the pie isn't going to get much bigger within their lifetimes. So by restricting (though not closing off) access to the dominant coalition, each member maintains a pretty enjoyable size of the rents that they extract from the peasants. Why wouldn't those outside the dominant coalition not try to form their own rival group anyway? Because the strongmen of the area are already part of the dominant coalition -- only the relative wimps could try to stage a rebellion, and the strongmen would immediately and violently crush such an uprising.

It's not that one faction of the coalition will never raid another, just that this will be rare and only when the target faction has lost some of its share in the balance of power -- maybe they had 5 strongmen but now only 1. Obviously the other factions aren't going to let that 1 strongman enjoy the rents that 5 were before, while they enjoy average rents -- they're going to raid him and take enough so that he's left with what seems his fair share. Aside from these rare instances, there will be a pretty stable peace. There may be opportunistic violence among peasants, like one drunk killing another in a tavern, but nothing like getting caught in a civil war. And they certainly won't be subject to the constant threat of being killed and their land burned in a pre-dawn raid by the neighboring tribe, as they would face in a stateless hunter-gatherer society. As a result, homicide rates are much lower in these natural states than in stateless societies.

Above natural states are open-access orders, which characterize societies that have market economies and competitive politics. Here access to the elite is open to anyone who can prove themselves worthy -- it is not artificially restricted in order to preserve large rents for the incumbents. The pie can be made bigger with more people at the top, since you only get to the top in such societies by making and selling things that people want. Elite members compete against each other based on the quality and price of the goods and services they sell -- it's a mercantile elite -- rather than based on who is better at violence than the others. If the elites are flabby, upstarts can readily form their own organizations -- as opposed to not having the freedom to do so -- that, if better, will dethrone the incumbents. Since violence is no longer part of elite competition, homicide rates are the lowest of all types of societies.

OK, now let's take a look at just two innate views that most people have about how the business world works or what economic elites are like, and see how these are adaptations to natural states rather than to the very new open-access orders (which have only existed in Western Europe since about 1850 or so). One is the conviction, common even among many businessmen, that market share matters more than making profits -- that being more popular trumps being more profitable. The other is most people's mistrust of companies that dominate their entire industry, like Microsoft in computers.

First, the view that capturing more of the audience -- whether measured by the portion of all sales dollars that head your way or the portion of all consumers who come to you -- matters more than increasing revenues and decreasing costs -- boosting profits -- remains incredibly common. Thus we always hear about how a start-up must offer their stuff for free or nearly free in order to attract the largest crowd, and once they've got them locked in, make money off of them somehow -- by charging them later on, by selling the audience to advertisers, etc. This thinking was widespread during the dot-com bubble, and there was a neat management-oriented book written about it called The Myth of Market Share.

Of course, that hasn't gone away since then, as everyone says that "providers of online content" can never charge their consumers. The business model must be to give away something cool for free, attract a huge group of followers, and sell this audience to advertisers. (I don't think most people believe that charging a subset for "premium content" is going to make them rich.) For example, here is Felix Salmon's reaction to the NYT's official statement that they're going to start charging for website access starting in 2011:

Successful media companies go after audience first, and then watch revenues follow; failing ones alienate their audience in an attempt to maximize short-term revenues.

Wrong. YouTube is the most popular provider of free media, but they haven't made jackshit four years after their founding. Ditto Wikipedia. The Wall Street Journal and Financial Times websites charge, and they're incredibly profitable -- and popular too (the WSJ has the highest newspaper circulation in the US, ousting USA Today). There is no such thing as "go after audiences" -- they must do that in a way that's profitable, not just in a way that makes them popular. If you could "watch revenues follow" by merely going after an audience, everyone would be billionaires.

The NYT here seems to be voluntarily giving up on all its readers outside the US, who can’t be reasonably expected to have the ability or inclination to pay for web access. It had the opportunity to be a global newspaper, leveraging both the NYT and the IHT brands, and has now thrown that away for the sake of short-term revenues.
As such, a project which was meant to bring into the same space as Wikipedia will now become largely irrelevant.

This sums up the pre-industrial mindset perfectly: who cares about getting paid more and spending less, when what truly matters is owning a brand that is popular, influential, and celebrated and sucked up to? In a natural state, that is the non-violent path to success because you can only become a member of the dominant coalition by knowing the right in-members. They will require you to have a certain amount of influence, prestige, power, etc., in order to let you move up in rank. It doesn't matter if you nearly bankrupt yourself in the process of navigating these personalized patron-client networks because once you become popular and influential enough, you stand a good chance of being allowed into the dominant coalition and then coasting on rents for the rest of your life.

Clearly that doesn't work in an open-access, competitive market economy where interactions are impersonal rather than crony-like. If you are popular and influential while paying no attention to costs and revenues, guess what -- there are more profit-focused competitors who can form rival companies and bulldoze over you right away. Again look at how spectacularly the WSJ has kicked the NYT's ass, not just in crude terms of circulation and dollars but also in terms of the quality of their website. They broadcast twice-daily video news summaries and a host of other briefer videos, offer thriving online forums, and on and on.

Again, in the open-access societies, those who achieve elite status do so by competing on the margins of quality and price of their products. You deliver high-quality stuff at a low price while keeping your costs down, and you scoop up a large share of the market and obtain prestige and influence -- not the other way around. In fairness, not many practicing businessmen fall into this pre-industrial mindset because they won't be practicing for very long, just as businessmen who cried for a complete end to free trade would go under. It's mostly cultural commentators who preach the myth of market share, going with what their natural-state-adapted brain reflexively believes.

Next, take the case of how much we fear companies that comes to dominate their industry. People freak out because they think the giant, having wiped out the competitors, will enjoy a carte blanche to exploit them in all sorts of ways -- higher prices, lower output, shoddier quality, etc. We demand the protector of the people to step in and do something about it -- bust them up, tie them down, resurrect their dead competitors, just something!

That attitude is thoroughly irrational in an open-access society. Typically, the way you get that big is that you provided customers with stuff that they wanted at a low price and high quality. If you tried to sell people junk that they didn't want at a high price and terrible quality, guess how much of the market you will end up commanding. That's correct: zero. And even if such a company grew complacent and inertia set in, there's nothing to worry about in an open-access society because anyone is free to form their own rival organization to drive the sluggish incumbent out.

The video game industry provides a clear example. Atari dominated the home system market in the late '70s and early '80s but couldn't adapt to changing tastes -- and were completely destroyed by newcomer Nintendo. But even Nintendo couldn't adapt to the changing tastes of the mid-'90s and early 2000s -- and were summarily dethroned by newcomer Sony. Of course, inertia set in at Sony and they have recently been displaced by -- Nintendo! It doesn't even have to be a newcomer, just someone who knows what people want and how to get it to them at a low price. There was no government intervention necessary to bust up Atari in the mid-'80s or Nintendo in the mid-90s or Sony in the mid-2000s. The open and competitive market process took care of everything.

But think back to life in a natural state. If one faction obtained complete control over the dominant coalition, the ever so important balance of power would be lost. You the peasant would still be just as exploited as before -- same amount of food taken -- but now you're getting nothing in return. At least before, you got protection just in case the strongmen from other factions dared to invade your own master's land. Now that master serves no protective purpose. Before, you could construe the relationship as at least somewhat fair -- he benefited you and you benefited him. Now you're entirely his slave; or equivalently, he is no longer a partial but a 100% parasite.

You can understand why minds that are adapted to natural states would find market domination by a single or even small handful of firms ominous. It is not possible to vote with your dollars and instantly boot out the market-dominator, so some other Really Strong Group must act on your behalf to do so. Why, the government is just such a group! Normal people will demand that vanquished competitors be restored, not out of compassion for those who they feel were unfairly driven out -- the public shed no tears for Netscape during the Microsoft antitrust trial -- but in order to restore a balance of power. That notion -- the healthy effect for us normal people of there being a balance of power -- is only appropriate to natural states, where one faction checks another, not to open-access societies where one firm can typically only drive another out of business by serving us better.

By the way, this shows that the public choice view of antitrust law is wrong. The facts are that antitrust law in practice goes after harmless and beneficial giants, hamstringing their ability to serve consumers. There is little to no evidence that such beatdowns have boosted output that had been falling, lowered prices that had been rising, or improved quality that had been eroding. Typically the lawsuits are brought by the loser businesses who lost fair and square, and obviously the antitrust bureaucrats enjoy full employment by regularly going after businesses.

But we live in a society with competitive politics and free elections. If voters truly did not approve of antitrust practices that beat up on corporate giants, we wouldn't see it -- the offenders would be driven out of office. And why is it that only one group of special interests gets the full support of bureaucrats -- that is, the loser businesses have influence with the government, while the winner business gets no respect. How can a marginal special interest group overpower an industry giant? It must be that all this is allowed to go on because voters approve of and even demand that these things happen -- we don't want Microsoft to grow too big or they will enslave us!

This is a special case of what Bryan Caplan writes about in The Myth of the Rational Voter: where special interests succeed in buying off the government, it is only in areas where the public truly supports the special interests. For example, the public is largely in favor of steel tariffs if the American steel industry is suffering -- hey, we gotta help our brothers out! They are also in favor of subsidies to agribusiness -- if we didn't subsidize them, they couldn't provide us with any food! And those subsidies are popular even in states where farming is minimal. So, such policies are not the result of special interests hijacking the government and ramrodding through policies that citizens don't really want. In reality, it is just the ignorant public getting what it asked for.

It seems useful when we look at the systematic biases that people have regarding economics and politics to bear in mind what political and economic life was like in the natural state stage of our history. Modern economics does not tell us about that environment but instead about the open-access environment. (Actually, there's a decent trace of it in Adam Smith's Theory of Moral Sentiments, which mentions cabals and factions almost as much as Machiavelli -- and he meant real factions, ones that would war against each other, not the domesticated parties we have today.)

We obviously are not adapted to hunter-gatherer existence in these domains -- we would cut down the status-seekers or cast them out right away, rather than tolerate them and even work for them. At the same time, we evidently haven't had enough generations to adapt to markets and governments that are both open and competitive. That is certain to pull our intuitions in certain directions, particularly toward a distrust of market-dominating firms and toward advising businesses to pursue popularity and influence more than profitability, although I'm sure I could list others if I thought about it longer.

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