Monday, January 19, 2009

Adam Smith, Profitability, and Efficiency

“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest,” Adam Smith wrote in The Wealth of Nations. “We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” True enough. The self-interest of profit maximization does keep us fed, clothed, sheltered, entertained, and much more besides. But profitability and economic efficiency are not always the same thing, and it is the latter that ultimately aids society. Profits, after all, can stem from sources other than efficiency, like rent seeking or market power, that are social bads.

For the last three decades or so, the general consensus was that markets could do no wrong and governments no right. Increasing numbers of people now realize, however, that some government agencies are economically efficient and some private businesses are not, though they may have been profitable for awhile. What matters, we are coming to realize, is not who owns or runs an organization but rather the structure of the market it operates in (competitive or monopoly at the extremes) and the degree to which internal incentive structures are aligned with the organization’s goals, as in the two by two matrix below.

Stereotypically, businesses inhabit the upper left quadrant, where competition and a high degree of internal incentive alignment ensure efficiency, while government agencies dwell in the lower right quadrant, the inefficient victims of monopoly and incentive misalignments. Some government agencies (and non-profits too), however, compete with other governments and/or private sector firms and have decent internal incentives. Think, for example, of the post office. Stockholder owned investment banks, by contrast, operated in markets that were less than fully competitive and had flawed internal incentives. Due to their market power and incentives they were profitable for a decade or so but ultimately their inefficiencies caught up with them, leaving society with the bill.

In the coming months and years, the government is likely to try to extend its purview, to regulate more aspects of the economy more thoroughly than hitherto. It may also try its hand at mortgage banking (via the remnants of Fannie and Freddie), commercial banking (via the Federal Reserve’s new lending powers), and maybe even automobile production. (If that sounds far-fetched, few before 1970 would have believed that the federal government would operate an extensive passenger railroad system for over three decades.) Rather than outright opposing such endeavors, American businesses would do well to use their expertise to try to move them as close to the upper left quadrant as possible. They would do well to try to move their own businesses in that direction as well, to fight their natural proclivity to create short-sighted incentive schemes and to strive for more market power. What ultimately matters for the economy is not jobs or profits but creating more output from the same input.

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