Insider trading: we all know it’s wrong, but we can’t agree why

If you’ve been following the financial and business press, you’ve read about the new, very high-profile insider trading scandal at SAC Capital. Basically, before he fired him, Steven A. Cohen used to employ an analyst named Mathew Martoma. Martoma was analyzing stock in Elan, a pharmaceutical company in which SAC held a very large stake. Martoma had been ‘consulting’ with a doctor whom he found via the Gerson Lehrman “expert network.” This doctor was involved with clinical trials of a potentially lucrative Alzheimer’s drug that Elan was developing. At a certain point, the ongoing clinical trials went sour, as the researchers discovered bad potential side effects. The doctor has told prosecutors that he informed Martoma of this, before this information had been publicized. Martoma, soon after this conversation with the doctor, contacted Steven A. Cohen. Soon after, SAC Capital sold its stake in Elan, then shorted the stock, and made billions.

The case is attracting a lot of attention, because of all the ethical questions involved–do doctors’ consulting fees corrupt? do ‘expert networks’ necessarily facilitate corrupt  insider trading?– and because Steven Cohen has been such a successful investor for so long. But it raises the broader, more interesting question: what’s so bad about insider trading in the first place? I think a lot of people haven’t seriously questioned that insider trading is a bad thing. I think it may be, but the reasons for why insider trading might be bad are very much non-obvious.

Let’s go back to the basics. Every single trade in a stock market is both (1) consensual and (2) in a certain sense adversarial. That is, (1) both parties to any given trade are willingly trading, each thinking it in their best interest, and (2) they have contradictory predictions for the asset — the seller thinks the asset will, at the price they are trading it at, return less than the market rate, while the buyer thinks it will return more than the market rate–so one party’s loss will be the other’s gain. (1) means that it’s hard to see how any trade in a financial market is intrinsically immoral–they’re both economic acts between consenting adults–and (2) means that it’s hard to see why any trade could be considered especially exploitative–after all, in every trade, each party is trying to profit from the other’s error, and only one succeeds.

How does insider trading differ from normal trading in financial markets? Well, insider trading is just when one party is placing a trade based on information that is not yet formally ‘public.’ What makes this kind of trading wrong? Does it do anyone any harm? Not directly, but perhaps very indirectly. Look at it this way: When you make a trade based on public information, you’re usually entering into a very liquid, very deep market for that asset, which means you are simply ‘taking’ the price in that market. So your counterparty–the person on the other end of the trade–is making the exact trade (s)he would have made in an alternative universe in which you did not have that insider information. So you’re not directly doing your counterparty any harm by using insider information. Now, theoretically, if you’re making a very large volume of insider trades, you could change the price of the asset (driving it up if you are a buyer, or driving it down if you are a short seller), which would, e.g., make the asset more expensive for other buyers, who would consequently not make as much of a profit once the inside information is made public. But these harms are very indirect. More, they’re balanced out: if your trades, based on your insider information, raise the price of an asset, you’re hurting buyers, but you’re helping sellers.

But this isn’t a complete defense. There is, of course, another standard of ethical behavior, beyond ‘do no harm,’ and it is fairness. Doesn’t the insider trader gain an unfair advantage over others? Perhaps. But it’s not immediately clear what, philosophically, distinguishes trading on insider information from trading on superior analysis. If you have access to a financial model and financial software that your counterparties do not, and these models and software allow you to make better predictions about the future, you’re also ‘taking advantage’ of counterparties who have inferior models, and changing the price of the asset in a way that makes some other buyers/sellers capture less of the benefits of future price movements. What fundamentally distinguishes the two?

So, as I said, the reasons why insider trading is immoral, and the mechanisms through which it causes material harm to people, are very much non-obvious.

Indeed, while there are highly distributed ‘harms’ to insider trading, an argument can be made that there are even greater distributed benefits. After all, what is the most fundamental purpose of capital markets? Intro economics tells us it is to allocate capital efficiently. That is, financial markets exist to get equity and loans to those enterprises that will make the very best use of them. Suppose that a private company is about to go public. Suppose you have insider information that suggests that the growth prospects of this company are much better than is generally supposed. The best thing you can do, for yourself and for society in this situation, would be to make known your commitment to buy as many shares as possible, which would drive up the IPO price of the company, which would bring more capital to this company. To generalize this thought experiment: If you want markets to efficiently allocate capital, you should want them to incorporate all relevant information as quickly as possible, without regard to whether that information is legally, formally considered public or private. By bringing more information into the market, insider trading, this argument goes, benefits us all. Indeed, an investor who short-sells a stock on insider information and thus drives its price down is actually benefiting future investors by bringing the assets price closer to the ‘true’ value, which the market will reach once the insider information is made public.

So you can tell a story in which Mr. Martoma’s insider trading actually did good for the world. He got his firm to take some capital out of Elan, freeing that capital up to go elsewhere, to some firm that had better future prospects. And his insider trading helped drive the price of the stock down to its “true” value, so that future investors actually lost less money when the clinical trials were made public.


So, then, why do developed nations ban insider trading? There are a couple traditional arguments, a couple more sophisticated ones, and a few more I’ve just thought up.

The most traditional argument is that if insider trading is widespread, ‘retail’ investors (individual people–you and me) will be less likely to participate in stock markets, because they’ll know full-time financiers have a huge, special informational advantage over them. People might feel that way. But should they? After all, if insider trading is rampant, that means more not-yet-public knowledge is incorporated into stock prices, which will mean that our bets will be less likely to go really sour (i.e., the stock price of Elan would already reflect the bad clinical trials–so we wouldn’t lose a lot of money when it got announced, if we had bought the stock).

A more sophisticated version of the argument, highlighted by Professor Stephen Bainbridge, argues that insider trading causes harm by inducing investors to make bad purchases. For example, if your analysis of publicly available information suggests that the value of a stock should be $20, but the stock is trading at $16, you’ll naturally want to buy. But if the reason the stock is trading at $16 is that its price has been driven down by people who secretly have access to insider information that suggests it will tank in a few months, then you’ll have gotten screwed; you would not have, in this case, gotten screwed if the insider traders had never gotten involved, and the stock had been trading for $20, where you wouldn’t have bought it, because you wouldn’t have gauged it to be under-priced. A market effected by insider trading has, consequently, ‘induced’ you to make a bad purchase that you otherwise would not have made.

I think this is the best argument that insider trading does harm to individual people, but I’m not sure it’s a super-compelling argument that it should be banned. After all, there’s a buyer for every seller in every trade, so as many people benefit from insider trading’s ‘mispricings’ as are hurt by it — society as a whole does just as well. More, if insider trading were legal and common, you would take that into account in valuing an asset, and wonder, upon seeing a really good deal, if somebody knew something you didn’t. More, if, in our highly-financialized economy, the two parties to any trade are usually enormous financial institutions, it’s not clear how much we should really pity the one which got unfairly screwed.


So I am, at this point, unpersuaded by the traditional arguments for forbidding insider trading. But I think there are other, more convincing arguments. I want to highlight two arguments, one of I found in a paper, and one of my own.

As I suggested above, overall, an individual investor isn’t necessarily more likely to get screwed when trading in a market with insider trading. But the investor might feel that way, and he might be particularly outraged when, if one of his bets goes bad, it can be attributed to insider trading. Even though you can theoretically expect the same return in a market with insider trading, your feelings of outrage, abuse, and having been taken advantage of, will make you less likely to invest in that market. That seems to be why, as this study found, enforcing laws against insider trading helps to lower the overall cost of capital, because those laws make people more willing to invest, all else equal. In transparent markets that appeal to people’s feelings about fairness, people feel more comfortable, more in control, and therefore more eager to get involved. Lower costs of capital mean that more firms can profitably make more investments, which makes us all more prosperous over time. (In this vein, though, laws against insider trading are helpful only as a concession to emotional human feelings of outrage, etc., rather than as things that are objectively needed to make markets work.) [[EDIT: My friend on Twitter argues, “Liquidity depends on people being willing to trade with you. Insiders in market make people suspicious, reduce liquidity.” I think this seems a better way of putting this basic thought. Without insider trading, if you have faith in your own stock analysis, you just assume your counterparty isn’t doing his analysis of the stock correctly. But if your counterparty might be an insider trader, you worry that she knows something you don’t, get suspicious, and maybe refuse to trade at all. That causes a lot of broader harms to capital markets.]]

I would like to proffer another argument, which I haven’t yet seen elsewhere, but I imagine someone else has likely thought of. Insider trading gives investors incentives to spend more time doing research and analysis that is not socially useful. By which I mean this: What social purpose is served by investors spending lots and lots of time trying to get ahead of each other in trying to figure out how the clinical trials at Elan are going? The information is going to be revealed and taken account of eventually, anyways. So firms that invest a lot of resources in trying to get that information are just playing a zero-sum game with no positive externalities (‘externalities’ are things that benefit others as well). But when firms compete to better understand, analyze, and make predictions off of publicly-available information, they’re producing knowledge that is socially useful. If you’re analyzing the stock of a company that is making a big push in China, you’ll make an effort to compete to produce better and better models of, say, what China’s future economic trajectory will be like–you’ll learn how development happens, how companies can best navigate emerging markets. etc. Or if you’re investing in tech, you’ll have to spend a lot of time trying to understand what the world’s technological future will be like–is it a bubble? or are we nearing the technological singularity? The knowledge and understandings that are produced by that research will help us all understand the world better, and therefore help us all allocate capital to the industries, geographies, and technologies where it is most needed. Getting a tip from a doctor involved with Elan doesn’t advance that kind of broader, universally useful understanding. So my thinking is that allowing people to trade on insider information just gives investors too much incentive to dig for particular secrets in a zero-sum game, instead of advancing our understanding of the world more broadly. And that, as we say in economics, is a socially inefficient allocation of resources.

Scandinavian Dependence on American Innovation

I recently came across an interesting paper by future-Nobel prize winners Daron Acemoglu and James Robinson (and Thierry Verdier). It’s summarized at VoxEU here. It provides an interesting gestalt shift for thinking about the relationships between and dependence among less egalitarian sovereign states, such as the U.S., and more egalitarian states, such as the nordic countries. Allow me to explicate.

Acemoglu, Robinson, et alt, riff of a simple model, in which there are two kinds of countries: One with almost no distribution (with “cutthroat capitalism”), and one that is far more egalitarian (with “cuddly capitalism”). Suppose we observe that the cuddly country isn’t, over all, much less wealthy than the cutthroat one, but its citizens do enjoy much more security. Shouldn’t then, the cutthroat country become more cuddly?

Not necessarily, say Acemoglu, et al. Why not? The basic idea here is that, as we all know, one of the main determinants of any country’s wealth, or the world’s wealth as a whole, is its technology. Now, who produces new technology? Often, entrepreneurs. Why do they produce it? Well, presumably, at least partly because they want to get rich, and not be poor. It follows then, that, at least to some degree, countries that allow some people to become very wealthy, as by taxing and redistributing less, provide greater incentives to entrepreneurs to research, develop, and market innovative technologies. Now, the interesting thing is that technology spills over borders very easily. So most new technologies may get made by entrepreneurs in the ‘cut-throat’ society, but the benefits of those technologies will soon be enjoyed in the cuddly ones as well, which is why the cuddly society isn’t much less wealthy after all. This sounds like a good deal for the cuddly countries, but it implies that if every country were to become a ‘cuddly country,’ that overall technological progress might slow or halt, which would undermine the very basis of the cuddly countries’ cushy existence.

As you might naturally think, our two archetypal countries here are supposed to map onto the United States, on the one hand, and the Scandinavian countries on the other. So Acemoglu and Robinson et al. draw from this a kind of varieties-of-capitalism economic pluralism: we can’t all be like the cuddly countries, because if we were, nobody would have the incentives to produce the innovations that allow cuddly countries to have such a high quality life. As they put it:

“it may be precisely the more cut-throat American society, with its extant inequalities, that makes possible the existence of more cuddly Nordic societies.”


This paper, by the way, is one which, I think, is true in theory, but not in fact. And that’s not to denigrate it. Things that are true in theory can be useful, even if they’re not true in fact. The reason I don’t think this paper is true in fact are twofold. First, I think the differences in levels of equality between the U.S. and the Scandinavian countries aren’t entirely driven by policy; nor can we say the differences in absolute levels of wealth are. One obvious difference is that Scandinavian countries are pretty homogenous, whereas the U.S. is a nation of immigrants, who have come to the country at different times, assimilated at different rates, moved into different professions, etc. We’re simply more diverse in every way, and that shows up in more variation in incomes. A significant portion of income inequality in the U.S. collapses into the problem of racial inequality, and the enduring historical legacy of slavery. I also happen to think a lot America’s worst poverty is created by family disruption, and the evidence suggests that Scandinavian countries have far fewer children being raised in disrupted, single-parent homes.

Second, while, as one with some right-leaning inclinations, I might like to say America’s higher wealth is attributable to our more cutthroat capitalism, I don’t think one can safely say that this is empirically true. There are a lot of the factors in our absolute wealth advantage — our unique political history, our access to Atlantic and Pacific, our position in the great wars of the 20th century, etc., all stand out as major contributors.

More, there are various ways in which reality is more complex than the simple stereotype that “U.S.= cutthroat capitalist, low-tax, low redistribution and Europe= progressive, redistributive, quasi-socialist.” For example, if you look just at income taxes, then France appears to have a much, much more progressive tax schedule than does the U.S. But when you factor in the fact that a higher portion of their tax revenues come from value-added taxes and consumption taxes, it’s no longer so clear. There are other complexities, too: How do we weigh the taxes and redistribution of  state and local governments? If you give a group or an industry a tax subsidy, does that count as a government expenditure? Depending on how you account for all of these factors, you could make the U.S. look more cuddly, in many ways, than many European nations.

But I’m confident Acemoglu, et al., know most of those things, and intended their simplified model not to fully reflect reality, but to provide us with an interesting theoretical way of interpreting it. And I think they succeed in that. The gestalt shift the paper provides suggests that ideal economic policy in part depends on your moral philosophy in a counterintuitive way: If you choose cosmopolitanism over nationalism, you should be slightly more inclined to support “cuthtroat capitalism” in your country, in order to provide the incentives to generate technological innovation that will spill over and help the world as a whole; if you choose nationalism over cosmopolitanism, you should be slightly more inclined to support “cuddly capitalism,” in order to give your compatriots a cushier life, as you all free-ride off of the technological innovations those Yankee tycoons create. In this vein, one can look at highly egalitarian countries not as super-enlightened societies that have attained a global ideal, but, rather, as technological free-riders, living off the fruit of others’ inequality.

Albany and Troy

Home for Thanksgiving, I decided to do some explorations of the area in which I grew up, the kind of exploration that doesn’t occur to one to do until one has been away from home long enough that it makes sense to stand back and regard it with curiosity.

Yesterday, I went with some neighbors to a farmer’s market in, Troy, New York, just a few miles upriver from Albany, and then drove around the city as a whole. Troy is a really quaint, fascinating city with a rich history. On its riverfront it has gorgeous early-2oth century facades; on its hills, it has spectacular Victorian mansions overlooking the Hudson river valley. But in between those two poles, the city is clearly very run down. Why is this?

The most basic reasons are: history and faceless economic forces. In the mid-to late 19th and early 20th century, Troy was a hub for textile manufacturing and distribution, which won it the nickname “the Collar City.” This made it the fourth richest  city in the U.S. on a per-capita basis in 1840. But as the U.S. grew wealthier, other areas began their own process of industrialization, and international trade developed and became cheaper and more ubiquitous, the U.S. obviously lost its comparative advantage in textile manufacturing. The city hit its population peak in 1910, and has been on a relatively steady decline since. It’s a very familiar story, common to many second-tier rustbelt cities. The weather isn’t helping these cities either.

Can Troy improve? As I explored the city, it occurred to me that the city has a lot of the ingredients that, we are told, are needed for success. The city has RPI, one of the top techie universities in the country. This university brings in skilled programmers, etc., to the city, as well as hip, cool arts institutions. (It also has, lower down on the scale, but equally necessary for broad economic development, the Hudson Valley Community College, which provides more vocational education.) It has an excellent, though all-girls, boarding school in Emma Willard.

Thanks to the city’s wealth in the late 19th and early 2oth century, it has a number of legacy institutions. The quaint, well-preserved waterfront area transports you to that period of time so thoroughly that is frequently used as the location for movies set in that period. Up on “Mount Ida” (not really a mountain), nearing Emma Willard, there are stunningly gorgeous victorian mansions. It’s an easy, relatively cheap, 2 hour train ride into New York City from the nearby Albany/Rensselaer train station.

More broadly, Troy is really part of the ecosystem of the Capital District as a whole. And that should bring it even more advantages. The Albany area as a whole is extremely well-educated, thanks largely to the many universities in the area, including just across the Massachusetts border, and also thanks to the state government, and the professionals that draws in. Many of the suburbs have truly excellent public schools. The area is culturally blue, part of the northeast, and so has the institutional acccoutrements of the “creative class” that Richard Florida tells us leads economic development.

So why isn’t Troy taking off during this period widespread revival of downtowns? And, more broadly, why isn’t the Capital District as a whole? I think there are three things to think about here:

(1) Beyond the institutional ingredients, the really, really important thing for a city is human-capital agglomerations. This is really just a jargony way of saying, “What makes a city take off is when a large number of talented, ambitious, upwardly-mobile people move there, and attract other talented, ambitious, upwardly-mobile people.” And this a virtuous cycle, a recursive process, and there’s an element of unpredictable randomness to what sets it off in the first place. Sometimes, as with Seattle, it has nothing to do with good policy or weather even, but the simple fact that one really significant founder happened to have been born there, and wanted to move back (this is Bill Gates I’m talking about). More, there are only so many really talented, ambitious, and upwardly-mobile people in the world, and so the more they agglomerate in other major cities, the harder it becomes to attract any of them to your own city and start your own virtuous cycle. Troy isn’t attracting and retaining the necessary core of talented, ambitious, upwardly-mobile people, because it doesn’t have a big enough core of talented, ambitious, upwardly-mobile people. See the problem?

(2) There are some other mundane factors. Probably a big one is the weather. If you have to choose between starting your company Chattanooga vs. Troy, you might go with Chattanooga because four months of the year are arguably much more pleasant there. I think taxes are probably too high, as well. One thing about New York State policy is that the government can get away with some bad policy behavior , simply because the finance industry is so tightly, inertly concentrated in Manhattan, and probably won’t move no matter how high state taxes go.  In other words, New York’s good luck with the finance industry enables the state government to adopt policies that cost the other industries in the state, and drive middle and upper-middle class people down South.

and (3) It’s important to keep in mind that, in the end, the city of Albany isn’t super-glamorous, but the Albany area as a whole is actually doing really well in the way that really matters, in providing a very high quality of life for ordinary, middle-class people. Many of the neighboring suburbs have really excellent schools. If all of the well-educated professionals want to live in the neighboring affluent suburbs, and not come in to revive Albany downtown, well, that’s their choice. The purpose of cities is to facilitate our efforts to flourish however we choose, not just to display lively downtowns for lively downtowns’ sake. And the area is just a great place to live–a beautiful place with easy access to the gorgeous Adirondacks in one direction, and New York City in the other.


What can be done? Not much. Unless Albany nanotech really, really takes off,  I don’t think there’s any way that Albany-Troy could become the next Raleigh-Durham. But the two cities can still do well. Maybe Troy could become more like Chattanooga — the Tennessee city that attracts retirees and tourists with its quaint and pleasant downtown, and has become just a nice place to live, without becoming a major tech hub. One pipe dream is that, if Emma Willard were to go co-ed, and if crime in the city were to be tightly controlled, more affluent parents and even retirees would be willing to move into some of the beautiful old Victorian houses. Albany’s universities, easy access to NYC, and core of educated professionals drawn by the state government, all mean that its downtown could be revived, if the self-sustaining process just got started. But it hasn’t show many signs of getting started lately.

An efficient market is like a traffic jam

According to the Efficient Market Hypothesis, an individual investor really shouldn’t be able to regularly and reliably beat the market rate of return by picking her own stocks.

A lot of people misinterpret what is meant by the efficient market hypothesis. They hear, I think, the word ‘efficient’ as a kind of normative valorization. They assume that people who use the term are really expressing an emotional sense that “markets are perfect and awesome.” Actually, the idea behind the efficient market hypothesis is that the market is like a traffic jam.

When you get stuck in a traffic jam, you usually feel like the lane immediately to your right or left is moving faster than you are. It’s tempting to try to quickly swerve into one of those lanes. But when you think about it more, you realize this might not be a good idea, and the other lane’s advantage is probably only temporary. After all, the traffic jam stretches miles and miles ahead of you. If that lane were really much faster than the other lanes for a long stretch, a lot of people ahead of you would have gotten wind of that idea, and turned into that lane themselves. That itself should have slowed, or already be slowing, that lane down, until the point where it’s going as slow as your lane. And, indeed, experience suggests that any one lane’s advantage in a traffic jam is transient.

This is analagous to the really basic, modest idea behind the oft-derided Efficient Markets Hypothesis.  If there were obvious, publicly available information that showed you could expect an above-market rate of return on any particular asset, other people would have, noting this, bid up the price of that asset until its expected return matched that of alternative assets. You can’t even beat the market with a semi-sophisticated prediction about the future (like, “This firm isn’t a big name yet, but it will has a large market share in China, and will do well in the future, as their economy moves from an investment-led to demand-based economy”) because everybody half-intelligent analyst also thinks that, and is pricing that into the firm’s value.

But then, there are people and trading strategies (surpassingly few, I should note), who do seem to beat the market to an extent that can’t be explained by chance. How can this be?

The ways in which you could beat the traffic parallel the ways in which you could beat the market.

(1) As we noted, no one lane is faster than the others for any long period of time. But some are faster temporarily. If you’re way more aggressive than everybody else, and have a car with a much better accelerator, you can move into each lane as soon as it starts to gain a temporary advantage, and, swerving back and forth like this, get ahead in little piecemeal jerks over time. (This strategy, of course, has a lot of downsides, like wasted gas.) This is sort of like high-frequency volatility trading. You could physically locate your firm super close to the NYSE, so you literally get information about price movements microseconds before others do, and use those to execute super short-term trades on that momentum. Each one will yield a small profit, but over time, like this, you can get ahead of the market. (The downside of this strategy, of course, is that transaction costs from making so many trades, like the wasted gas, could erase your gains.)

(2) You could simply drive in the breakdown lane, and pass everyone, and hope you don’t get pulled over. This is sort of like (1) breaking the law or (2) executing a really, really high-risk strategy. But if you ‘beat the market’ by bearing more risk, you’re not really beating the market — you’re just getting lucky this time, doing something that others could have done, but thought better of.

(3) You could call up your buddy who works as an EMT, and ask him to listen in on some calls to figure out what sort of accident caused the traffic jam. Was it on the left side or the right side of the road? This will give you an informational advantage over the other drivers around you, regarding which lanes will be closed off in the future, so you can get out of them now. This is like trading on insider information.

(4) You could notice some surprising difference, probably stemming from a glitch of human psychology, and take advantage of it. For example, humans are naturally trained to, when they are dissatisfied with the speed of traffic, look to leftmost, passing lanes. This might give people an ingrained psychological bias to overrate the speed advantage of the left lane. This would, if true, mean that the right lane would be the fastest over the long run. Or you could rely on some funny legal effect. Of course, once other people figure this fact out, the strategy will mostly stop working. This is like any number of strange trends in stock market history, like the “January effect” or the small-company advantage, which have largely faded over time.


The big difference between a traffic jam and financial markets is that financial markets are a multi-trillion dollar business. That’s a lot of money incentivizing a lot of really smart people to make sure they don’t let obvious profit opportunities escape their notice. So, no, you almost certainly can’t beat the market.

Some minimum wage theory (Econ for poets)

On this blog, I have a bias toward highlighting center-right economic ideas and research, because most of my friends and most intellectuals have left-of-center inclinations, and I like to try to provide a helpful counterweight. But I am, consequently, left vulnerable to accusations of selection bias in the evidence I confront, and of providing a forum for ideas that is biased itself.

So in the spirit of guarding against that, here is a cool article in The Economist that highlights some recent economic research that defends the minimum wage. Now, as the article notes, until recently, the idea that the minimum wage did little to boost wages, and much to increase unemployment, was not even a center-right idea, but simply the consensus position in economics. In fact, in economic circles, the argument against the minimum wage is well-known, because it is used as an iconic example of how simple theory can show that government interference in markets (in this case, labor markets) has unintended consequences that hurt its intended beneficiaries. So, first, let me present the economic theory that explains the case against the minimum wage. (By the way, I should note that the word ‘theory’ should not be taken to mean ‘aerie speculation.’ ‘Theory,’ rather, is behind any causal claims about the world, and hence can be demonstrably true or false, and is also hence necessary for any policy recommendations. Indeed, any time you have ideas about the world that go beyond purely disjointed empirical observations — any time you even use the word ‘because’ — you have theory.)

Let’s start with a super simple model of a labor market, which consists of one person, a weaver, trying to get a weaving job. Suppose this weaver can, given access to a loom, produce fine linen worth $100 more than the cost of the raw flax, every day. This is her ‘marginal product.’ There are five weaving factories in town that have the looms our weaver needs.  Theoretically, every one of them should be willing to offer our weaver up to just around $100 a day to work there. If one factory offers her $85, another factory stands to make an extra $10 profit a day by making her a counter-offer of $90 a day. And so on. You get the picture. We all should make around our marginal product in labor markets — if we are making more than our marginal product, firms stand to profit by firing us; if we are making less than our marginal product, firms stand to profit by competing for our labor, bidding up our salary.

Now imagine in this world that a conscientious government decides it is unconscionable that a full day spent at the loom should yield only $100 in pay. It sets the minimum wage instead at $120 a day. What will happen to our weaver? The government wants to give her a pay boost, but in fact it will get her fired. She, necessarily, is now costing her firm $20 a day — they’ll bankrupt themselves if they make a practice of employing people at such a loss.

So, let’s generalize this model into an economic theory: In general, your pay should approximate your ‘marginal product.’ And, if the minimum wage sets wages below your marginal product, it doesn’t effect you at all. If it sets wages above your marginal product, then you should get fired, because your employer will be losing money every day she employs you. So a minimum wage, according to this economic theory, should have no benefits whatsoever, and its only effects should be to increase unemployment and make firms contract their output (because they have fewer workers). Economists thus generally prefer to help the poor through earned income tax credits, and other such incentives, which  increase the take-home pay of workers without reducing employer’s incentives to hire them.


Now, back to The Economist article. It reports that, “a pioneering case study by two noted labour economists, David Card and Alan Krueger, examined the response of fast-food restaurants to a rise in New Jersey’s state minimum wage. It found that this had actually increased employment.” Now, this research has faced some empirical contention. But the more immediate and important objection than that empirical research is the theoretical question — how could it possibly be the case that a minimum wage not only doesn’t decrease employment but actively increases employment? It doesn’t make any sense with the simple labor-market model we constructed.

Economists are theory-minded people, so surely they have a reply. The Economist gives its readers a brief hint: “economic theory allows for the possibility that wage floors can boost both employment and pay. If employers have monopsony power as buyers of labour and are able to set wages, for instance, they can keep pay below its competitive rate.”

Let’s unpack this in full. First, ‘monopsony.’ We know what a ‘monopoly’ is, and why it’s a problem. A monopoly, of course, happens when only one firm is selling a good. Because it has no competitors, the monopolist can sell the good for as high a price as it likes. Not only do the consumers thus face higher prices when they buy the good, some of them don’t buy the good at all — these are two forms of ‘welfare loss’, relative to what society could have gained if the good were sold in a competitive market. Under monopoly, society as a whole does not gain the benefits that, given its technology and resources, it really could gain from this product.

A monopsony is the opposite of a monopoly — it’s when there is only one person/firm/entity buying a good from many different suppliers. In the labor market this is like only one firm hiring (i.e, ‘buying’ labor) while thousands of people are searching for a job (i.e., hoping to ‘sell’ their labor). Just as a monopoly causes goods to be overpriced, because the supplier has all the power, a monopsony causes the good — in this case, labor — to be underpriced.

So let’s revise our model by fastforwarding in the history of our imaginary town. Suppose the textile industry is no longer expanding. A good weaver can still produce fine linen worth $100 per day. But there is now only one linen company in town, with space at its factory benches and looms for only one more worker. Because the long-term prospects of linen look grim, no more companies plan to make the big capital investment to establish new factories nearby,  nor does the one company plan to expand its own facility. So there’s only one weaving job available, and no hope for more in the future. Now, too, it’s a recession with widespread unemployment, so our weaver faces competition from twenty other prospective employees. Suppose the factory owner makes an offer to our weaver of $50 a day. This is an outrage — utter exploitation — but she has no choice. There are no other employment opportunities, so if she refuses this offer, one of the next 19 weavers will take it, and she could be out of work forever. (Indeed, in a perfect monopsony, the owner should be able to drive her wage down to next to nothing.)

So this model shows how under conditions of ‘monopsony,’ as when, for example, a labor market is dominated by a few enormous, consolidated firms, or in which a general recession yields high unemployment, such that there are many many applicants for every job opening, laborers actually do not get paid their marginal product, and get paid much less. In this situation, the government can improve general welfare by setting the minimum wage somewhere above people’s current, suppressed wages, but below their marginal product. In our new, revised, model, this means the government should set the minimum wage at, say, $90 a day. The factory will still employ our weaver, because it’s still making $10 a day profit off of her, and it would make $0 profit by firing her. And she would make an extra $40 a day. If the government raised the minimum wage to $110, it would cause her to get fired — but anything in the $50-$100 range is an improvement.

So now we have a theory that explains how, in economic conditions in which employers have monopsony power over their employees, raising the minimum wage can give workers a pay boost, without causing unemployment. But this still doesn’t explain how a minimum wage could also boost employment. How is that possible? Our revised model doesn’t quite explain it — higher labor costs, should not, in any simple model of rational economic actors, induce firms to use more labor. So what’s going on? The long and short of it is: this is where the model gets messy. But the basic idea is that in the real world, employers of low-skilled workers do have a lot of monopsony power that allows them to drive low-skilled wages below the workers’ marginal product, and it’s also the case that, due to welfare, unemployment benefits, the safety net, black markets, etc., some prospective workers can just leave the labor market altogether. They might, in outrage, refuse to work for excessively low wages. And so a minimum wage that raises their wages below a depressingly-low level, while keeping them below their marginal product, doesn’t cut any of them out of the labor market by making them an unprofitable hire, but it does give more of them a greater incentive to actually join the labor market in the first place. (This is like, our revised model, our weaver refusing to take the $50 offer — except, in the real world, labor markets are dynamic over the long run, so it’s not just as if she gets replaced right away, and permanently locked out of employment opportunities.)

The Economist goes into some other interesting effects, as well. Because we humans rely on ‘anchors’ in a lot of our decision-making, a minimum-wage hike also, it seems, can boost wages up the income and skill scale. The idea here is that your employer really doesn’t have a good idea of how to calculate your marginal product, or what other firms might pay to steal you away, and so in setting your wage, she’s actually thinking something like, “Well, hmm, well my Matthew must be worth at least twice as much as a minimum-wage burger-flipper.” So the minimum wage boosts your wage by boosting that salient anchor.


I thought it was fun to unpack this theory, and this was a useful exercise for guarding against libertarian economic triumphalism. And the evidence does seem to suggest that the ‘costs’ of the minimum wage are probably lower than traditional economic theory suggests, and so, at the very least, market libertarians should focus on other market-oriented reforms, such as decreasing the barriers to entry to costly and lucrative professions like medicine and the law. But I still honestly doubt that the minimum wage is the ideal policy for helping the poor. One thing even our revised economic theory does not comprehend is that every single employment situation is unique — while, no doubt, many people at the minimum wage are getting paid less than their marginal product, under their employer’s monopsony, there are no doubt other firms where the workers’ minimum wages are competitive with their marginal products, and so a hike in the minimum wage could cause them to lose employment. So even if it were true that the minimum wage increased employment and wages overall, there should be more efficient ways to do so. For example, larger negative-income taxes generally (like, for a specific example, the Earned Income Tax Credit in the U.S.) should theoretically have all the encouraging effects of drawing more people into the workforce with higher take-home pay, with none of the downsides of cutting some people out of the labor market altogether.

So, executive summary: The minimum wage isn’t as harmful as a lot of libertarians think, and may even be beneficial overall. But hiking the minimum wage would still not be as good a way to help the poor as, e.g., greater negative income taxes.

Bolingbroke and Burke on Leadership, Meritocracy, and Inequality

In most of my blog posts, I try to, like a good analytic philosopher, articulate some relatively narrow points with utmost clarity, in a way that I hope would be persuasive to almost all readers. In this blog post, I’m going to do just the opposite, and try to alienate my readers with a winding discursion on some ideas that will be discomfiting to pretty much everyone, as a way of stretching our imagination about the topic. To use a spatial metaphor, the typical blog post tries to hone in on a narrow target, while this blog post attempts to expand the territory that we include on the map. In fact, this is one of those posts which, were I ever to become known or influential, people would try to use against me. And that’s because I’m going to express some premodern ideas about inherited privilege that we moderns find radically strange and noxious.

So, here goes: We Americans, and, more generally, we modern Westerners, are at least weakly committed to the idea of meritocracy. That is, nearly everyone would agree with the idea that “All else equal, giving everyone in society, regardless of birth or station, more of an equal chance is a moral improvement.” We put different caveats on this claim—e.g., in the private sphere, a small, less well-endowed university often finds that as a matter of financial realism, it must give admissions priority to ‘full-pay’ students; in the policy sphere, sometimes we conclude that an effort to promote greater equality of opportunity for some has too great costs for society as a whole; Left and Right disagree descriptively about how much equality of opportunity our society actually has, and normatively whether we should also strive for greater equality of outcomes as well (that is, many on the Left would say ‘even if it were true that a wealthy person had meritocratically deserved all of her wealth, we would be in favor of taxing some of that away to support poor people, even if were true that those poor people’s poverty came from bad choices’). So our debates about meritocracy and inequality take place along these dimensions, with everyone ultimately thinking that meritocracy is by itself a worthy goal.

This weekend, I saw a production of Henry IV, Part I, at a women’s college in Massachusetts. As you know, Henry IV, Part I  chronicles the rise of Prince Hal (who is to become Henry V), who goes from being a prodigal son who spends his day carousing with commoners at the Eastcheap bar, to assuming his role as a prince, defending his father’s claim to the crown . I like Henry IV, Part I, because there’s a lot of interesting political theory to it. Notably, the king, Henry IV, Bolingbroke, has great difficulty carrying gravitas as a king, because the theoretical basis of his claim to the throne is questioned throughout the play—he is often troubled with guilt over his murder of Richard II, and the idea that he is elected by God to rule is questioned. His most basic commands are disobeyed, his whole reign is characterized by rebellion.

But the much more interesting aspect of the play, particularly to modern audiences, is Prince Hal’s coming of age story. Prince Hal has spent his youth drinking and playing pranks and sleeping late with people whom others of his class regard as lowlifes—the fat, lascivious drunkard Falstaff, and his band at Eastcheap. Yet Hal insists that he is not abandoning his princely duty in doing this. He soliloquizes, defensively:

Yet herein will I imitate the sun,
Who doth permit the base contagious clouds
To smother up his beauty from the world,
That, when he please again to be himself,
Being wanted, he may be more wonder’d at,
By breaking through the foul and ugly mists
Of vapours that did seem to strangle him.

In other words, Hal claims that he is doing all of this merely to contrast the rise he plans in his future, to make him shine all the brighter, increasing the authority of his future office. This is his justification for hanging out with low-lifes, before assuming political leadership. (There’s also another implicit justification. Later on, when Prince Hal becomes King Henry V, he becomes, at least in Shakespeare’s rendering, a charismatic, popular King with the common touch, and greater legitimacy and gravitas than his father, perhaps stemming from his early life among the people. Shakespeare puts in Henry V’s mouth the famous St. Crispin’s Day speech, in which he promises to the commoners that “this day shall gentle your condition.”) So Hal claims that he will be a better leader by, in a sense, emerging from the lower classes. He signals his commitment to leaving this low life behind when, role-playing with Falstaff, he says, “I will, I do [banish Falstaff and the Eastcheap crew from his company].”

When King Henry IV summons Hal on the eve of civil war, the king is, to say the least, skeptical. He says to Hal,

Had I so lavish of my presence been,
So common-hackney’d in the eyes of men,
So stale and cheap to vulgar company,
Opinion, that did help me to the crown,
Had still kept loyal to possession…

By being seldom seen, I could not stir
But like a comet I was wonder’d at;
That men would tell their children ‘This is he;’

In other words, Henry says that Hal has made his presence ‘cheap’ by offering it too freely, while Henry made his presence very rare, and hence, very dear, and thereby retained his majesty, which allowed him to command with greater authority and legitimacy. The commoners, Henry says, could not have respected his rule if he had lowered himself to their level.

If you catch my drift, I’m getting at, in somewhat oblique fashion, a broader and still relevant question of “from which classes should our leaders emerge?” To the modern ear, this question sounds somewhat antiquated. To the pure meritocrat, it is obvious that our leaders should emerge from any old class—wherever the best talent happens to be found, as represented by SAT scores or GPAs or whatever. Someone with more left-leaning, progressive inclinations caveats this idea with, “Yes, but, all else equal, let more of our leaders come from the working and lower classes, and underrepresented groups, so that they can better sympathize with the plight of the poor and marginalized.” I wrote a few months ago about my conversation with Professor Jeffrey Liebman, who claimed that the source of Bill Clinton’s charisma, common touch, and policy successes, was life in the small, poor state of Arkansas, where he learned to inhabit the lives of “people in trailer parks.”

One of the more provocative and, in the modern world, discarded ideas in the history of political theory however, is the idea, which King Henry gestured at, that in fact it is better for our leaders to, all else equal, come from the highest social strata. I.e., that we should almost have a reverse class-based affirmative action. This is an idea defended by Edmund Burke, who is most noted as an opponent of the French revolution, including (obviously) its attempt to overthrow the aristocracy and their inherited privileges. A friend of mine who is doing her PhD in political theory at Harvard recently did a seminar on Burke. She wrote afterward that the seminar leader said at the end of the term that the seminar was the greatest failure of a course in his career, because, ultimately, nobody in the seminar could bring herself around to support Burke’s idea of inherited privilege. So with that in mind, here is Burke’s idea, which most of us find unacceptable:

Burke claims that a man who has grown up as a part of the aristocracy is more fitted by nature for good political leadership. Burke claimed this despite the fact that he, himself, was not an aristocrat, and made his way to Parliament on his merit. His  basic argument is that by being told, “you are an aristocrat,” from an early age and knowing that you are hence subject to public scrutiny, you grow up with a greater gravity of bearing, a greater attention to the large consequences of your actions, a greater attention to the public sphere, all of which will fit you for the challenges of political leadership when you come of age. Burke gives so much attention, in all of his work, to how the unconscious mores, unwritten rules, and inarticulable ideas of tradition govern the behavior of society. This is sort of a micro-level version of that idea: Leadership, Burke claims, is something that cannot be learned or expressed algorithmically, but must be passed down, from one generation to the next, in family dynasties. One’s character is ultimately fixed by these deep, persisting influences, and so a person cannot truly emerge from ‘base’ society, to come to comfortably and reliably assume political leadership.

This is, as I warned, noxious to the modern ear. But we clearly see the influences Burke is talking about in every other sphere, every day. A son of two journalists may grow up to be sharp and quick with language and up on the news and opinion, but somewhat more oblivious about the mundane details of how most people make a living in the private sphere; the daughter of a financier will quickly gain a grasp of Wall Street, even if she majored in art history, simply by virtue of having been exposed, from early age, to the language of equities and leverage, etc. While it is certainly okay to allow the sons of journalists to become financiers and vice versa, Burke might say that the stakes are so much higher for political leadership (if you screw up as a journalist, you just lose your own job; if you screw up as commander in chief, you lose much more), that we should take fewer risks, and select more of our political leaders form the leadership class.

I guess a more accessible way of saying what I’m saying is that Burke conceives of leadership as a craft which must be passed down, rather than as a method that can be learned by the sufficiently clever. Just as we are not particularly surprised or scandalized that the son of a fine carpenter is more likely than the general population to himself become a fine carpenter, because he breathed in the knowledge and the sense of the craft from birth, perhaps, under this interpretation, we should not be so scandalized by political dynasties.

So on the basic question of, “from where should we draw our leaders?” Burke gives the provocative, anti-modern, answer that we should essentially, reproduce political privilege and accept some measure of aristocracy.

Burke was a very beautiful and sharp writer, but he didn’t have access to the knowledge that we have accumulated with modern social science. One social-scientific phenomenon I’m really interested in is the so-called “Matthew effect.” The name of the effect is taken from a passage in the Gospel of Matthew that says something like, “To him whom much has been given, more will be given.” The modern social scientific take on this idea is that, if you start out initially with a small advantage, that advantage will allow you to also gain and accumulate other advantages as well, compounding your advantage over time. Let me give a stylized example of how this works.

Suppose you are born to affluent and educated Americans. In your most basic fetal development, you are among a small lucky class of persons in all of human history, as one whose mother will probably not do anything or have any major nutritional deficiencies that will impair your brain development. When you are out of the womb, you will quickly be exposed to smart conversations between your parents, and will have a functional and loving home environment. This will give you a great facility with language from an early age, improving your ability to read, and hence to succeed in school, which will also make you feel more rewarded by schoolwork, increasing your proclivity to compound this advantage by studying more in the future. The functional social environment that surrounds you will also make you more trusting of other people, and more inclined to pro-social interaction, which will make you more affable, confident, and popular for life. If your parents are affluent and educated, chances are so are their peers, which means your peers will enjoy your advantages as well, and so your interactions will compound those advantages. You get into a good college, which helps you land a good job, which strengthens your application for business school, whose prestige then helps you land an even better job. This professional prestige helps you land an awesome marriage partner, with whom you have kids who… and so on, ad infinitum.

There are even weirder, more surprising effects going on: Your dad’s social status at the time of your birth effects the hormonal environment you are exposed to in utero. This is why the offspring of Fortune 500 CEOs are disproportionately male. Certain of these hormonal influences will effect, for life, your aggression and proclivity to seek and bear risk, which is a huge influence on your potential success in the business world.

There is a left-wing and a conservative interpretation of these stylized facts. The left-wing interpretation is that the sources of inequality go so incredibly deep that nothing short of a radical transformation of the structure of our society will adequately deal with them—small amounts of redistribution, class-based affirmative action, etc., simply cannot do the job, because they cannot overcome this series of compounding advantages. The conservative interpretation is that the sources of inequality go so incredibly deep that nothing short of a radical transformation of the structure of our society, a transformation that could have unintended consequences that could bring tremendous harm (see: history of socialism), could deal with them, so we must accept that the universe is tragic, and inequality will reproduce itself.

But even further to the Right is Burke’s claim that we should not only accept this inequality, but embrace it, because inequality itself—the experience of growing up thinking “I am part of the leadership class; I need to get my noblesse oblige on”—is the very thing that prepares people for the enormous challenges and responsibilities of statecraft.

How do these reflections check out with lived experience? Well the most recent salient example of a political dynasty was a major disaster: namely, George W. Bush. But there are others. Recently, we elected a new, young Kennedy to office in Massachusetts. No doubt, some of his success came simply from the resonance of his name in this state. But, as I saw his acceptance speech, I couldn’t help but think he seemed pretty fit for office. Pretty good at bearing himself publicly, with dignity and gravitas, without self-deprecation. He’s checked all the right boxes in his life—no scandals have come to light, which is pretty impressive for a young person in the digital era. Presumably this good behavior and weighty bearing comes from growing up knowing, “You are a Kennedy; you must behave accordingly.”

I often debate whether, in the future, I would like to send my kids to elite private schools. I went to an excellent public high school of the sort that, e.g., had at least a dozen kids at Yale during my time there. The main thing that probably separated my experience at BCHS from the experience I would have had at, say, Stuyvesant, was probably not the quality of the coursework itself, but probably simply the experience of walking through the halls each day and thinking, “This is the best high school in the country; we are the future leaders of America.” I think that experience could have had very negative effects on me, like greater arrogance, or very positive effects, like a faster maturation, stemming from a feeling of oblige from an early age.

For me, the question of whether I should send my kids to elite private schools is not a question of how much I should value the quality of their academic instruction—in the right highly-educated suburbs, the public schools could make room for my offspring’s maximum academic efforts. The question is whether I want them to grow up conceiving of themselves as members of the leadership class or not. I have within me both populist-democratic and revanchist instincts, which carry me in different directions on this question.

 Let me close with a caveat: I really do not think our society is anywhere near suffering from a glut of too much equality of opportunity. This discursion is very much on the most highly theoretical level. As a matter of policy, I am very much in favor of efforts to promote much greater equality of opportunity than we have today. As a matter of theory, however, I am interested in a transgressive philosophical discussion of how many caveats we should place on the ideal of meritocracy, and how many political dynasties, or how much reproduction of inequality, is inevitable and/or acceptable. I am especially interested in this philosophical discussion in light of the fact that so many of my friends, who claim to be committed to equality of opportunity, will eventually send their kids to elite schools whose traditions train their pupils to think of themselves as members of a leadership class. How do you, gentle limousine-liberal reader, resolve this dissonance?

I by no means want to make American more of an aristocracy, but I’m also not sure that I think meritocracy is the right answer for political leadership either. I say this as one who is, with the exception of my tendency to voice uselessly controversial opinions online, the very model of a modern major meritocrat, exceptionally good at standardized tests &etc. The same goes for most of my friends. We’re sharp, clever, and good at jumping through hoops. Most of us, not coincidentally, also hail from the upper-middle class, where our parents passed down to us the skills of being sharp, clever, and good at jumping through hoops. We, not coincidentally, then, have relatively homogenous world-views and perspectives. The question that troubles me is this: If our ‘abilities’ are largely inherited privileges, what, then, makes us either more fit for, or more deserving of, political leadership than the old aristocrats, other than the fact that we feel more morally entitled to it, and that we have not been raised in the craft of statesmanship?

The Social Responsibility of (Many) Businesses is to Decline, Profitably

(Brief note: This post is, as will be obvious to her, inspired by a conversation I had with a dear friend very recently. I note this only so I can clarify that the purpose of this post is not to get the last word on her, but, rather, to articulate some ideas that our sparkling and sharp conversation helped to generate.)

Here’s a thought experiment: Suppose there is a world we shall call “World A.” In World A, there is an incorporated public company, called “Company A.” (Still with me?) This company has within it two main ventures: a grocery retailer which is much like this world’s version of Stop-n-Shop, and a digital-technology venture which is much like an early version of this world’s Apple. Right now, the grocery retailer is making decent profits, while the digital-technology venture is making a slight loss. In this world, the population is no longer really growing much, and a number of innovative startups have started delivering groceries directly to people’s doors, sopping up demand for, and cutting the margins of, the grocery retailer; there are also a lot of other traditional grocery retailers competing with this retailer, keeping prices very low; more, the people in this world are sober utilitarian types when it comes to food, so it seems unlikely that the retailer could win exorbitant market share just by making itself a ‘hip’ brand. Sober, dispassionate, outside analysts predict that the grocery retailing industry can’t really expect much growth, or extraordinary returns and profits. But Company A’s technology venture may be a different story: in this world, technology is advancing really fast; middle-class consumers will throw two full weeks of wages into the latest pocket-sized gadget. Not only that, but Company A is lucky to have happened upon a really sleek, attractive, distinctive design for its gadgets, which is already giving it an awesome brand, and hence an outsized market-share in this nascent industry.

Last year, the grocery retailer made $10 billion in profits; the digital-technology venture took a $2 billion loss. Problem question: What should the company’s board of directors and management decide to do with the $8 billion in total profit? 

It seems pretty obvious, given this setup, that the directors and management should reinvest the cash in the technology venture specifically, funneling the whole $8 billion in profits into new R&D, hiring new designers and programmers, etc., in the hopes of making the tech venture into this world’s Apple. The investors won’t mind foregoing dividends for a year when the company has such good prospects for what it can do by reinvesting this capital. As long as the grocery retailing venture is making decent returns, it makes sense to keep it around, and keep receiving normal profits and a normal rate of return on the capital investments it has already made. But it wouldn’t make sense, given the grocery market’s overall prospects, to invest a lot in massive advertising campaigns, major capital investments in new trucks or stores in high-profile or low-density areas, etc., particularly given the excellent prospects of the alternative destination for that capital. So it seems pretty clear that the board of directors and managers should reinvest as much capital as possible in the technology venture, while just doing basic upkeep on the grocery retailer. That’s what will ultimately provide the highest return to its shareholders. It will also land them on the cover of World A’s Forbes in a few years (but, really, their responsibility is not to worry about personal fame, but to focus on the shareholders).

Now, here’s the cool, somewhat cheesy, thing that you so frequently come across in economic reasoning: What’s best for the shareholders, reinvesting the profits in the technology venture, is also what’s best for society. The fact that the grocery retailing market is not growing very quickly is proof that society is saying, “Our grocery needs are  more or less satisfied already — thank you very much.” If there’s already a couple of satisfactory and competitive grocery retailers in every town in World A, and even new innovative online-grocering startups, then the world cannot really benefit that much from new capital investments in grocery stores. And society, by being willing to pay so much for the latest pocket-sized digital gadget, is telling us that it has strong desires and needs for novel products in that space. They’re trying to pull capital in, by paying so much. In a very real sense, an estimation of a return on any particular investment is a rough measure of the strength of society’s future need for it.

So I’ll hope you’ll agree with me, that the best thing for Company A — its management and shareholders — and for World A as a whole is that the capital be reinvested in the digital technology venture. This should be obvious.


Now, let’s make things interesting. Suppose we have a world we shall call “World B.” It is exactly like World A in every way except for one: Instead of having a single Company A with two ventures (grocery retailing and digital gadgetry), World B has these two exact same ventures under two different incorporated companies, which we shall call Company G (for groceries) and Company T (for technology).

Everything else from above maps onto World B directly: Company G made $10 billion in profits last year, but its long-term prospects look steady but unremarkable. Company T took a $2 billion loss, but it has great future prospects.

Problem question: What should Company G do with its $10 billion in profits? Well, hopefully my setup makes clear what I’m trying to do here. The two problem questions here are fundamentally the same. The only thing that really separates the two worlds from each other is legal artifice — in World A we conceive of the two ventures as a single company; in World B we conceive of the two ventures as two companies. But the  real, fundamental economic considerations are the same. But since in World B, Companies G and T are legally distinct, under legally distinct ownership and management,  Company G can’t just reinvest the cash in Company T. Instead, the most reasonable thing for Company G to do is to return the $10 billion in profit to its shareholders, either in dividends or in share repurchases. The shareholders can themselves take the cash and invest it in new stock offers from Company T, which has enormous growth prospects. This is, once again, best for everybody. Company G’s  shareholders wouldn’t have gotten a higher-than-the-market-rate return on any new capital investments in grocery stores anyways; the company can coast on the capital investments its already made, and any aggressive investment effort would be in vain. So Company G’s directors have an obligation to return the cash to shareholders, for the simple fact that Company G could not make an above-market-return on new internal capital reinvestments, and also, more explicitly, so that those shareholders can choose to invest their new cash elsewhere,  where they think it can get a higher return — Company T seems like a really good bet, so that’s likely where much of the capital will go. Company T can use the extra $10 billion invested in it to pay down the $2 billion in debt it had incurred the previous years, and make $8 billion in those R&D investments, and hires of programmers and designers.

Everything that happened here, in World B, is fundamentally the same as what happened in World A. Only the legal characterization of the entities involved has changed. And so all the same moralistic reasoning from above applies as well: The world is asking for, and will most benefit from, more investment Company T’s business, and doesn’t need any new capital investment in Company G’s business. So the social responsibility of Company G in World B is to accept its relatively modest status in the business world, and to return as much profit as possible to its investors as dividends or share repurchases, so that they can go out and invest that capital in other, more worthy, more promising, ventures.

The only significant difference between these worlds is that, in World B, the self-esteem of the management of Company G will be much lower than in the alternative World A where they were part of the senior management of a company that oversaw both the grocer and the Apple equivalent. They won’t end up on the cover of Forbes magazine; they won’t get status by association. They won’t be able to use some story about how they oversaw enormous growth to help them get another great job. Pity them. Nevertheless, I submit that it is their obligation as managers, and as responsible and realistic human beings, not to invest society’s and their shareholders’ resources in vainglorious attempts at expansion in a legacy industry that technological progress and demographic changes are rendering less important. Their obligation is to accept a relative decline that generates the best realistic returns for their investors, who can thence invest that capital where it is more needed and will be more profitable.


The interesting and fun thing I get out of this thought experiment is a gestalt shift which I find amusing because it seems to so discordantly mix tripping hippie “everything is connected” and neo-liberal/evil capitalist ways of viewing the world: In modern shareholder capitalism the boundaries and distinctions between different corporations are actually pretty meaningless and insignificant. We should try not to think about them so much. We should look at the whole business world as a grid divided by not by corporate charters, but divided into particular projects and ventures requiring investment. We should always be thinking about how to get investments to those projects, rather than worrying too much about which management or corporate name will be attached to them. In a world in which small tech companies are all looking to be bought out by Google or Facebook or a private equity firm, from which they may later be spun off, and in which major companies have their own proprietary investment and M&A divisions, and most publicly-listed companies are significantly owned by mutual funds which blend the savings of million small investors, this is a more sensible way to look at the business world: A place where potential projects seek potential investment, and the name we apply to these projects, the ‘corporation,’ is an insignificant transitory legal artifice. It’s a mistake to anthropomoprhize particular companies, to get personally involved in their narratives, or to hope for success for this particular company, or lament the decline of this particular long-standing company of historical significance. The only question that actually really matters is: “Is capital getting invested in ventures where it will produce things that will meet human needs now and into the future?”

But wait! This idea has more significance than as a fun gestalt shift for socially dysfunctional intellectuals such as your correspondent. This has real, practical import. It means we humans are, given our tendency to anthromorphize legal entities and understand the world in narrative, are probably doing some things wrong. We’re doing too much to idolize “turn-around” managers, many of whom probably just got lucky. We’re too harsh on management that oversee companies in decline (sometimes that’s exactly all that company can and should do) and doing too much to pressure them to turn it around — if an industry is mature, the best thing those managers can do with spare cash is probably to return it to investors. Investors should demand that sometimes their managers should just be boring and bourgeois — and just continue to skim modest profits to be returned as dividends — and resist the temptation to make a shot for a Forbes cover story.