Liquor

To any out of state readers:

Utah is undertaking a major reform of its liquor laws. It will now be easier to get a drink here.

I think this is a small step in a big trend. Utah is slowly becoming more like the rest of the US. More on the resulting big picture economic ramifications --- including why YOU should move here --- soon.

Google AdSense

You might notice that I've had ads on this blog for a while now. Lest you think I'm hoping to use the earnings from this blog to retire early, be advised that so far I've made $0.53. That's from almost 2,000 "page impressions" and exactly one "click." You have to get $10 in earnings to get a check, so I anticipate getting a check from Google in about, oh, seven years. I promise I'll send any earnings to charity; this blog is a public service project not a business plan. I mostly signed up for the ads because there's a lot of interest among economists in how the auctions for these ads are done, and I wanted to see how they work. My OIS colleague Vandana Ramachandran is doing some interesting work along these lines.

(I think the Google AdSense terms-of-service requires that I NOT encourage readers to click ads. So don't!)

Anyway, imagine my surprise when I noticed that ads for Westminster College's business programs popped up. I guess I write about business and education and Utah, so their algorithm is just giving people what it thinks they want.

Now, I'm not going to tell you not to go to Westminster to get an MBA; everyone should pick the program that's right for him or her.

But don't go there thinking you're getting something similar to what you'd get at the U of Utah.

What's the difference? Faculty.

At Utah, our faculty are leading researchers in our fields. Just a snippet (and apologies for not mentioning everyone): Hank Bessembinder is one the world leaders in understanding how specific details of the trading process affects prices in financial markets. Mike Lemmon is a top guy (again, worldwide) in studying the financial structure of firms. Mike Cooper just spent a leave-of-absence helping a large bank run a hedge fund --- he's one of the top guys in that area. Rachel Hayes is a leader in studying how accounting information is used in CEO compensation contracts. David and Marlene Plumlee spent a year recently at the SEC, helping regulators there understand how investors use financial statement information. Christine Botoson is a leader in advising accounting standard-setters, and has worked extensively with the FASB. And that's just in our finance and accounting departments; I could go on and on.

For proof, scroll down the list of Utah faculty... and enter our names into Google Scholar. Look for papers we've written, and check the "Cited by" numbers. A "cite" is when a professor at another university builds on our ideas --- and includes a reference to our work in their bibliography. High cites mean high impact.

The Eccles School has literally dozens of professors who are who are actively shaping how faculty across the world think about their subjects. This just isn't an imperative for Westminster faculty, like it is for ours.

And so what, you ask? If the Westminster faculty isn't spending all their time doing that publishing in academic journals, won't they be better teachers?

Actually, no.

The reason is that "management" isn't a completely solved problem. Business schools don't know the answers to all the questions. There are textbooks, of course, but there are lots of really important questions that the textbooks are just silent on. At Utah, faculty are actively working on filling in those gaps. When those questions come up in the classroom, we'll have better answers. We'll have ways to help you think through those issues. We'll be able to help you avoid the common pitfalls. When the answers are developed, you'll have connections to our faculty and alumni network, to help you make use of the answers in your career.

Teaching and research are complements, because being at the forefront of research in your field forces you to be better informed as a teacher.

And that's the difference you get at Utah.

Who Needs a Million Bucks?

Why is it a good thing to allow CEOs to get paid a lot of money?

One idea you hear floating around these days is that nobody really "needs" to earn $1 million a year or more. So there's really no argument for continuing to allow the very large pay packages that CEOs typically earn. It's a bit of a variation on the old quote by Marx --- something about "to each according to his needs."

I have a couple of responses to this point, and I'll focus on one of them today.

This argument --- that no social purpose is served by allowing CEOs to earn large sums --- ignores the role of matching in the managerial labor market.

What do I mean by this?

One problem we face in the economy is getting the right employees working for the right firm. Think about all the resources that are expended in job interviews and applicant screening. It's important, in most firms, to get the right employees; that is, to get the employees that are going to help the firm create the most value. And the same is true for CEOs.

Think about the following example: Jimmy the CEO is a pretty good CEO for the ABC company. Let's suppose that if ABC employs Jimmy, then the firm's profit (gross of Jimmy's salary) will be higher by $1 million than the profit would be if the firm employed its next best CEO. Let's also assume that jobs and profits are positively related (which they often are but sometimes aren't). If ABC employs Jimmy then the firm will create 100 additional jobs, compared to what would happen if ABC employed its next best CEO.

But Jimmy the CEO is no one-trick pony.

Let's suppose that XYZ company also wants him. And let's suppose XYZ's profit will be higher by $2 million (again gross of Jimmy's salary) and its jobs higher by 200, again compared to the case where XYZ employs its next best CEO.

Now... Where should Jimmy work?

Both profits (for Wall Street) and jobs (for Main Street) are highest if Jimmy works at XYZ, not ABC.

But suppose there's a government-mandated cap on CEO pay; the most Jimmy can be paid is $500,000. And let's also suppose ABC makes Jimmy a job offer with a half million dollar salary. What should he do?

He can't do any better by waiting around for another offer. So he might as well take it. Jimmy ends up working for ABC. And 100 jobs and $1 million in profits are lost as a result.

Now let's suppose that Jimmy's pay isn't capped.

ABC offers half a mil. Jimmy thinks "Oh, that's plenty. I'll take it." But then XYZ counters with $750,000. Jimmy thinks "Cool, now I can get a bigger boat!" And ABC counters with $900,000. XYZ finally wins the bidding with an offer of $1,000,001. ABC is not willing to match this offer, because it earns higher profits when employing its next best manager, rather than paying Jimmy that amount.

So Jimmy gets richer under this arrangement. But that's not the only thing that happens. More overall profit is created (some going to shareholders and some to Jimmy), and that money can be reinvested in other socially valuable activities. And more jobs are created too. All because the bidding didn't just change what Jimmy was paid, it changed where he worked.

This is related to Hayek's ideas (which I have discussed before) about how prices convey information. People tend very much to focus on the role of wages --- which are just a "price" in a labor market --- in determining who gets rich and who doesn't. But wages also communicate information about socially valuable career choices. And that's what's going on here.

My example is just, well, an example. There's no reason to think that this describes everything about the managerial labor market. But this effect is potentially important, and we'll at least want to think hard about this effect before legislating pay caps.

Enough with the Basketball Already

I know, I know, I write about basketball too much. Lucky for you the season's almost over.

A friend forwards this article from ESPN Magazine. It's another about measuring performance of basketball players, which, as I've noted, is harder than measuring the performance of baseball players.

But the interesting thing is how the author complains that the "experts" aren't saying anything. That is, they won't say what they're measuring or how. (This came up the Battier article previously, as well.) The reason is that these basketball experts work for basketball teams, and they don't want to give away their competitive edge.

And this makes me think about... finance. I don't know much about finance, but what little I do know comes from having sat through three plus years of finance seminars at the U of Utah. A lot of the seminars have to do with asset pricing; that is, trying to explain and predict how prices of stocks and bonds move.

Asset pricing is tough. The prices don't move in the way our theoretical models predict (there's apparently way too much day-to-day price variation), so we have a hard time explaining the data with economic theory. Further, while there's a lot of variation, there's very little in the way of predictable variation. This fact makes it exceedingly difficult to devise trading strategies that consistently win.

But my overarching thought about the asset pricing literature is this: I wonder how much of what's known is publicly known. I mean suppose you're a finance genius and you figure out a theory that explains and predicts asset prices. You could publish your model in the Journal of Political Economy, and probably win a Nobel Prize in Economics.

Or...

You could start a hedge fund and trade on your idea. And if you did that, then the last thing you'd want to do is tell anyone what your idea is, lest they replicate your trading strategy and reduce your profits.

The "publish" option makes you extremely famous among an extremely small group of people (basically economists and no one else). The "hedge fund" option makes you fabulously wealthy. Hmmm....

So this is why I wonder how much of the asset pricing knowledge is really making it to the academic community at large. I suspect the banks might know a thing or two that us finance profs don't. And the same thing seems to be happening with regard to measuring the performance of basketball players.

I promise --- no more basketball posts for the whole rest of this week.

AIG

I received a question from a friend about AIG, but not about the on-going bonus scandal.

Are we giving all of this money (or a huge chunk) to AIG as a result of the CDS (credit derivative swap) positions they had vis-a-vis Lehman? Would we have been better off bailing out Lehman?

How about this for a hedge of an answer: Mostly No and Maybe Yes.

To get a sense what happened that brought down the financial system in mid-Sept, read this first.

Lehman's failure didn't affect just Lehman's counterparties. Lehman's failure caused everyone to worry about all their counterparties. That is, Lehman's failure made everyone worry about the failure of everyone, and this made it impossible for AIG to get out of all their CDS positions, not just their Lehman positions.

It's possible that things would have been better had Paulson simply bailed out Lehman, although we'd still be facing the problem of lots of bad assets on bank balance sheets. Suppose Paulson had bailed out Lehman. Morgan Stanley would have been next, and then others. At some point, political patience would have run out and they'd have let someone fail. And that would have brought AIG down.

I think Paulson didn't expect the bank-run type of phenomenon (described in the nyt article) that was kicked off by the Lehman failure. I think he did expect Lehman's failure to cause AIG to have to write off a lot of losses due to its Lehman CDS's. But he figured AIG would be able to get access to enough liquidity to cover those losses, and that's where he was wrong.

And what about the bonus scandal?

The depth of the public outcry has me concerned about bad regulations being written regarding managerial labor markets. Getting managerial incentives right is both hard and important. And frankly, quizzing the man on the street about how to do it is probably not too productive, but that seems to be roughly what Congress has in mind.

While it's clear that too much risk was taken on Wall Street over the past decade or so (with disastrous consequences), it's also clear that encouraging the right amount of risk taking is really important. Innovation is the goose that laid the golden egg for the US economy, and we don't want to stifle innovation (which, by nature, is risky) in a misguided attempt to punish Wall Street. We want entrepreneurs with good ideas to get funded, and the financial system plays a key role in this process. A populist backlash would, I think, not be a good thing for standards of living in our country.

Unpopular Thoughts About Business Education

Great article in the NYT about business education.

At the risk of being flayed for being a non-visionary, status-quoist, doofus, I'll respond with some thoughts about why business schools have somewhat of a harder time instilling "professional standards" and "codes of ethical conduct," at least compared to law schools and medical schools.

One big difference between law/medical schools and business schools is that business schools compete against non-consumption.

What does this mean?

If you want to be a lawyer, you need to go to to law school. There's no other way to do it. If you want to be a doctor, you have to go to medical school. There's no other way to do it. But if you want a career in business, you don't have to get an MBA. You don't even need to have a bachelor's degree in business. There are a thousand ways to have a business career that don't involve spending time at a business school.

This fact might make it harder for b-schools (relative to law schools and med schools) to require students to acquire skills that have social value but not private value.

Here's why:

When students decide whether to go to any kind of school, they compare the private value of going to school to the private cost. "Private value" here is the amount by which school will make the person's lifetime earnings higher. "Private cost" is the amount it costs the person.

Where does private value come from? Private value comes from the market value of the skills that the person will acquire. If we teach you how to apply the net present value rule and employers like that skill, then they'll be willing to pay you a higher wage as a result of your having gone to school. If we teach you how to make better ethical decisions and employers value that skill, then they'll be willing to pay you higher wages as a result. Both skills allow the student to capture some private value.

But suppose employers aren't willing to pay for skills involving ethical decision-making. Suppose these skills make the world a better place, but they don't make the employer a higher-profit firm. (You might, in fact, think that one reason to emphasize ethics is to help students make better decisions in cases where the profit motive and "what's right" don't line up.) In this case, we'd say that the skills have social value but not private value.

Developing these skills is still costly --- the school still has to pay the instructor --- but the skills don't allow the student to capture any direct benefit, because the employer isn't willing to pay higher wages as a result.

Now, schools could still require the student to get the skills because it's the right thing to do. But this raises the private cost of getting the education without raising the private benefit. And this makes getting the degree less attractive.

Here's where the difference between law/medical schools and b-schools really bites. Law schools don't face competition from non-consumption. Neither to med schools. So, pushing lawyers and doctors to get socially-but-not-privately-valuable skills doesn't have a significant effect on student demand for the degree.

I'd guess the same isn't true for b-schools --- pushing students to acquire socially-but-not-privately-skills might well have a larger effect on student demand here. Imagine a potential student saying "Why should I go to b-school where they'll teach me all that stuff I don't need? I'm just going to keep working and try to move up the ladder without the degree. I'll learn more practical skills here at work anyway."

So, competition against non-consumption is one possible reason why business schools differ from law/medical schools when it comes to professional standards.

To put this another way, if the schools have a monopoly on certifying people for a profession, then it's easier for the schools to impose good-for-the-world standards. If access to the profession is open, then it's harder for schools to insist on such standards; people might just opt out of school.

Now, my argument here relies on a number of assumptions that might not be true.

First, I've assumed that students look at private benefits and costs only, and aren't thinking too hard about whether their training will help them make the world a better place. If "student altruism" rises, then this assumption won't be true, and schools should respond with more ethics in the curriculum.

Second, I've assumed that employers might not have a sufficiently high willingness-to-pay for ethical decision-making skills. If, going forward, employers have a much higher willingness to pay for these skills, then b-schools can push curriculum that direction without reducing student demand. If employer willingness-to-pay for ethics rises, then more ethics-in-curriculum will actually increase student demand for the degree.

Education Policy

Really interesting: President Obama has come out pretty strongly in favor of pay-for-performance for teachers, and against tenure for teachers who are underperforming.

As I've noted here before, measuring the performance of teachers is not a trivial thing. It will be interesting to see how the administration approaches this issue. The details of the policy matter, but the details are a little fuzzy just now.

Old Friends (Continued)

I had two roommates throughout most of my college and grad school years. One of them was Scott Smith, and he's found this blog through Facebook.

Smith (we had to dispense with first names due to the commonality) ended up getting a PhD in MechEng at Stanford. Somehow he missed his chance to become an economist --- I recall he took Don Brown's intermediate micro class sometime during college, but I guess the ME geeks already had their hooks in him by then.

Anyway, his interest in economics seems to have returned. He's started reading the blog, and a couple weeks ago he emailed a message to my readers.

Of course, Smith has many stories about me that I don't want shared, so I have no choice but to do as he instructs and post the message. His comments are quite complimentary to this blog, but I hope posting it doesn't make it seem like I'm fishing for such compliments. Really I'm not.

(And no I don't know why he wrote this. Let's just say I long ago gave up wondering why Smith does the things he does.)

To Utah Residents and Others Who are NOT Economists,

I first met Scott when we were eighteen years old, before either of us had taught a class, had children, or the word blog was in use. If you must pin us down, lets just say he brought an Apple 2e to college (and roomed with future World Series of Poker bracelet winner Rafe Furst.) And as Scott is the first to recognize, he has spent most of his educational and professional life since then in the pursuit of understanding, explaining and furthering economics. If I can offer one thing beyond the pat-on-the-back compliment, it is this: Economics is not what I thought it was, which is great news because it is actually much more interesting than I thought. And since I have not spent a lifetime pursuing economics, I consider myself qualified to talk about how to approach a blog on economics if you are not an economist.

If I saw a blog by an economist, I might expect to see a few paragraphs on where the stimulus package is being spent, a blog entry on where people are likely to spend their money in a contracting economy, and perhaps some references to money supply. I seem to remember M1 and M2 having specific definitions regarding money supply. In short, I might expect to see a more formal perspective on the same articles you can find in the business section of the Salt Lake Tribune or the Wall Street Journal.

But like I said before, since I knew Scott as he discovered his own interest in economics, I can offer some insight into what you see here and what you do not. When I was younger, I assumed economists studied money, but it is more interesting than that. They study incentive and motivation, value and the exchange of value, optimization and efficiency. Money just becomes a measuring tool (and a finicky one at that). So between the daily articles on the business page and grandiose pronouncements of an efficient market, there are great insights that an economist can provide.

A journalist will ask which firms will have price caps on executive pay, when the caps are going to be in place, what the upper payment is, and who will oversee their enforcement. Scott and other economists can present more useful information. They are keepers of answers to questions like: How will executive price caps affect the value of the decisions made by the restricted firms? And, Is there proof that firms with highly-valued (and highly paid) executives outperform firms with lower paid executives?

And Scott is always willing to use a more captive environment to further discussion. Right now, the NBA is distributing upwards of $175 million dollars to some of its member teams that are losing money. (Sound familiar). Are they considering setting lower price caps on the players for teams that receive the stimulus money (in other words, lowering the salary cap)? Should they? Ask Scott. And if you live in Utah, imagine if the salary cap for the Jazz was cut in half. Would your reaction be, good, the players are overpaid. Or would it be, hey that’s not fair, how can we compete with the Lakers now? Again, ask Scott. And trust me, after growing up in Portland, he too does not want to give the Lakers any advantage.

The list of possible topics is long and varied. Why do colleges offer tenure to professors, where few other jobs have that kind of guaranteed employment? Twenty years ago, the answer was because the only judges of the quality of advanced intellectual work are other professors, and the incentive given to gain their unbiased answer to the work of an assistant professor, is to remove the competitive approach of competing for a job. Do the business school students at the University of Utah learn more than the students at Harvard business school? Again, twenty years ago, the answer was there is very little difference, and the variation in the graduating students is due to the quality of the applicants. Personally, I am curious if a lifetime of study has shifted any of these views.

And if you are wondering, yes Scott does speak math, advanced math. But the beauty of economics is both the questions and the answers are best explained using good old fashion English. Keep in mind, you can always ask if his model accounts for or has any comments on a certain issue. If the language of economic modeling seems to misplace the seriousness of some issues, please forgive him. When he says, “One outcome of this game is for no [firms] to have a layoff. Another outcome is for everyone to have a layoff,” he knows it is no game; game theory is a mathematical term. And you can ask him, what insight do economists have in the effects that cause the shift from the layoff outcome to the no-layoff outcome? And I can presume a third outcome is firms hire. In other words, what insight do economists have in the seemingly cyclical nature of recessions, which seem to happen every four to eight years. Is it really a cycle, or are the changes random occurrences?

So I encourage everyone to keep reading. Remember behind each small article is another insight into incentive, value and efficiency. And in my opinion, once you get the basic facts from the general news, the information Scott provides is of the highest quality and use.

Friedman and Walsh

So unfortunately I won't be able to go listen to Thomas Friedman tonight. A work-related dinner came up and I have to go to that. I'm sending my brother-in-law and his friend instead; perhaps he'll report back.

Meanwhile, Rebecca Walsh of the SL Trib criticized the Utah Museum of Natural History and the Hinckley Institute of Politics over the whole thing in her column last Sunday.

While I often like Walsh's work, I disagree with her on this. (And I should say that I'm in no way affiliated with either the UMNH or the Hinckley Institute, although both are affiliated with the U of Utah.)

It's certainly the case that Friedman is earning a lot of money for this visit. And it's also the case that the message he'll deliver isn't that different from what a lot of people are saying. The UMNH could, for example, hire yours truly to deliver an insightful lecture on carbon taxes vs. cap-and-trade systems --- and I'd probably do it for a just bit less than the $75,000 Friedman is going to make.

But the local media wouldn't cover a talk from me like they'll cover a talk from Friedman.

And let's keep in mind that the UMNH's mission is to "illuminate the natural world and the place of humans within it." Paying me (or other U faculty) will get you a lecture, but no "illumination" because my talk wouldn't be in the news. Paying Friedman gets you a lecture plus a lot of illumination.

Given that the Museum has a budget, it seems like we should let them spend in the way that they think will have the biggest impact with respect to their mission. Friedman's a high-impact guy. It seems completely reasonable to me to have one expensive-but-high-impact guy, rather than ten cheap-but-low-impact guys. I don't know that Walsh would criticize if the Museum was spending $7,500 each on ten low-profile speakers. (Or $750 each on a hundred really-low-profile speakers, like me.)

Perhaps the Museum shouldn't have a budget at all in these lean times, but that strikes me as a somewhat different conversation.

Comments / Performance Measurement

More on the "Good Comments from Readers" thread. Regarding pay-for-performance in basketball, reader Jay writes:

(Players) should be getting paid for the overall team performance. Incentives are (probably) not aligned.

This comment perfectly illustrates one of the main performance-evaluation tradeoffs. Here's how:

Imagine you're the Memphis Grizzlies. Your record this season is 16-46. Not too good. But you've got rookie OJ Mayo, who's averaging more than 18 points per game.

Is it Mayo's fault that the Grizzlies are so bad? Should his pay be lower because the other players on his team stink? Mayo cannot, after all, help Quinton Ross (a 39% FG shooter) make shots.

Or...

Should we pay OJ Mayo based on how HE plays?

If we pay Mayo based on how he does, then we face the problem of measuring his performance. And this is hard. We usually think points-scored is a good measure, but as the Shane Battier article points out, there are times when the best thing for a player to do is pass the ball. If we use "points" as a performance measure, then Mayo might be motivated to shoot when that's not the best thing for the team.

If we pay Mayo based on how the team does, then he'll never shoot when he should pass. That is, Mayo's incentives will be aligned. But his pay will depend on whether Quinton Ross can shoot or not. And this means Mayo's pay will depend on random factors beyond his control. And just like we don't like it when the stock market goes up and down (affecting our investments in a way that's beyond our control), employees usually don't like this.

So, there's your tradeoff. Firmwide performance measures get good alignment, but subject employees to risk. Individual performance measurement can reduce risk, but won't necessarily get good alignment.

Utah WBEC Roundup

Last week, I hosted the fourth annual Utah Winter Business Economics Conference.

We had a good turnout of economists from around the world, with the following universities represented: Carnegie-Mellon University, Columbia University, Duke University, Massachusetts Institute of Technology, Michigan State University, Northwestern University, Queen's University (Canada), Stanford University, University of California San Diego, University of California Santa Cruz, University of Chicago, University of Michigan, University of Munich, University of North Carolina, University of Rochester, University of Texas, University of Toronto, Washington University (St. Louis), and Yale University.

Why does the University of Utah do this?

Actually there are multiple reasons.

First, it's a great way for us to keep up with developments in our field. The academic format has six professors from other schools present papers. Then six other professors comment on the papers, and we take questions from the audience. It's one way I keep up with the flow of new ideas.

Second, it's cheap for us. The U of U --- and by extension, the Utah taxpayer --- doesn't spend a penny on this conference. When I joined the U faculty in 2005, I negotiated a small budget to help defray conference expenses in the first year. Since then, I've tried to maintain that starting budget as a cushion. I aim each year to have the conference break even, and I do this by charging participants a small registration fee.

Third, it's part of our faculty recruiting strategy. We are a small state and U of U salaries are typically below market. When the DESB goes head to head with, say, Duke in trying to attract a professor, the Utah salary offer is typically lower. So how do we attract faculty? One way is to target offers to people who want to live here because of the abundant outdoor recreation opportunities. And one way we identify those folks is to invite them to come skiing for a weekend in February. A professor who visits year after year might just be somebody we want to talk more to.

Layoffs vs. Salary Cuts

I skied 5 straight days (Th through M). My legs hurt.

As I noted recently, the U was considering some salary cuts for next fiscal year. (It's now looking like salary cuts might not happen next year, because the legislature is going to use some federal stimulus dollars to support higher ed.) Utah State already cut everyone's pay by 2% for this year.

In other news, IBM announced higher profits, and shortly thereafter, a round of layoffs.

Both IBM and Utah State are trying to reduce labor costs. Why is one doing it through layoffs and one through salary cuts?

This is actually one of the big questions in economics. Wages, it turns out, tend to be sticky in the downward direction. And this is weird.

In a normal market, prices fall when demand goes down. Think about what's happened with oil recently. Demand has fallen, and so has the price. The price falls so that quantity demanded and quantity supplied are the same --- the market is in equilibrium.

IBM's demand for labor has fallen. Are they cutting wages? No --- IBM is keeping wages the same for the workers who keep their jobs. The fact that wages stay the same means that the quantity of labor demanded and the quantity of labor supplied are not the same. We've got an excess supply of labor. We call this "unemployment".

In some sense, it would be better if firms cut wages rather than cutting people. Why? Let's apply some marginal analysis to the question of how many workers a firm should employ. A firm should keep hiring until the worker's marginal revenue product --- that is, the extra revenue the firm makes as a result of hiring the next worker --- is no longer larger than the wage.

So let's suppose times are "good", and my marginal revenue product at my employer is $105. If my wage is $100, then the firm is happy to employ me, because it earns $5 in profit. If times turn "bad", my marginal revenue product might fall (due to decreased demand for my employer's products) to $95. If I'm bringing in $95 to the firm but costing the firm $100, then I'm a prime target for a layoff.

But what if I'd rather work for $90 than be unemployed? Then the firm and I can both be made better off if I stay employed but take a wage cut. If the firm lays me off, then it earns $0 and I am unemployed. If the firm keeps me around but cuts my pay to $90, then the firm earns $5 and I stay out of the unemployment line.

In that sense, salary cuts make both parties better off.

But in the real world, things are more complex. And this is due in large part to asymmetric information problems.

In real recessions, employees don't really know their marginal revenue products. And as a result, employees might worry that firms are using the recession as a pretext for cutting pay. An employee might wonder "Are times really so bad? Or is my employer simply using the recession as an excuse to cut pay so it can make more profits?"

This is the sort of thing that could make employees mad. And employees can do a lot of subtle things to retaliate against an employer who they think has treated them badly.

As a result, a firm might be better off cutting employees rather than cutting salaries. The employees who are let go will be unhappy, but they won't be around to cause trouble.

The argument I'm sketching here is laid out in a book by Yale economist Truman Bewley. This is truly one of the most unusual books in economics: Bewley is quite famous as a serious math-econ theorist, but in this book he eschews math entirely and simply goes out to interview managers and ask them why they do what they do.

It seems to me that this recession is seeing more across-the-board salary cuts than we've seen in the past. A former student sends in this article about Microsoft. I have not seen any data on this point, but I'm sure some enterprising labor economist will be exploring this question soon.

One reason might be scale of this downturn. Because everyone knows that this recession is pretty bad, employees might not be as prone to think that employers are simply using the recession as an excuse to cut pay. But at least some MSFT employees seem pretty grumpy about the whole deal.