Why Work Is Like It Is

Awesome article in the New York Times Magazine last Sunday.

The Case for Working with Your Hands

The article is written by University of Chicago PhD in political philosophy (Matthew Crawford) who gives up on being a so-called "knowledge worker" (that is, somebody who sits in an office and processes information all day), and instead opens a motorcycle repair shop.

The awesome economics in this article just goes on and on... So unfortunately this blog post will go on and on as well.

One great thing about the article is that it re-iterates Princeton economist Alan Blinder's point that young people should think about future labor market competition when choosing careers. If your job can be done over the wire, then you're likely to face competition (if not now, then in the future) from low-wage workers in other countries. Crawford recounts Blinder's great line: "You can't hammer a nail over the internet." This is really useful advice for everyone who's making human capital investments.

Another great thing about this article is how it questions why work is like it is. There's a discussion of how fixing motorcycles is a sort of unconstrained problem-solving that requires both deep knowledge and hard thinking. It's not the sort of job that can be done (well) by people who are simply following steps out of a rule book or owner's manual. Crawford criticizes jobs where people are constrained by rules, steps and processes:

There probably aren’t many jobs that can be reduced to rule-following and still be done well. But in many jobs there is an attempt to do just this, and the perversity of it may go unnoticed by those who design the work process.

While I agree that rule-following has its problems, I don't think it's the case that managers mechanically reduce jobs to rule-following for no reason. So what's the reason? Why is work like this?

Crawford is obviously a brilliant guy. (U of Chicago is no Stanford --- neener neener --- but still they don't let just anybody get a PhD there.) Further, the mechanics that Crawford admires have spent 30+ years acquiring knowledge about how to fix bikes. Brilliance is scarce and career-long investments in knowledge acquisition are costly. As a result, not everyone can succeed in jobs that require skill at the sort of unconstrained, open-ended problem solving that Crawford likes.

So what are the economic implications of this scarcity of problem-solving skill and talent? One is that skill and talent is going to be high priced. And this means people will try to economize on skill and talent. And how do we do this? We try to reserve the skilled and talented people in our economy for solving the really hard problems. We try to give the easier problems to the less skilled and the less talented. And we give them a set of rules to follow, to try to help guide them to the right answer. If they can't get to the answer, then problems tend to get passed up the problem-solving hierarchy, eventually landing on the desks of the most skilled and talented problem solvers. (I'm sketching a model written by Luis Garicano, formerly a professor at, yes, the U of Chicago, and now at London School of Economics.)

In other words, if everyone were as smart as Crawford, then the "rules" that Crawford dislikes so much wouldn't be necessary, because we wouldn't have to economize on skill and talent. But unfortunately that's not the case.

Great thing number 3 is how Crawford points out the "moral maze" of middle management. One interpretation of this is the following: Some jobs make you feel good about yourself. Others not. (This calls to mind the awesome Billy Mays ESPN360 commercial, where a worker reports "Now my job is way less soul crushing!") Would the world be a better place if we didn't have a job called "middle manager"? Maybe... because fewer people would find their jobs to be soul crushing. But that's only the "cost" of having middle managers. What's the benefit?

One benefit is that middle managers allow firms to get big. Think about it... You really can't have a big firm without having middle managers, and you really only get middle managers once firms reach a sufficient scale. And is scale good? It can be, because some of our modern production technologies have increasing returns to scale, which means that average costs fall with size. The benefit side is therefore this: Middle management facilitates scale, which allows society to utilize its resources more efficiently.

So there are costs and benefits.

And is there any reason to think that labor and product markets will get this cost/benefit balance right?

Actually, yes. I'm not a "market outcomes are always efficient" kind of economist, but I do think in this case there's reason to believe that markets will push things in the right direction. If people hate being middle managers, then middle management jobs will have to pay higher wages. (There's ample evidence that people get paid less for jobs that they enjoy, and more for jobs they dislike....) So firms will only hire middle managers if the benefit to the firm (coming from more efficient production technologies allowing the firm to produce goods and services more efficiently and meet customer needs better) exceeds the "cost" to the worker of having a crummy job.

The labor and product markets force the firm to essentially say to the prospective middle manager: "Look, we know this job will be soul-crushing. But your presence is going to make our firm so much more productive that we are willing to pay you enough to make it worth your while."

Great thing number 4 is the discussion of his own soul-crushing job, where Crawford wrote abstracts for scientific journal articles. The article makes clear this exercise was totally absurd; none of the workers had anywhere near the expertise to write abstracts of scientific journal articles. This was completely wasted effort. How can markets be efficient if jobs like this get created?

The answer is that markets aren't ever literally efficient, and Crawford's tale is a great example of that. But markets do have the ability to move things in an efficient direction.

And who's the efficient person to write an abstract for a scientific journal article? The author, of course. And how might markets make this happen? A librarian, unhappy with the cost and low quality of a journal abstracting service, might tell a journal that he has higher willingness-to-pay for a subscription to the journal if the journal requires authors to submit an abstract.

Might this actually happen? Compare this article from the American Economic Review published in 1980 to this one published in 1990.

Economics for Accountants (Part 4)

Finally returning to the much promised Part 4.

The last point I want to make about the Market for Lemons is how it helps us understand the recent financial crisis. You really can't appreciate how the crisis impacted credit markets without understanding the Market for Lemons, and here's why.

One of my favorite articles about the crisis was published in the NYT way back in October:

As Credit Crisis Spiraled, Alarm Led to Action

The great thing about this article is the description of how the entire financial system came to a screeching halt after Lehman Bros. failed. It's the regular old Market for Lemons logic, applied to credit markets. If I'm a bank, I'm happy to lend money to "plum" credit risks. What do I mean by "a plum credit risk?" It's a borrower who is very likely to have the funds to be able to pay me back. And I'm happy to lend money to lemon risks, as long as I get terms that are favorable enough to the lender --- usually, very high interest rates and a lot down. But I'd never want to lend money at a plum rate to a lemon credit risk.

And if I can't tell the difference between plum risks and lemon risks? Then the market for plums ceases to function, and borrowers with plum risks cannot borrow at plum rates.

People with lots of money --- college endowments and hedge funds --- deposit funds with big banks all the time. Making a "deposit" with a financial institution is just like loaning money to the institution, so the hedge-fund/endowment lenders will want to think about whether their commercial-and-investment-bank borrowers are plums or lemons. Because of federal deposit insurance, most of us don't worry about this issue when we put our paychecks in the bank. But if you have millions and millions of dollars, you're way beyond the upper limit of deposit insurance. And this means you could lose out --- big time --- if the bank where you've deposited your money fails.

And normally, the huge financial firms that make up the backbone of our financial system are viewed (themselves) as plum credit risks. Prior to a couple years ago, the possibility of failure for a big bank like Bear Stearns or Lehman Bros was viewed as quite remote. Banks did fail, due most commonly to rogue traders, but it wasn't something that people worried a lot about. And as a result, these firms were able to borrow funds from depositors at plum (that is, low) rates, and were therefore able to lend more cheaply.

But last September, depositors suddenly found they had no idea whether Goldman or Citi or Wells Fargo or Merrill was a lemon risk or a plum risk. If Bear Sterns and Lehman fail, who knows what's next? Lenders refused to lend to anyone (except the US Federal Government) at plum rates --- and banks' sources of capital dried up. The "freezing up" of the credit markets was 100% exactly a case of the failure of a market for plums.

Positively Fifth Street

No time to finish the Immigration or Accounting Part 4 posts today. Soon...

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Positively Fifth Street: Murderers, Cheetahs, and Binion's World Series of Pokeris the self-told story of Chicago-based reporter and amateur poker-player Jim McManus. In 2000, McManus was sent to Vegas to cover the World Series of Poker for Harper's Magazine. One thing leads to another, and the author ends up in the tournament, at the final table. Pretty unlikely, but also pretty good reading.

The cool economics in this book comes because poker is a game of asymmetric information. It's a more complex version of the Spence signaling model, or the Market for Lemons, or hundreds of other games that economists have studied over the past 30 or so years. (My recent Lake Wobegon Effect paper models CEO pay as a game of asymmetric information.)

What I try to emphasize when teaching MBAs to think about games with asymmetric information is this: Think always about what you can infer about your opponent's information by observing his actions. And think about what your opponent is going to infer, in the other direction.

And this is exactly what great poker players do. So it's really interesting reading --- from this non-poker player, but trained game theorist's perspective --- to think along with a poker player as he does this. The best such story starts on page 293, where McManus wins $400,000 from one of his poker idols, TJ Cloutier. Cloutier is a celebrated author within the poker world, having written Championship Pot-Limit and No-Limit Poker. McManus, who has studied Cloutier's books in detail, is constantly thinking through what Cloutier's actions must imply about his cards. McManus gets it right, and also manages to confuse Cloutier's inferences by making some unexpected choices.

I do have one beef with the book --- By my count, there is only one Tiltboy in this story. How can that be?

Education vs. "Real World" Experience

A couple of labor-market related items in yesterday's SLTrib. I'll save the immigration story for next week and write today about a story on a new report on Utah's working families:

Utah working families face economic hardships

Here's a quote:

(W)ithout investment in the state's poor working families,... they will not be an integral component of Utah's future economic growth and prosperity. (The report's author) called on legislators to ensure that educational and training programs are affordable, accessible and tailored to the demands of a knowledge-based economy.

But will that really work? Will additional investments in education help the working poor?

Data say... yes.

Here's why:

Let's think about the factors that increase peoples' wages. One factor is experience. As people get more experience in the workforce, they acquire more skills and become more productive. Supply and demand bids up wages for more productive workers, so more experience means higher wages. On average, it turns out that an additional year of labor market experience boosts wages by 1.5% (depending a bit on how and when you measure it). This is one reason that the poor tend to be young; they haven't had time to acquire enough skills to earn their way out of poverty.

Another factor that increases wages is education. As people get more education, they become more productive. Again, supply and demand bids up wages, so more education means higher wages too. On average, it turns out that an additional year of education boosts wages by an astonishing 8%. Yeah, that's right --- "real world" experience is valuable... but a year of education is more than five times as valuable. Five times! (And of course the exact figure depends on how you measure, but I think the consensus of labor economists is that my numbers are about right.)

These aren't made up numbers. They come from studying the relation between real wages and real experience and real education (using linear regression models and some tricks to help figure out causal linkages) in huge data sets collected by the US Census.

So, if a local high school grad has to skip two years at SLCC and instead go into the workforce... that's a net difference in yearly wages of around 13%. Think of how much of a difference a 13% raise would make for a working family. That's a lot of money, when you add it up over forty years in the workforce.

We always hear that education is a great investment. And labor economists' numbers bear that message out.

Google Runs a Regression

A former Kellogg student forwards this cool article about Google using an "algorithm" to try to figure out which of its employees are likely to quit.

Google Searches for Staffing Answers

While Google is being tight-lipped about what they're doing, I am here to tell you that it's not so complicated. I doubt they're doing very much more than running a simple regression, not that much more advanced than what MBAs learn in b-school. Linear regression is, as MBAs know, is the best linear unbiased estimator of an underlying relationship. So it's exactly the tool for picking out the relationship between "quits" and various factors affecting the work environment.

Here's how you do it:

The simplest way is to estimate what's called a "linear probability model." Let the dependent variable in your regression be a zero if the employee doesn't quit, and one if he does. Let the independent variables be all the data you have pertaining to the employee's personal characteristics and work environment. Run a linear regression, and look for factors that strongly predict quit behavior. In a linear probability model, you can interpret the coefficients on the explanatory variables as how much a one unit change in that explanatory variable increases the probability of a quit.

Now the linear probability model isn't exactly the best thing to do, because of some funny characteristics of probabilities. Specifically, because probabilities have to be between zero or a one but the linear regression model doesn't account for that, you can get situations where the predicted quit probability for a given individual is less than zero or greater than one. So keep that in mind. But the linear probability model is quick and dirty, and it will give you insight into the relationships in your data.

To do something a bit more rigorous, you can do a logit or probit regression. Most of your standard statistics packages can handle this kind of regression pretty easily, and these methods always yield sensible quit probabilities. You have to do some more work to figure out the strength of the relationship using these methods, but it's not too tough.

After you've identified factors that are associated with quits, you can think about doing something about those factors --- and perhaps reducing your turnover.

One danger in this kind of analysis, though, is misinterpreting what causes what. People who know they're likely to quit are probably people who aren't going to undertake long-term projects at work. So the data might well tell you that people who work on a succession of short-term projects are more likely to quit than people who work on long-term projects. But this doesn't mean that shifting everyone to long-term projects will reduce turnover, because it's the employee's turnover intentions that drive project choice, not vice versa. So you need to think hard about what your data means before making wholesale changes in your organization.

Now you're as smart as Google. But unfortunately not as cool.

News Flash: Demand Curves Shift

Back to Accounting shortly....

But I'm teaching Managerial Econ for the 2010 EMBA class this summer, so I'll of course be thinking about some managerial econ ideas over the next ten weeks. And here's one thing that strikes me every time I cover the material about where demand curves come from: Journalists love --- love! --- to write about shifting demand curves.

Remember last summer when gas prices were so high? Every time you opened a newspaper (yes, I'm old-fashioned), there was a story about how people were changing their behavior because of high gas prices. People increased their demand for hybrids, bus passes, and city-center apartments, and reduced their demand for hummers and houses in exurbia.

And here's the latest from the NYT:

Yes, I Look Fabulous, But Inside I'm Saving

Even Hollywood A-listers are reducing demand for certain goods and services now that everyone's 401k is 40% down from last summer. Why, Alice Cooper's bass player parks his own car rather than paying $10 for the valet.

For most goods, we reduce our consumption when our income falls. But falling income leads to hard choices, and these are the sort of choices that attract journalists. This article focuses on how Hollywood-types are reducing spending on status goods only a little, but are cutting back more on goods that don't convey status. One exec canceled her vacation but still splurged in an Audi A5. Apparently nobody can tell whether you went to Fiji or Fresno over spring break, but tongues wag over your sporty new ride.

This article was in the Times The Arts section, which just goes to show that you can find cool economics pretty much anywhere you look.

Economics for Accountants (And Entrepreneurs) (Part 3)

In Part I of this post, I explained why the Market for Lemons results in unrealized gains from trade. This means that there are buyers and sellers out there who could both be made better off by trading... But they can't get the deal done. In the specific case of the Market for Lemons, trade fails because the buyer cannot be certain he is dealing with a plum seller.

Here's an important, related notion: Every business plan ever written starts with the observation that there are unrealized gains from trade. This sounds like an outrageously bombastic proposition, but I argue that it is literally true. When VCs and entrepreneurs ask "What's the value proposition?" (which they do), they are really asking about where the unrealized gains from trade are.

If there were no unrealized gains from trade, then you could never start a new business. Why? Because what businesses do is buy inputs (capital, labor, and intermediate goods) from suppliers, convert them into output (think of goods and services), and sell the output to customers. If the trade between suppliers and customers were already perfectly efficient --- in the sense that there was no way to rearrange things to offer both suppliers AND customers a better deal than they've already got --- then you'd never be able to get the new business off the ground.

Unrealized gains from trade can arise in a lot of ways. As one example, consider search costs. Amazon.com's business is built (partly) around reducing search costs, and hence allowing buyers of books and sellers of books to find each other more easily. That is, before Amazon existed, some buyers and sellers were prevented from realizing gains from trade because of the difficulty of finding each other. A buyer who really wanted quite a specific book might not be able to find it at his or her local B. Dalton Bookseller, and hence the trade wouldn't happen. Amazon makes it easy for buyers to find just what they want. Think of all the trades that didn't happen before Amazon existed, and think of Amazon taking a just a small piece of the value in each trade. Those pennies add up.

As we've been discussing, unrealized gains from trade can also arise from informational problems, as in the Market for Lemons. Because there are unrealized gains from trade, there's money to be made from figuring out how to get the trade to happen.

This explains Carmax. It also explains Executive Search Firms (aka headhunters).

If you think about Carmax's business model, they are an intermediary in the used car market. That is, they buy AND sell used cars. And if they're going to make a profit doing that, then there must be some reason why they're able to do better than buyers and sellers would be able to do on their own. That is, at least some sellers have to prefer dealing with Carmax to dealing with buyers directly. And at least some buyers have to prefer dealing with Carmax to dealing with sellers directly.

Let's start on the buyer side. What buyers are afraid about in the Market for Lemons is buying a Lemon car at a Plum price. This is why buyers shy away from cars with plum prices. But what if Carmax is selling a used car at a plum price? Should buyers believe that the car is actually a plum? There's reason to think that Carmax can do a better job (compared to individuals) of committing to sell ONLY plums at plum prices. Carmax can more easily offer warranties. And it can more easily develop a reputation for honest dealing, at least compared to an individual who sells a car once every five years.

On the seller side, in the Market for Lemons the plum sellers can't sell at all, because buyers fear buying a lemon car at a plum price. But suppose Carmax employs skilled mechanics who can, after inspecting a car for a while, do a good job of distinguishing plums from lemons. Then Carmax can be confident that when it pays a plum price it isn't getting a lemon, and plum sellers will be better off selling to Carmax than selling directly to a buyer who is afraid of buying a lemon.

Now, this isn't everything about the Carmax business model, but it's part of their edge. They facilitate trade in the used car market and, like Amazon, take a small chunk.

Headhunters work on much the same principle. The Market for Lemons affects the labor market because no firm wants to pay a plum price only to find they've hired a lemon executive. Headhunter firms connect buyers (firms looking to hire) with sellers (executives looking for new opportunities) and reduce search costs like Amazon. But they also check references and try to develop a reputation for successful placements. This reduces information asymmetry, and is what allows the headhunters to charge high fees.

So, an important point about the Market for Lemons is this: If markets fail to realize gains from trade, then there's a profit opportunity. So firms (and other economic institutions) will try to arise to get that trade to happen. Accounting is one economic response to the Market for Lemons. Entrepreneurship is another.

So entrepreneurs and bean counters have more in common than they think.

Entrepreneurship Reality TV Needs Utahns

Two notes before I get to my actual post.

(1) Turns out it's hard to get motivated to blog about economics when the springtime sun is shining in the Wasatch Mountains.

(2) I'll return to your regularly scheduled discussion of accounting shortly.

For today, I got an e-mail from my college friend Rafe --- He's connected to all kinds of Hollywood types, and he sent me a casting call for ABC's new show "Shark Tank." Apparently the idea is to put budding entrepreneurs in front of money people, and then watch the money folks rip the poor little entrepreneurs to shreds. Sounds like great TV, right? Somehow at the end, the winning entrepreneur gets funded.

Anyway, we all know that reality TV loves Utahns, so everyone out there should sign up.

Here's the call:

DO YOU HAVE THE NEXT GREAT MONEYMAKING IDEA? We are currently on the search for entrepreneurs, inventors, businesspersons, dreamers, promoters, creators, innovators, etc. If you feel you have a lucrative business idea but just can't seem to secure the financial backing to get it off the ground then Shark Tank is just the show for you. Each episode features aspiring entrepreneurs pitching their business ideas to moguls in hopes of landing investment funds. Apply now for your chance to enter the "Shark Tank" and see if your idea survives.

All interested parties should email David Polanzak at dpo.casting@gmail.com with the following information:

Name:
Age:
Hometown:
Phone:
Photo:

*Please put in the Subject Line of your email if you are an: Inventor, Entrepreneur or both

As if you needed any more inducement, Rafe is willing to sweeten the deal in various ways. If you sign up, let me know and I'll connect you to Rafe.