My main criticism of the Oath is that I'm not sure that the authors have thought very hard about what "social value" is. To economists, at least, this term has a precise meaning. And there are many things that firms do --- things that I doubt the authors of the Oath would condemn --- that destroy social value.
Here's a great example from the Wall Street Journal: Toyota Builds Thicket of Patents Around Hybrid To Block Competitors.
Is building a thicket of patents an activity that enhances social value? Well, the way economists think about social value, it most certainly is not.
Why?
When economists think about "social value", they think about whether the potential gains from trade are being turned into actual gains from trade. One of the great things about trade is that it's voluntary, and when two people trade they're both made better off. So, if all the potential gains from trade get turned into actual gains from trade, then we're doing great. If there are potential gains from trade that don't get turned into actual gains from trade, then we're not doing great; we're not maximizing overall social value.
Asymmetric information is one factor that can cause gains from trade to go unrealized, as I've written before.
Market power is another. A seller has market power if that seller has the ability to influence the price at which it sells its product.
Here's an example to show how market power reduces social value. Suppose I have two daisy seeds, and I am the only seller of flowers. There are two potential buyers of daisies. Buyer 1 is willing to pay up to $10 to buy a daisy. Buyer 2 is willing to pay up to $5. My cost of turning a daisy seed into a flower is $3.
What will happen if I am forced (say, by a Soviet-style central planner) to produce two daisies, and sell each for $4? I earn profits of $2. Buyer 1 is willing to pay $10, but is able to buy a daisy for $4 --- this yields "consumer surplus" of $6. Buyer 2 ends up with consumer surplus of $1. If we add up my profit plus the buyers' consumer surplus, we get $9.
What will happen if, instead, I am allowed to charge whatever price I like, with the caveat that I must charge the same price to all buyers? If I'm trying to maximize profits, then the best thing for me is to produce just one daisy, and sell it for $10. This leaves me with profit of $7, and yields zero consumer surplus for both buyers. Again, adding up profit and consumer surplus, we get $7.
The $9 turned into a $7... how? Where did the $2 go?
The $2 represented the lost gains from trade coming from the lost sale to Buyer 2. When I sell to Buyer 2, I incur costs of $3. But Buyer 2 gets something he values at $5, so there are $2 of potential gains from trade. When I have market power, that trade doesn't happen. Social value is destroyed because I refuse to trade with Buyer 2 in order to extract a higher price from Buyer 1.
Ok, fine. But what does this have to do with the MBA Oath?
Toyota is putting up a thicket of patents around its hybrid technology to preserve its market power. Toyota wants to be able to keep competitors from offering similar products, because the existence of similar products will reduce Toyota's ability to charge high prices (and earn big profits) on the Prius. The plain fact is that protecting intellectual property preserves market power, and thus destroys social value --- just as surely as my $10 price on daisies.
Would the MBA Oath folks condemn Toyota for their thicket of patents? I'm guessing not. And the reason why is that they realize that Toyota's intellectual-property-based market-power is granted as a sort of "reward" for innovating in the first place. We grant patents in order to reward inventors by allowing them to charge monopoly prices for some period of time after their invention. We do this because innovation creates social value and unless we allow inventors to capture some of this value, there is little incentive to create value.
So mull this over a bit... In order to get inventors to create value (by innovating) we let them destroy value (by exercising market power). Quite an odd circle...
And this is why blanket statements about promising to create social value are kind of troubling to me. In our modern economy, we want firms to create social value, on net. But our legal system seems to recognize that allowing firms some market power in some cases --- thus destroying social value --- can be a good thing, on net.
While this post is a little critical of the Oath, there are some things I like about it. I'll get to those next time.
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2 comments:
Hi Scott,
My name is Max and I'm one of the student organizers of the MBA Oath, though I'm speaking only for myself in this comment. I read your blog this morning and liked what you wrote. I think the Toyota case you bring up is a great example of the tradeoffs we face in creating economic, social, and environmental value.
Like you say, it seems that allowing Toyota the patents would destroy the social value of getting more hybrids on the road, but it would reward Toyota for it's ingenuity. I do agree that we ought to reward companies and entrepreneurs for their innovation or we will destroy much of the incentive they have to innovate. However, cases like your Toyota example challenge that principle. A similar example I think of is patent protection for pharmaceutical companies that develop drugs which could be used to fight disease in the developing world. The pharma companies spend hundreds of millions of dollars getting their drugs to market so they want and should be rewarded for the effort. On the other hand, how can you look into the eyes of someone dying of a treatable disease in India or Africa and say that we won't bend the rules to get you the medicine you need? It is a heartbreaking and difficult dilemma.
Isn't time one of the issues at play in both our cases? Patents have a definite life, after which they lose their protective value. I think most people would agree that in order to encourage innovation (which is something we all want) innovation ought to be protected and rewarded. At issue is how long that protection lasts. We would feel differently about the patents of Toyota and drug companies if they were 1 year or 10 years or 50 years. The goal should be to find the right length of time for protection so that the business is rewarded fairly but we don't delay a moment longer than necessary in getting the benefits of the innovation to those who need it.
I don't pretend that making decisions about "social value" is easy or that we have it all figured out. I think our intention is not so much to lay out rules for managers to follow as much as it is to get managers to be more thoughtful about these decisions. These economic v. social value tradeoffs already exist today. Our hope is that the oath will be a reminder to managers to think about the tradeoffs carefully. They don't always have to choose one side over the other, but they should always make decisions with a profound sense that they are affecting a broader group of stakeholders.
Looking forward to reading your future posts.
Max,
It seems to me that the managers are agents of the firm, and therefore should act in the best interests of the firm. In essence the oath is trying to persuade managers to be the agents of society at large, even while they receive incentives to act in the firms best interest. Supposing that the goals of the firm are at odds with the goals of society, but not specifically illegal (the case that the MBA Oath deals with). There is no counter weight for society, after all "No man can serve two masters (Matt 6:24)"
The truth is that the vast majority of the times the firm's goals are fairly well aligned with society, and societal value is created.
I have not signed the MBA Oath because I deem it to be fluff. I understand the sentiment of it. I think it is laudably, but it does not have any real teeth to back it up, nor should it. I suspect it will soon fade away being of no consequence.
(P.S. Dr. Schaefer I'm prepared for you to point out all the flaws of my reasoning)
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