Explaining Persistence in Cost Efficiency Indices

0:00Okay, it's an honor to be here. So I'm very happy to be here. This is my first conference. I'm enjoying it very much, and I've learned quite a bit, and I've been studying Austrian economics for quite a while, but I also study other things, including agriculture economics. I'm an agriculture economist. My background is primarily farm management. I work with agribusinesses and farmers, and so I get a first-hand glance of entrepreneurs, and I can tell you right now that neoclassical theory falls on its face when you Neoclassical theory leaves no room for the entrepreneur.

1:00Efficiency and Productivity Indices The standard discussion of cost efficiency in neoclassical economic textbooks and journal articles suggests that the firm's advantages are very fleeting. What I mean by that is if a firm does have an advantage, either just by luck, they did something that someone else didn't do, or they were a good manager and they did something well and they actually make more profit than one of their competitors, The empirical research indicates that some firms have sustained competitive advantage.

2:17I'm not going to go into that literature, but there's literature in strategic management, there's literature in finance, there's literature in economics, and there's literature in ag economics that suggests that some firms actually do have a sustained competitive advantage. What I mean by that is they earn above normal profits over a long period of time. Neo-classical theory absolutely cannot explain that. If this was not the case, if we didn't see the sustained competitive advantage, some of the things that I like to do, specifically benchmarking, would be a lot less useful. That's a little strong statement to say it's irrelevant, because it probably would still have some relevancy, but it would be a lot less useful, because we wouldn't have targets to shoot that firms that are not doing so well to shoot for. And I work with farmers specifically, but I work with farmers in workshops where we specifically talk about these benchmarks, and we spend all this time calculating these benchmarks.

3:09Why do we do that if that's not important? So the objective of this paper is to examine how Austrian economics can be used to explain this persistence or the sustained competitive advantage. The sections of the paper, I'm just going to have to touch on those very briefly here. Role of the entrepreneur, entrepreneurial heir, I won't spend much time on that because that's pretty standard to the Austrian literature. I want to talk a little bit about defining cost efficiency for those of you that are not so familiar with that term and then I'll try to relate all of this to persistence and efficiency which is the main topic. So the role of the entrepreneur, this is from Bredo, a book in 1989, he basically had four different categories, entrepreneur as coordinator, entrepreneur as arbitrager, that's Kirzner, entrepreneur as innovator and entrepreneur as uncertainty bearer, Knight and others, there's quite a few in that last category there, but these are some of the people that have been involved in these different theories of the entrepreneur, I'm going to focus on

4:08on Kirzner, entrepreneur as arbitrager. And so Kirzner talks about entrepreneurial error. In his early work, he primarily focused on entrepreneurial profit, but in later work, he said yes, it is possible for entrepreneurs to make mistakes, and so entrepreneurs can also have losses because they're dealing with uncertainty, and the scenario that they thought was going to play out may not have played out. And so certainly there's entrepreneurial error. He notes that the market offers incentives for discovery of errors and so if there are errors people try to discover those and make adjustments to their plans. However, this error does generate what I call inefficiency, which I'll define here in a little bit. It does cause the firms to have losses when they have these entrepreneurial errors. Entrepreneurial error is not necessarily the same thing as X-in-efficiency, I can't get into that in in detail, but I get into that in the paper.

5:04But excellent efficiency is a much narrower concept than Kirzner's entrepreneurial air. Much narrower. In fact, excellent efficiency primarily deals with what Liebenstein calls gaps in knowledge for like oligopoly firms. Well, here I'm talking about forms. And so it's a much narrower concept than entrepreneurial air. I would like to note that entrepreneurs have differing abilities to gauge profit opportunities, This is related to resource-based theory of the firm, resource advantage theory, strategic management. All of those strategic management theories have noted that, that there is a lot of differences in entrepreneurs' ability to gauge profit opportunities. But this is particularly true, I would argue, in industries dominated by small businesses like agriculture.

5:53And again, anecdotal evidence, working with numerous farmers, there's a lot of difference in their ability to gather information, to process information, to really think about scenario analysis and on and on and on. And so there's just a lot of difference between the producers and therefore that leads to entrepreneurial profits and entrepreneurial losses, I would argue. So let's talk a little bit about cost efficiency before I tie this into persistence in cost efficiency. Cost efficiency is really fairly simple concept. It's usually measured using cost returns to scale. And all we're doing is we're looking at the minimum cost to produce a given level of output. And so if you're thinking about a cost frontier, we're trying to produce on the cost frontier, the total cost frontier.

6:43Firms that are inefficient are not producing on the cost frontier. Cost inefficiency can be due to numerous things, including technical inefficiency, allocative inefficiency, or scale inefficiency. But I want to tie this cost efficiency to Austrian economics, and so let me have a couple slides here to attempt to do that. I've got more detail in the paper. First of all, there's persistence and efficiency is related to organizational competence or sustained competitive advantage. I think it's pretty easy to relate persistence and efficiency to these theories, but I would argue that Austrian economics can add to those theories and can add additional information that's not in these strategic management theories that helps us explain this persistence and efficiency.

7:28Before I do that in the next slide, increases in firm productivity can result from increases in either efficiency or effectiveness. We can more efficiently create value or we can efficiently create more value. And so this is the idea that we can improve our costs or we can have product differentiation and improve our price. This is very standard in strategic management literature. So tying this back to Austrian economics, again, resource-based theory is the primary theory that I'm relating to here in strategic management. I think it does lend us some ability to begin to figure out why some firms are more successful than others, and conversely, why some firms really don't do very well.

8:19And you can ask yourself, well, how in the world could they do that? Well, I have evidence of firms that haven't made any money in 20 years. How can they do that? Well, if you own your land and you're willing to take a crappy return on your land and a crappy return for your labor, you can farm for a long time. Conversely, there's farms that are very successful, have very high profits over a long period of time, and are growing very rapidly. And so it leads to a lot of differences in an industry like farming that I'm dealing with. The key Austrian insights here that are related to this. Relevant knowledge is local and tacit. This makes it very difficult for those that have been less successful to mimic those that have been successful. The knowledge is tacit.

9:12What are you going to do? How are you going to pick the guy's brain? It's just not possible to get some of that information and to mimic what the successful producers are doing. Also, the firm, like the entrepreneur, learns about local facts, and so there's learning involved here. And I think it's obvious that some entrepreneurs are probably better than others in terms of their ability to learn, particularly related to new technology. In production, agriculture, technology is very important, and if you don't adopt the right technologies, what I mean by right is those that have the most benefit over the cost, you're going to fall behind in terms of your efficiency or your productivity. And so that's also important, a lot of differences between entrepreneurs related to that fact. Also firms incorporate market routines, and so people do the obvious.

10:01They look around and do the obvious things. If, for example, if I'm from Indiana, if some farms are adopting a different tillage system and it's successful, they're going to see that, okay? And so the market routines are incorporated, however, firms also adapt to changing environment. That's where some entrepreneurs really fall behind. You know, when the environment is changing, some people say, well, what I've done in the past has been okay, so I'll just stay with what I've done in the past, may not adopt new technologies, new methods, and therefore fall further behind. Also, this is the one most closely related to strategic management, not all routines or capabilities are equally efficient. And so some people are just better managers.

10:46I've tried to talk to some of my colleagues that are really fond of neoclassical economics and just ask them that question. You think everybody has similar managerial ability? Does professors have similar ability? Well, they do. Maybe I should get paid the same as you, or maybe you should get paid, or vice versa kind of thing. I think that's such an obvious thing, but it's something that neoclassical economics really doesn't do very good in terms of explaining. You really need a theory that's related to entrepreneurs, and I think tying that with strategic management literature to really help explain that. And so I think it's key that we make room in the theory for the entrepreneur, in addition to tying in some of the strategic management.

11:34Over time, entrepreneurs tried to catch up to their rivals. There's a tendency for earlier entrepreneur heirs to be replaced by profit-seeking entrepreneurial corrections. However, this process is not static, so inefficiency can persist. So even if we could figure out these entrepreneur heirs, if someone that's less successful could figure out these entrepreneur heirs that they've made and say, that wasn't a very good decision, I'll make that correction, This isn't static. I don't know how many of you are familiar with Michael Porter's work. He changed his work over the years from more of a static to a dynamic analysis because of this. Competitive advantage and efficiency is not a static concept. I always think of it as a moving target. Right now, farming has a pretty high profit margin. That doesn't mean five years from now it's going to have the same profit margin or you need to do the and the same things to be successful, you know, five years from now, and so it's a moving target, it's very difficult, quite frankly, to be on that cost frontier, because it is a moving target, and even if you're on the cost frontier one year, if you don't continually make changes adapting to the new environment, you're going to fall behind the cost curve, and so that's a point that's very important to make, is the reason that this is so complicated is the fact that this is not static.

12:59Summary and Conclusions, the following two problems are often ignored or glossed over in efficiency and productivity literature. I mentioned earlier that there are two things that we have a hard time explaining. These are the two things that we have difficulty explaining. One of them is the large differences in efficiency among firms. Why is there so much difference among firms? I remember presenting a paper about 20 years ago and one of my colleagues, somebody I got a PhD with, University of Nebraska-Lincoln, University of Nebraska-Lincoln, he was getting a PhD, I was getting a master's, I got my PhD at Purdue, but we were together in graduate school and I was at this meeting, we were both at this meeting and I was showing these results and he says, this can't be.

13:52How can one person have an efficiency index that's 60% and so has a 40% difference in cost? And he says, well, look at the data. What's wrong, the data or your neoclassical theory? He didn't have a very good response to that, at least I didn't think he did. And so this is something that we've been trying to explain for a long time. I think Austrian economics can help us explain this, okay? There's nothing in entrepreneurial theory that suggests that all entrepreneurs are equally

14:51The difference in the profit margin between those that had above average performance and below average performance was about 25%. The above average was like 20% profit margin and the below average for souls were negative 5%. They were having very low return on their labor, for example. and so there is huge differences both in a particular year but there's also large differences over time. I've argued here and I argue in the paper that Austrian economics along with strategic management can be used to help explain these two artifacts of efficiency and productivity literature and so when we get these results we can more fully support and explain why these results look the way they do which I think is very important to be able to do if we're going to continue these efficiency of productivity studies, which we're going to, because it is a very effective way to get a little better idea of how firms are doing vis-à-vis other firms in the industry.