Greed in Public and Private Institutions

0:00Well, it's always wonderful to present at the Austrian Scholars Conference. And this time I want to talk a little bit about greed, something that is not on anyone's mind. If you ask the average person out there about the business cycle, they would say, well, it's greed that causes it. In fact, it's bouts of greed that punctuate stretches of moderation. That's why we have business cycles. And then if we look at the Occupy rallies, right, they're like down with the greedy bankers, down with the greedy banks, you know, just grubbing for their profits and such. And so what we really see is that this is just self-interest, right? Because if we ask ourselves what is greed, greed is just wanting something too much, right?

0:48The guy's greedy for it. Well, what is it? Well, he wants something too much. Well, in science we need precise definitions and in social science of economics we really have to adhere to this and so when we look at the word greed where we say we just want something too much, we have to absolutely reject that because it's not precise. So what we recognize then is that self-interest is omnipresent, it is what propels the butcher, the Brewer and the Baker to serve others. So it becomes a question of aligning incentives. It's a principal agent problem. So if we look at, suppose, Ken Lay of Enron or Bernie Madoff or some other suitable villain that you want to throw in charge.

1:39But put them in charge, not of a for-profit private company, but a bureau, a governmental bureau. What are the implications if you put those people in charge? Or take it another step, suppose it's a private, non-profit organization, now what are the implications? And so we have two questions that come up, and the first one is, can the institution effectively allocate resources to satisfy the most intense wants and desires of consumers? And the second one is, can the principal agent problem be overcome to ensure that the leadership will carry out its attendant purpose, or will the leadership use the entity as a means to a selfish or greedy end? So we have two problems.

2:24The first one is the economic calculation problem, and essentially it's this. We've got resources over here, we have plans of how to put resources together, and we've got consumers over there. But the consumers, they want stuff, they desire things, but it's all subjective. So how do we then combine these resources into useful things, but not just randomly useful things, we want useful things that satisfy the most intense wants and desires of the consumers first, otherwise it's wasting. And then of course you've got consumers and they don't tell us, they just show up, they will walk through Wal-Mart and they're not saying I want to bargain with you, no no no, if you don't have what they're looking for on the shelves, at a quality, at a price, and then they want it, what do they do? They just leave and they don't even tell you why.

3:14That's a tough, tough job to overcome. Now, the question is how do we communicate this information? Well, markets have a solution. These are for-profit companies. But there are also non-market solutions. We have government bureaus and non-profit organizations. Now, regardless of the type of organization, we have decision makers have personal preferences and when we see that the decision maker makes good decisions that they're able to over that their their decisions benefit both the organization and themselves but there's an incongruity that can arise between the two and this is an opportunity for personal benefit and this is where the principal agent problem emerges so in my paper I look to for-profit firms and we Economic Calculation, Mises Economic Calculation, Socialist Commonwealth, Socialism, Bureaucracy, Profit and Loss in Planning for Freedom, Hayek, 1935, Use of Knowledge in Society, 1945 So here's the big thing about for-profit firms, and it's a dirty little secret, but the purpose of a for-profit firm is to make profit.

4:39I know, surprising. But what happens here? Well, both sides trade, both sides benefit. We see that profit is when revenues exceed cost, but which costs? Well, the only cost that's relevant is always opportunity cost. And so what we then see is that the firm then is the best approximation, a for-profit firm then uses these tools for the best approximation to satisfying the most intense wants and desires of consumers. And it's these prices that convey the relative scarcities and allows economic actors to adjust and integrate themselves into the greater whole. And this part is also fairly important. It's the loss side. So when economic decision-makers make wrong choices, well, they lose control of these resources, okay?

5:31So that's the feedback mechanism on the for-profit firm side. And so the principal agent problem then says, we have owners that hire decision-makers. Then these decision-makers engage in perquisites, or PERCs for short. And they basically have the big corner office, the mahogany desk, and line-and-dine clients Private Jet Out to Tahiti for Nine Rounds of Golf, sort of stuff. Well, we have a lot of literature out there about creating incentive compatible contracts to overcome these features, and they have varying degrees of success. But ultimately, the principal agent problem is backstopped by the market test. Enron and Madoff were revealed by the market, not by the SEC.

6:16So what we then see is that greed is usually checked by the Fear of Losing Wealth. And so after a long discussion and excellent discussion about that in my paper, I then move on to bureaus where I talk about economic calculation. Now, the governmental bureaus do not have the tools to engage in calculating economic efficiency. Revenues are decoupled from their output and distribution decisions. The inflows of fund are not dependent upon the Sales by Bureaus. So even though we have these sort of entities that will charge for services like the post office, they never can go out of business. And so they fail this, they don't have these sorts of tools because they don't have to fear losses.

7:07The decision makers also don't lose control when they do have losses. Take for example, failing schools, right? If a school doesn't educate a kid, not only do they not get shut down and go out of business, we give them more money. How insane is that? And so we don't have a feedback channel for bureaus. They don't even use prices. In Wake County, North Carolina, where I live, we had a drought a few years ago. And so the politicians were saying, oh, how can we ration water? And the economist, the good economist said, well, why don't we just raise the prices? No, we can't do that. Why? So instead what we'll do is we'll limit how you can wash your car and when you can water your lawn and ask restaurants not to give water when you walk in, blah, blah, blah.

7:55And of course this is all very wasteful and awful. But then after people started using water-saving devices, rain barrels and everything, and the drought was over, the revenue to the water department was way down. Why? Because people weren't using as much water because they were saving and conserving water. And so the water department did what? They raised prices. Amazing that the poor weren't hurt by this at this time, but anyway. So the point is that they don't use prices to help them figure out what is efficient. And so then this brings us to the principal agent problem facing bureaus. The decision maker is not selfless. When decision makers' preferences are in discord with the purpose of the bureau, we have the principal agent problem.

8:41Now, we all own the Bureau, so nobody really owns the Bureau, so losses are not coming out of anyone particular's pocket, but fortunately, governments have long recognized that these bureaucrats can get out of control, and so they impose rules. We don't just give to the superintendent of the school system, here's a check for $14 billion, go educate some kids, right? With all of this, we give them a rule book and we give them regulations, they say under this sort of circumstance behave this way and under this is your rule of conduct and what this creates is a tension and a trade-off. It reduces rules and regulations, reduce flexibility for problem solving and so it binds them, but on the other hand, when we try to introduce flexibility, up comes the principal agent problem.

9:34And so then I turn to non-profits and we have again the economic calculation problem. Now again non-profit organizations decouple revenue from production and distribution of goods but it differs with governmental bureaus in two ways. First they can go out of business and then the funds also come from donations. Now government grants can be treated as a form of donation. Now, donors will withhold donations when the marginal benefit is less than the marginal cost, which reduces the size and scope to command resources. Now it's similar but not the same as profit and loss. There's no way to know if a non-profit uses excess, use of resources exceed its opportunity cost.

10:22Those that consume the product are not paying the full price. Here at the Scholars Conference and at Mises University, these are subsidized. or we don't even approximately know the intensity of the preferences of the participants. And so because production is subsidized, resources are most likely used for lowered valued uses. We can suppose that particular big donor might give a whole bunch of money to the Mises Institute, you know, and he gets a lot of value out of it, but that point itself just confirms that and the narrowness of that ever happening, and so it should confirm the general point that when we subsidize these sorts of things that it's for a lower opportunity cost use or a lower value use.

11:13So nonprofits, the bottom line is that nonprofits cannot calculate economic efficiency. Now notice that the division is not between private and public. It is between for-profit and not-for-profit entities and the not-for-profits, they don't have a feedback loop to guide the decision makers. Non-profits compare wrong opportunity costs. A for-profit firm uses weighted average cost of capital or internal rate of return. Non-profits, they move on to the next profit that fulfills the mission. There isn't a minimum internal rate of return that they have to use in order to justify a project. If they have the funds, they're gonna do it. So the ultimate backstop for a non-profit are donors. but this doesn't solve the efficiency problem and to the extent that donations come from political sources insulates the non-profit from market conditions and so here comes the principal agent problem.

12:08There's no market test and so there's really nothing to align incentives with. We can't just say to the CEO, go out and make profit and so the president of Stanford University, Donald Kennedy, use federal grants to live big, right? The Board of Trustees can set some sort of rules, but when they do that, there's high monitoring costs and it reduces the flexibility of the decision makers. But now, let's take another step. What if the decision maker and the Board of Trustees both agree to use these sorts of things and conspire against the donors? Well, we have a tremendous amount of research showing the misuse of funds in universities.

12:57This is from Vance Fried from the Cato Institute. He says, the more subtle forms of the principal agent problem manifest in a number of ways, such as, quote, spending on some combination of research, graduate education, low demand majors, low faculty teaching loads, excess compensation, and feather bedding. Fried measured the extent of this problem, quote, based on tuition revenues alone, the average private undergraduate school makes about 5,500 per student. When donations and endowment income are added, profits jump to about 12,800 per student. That's more than 60% net profit margin per student, double the margin of for-profit University of Phoenix, and that's just the average. Now, case after case, colleges, universities, United Way of North Carolina, Media Matters, et cetera, they all abuse donations and status.

13:44So if you're a university and you get a grant, who knows that they even get a grant right you don't know they don't open the books because they're private they don't just let any faculty member look at the books right this decreases the scope of whistleblowing and and not even the donors know if their funds are being used properly so are there any solutions and the short answer is well no now that doesn't sound very good but but look at the non-profits and and the not-for-profit sector, you don't have economic calculation, you have no feedback loop, they're basically flying blind. Private non-profits, they set their own goals by which they measure success and they set their own rules on their use of funds.

14:31You can have a private entity like Charity Navigator which sort of helps out in how they manage their money but really that doesn't solve the principal agent problem and so an approximate solution is this, So I divide people into two groups. You have your ideologues or your true believers, and you have your careerists, the people who are just there for a job. Well, the thing is, and I get through this in the paper, the more careerists you have, the higher the principal agent problem. And the further removed you are from the founding of the nonprofit, like Harvard University or Duke, you have mission drift. And so the basic point is that you You need to hire the true believers, but that reduces your talent pool. And so basically, even though you have no tool then to curb any of this greed, if you put them in charge, they have no tool to say, that's greedy, this is the feedback that stops all of that.

15:32And so the conclusion is this, for-profit firms, for all their faults, are far better and government bureaus and private non-profit organizations for solving the economic calculation problem and the principal agent problem. Thanks.