The Economics of Being Able to Fire People Who Provide Me Services

Josh Wright —  10 January 2012

Via Professor Bainbridge, I read today about the nonsense surrounding Mitt Romney enjoying firing people.  I’m late to the this one, but here is the quote in context for anybody who missed it:

“I want individuals to have their own insurance,” he said. “That means the insurance company will have an incentive to keep you healthy. It also means if you don’t like what they do, you can fire them. I like being able to fire people who provide services to me.

“You know, if someone doesn’t give me a good service that I need, I want to say I’m going to go get someone else to provide that service to me.”

Bainbridge explains why, even if one was to take this quote and extend it to Romney’s days at Bain Capital, the ability to fire people who are are failing to provide a needed service is a feature of a well-functioning market for corporate control, not a bug:

In many cases, restoring a business to efficiency and profitability thus requires the kind of shakeup occasioned by a corporate takeover, such as the sort of LBOs in which Romney specialized, which brings in new managers who are willing to fire people.   LBO specialists who like to fire people thus played — and still play — a critical role in ensuring that US corporations are sufficiently lean to compete effectively in a pitiless global economy.

The economic point goes well beyond the market for corporate control.  The ability to impose sanctions on an economic partner is fundamental to modern contracting.  In nearly every treatment of the economics of contracting, one begins with the notion that the transacting parties potentially have at their disposal both reputational capital — that is, self-enforcement — and written enforcement as means for assuring contractual performance.  Klein & Leffler (1981) is the model that comes to mind.  The key insight is that parties do not have to rely upon imperfect court enforcement, but can create self-enforcement mechanisms were performance is assured not by litigation, but by threat of termination of the economic relationship.  The costs imposed on the non-performing party are not damages, but the loss of the expected premium stream from the economic relationship. In the economic literature, self-enforcement has been used not just to explain economic relationships in which court enforcement is entirely unavailable, but the complementary nature of written terms and reputational enforcement in a wide array of complex contractual arrangements including franchising arrangements, tying, resale price maintenance and exclusive dealing.  I discuss the distinction between standard economic approaches to contract that ignore these complementarities and the Klein (and also Oliver Williamson) approach to self-enforcement here.

The role of termination in facilitating well functioning economic relationships is critical in not just the market for corporate control,  but it all kinds of product and service markets.   It is hard to take these arguments against Romney seriously — even harder than the arguments disparaging his role at Bain.   In context, what Romney actually said is unremarkable.  How many of us don’t want to be able to terminate our economic relationship with the restaurant that feeds us low quality food or the service person who we find out shirked and provided shoddy quality work after the fact?  Our ability to do so constrains economic opportunism.  Perhaps the real objection is not that Romney talked about termination, but that he expressed a preference for terminating shirkers with whom he has economic relationships.   Not only does he fire people, but he likes it!  Perhaps the appropriate response then, from an economic perspective, is not to pillory him for it a la Huntsman, but to thank him for allowing us to free-ride on his efforts.

6 responses to The Economics of Being Able to Fire People Who Provide Me Services

  1. 

    Investment capitalists are efficiency enhancers…..or rent seekers, depending on the circumstances, or the point of view I suppose.

    Anyway, my understanding is that the criticism on Romney’s quote was that rather than “fire” health insurance companies people are normally afraid of being “fired” by them, or, worse still, not being “hired” in the first place…..so your general comment is sensible but misses the point.

  2. 

    “The problem is that the general public—many of whom will vote—have the impression that when a company is underperforming, the managerial response (especially the response of a new management) is to fire people indiscriminately first, and to try to implement a more service-friendly culture afterwards. ”

    But sometimes your employees are, in fact, actively opposing that more service-friendly, profit-friendly culture. And sometimes the previous management has made the situation much more dire by avoiding all these painful decisions for years, or decades.

    “Yes, it took investors a bit more patience, but it is amazing what a policy of staff attrition and gentle shoves out the door via voluntary severance, early retirements, retraining, and the like, can accomplish, with less pain, over, say, three years.”

    If your stockholders and your creditors are willing to give you three years, then that might indeed be the best option. But that strategy comes with complications of its own. When a competent management fires people, they can target people who are not vital to the operation of the business. Are they always right? Of course not. But at least they can make an attempt. Whereas early retirement, for example, can result in your most knowledgeable employees simply disappearing all at once. And it’s debatable, IMHO, if gradually shifting responsibilities to other remaining employees is any better than making a rapid transition.

    Anyway, a company that doesn’t have the ability to manage its own payroll as it sees fit won’t be around for very long. Not if the customers and creditors have a choice. When the Federal government is the employer, I’m a customer, and a creditor, and a shareholder, too. I want a President who’s willing to exercise that choice.

  3. 

    I meant to say, “a more service-friendly, profit-friendly culture.” I also should have added that the boost to profits of dramatic layoffs is temporary, and if the company has weakened vital functions in the process (sales and distribution capabilities, r & d), not only will the boost to profits be short-lived, over the longer term, the company is behaving in a counter-productive fashion. A brief examination of the career of “Chainsaw Al” Dunlap adequately demonstrates this point. This is the side of market capitalism that scares the public, and with good reason: it doesn’t produce long-term value, and it causes a lot of short-term misery, while creating a tiny minority who remind too many in the general public of the aristocrats who made the earth fertile for revolutions. Anything we say that seems to support this model is ultimately going to rebound on our heads.

  4. 

    The problem is that the general public—many of whom will vote—have the impression that when a company is underperforming, the managerial response (especially the response of a new management) is to fire people indiscriminately first, and to try to implement a more service-friendly culture afterwards. There is an incentive in our country to do it this way, because the bottom line improves dramatically after head-count decreases, and this makes the new management look good to shareholders. Unfortunately, the cost in human capital is high if you do it this way, and companies are really externalizing most of the costs of layoffs to the rest of the economy. That’s why the “I like being able to fire people,” aside from providing an ugly sound bite, has a dangerous resonance among those who are—temporarily, we hope—victims of a free-market economy.

    I’m not advocating we full-heartedly embrace policies that helped cause Eurosclerosis, but in my long investment career, I have seen companies faced with the need to restructure get their head count down, and transform an under-performing corporate culture dramatically, without firing everybody in sight in two quarters. Yes, it took investors a bit more patience, but it is amazing what a policy of staff attrition and gentle shoves out the door via voluntary severance, early retirements, retraining, and the like, can accomplish, with less pain, over, say, three years. The advantage is that it gives existing employees a chance to adjust their behavior to a new corporate culture and perform better, and it gives those who must go time to find something else. It also avoids ugly headlines, angry confrontations, and sudden impacts on unemployment insurance, as well as a huge hit on consumption in the broader economy. Of course, you have to avoid going so far that significant numbers of workers are encouraged to coast, or to decide to live on generous unemployment benefits and welfare, but the sudden shock to the system that we practice over here may not always be the best medicine.

    The free-market system of course produces winners and losers. But we should all be alert to the danger that when major losers begin to outnumber the winners, and the downside for most becomes significantly greater than the upside, then public support for the free market drops, and the nanny state becomes more attractive to the general voter again.

  5. 

    Couldn’t agree more. I can’t help wondering if this line of criticism gains traction because of the current prominence of the bogus argument that the tax code has to be made regressive so as not to tax the wealthy because they are “job creators.” (Based on a quick perusal of his website, Romney himself seems careful not to make that argument.) Regardless of the merits of changing the tax code and size of government, that particular claim is of course false, because job creation isn’t the role of investment capitalists–they are efficiency enhancers. Some enhancements of efficiency may increase the demand for labor, others and probably most may not. I’m reminded of a response by then Prof. Posner in a cross-examination in a railroad merger case, where he was asked by an opponent of the merger what he thought about claims that the merger would result in a loss of employment, and he responded, “That’s not a cost of a merger, that’s a benefit.”

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  1. More on Mitt Romney's taste for firing people - ProfessorBainbridge.com - January 11, 2012

    […] In context, Romney was making the unobjectionable point that, as Josh Wright puts it in a great post, "The ability to impose sanctions on an economic partner is fundamental to modern […]