Archives For Markets

A recently published book, “Kochland – The Secret History of Koch Industries and Corporate Power in America” by Christopher Leonard, presents a gripping account of relentless innovation and the power of the entrepreneur to overcome adversity in pursuit of delivering superior goods and services to the market while also reaping impressive profits. It’s truly an inspirational American story.

Now, I should note that I don’t believe Mr. Leonard actually intended his book to be quite so complimentary to the Koch brothers and the vast commercial empire they built up over the past several decades. He includes plenty of material detailing, for example, their employees playing fast and loose with environmental protection rules, or their labor lawyers aggressively bargaining with unions, sometimes to the detriment of workers. And all of the stories he presents are supported by sympathetic emotional appeals through personal anecdotes. 

But, even then, many of the negative claims are part of a larger theme of Koch Industries progressively improving its business practices. One prominent example is how Koch Industries learned from its environmentally unfriendly past and implemented vigorous programs to ensure “10,000% compliance” with all federal and state environmental laws. 

What really stands out across most or all of the stories Leonard has to tell, however, is the deep appreciation that Charles Koch and his entrepreneurially-minded employees have for the fundamental nature of the market as an information discovery process. Indeed, Koch Industries has much in common with modern technology firms like Amazon in this respect — but decades before the information technology revolution made the full power of “Big Data” gathering and processing as obvious as it is today.

The impressive information operation of Koch Industries

Much of Kochland is devoted to stories in which Koch Industries’ ability to gather and analyze data from across its various units led to the production of superior results for the economy and consumers. For example,  

Koch… discovered that the National Parks Service published data showing the snow pack in the California mountains, data that Koch could analyze to determine how much water would be flowing in future months to generate power at California’s hydroelectric plants. This helped Koch predict with great accuracy the future supply of electricity and the resulting demand for natural gas.

Koch Industries was able to use this information to anticipate the amount of power (megawatt hours) it needed to deliver to the California power grid (admittedly, in a way that was somewhat controversial because of poorly drafted legislation relating to the new regulatory regime governing power distribution and resale in the state).

And, in 2000, while many firms in the economy were still riding the natural gas boom of the 90s, 

two Koch analysts and a reservoir engineer… accurately predicted a coming disaster that would contribute to blackouts along the West Coast, the bankruptcy of major utilities, and skyrocketing costs for many consumers.

This insight enabled Koch Industries to reap huge profits in derivatives trading, and it also enabled it to enter — and essentially rescue — a market segment crucial for domestic farmers: nitrogen fertilizer.

The market volatility in natural gas from the late 90s through early 00s wreaked havoc on the nitrogen fertilizer industry, for which natural gas is the primary input. Farmland — a struggling fertilizer producer — had progressively mismanaged its business over the preceding two decades by focusing on developing lines of business outside of its core competencies, including blithely exposing itself to the volatile natural gas market in pursuit of short-term profits. By the time it was staring bankruptcy in the face, there were no other companies interested in acquiring it. 

Koch’s analysts, however, noticed that many of Farmland’s key fertilizer plants were located in prime locations for reaching local farmers. Once the market improved, whoever controlled those key locations would be in a superior position for selling into the nitrogen fertilizer market. So, by utilizing the data it derived from its natural gas operations (both operating pipelines and storage facilities, as well as understanding the volatility of gas prices and availability through its derivatives trading operations), Koch Industries was able to infer that it could make substantial profits by rescuing this bankrupt nitrogen fertilizer business. 

Emblematic of Koch’s philosophy of only making long-term investments, 

[o]ver the next ten years, [Koch Industries] spent roughly $500 million to outfit the plants with new technology while streamlining production… Koch installed a team of fertilizer traders in the office… [t]he traders bought and sold supplies around the globe, learning more about fertilizer markets each day. Within a few years, Koch Fertilizer built a global distribution network. Koch founded a new company, called Koch Energy Services, which bought and sold natural gas supplies to keep the fertilizer plants stocked.

Thus, Koch Industries not only rescued midwest farmers from shortages that would have decimated their businesses, it invested heavily to ensure that production would continue to increase to meet future demand. 

As noted, this acquisition was consistent with the ethos of Koch Industries, which stressed thinking about investments as part of long-term strategies, in contrast to their “counterparties in the market [who] were obsessed with the near-term horizon.” This led Koch Industries to look at investments over a period measured in years or decades, an approach that allowed the company to execute very intricate investment strategies: 

If Koch thought there was going to be an oversupply of oil in the Gulf Coast region, for example, it might snap up leases on giant oil barges, knowing that when the oversupply hit, companies would be scrambling for extra storage space and willing to pay a premium for the leases that Koch bought on the cheap. This was a much safer way to execute the trade than simply shorting the price of oil—even if Koch was wrong about the supply glut, the downside was limited because Koch could still sell or use the barge leases and almost certainly break even.

Entrepreneurs, regulators, and the problem of incentives

All of these accounts and more in Kochland brilliantly demonstrate a principal salutary role of entrepreneurs in the market, which is to discover slack or scarce resources in the system and manage them in a way that they will be available for utilization when demand increases. Guaranteeing the presence of oil barges in the face of market turbulence, or making sure that nitrogen fertilizer is available when needed, is precisely the sort of result sound public policy seeks to encourage from firms in the economy. 

Government, by contrast — and despite its best intentions — is institutionally incapable of performing the same sorts of entrepreneurial activities as even very large private organizations like Koch Industries. The stories recounted in Kochland demonstrate this repeatedly. 

For example, in the oil tanker episode, Koch’s analysts relied on “huge amounts of data from outside sources” – including “publicly available data…like the federal reports that tracked the volume of crude oil being stored in the United States.” Yet, because that data was “often stale” owing to a rigid, periodic publication schedule, it lacked the specificity necessary for making precise interventions in markets. 

Koch’s analysts therefore built on that data using additional public sources, such as manifests from the Customs Service which kept track of the oil tanker traffic in US waters. Leveraging all of this publicly available data, Koch analysts were able to develop “a picture of oil shipments and flows that was granular in its specificity.”

Similarly, when trying to predict snowfall in the western US, and how that would affect hydroelectric power production, Koch’s analysts relied on publicly available weather data — but extended it with their own analytical insights to make it more suitable to fine-grained predictions. 

By contrast, despite decades of altering the regulatory scheme around natural gas production, transport and sales, and being highly involved in regulating all aspects of the process, the federal government could not even provide the data necessary to adequately facilitate markets. Koch’s energy analysts would therefore engage in various deals that sometimes would only break even — if it meant they could develop a better overall picture of the relevant markets: 

As was often the case at Koch, the company… was more interested in the real-time window that origination deals could provide into the natural gas markets. Just as in the early days of the crude oil markets, information about prices was both scarce and incredibly valuable. There were not yet electronic exchanges that showed a visible price of natural gas, and government data on sales were irregular and relatively slow to come. Every origination deal provided fresh and precise information about prices, supply, and demand.

In most, if not all, of the deals detailed in Kochland, government regulators had every opportunity to find the same trends in the publicly available data — or see the same deficiencies in the data and correct them. Given their access to the same data, government regulators could, in some imagined world, have developed policies to mitigate the effects of natural gas market collapses, handle upcoming power shortages, or develop a reliable supply of fertilizer to midwest farmers. But they did not. Indeed, because of the different sets of incentives they face (among other factors), in the real world, they cannot do so, despite their best intentions.

The incentive to innovate

This gets to the core problem that Hayek described concerning how best to facilitate efficient use of dispersed knowledge in such a way as to achieve the most efficient allocation and distribution of resources: 

The various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process, and the problem of what is the best way of utilizing knowledge initially dispersed among all the people is at least one of the main problems of economic policy—or of designing an efficient economic system.

The question of how best to utilize dispersed knowledge in society can only be answered by considering who is best positioned to gather and deploy that knowledge. There is no fundamental objection to “planning”  per se, as Hayek notes. Indeed, in a complex society filled with transaction costs, there will need to be entities capable of internalizing those costs  — corporations or governments — in order to make use of the latent information in the system. The question is about what set of institutions, and what set of incentives governing those institutions, results in the best use of that latent information (and the optimal allocation and distribution of resources that follows from that). 

Armen Alchian captured the different incentive structures between private firms and government agencies well: 

The extent to which various costs and effects are discerned, measured and heeded depends on the institutional system of incentive-punishment for the deciders. One system of rewards-punishment may increase the extent to which some objectives are heeded, whereas another may make other goals more influential. Thus procedures for making or controlling decisions in one rewards-incentive system are not necessarily the “best” for some other system…

In the competitive, private, open-market economy, the wealth-survival prospects are not as strong for firms (or their employees) who do not heed the market’s test of cost effectiveness as for firms who do… as a result the market’s criterion is more likely to be heeded and anticipated by business people. They have personal wealth incentives to make more thorough cost-effectiveness calculations about the products they could produce …

In the government sector, two things are less effective. (1) The full cost and value consequences of decisions do not have as direct and severe a feedback impact on government employees as on people in the private sector. The costs of actions under their consideration are incomplete simply because the consequences of ignoring parts of the full span of costs are less likely to be imposed on them… (2) The effectiveness, in the sense of benefits, of their decisions has a different reward-inventive or feedback system … it is fallacious to assume that government officials are superhumans, who act solely with the national interest in mind and are never influenced by the consequences to their own personal position.

In short, incentives matter — and are a function of the institutional arrangement of the system. Given the same set of data about a scarce set of resources, over the long run, the private sector generally has stronger incentives to manage resources efficiently than does government. As Ludwig von Mises showed, moving those decisions into political hands creates a system of political preferences that is inherently inferior in terms of the production and distribution of goods and services.

Koch Industries: A model of entrepreneurial success

The market is not perfect, but no human institution is perfect. Despite its imperfections, the market provides the best system yet devised for fairly and efficiently managing the practically unlimited demands we place on our scarce resources. 

Kochland provides a valuable insight into the virtues of the market and entrepreneurs, made all the stronger by Mr. Leonard’s implied project of “exposing” the dark underbelly of Koch Industries. The book tells the bad tales, which I’m willing to believe are largely true. I would, frankly, be shocked if any large entity — corporation or government — never ran into problems with rogue employees, internal corporate dynamics gone awry, or a failure to properly understand some facet of the market or society that led to bad investments or policy. 

The story of Koch Industries — presented even as it is through the lens of a “secret history”  — is deeply admirable. It’s the story of a firm that not only learns from its own mistakes, as all firms must do if they are to survive, but of a firm that has a drive to learn in its DNA. Koch Industries relentlessly gathers information from the market, sometimes even to the exclusion of short-term profit. It eschews complex bureaucratic structures and processes, which encourages local managers to find opportunities and nimbly respond.

Kochland is a quick read that presents a gripping account of one of America’s corporate success stories. There is, of course, a healthy amount of material in the book covering the Koch brothers’ often controversial political activities. Nonetheless, even those who hate the Koch brothers on account of politics would do well to learn from the model of entrepreneurial success that Kochland cannot help but describe in its pages. 

Paul H. Rubin is the Dobbs Professor of Economics Emeritus, Emory University, and President, Southern Economic Association, 2013

I want to thank Geoff for inviting me to blog about my new book.

My book, The Capitalist Paradox: How Cooperation Enables Free Market Competition, Bombardier Books, 2019, has been published. The main question I address in this short book is: Given the obvious benefits of markets over socialism, why do so many still oppose markets? I have been concerned with this issue for many years. Given the current state of American politics, the question is even more important than when I began the book.

I begin by pointing out that humans are not good intuitive economists. Our minds evolved in a simple setting where the economy was simple, with little trade, little specialization (except by age and gender), and little capital. In this world there was no need for our brains to evolve to understand economics. (Politics is a different story.) The main takeaway from this world was that our minds evolved to view the world as zero-sum.  Zero-sum thinking is the error behind most policy errors in economics.

The second part of the argument is that in many cases, when economists are discussing efficiency issues (such as optimal taxation) listeners are hearing distribution issues. So we economists would do better to begin with a discussion showing that there are efficiency (“size of the pie”) effects before showing what they are in a particular case.  That is, we should show that taxation can affect total income before showing how it does so in a particular case. I call this “really basic economics,” which should be taught before basic economics. It is sometimes said that experts understand their field so well that they are “mind blind” to the basics, and that is the situation here.

I then show that competition is an improper metaphor for economics.  Discussions of competition brings up sports (and in economics the notion of competition was borrowed from sports) and sports is zero-sum. Thus, when economists discuss competition, they reinforce people’s notion that economics is zero sum.  People do not like competition. A quote from the book:

Here are some common modifiers of “competition” and the number of Google references to each:

“Cutthroat competition” (256,000), “excessive competition” (159,000), “destructive competition” (105,000), “ruthless competition” (102,000), “ferocious competition” (66,700), “vicious competition” (53,500), “unfettered competition” (37,000), “unrestrained competition” (34,500), “harmful competition” (18,000), and “dog-eat-dog competition” (15, 000). Conversely, for “beneficial competition” there are 16,400 references. For “beneficial cooperation” there are 548,000 references, and almost no references to any of the negative modifiers of cooperation.

The final point, and what ties it all together, is a discussion showing that the economy is actually more cooperative than it is competitive. There are more cooperative relationships in an economy than there are competitive interactions.  The basic economic element is a transaction, and transactions are cooperative.  Competition chooses the best agents to cooperate with, but cooperation does the work and creates the consumer surplus. Thus, referring to markets as “cooperative” rather than “competitive” would not only reduce hostility towards markets, but would also be more accurate.

An economist reading this book would probably not learn much economics. I do not advocate any major change in economic theory from competition to cooperation. But I propose a different way to view the economy, and one that might help us better explain what we are doing to students and to policy makers, including voters.

On Debating Imaginary Felds

Gus Hurwitz —  18 September 2013

Harold Feld, in response to a recent Washington Post interview with AEI’s Jeff Eisenach about AEI’s new Center for Internet, Communications, and Technology Policy, accused “neo-conservative economists (or, as [Feld] might generalize, the ‘Right’)” of having “stopped listening to people who disagree with them. As a result, they keep saying the same thing over and over again.”

(Full disclosure: The Center for Internet, Communications, and Technology Policy includes TechPolicyDaily.com, to which I am a contributor.)

Perhaps to the surprise of many, I’m going to agree with Feld. But in so doing, I’m going to expand upon his point: The problem with anti-economics social activists (or, as we might generalize, the ‘Left’)[*] is that they have stopped listening to people who disagree with them. As a result, they keep saying the same thing over and over again.

I don’t mean this to be snarky. Rather, it is a very real problem throughout modern political discourse, and one that we participants in telecom and media debates frequently contribute to. One of the reasons that I love – and sometimes hate – researching and teaching in this area is that fundamental tensions between government and market regulation lie at its core. These tensions present challenging and engaging questions, making work in this field exciting, but are sometimes intractable and often evoke passion instead of analysis, making work in this field seem Sisyphean.

One of these tensions is how to secure for consumers those things which the market does not (appear to) do a good job of providing. For instance, those of us on both the left and right are almost universally agreed that universal service is a desirable goal. The question – for both sides – is how to provide it. Feld reminds us that “real world economics is painfully complicated.” I would respond to him that “real world regulation is painfully complicated.”

I would point at Feld, while jumping up and down shouting “J’accuse! Nirvana Fallacy!” – but I’m certain that Feld is aware of this fallacy, just as I hope he’s aware that those of us who have spent much of our lives studying economics are bitterly aware that economics and markets are complicated things. Indeed, I think those of us who study economics are even more aware of this than is Feld – it is, after all, one of our mantras that “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” This mantra is particularly apt in telecommunications, where one of the most consistent and important lessons of the past century has been that the market tends to outperform regulation.

This isn’t because the market is perfect; it’s because regulation is less perfect. Geoff recently posted a salient excerpt from Tom Hazlett’s 1997 Reason interview of Ronald Coase, in which Coase recounted that “When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies – perhaps all the studies – suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been.”

I don’t want to get into a tit-for-tat over individual points that Feld makes. But I will look at one as an example: his citation to The Market for Lemons. This is a classic paper, in which Akerlof shows that information asymmetries can cause rational markets to unravel. But does it, as Feld says, show “market failure in the presence of robust competition?” That is a hotly debated point in the economics literature. One view – the dominant view, I believe – is that it does not. See, e.g., the EconLib discussion (“Akerlof did not conclude that the lemon problem necessarily implies a role for government”). Rather, the market has responded through the formation of firms that service and certify used cars, document car maintenance, repairs and accidents, warranty cars, and suffer reputational harms for selling lemons. Of course, folks argue, and have long argued, both sides. As Feld says, economics is painfully complicated – it’s a shame he draws a simple and reductionist conclusion from one of the seminal articles is modern economics, and a further shame he uses that conclusion to buttress his policy position. J’accuse!

I hope that this is in no way taken as an attack on Feld – and I wish his piece was less of an attack on Jeff. Fundamentally, he raises a very important point, that there is a real disconnect between the arguments used by the “left” and “right” and how those arguments are understood by the other. Indeed, some of my current work is exploring this very disconnect and how it affects telecom debates. I’m really quite thankful to Feld for highlighting his concern that at least one side is blind to the views of the other – I hope that he’ll be receptive to the idea that his side is subject to the same criticism.

[*] I do want to respond specifically to what I think is an important confusion in Feld piece, which motivated my admittedly snarky labelling of the “left.” I think that he means “neoclassical economics,” not “neo-conservative economics” (which he goes on to dub “Neocon economics”). Neoconservativism is a political and intellectual movement, focused primarily on US foreign policy – it is rarely thought of as a particular branch of economics. To the extent that it does hold to a view of economics, it is actually somewhat skeptical of free markets, especially of lack of moral grounding and propensity to forgo traditional values in favor of short-run, hedonistic, gains.