Monday, September 11, 2017

Arbitrage and efficiency - externalising costs and capturing gains

This post is triggered by Neil Irwin's fantastic article that I blogged here.  

Consider these. Robots replacing human workers to reduce defects and increase output. Companies focusing on their core-competencies by outsourcing non-core activities. Companies that either outsource or off-shore their production facilities to lower costs. Executives and companies that cut costs by aggressive reduction of their workforce and hiring contract labour, all in the name of competitiveness. Internet-based companies that reduce market frictions by bringing together buyers and sellers of goods and services. Constructing complex ownership structures that enable cross-border shifting of profits so as to minimise tax obligations. Supercomputers that connect to the exchanges through dedicated optic fibre cables over the shortest distance to promote high frequency trading that claim to increase market liquidity and thickness. 

The common thread in all these stories is the search for efficiency and value for money, both in turn aimed at maximising profits, even if, and often because so, at the cost of jobs or the quality of jobs. These trends are considered essential and desirable attributes in today's capitalism, in fact even the ultimate objective of the business enterprise. But this has not always been the case.

The traditional idea of a good business firm was of one which created jobs, productive jobs. Apart from being socially responsible, this was also sound economics. After all jobs provided the demand that sustained businesses, the economy itself. In other words, the firm's actions contributes to the creation and sustenance of the market itself. It is capitalism which generates a win-win equilibrium of private and social gains. It also involves both the firm and the workers accepting trade-offs to create a mutually beneficial system.  

Fast forward to today and the conception of a good business firm has changed dramatically. Ironically, today's good business firm is one which maximises shareholder value, even if by inflicting unacceptable social costs. This in most cases, translates to cutting costs, by among other things, reducing the expenses on labour. The embrace of labour-displacing robots is only the most direct and extreme manifestation of this trend. In other words, today's business firm is an entirely private entity, with limited social responsibility and aimed at maximising private gains. Sustenance of the soil on which the enterprise itself grows, the market, is the least of considerations.

Whereas annual reports of companies earlier took pride at highlighting the number of jobs created that year, today it is all about the bottom-line, even proudly mentioning the savings from lay-offs and tax avoidance. 

In the pursuit of individual business models that rely on realising returns through arbitrage and externalising the associated costs while appropriating all the benefits, capitalist enterprises are collectively chipping away at the sustainability of the market, and thereby capitalism, itself.  

In the cases mentioned at the beginning, it is debatable as to how many of them would be sustainable if all the social costs are internalised. In many of them, far from directly improving the net productivity (across markets) by way of inventing a new technology or a new business model, the efficiency gains arise from arbitraging across markets. These arbitrage opportunities arise from differences in input costs (outsourcing, offshoring, contracting) arising significantly from failures to internalise costs, regulatory standards (digital commerce, tax avoidance), information access (HFT), and so on. The gains from these arbitrages are privately captured, whereas their costs are borne by the society at large. In simple terms, where possible, today's business enterprise seeks to privatise gains and socialise costs.

This is not to decry all arbitrage opportunities. In fact, all economic transactions involve some form of arbitrage, including the mother of all arbitrages, comparative advantage in the natural order of things. Accordingly, labour wages in developing countries are lower than in developed ones, or farm produce is cheaper in villages than in the cities, and so on. Outsourcing and off-shoring can be legitimate productivity enhancing business models. Where these and others become less benign is, as aforementioned, when the private party appropriates all the gains in the arbitrage transaction and externalises all costs. 

It is disturbing when arguably some of the most exciting business opportunities of our times - e-commerce and sharing economy firms - is in making money pursuing activities whose competitiveness lies in regulatory arbitrage that allows externalisation of the negative social and other costs inflicted by them. It is equally disturbing sign when the most admired business leader and company of our times, Steve Jobs and Apple, have made their staggering fortunes not by fulfilling market "needs" but almost exclusively by creating market "wants". Finally, it is disturbing that both these cases are considered today's touchstones of a shift towards a higher trajectory of economic progress.

No comments: