It Was Only a Matter of Time . . .

29 December 2008 at 12:59 am 12 comments

| Peter Klein |

 . . . before someone blamed the financial crisis on agency theory. Sure enough, Raymond Fisman and Rakesh Khurana trace the source of the current mess not to expansionary monetary policy, or lax underwriting standards, or implicit (now explicit) government guarantees against market discipline, or the Basel Committee, or a host of other policy and institutional failures, but to business schools, and the critics’ favorite bête noire, the concept of shareholder wealth maximization. 

[B]usiness schools [promote] a particular brand of free-market ideology — squarely focused on shareholder maximization theories — that forms the staple fare of MBA and executive education courses today. . . .

In the world views that underlie modern business education, the market always “gets prices right” and “managers” are merely agents for shareholders. An individual’s worth can be reduced to one’s worth in the market.

If I get $100 million in compensation, the thinking goes, it is because ‘I deserve it.’ There is no discussion of the role of circumstance, luck or market failure. It is the type of thinking that has resulted in literally hundreds of billions of dollars being transferred away from organizational resources and into the personal bank accounts of CEOs, and is now bringing capitalism to its knees.

So, teaching future managers how the price system works, how managerial behavior effects shareholder wealth, how marginal productivity affects wages, and the like is equivalent to encouraging managers to lie, cheat, and steal! I suppose it would be better to teach that water runs uphill, that central planning is more efficient than free markets, and that men are angels. Perhaps we should cover socially responsible statistics and accounting too.

Sumantra Ghoshal famously blamed transaction cost economics and agency theory for much of the world’s ills, including the Enron affair. At least Ghoshal offered some arguments. Fisman and Khurana can’t be bothered. (HT: Ben Asa Rast.)

Entry filed under: - Klein -, Education, Management Theory. Tags: .

My New Office Poster What First-Year Economic Theory Courses Are Like

12 Comments Add your own

  • 1. Zach  |  29 December 2008 at 3:34 am

    Although it is true that the profit motive is instrumental to the power of market forces; it is also a question of social embeddedness.

    Fishman and Khurana do not seem to be critiquing market forces as such, but rather the social positions of the those making a great deal of money. It is not that they are attacking greed or cheating, but that B-Schools fail to teach their students to understand how factors like luck or their socioeconomic background contribute to their own success. Yes, it is of course a question of diligence, but this is not the whole story.

    You are mischaracterizing their argument, rather, it is a claim to a cultural logic, not an argument against the basic mechanisms of a free-market.

  • 2. Noel  |  29 December 2008 at 5:20 am

    Zach, did you know that 95% of American millionaires are millionaires of first generation? Is that one of circumstances of “luck of their socioeconomic background” you are referring to as absent from economic tea?

  • 3. Joseph Mahoney  |  29 December 2008 at 11:40 am

    There is a large market failures literature:

    Asymmetric information and search costs;
    Economies of scale and sunk costs;
    Externalities and positive transaction costs

    Under these circumstances, prices are not perfect signals of resource allocation from an efficiency perspective.

    In terms of “deserving” what the market offers. A person may serve the poor in a soup kitchen for minimum wage, while another person may obtain $100 million over 10 years to jam a basketballl through a hoop. Does any reflective person maintain that all schools of thought in the history of philosophy would place the ethical basis of capitalism as fully secure?

    Finally, in opposition to the Chicago school philosophy of “let them be bribed” — a philosophy held by my play-for-pay governor, Rod Blagovich — I maintain the view expressed by Kenneth Arrow in THE LIMITS OF ORGANIZATION that the price system should not be the complete arbiter of social life.

  • 4. Peter Klein  |  29 December 2008 at 11:47 am

    Joe, in my managerial economics and strategy courses I teach about asymmetric information, search costs, economies of scale, sunk costs, externalities, and positive transaction costs, among other topics. Who doesn’t? Are there really any business schools that teach that prices are “perfect signals of resource allocation from an efficiency perspective,” that people “deserve” (in some ethical sense) what the market offers, or — a fortiori — that the price system should be “the complete arbiter of social life”?

    I’d call Fishman and Khurana’s argument a straw man but this would be an insult to straw men!

  • 5. Joseph Mahoney  |  29 December 2008 at 5:23 pm

    Peter,

    Feel free to report me to the society for the prevention of cruelty to strawmen.

    You may think I am beating a dead horse, but the number of folks who believe fully in the ethical basis of capitalism suggests this dead horse still has a strong kick.

  • 6. whittaker  |  1 January 2009 at 8:02 pm

    OK, you guys, I have a simple hypothetical.

    Let’s say I have some emergency where I need $1000 in cash to be delivered ASAP to my mother 5 blocks away. I approach a stranger and ask him to deliver the cash, and offer him an extra $100 to keep for himself in return for his help.

    Now, if the stranger accepts the mission, I think you would say he has a fiduciary duty to take care of the money as best he can, and deliver it safely. But he also has his own self-interest, and thus a temptation to abscond with some or all of it. So we have an agency problem, right? What are the odds that this problem will be overcome and the cash will all get delivered? Maybe 80%, maybe 90%, but certainly less than 100%.

    Now suppose the stranger has worked all his life strategizing and jockeying for position in order to get to be entrusted with this mission. Is he more, less, or equally as likely to be trustworthy?

  • 7. Peter Klein  |  2 January 2009 at 12:00 am

    Whittaker, I’m not sure exactly what you’re getting at. Neither agency theory nor TCE has much to say specifically about the last part of your hypothetical. Agency theory addresses your contractual relationship with the stranger — is his performance monitored? Does he have an incentive to deliver the bundle rather than abscond with it? Does he expect to be hired for similar errands in the future, and is there a mechanism for disseminating information about his performance to potential future employers? What is the nature of your contractual relationship with the stranger? Etc. More generally, economic approaches to organization and governance tend to take the “trustworthiness” of agents as given, and focus on incentive alignment, mechanisms to mitigate opportunism, and the like. The “performativity” crowd would argue that teaching students about opportunism makes them opportunistic, but the theory and evidence strike me as pretty weak.

  • 8. David Hoopes  |  2 January 2009 at 4:00 am

    Gosh. It’s amazing how much people read into capitalism. No one ever said the results are “fair.” It is simply supposed to be a way of each person getting closest to his/her wants. Granted, many do not get what they want. But, surprise, they won’t get want they want under a planned economy either. You get what someone else thinks you should want.

    Also, how many people think markets are perfect? This is an assumption that allows a theorist to isolate other phenomena. I review simple micro based on price theory to all my strategy classes. But I don’t claim any markets are “perfect.” Quite the contrary. Still, price theory is incredibly useful for discussing any number of business and economic topics.

    I get so tired of people who clearly don’t understand simple microeconomics 101 and who probably do not have degrees from business schools telling everyone what “economics” means and what business schools teach.

    Yikes.

    You could probably write a book or paper based on comments posted at O&M on how economics is so commonly misconstrued.

  • 9. whittaker  |  2 January 2009 at 8:17 am

    Here’s what I’m getting at:with the amounts of money controlled by modern CEOs and boards of directors, the restraints imposed by the notions of honor and fiduciary duty are often too weak to be effective. The concept of agency breaks down in this environment.

    Is the performance of the agent monitored? Yes. Does the agent care? No, because if he can abscond with the money, or some of it, under some pretense, he’s set for life. He may or may not be able to get similar engagements in the future, but he’s so far down the utility curve that it doesn’t matter that much.

  • 10. Peter Klein  |  2 January 2009 at 9:31 am

    Whittaker, do you have any evidence that, beyond a certain level of wealth, individuals no longer respond to incentives, do not weigh costs and benefits at the margin, ignore the future consequences of their actions, break contracts at will, and so on? Does this model apply to professional athletes and entertainers — many of whom earn vastly more than all but the highest-paid CEOs — or only to business executives? How about wealthy heiresses like Ariana Huffington or Caroline Kennedy? How about wealthy politicians?

  • 11. spostrel  |  10 January 2009 at 10:02 pm

    1) The value-merit distinction is one that Hayek and many, many others have made. Even Ayn Rand, for crying out loud, thought it was great for Elvis Presley to get paid lots of money even though she thought his music lacked merit. So the strongest ethical defenders of capitalism do not pretend that payments = individual merit.

    2) Meritorious distributions of wealth may or may not be ethical, even if we could agree on what was merit. It depends on how much you value a lot of other things, like material satisfaction, freedom, equality, etc. in addition to just economic deserts.

    3) The above hardly matters because in no way do we have anything like a consensus on what is meritorious. Even within narrow frames, such as professional basketball, there are people who think the selfless role players who glue the team together are more meritorious than the superstar scoring machines. In broader frames, such as American life, seeking consensus on merit is hopeless. Except that everything I do is great, of course.

    4

  • 12. SkepticProf  |  19 June 2011 at 6:02 pm

    Khurana’s vita is very interesting. He has several AJS’s and a JEL…but they’re all BOOK REVIEWS. Afraid of peer review much, I wonder?

    http://drfd.hbs.edu/fit/public/facultyInfo.do?facInfo=pub&facId=6921

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