Echoing Hayek Market economies are successful, in large part, because they are superior at creating useful knowledge. The main mechanisms of this knowledge generation are market signals from trade—prices, profit and loss, and free speech. (SoS, p 99)
“Knowledge fuels prosperity but signaling and guiding resources to higher-valued uses.” p. 101 A basic observation about how markets work. (And exactly how does this happen?)
“A company must draw on the knowledge dispersed among its employees.” (ft 4) (Cites Hayek) (Not “The Use of Knowledge in Society,” but a related paper.)
Measuring things “It is tempting to measure things that are easy to measure; instead we should measure things that matter, even when it is tempting to do so.” (Looking for the car keys under the lamp post.)
In a section citing Porter: “Generally, a business person should attempt to be a price seeker rather than a price taker.” “This is best done by discovering new ways of creating of creating value that are difficult to imitate.” p. 107 Price will lie between cost and value. (not a quote, but the gist of this this discussion)
Marginal Analysis (Enough said, but let’s do it anyway.) “Marginal analysis entails weighing the costs and benefits of a change.” “Marginal analysis looks at the benefits of costs and benefits associated with a specific change rather than the average or the whole.”
First, optimize, then do marginal analysis “When considering an expansion, it is wrong to conclude that because we already have excess people, we don’t need to include the expense of adding any. The analysis should be done with the excess people removed from the base case and added to the extent required in the expansion case.” Interesting, difficult.
Benchmarking Ok, this isn’t really economics, but it is worth mentioning. Southwest airlines studied NASCAR pit crews. (Again, not really economics)
Back to work, opportunity cost “The true cost of any activity is the highest- valued activity forgone.” Again, basic economics, but it goes on… “[P]rofit can be increased by eliminating some profitable, value-adding activities when doing so enables a business to capture higher valued opportunities.”
This really has little to do with our theme, but “Don’t measure yourself by what you have accomplished, but rather by what you should have accomplished with your ability.” p. 110 John Wooden, UCLA basketball coach (The quote is related, loosely, to opportunity cost)
Nice opportunity cost example Koch Material Company had an asphalt plant that was profitable. However, a sales representative becomes aware that a company was looking for a location for a casino. He considered that even though the plant was “consistently profitable,” the land would be more valuable as a casino site than as an asphalt plant. (It’s now a casino. The asphalt plant was relocated.)
Profit Centers Pages 110 – 112. Will be a nice introduction to the transfer price discussion. “Profit centers can be created wherever there are identifiable products, market prices, customers, suppliers and assets such that profit statements can be prepared.”
Essential to the M form enterprise Pioneered at DuPont and General Motors, profit centers allowed accountability for the separate divisions.
Chapter 6. Decision Rights “Markets maximize benefits [when they are] supported by externally enforced property right rules that prohibit taking without giving in return.” -- Vernon Smith (ft 3) “Some Economics and Politics of Globalization,” Speech given at North Carolina State University, March 2, 2005. (This was the first Pope lecture)
In this chapter…. there is a discussion of the general role of property rights in the economy. Property rights create powerful incentives for people to act to create wealth. In the absence of secure property rights, all investments are insecure. The worker cannot be sure that she will receive the value of her work. We see this in play in many of the third world economies.
Then this theme is brought to the business “At Koch industries we use decision rights to attempt to replicate the beneficial roles of property rights in society. Decision rights can be thought of as property rights in the organization. We create decision rights by making sure that employees have clearly defined roles, responsibilities and authorities.” “Decision rights should reflect an employee’s demonstrated comparative advantages.
On Local and General Knowledge Those with local knowledge are often in a better position to solve the problem at hand. The ideas and creative energy of all employees should be leveraged…
Continuing “Some decisions, if made at the local level, can be unprofitable because a broader perspective is required” “The mindless application of either approach—universally centralized or completely decentralized is not the answer.”
Chapter 7 Incentives “At Koch, we use incentives to attempt to align the interests of each Koch employee with the interests of both the company and society.” P 139
Pilgrims and Convict Ships In 1620, the Pilgrims’ property was held in common. … Everyone worked for the collective, with equal rewards to equal rewards to all, no matter how much a person contributed. After two and a half terrible years…” Parcels of land were given to families. Things got better. (Reported by William Bradford, Governor)
Convicts to Australia Initially, captains were compensated by the number of convicts put on the ships. Mortality rates were high. The incentives were to pack as many men as possible on to the ships and to feed them as little as possible. Mortality rates were high. Basing compensation on the number who got off the boats in Australia reduced mortality and improved the health of the convicts that arrived.
Outside agents Common practice is to pay agents a percentage of total sales. Koch pays a higher commission rate, but on margins (price less opportunity costs). This practice induces the agents to focus on profits, rather than total sales.
Ranching Recognizing that people don’t go into ranching for money but for lifestyle, of which a big part is working with their families, the policy of not letting family members work on the ranch was changed. Further, houses were built on the ranch for each family.” “The ranch immediately attracted a far superior work force.”
One more thing “At Koch Industries, we don’t reward roles.”
Dropping back to introduce transfer pricing p. 110 “Transferring products using a cost based system leads to faulty profit signals and bad decisions. Sometimes, restricting our business units to buying internally can be just as wasteful. These profit-distorting practices are especially wasteful when they are used to prop up a struggling business or plant.”