Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (14 page)

So what makes the free market superior to government planning? Part of the answer is that the market creates stronger incentives for people to consider the effects that their actions have on others. A clear example of this is seen in the growing practice of diversified stockholding. Some 5,000 stock mutual funds in the United States hold over $5.2 trillion in assets.
³¹
It has become common knowledge that investors should hold a well-diversified stock portfolio, but most people do not realize that this practice also encourages cooperation among competing companies.
³²

Consider a simple example I came across when I was teaching at the Wharton Business School. Albert J. Wilson, then vice president and secretary for TIAA-CREF, a huge teacher’s retirement fund, gave an informal talk to some faculty in December 1992. Texaco and Pennzoil had previously been locked in a protracted, costly legal battle. Owning stock in both companies, TIAA-CREF was hurt by the litigation, which reduced the value of both firms. If one firm eventually won the dispute, it would not have benefited TIAA-CREF, since the result would just move a lot of money from one firm to the other. Lawyers were making a lot of money from the litigation, but unfortunately the retirement fund didn’t own any stock in the lawyers. Wilson told us that the pension fund had used its influence as a large shareholder in both companies to get them to settle their lawsuit. He also revealed that the pension fund had similarly helped to convince Apple and Microsoft to settle some mutual legal disputes.

While investors care about the value of each stock they own, they care more about the value of their total portfolio. If some corporate decision causes the price of one stock in an investor’s portfolio to rise but depresses the value of another of his stocks by an even greater amount, the investor will not be pleased. As stockholding in general and diversified stockholding in particular has risen over time, corporate decisions have increasingly come to affect other firms and their stockholders.

This phenomenon has been evident in Japan for decades. Japan’s keiretsu are a group of companies that cross-own stock in each other in order to promote cooperation among the constituent firms. The practice represents a kind of halfway point between total independence and a complete merger. In 1989, the Texan tycoon T. Boone Pickens purchased a large stake in Koito, a Japanese automotive lighting and air conditioning company that belongs to the Toyota keiretsu. Toyota works closely with Koito and other suppliers in designing products to fit its cars.

Pickens became upset that Koito was charging Toyota low prices. But the other companies in the Toyota keiretsu did not share his concern. Unlike those companies, Pickens only owned shares in one of the keiretsu’s firms. So he was only interested in maximizing Koito’s share price, while the other shareholders cared about the overall value of all the keiretsu’s companies. If Pickens had also owned Toyota stock, he wouldn’t have had much of an incentive to try to charge Toyota higher prices. In fact, the income he hoped to gain from raising Koito’s prices to Toyota would have been smaller than the loss imposed on Toyota.
³³

In the U.S., mutual funds and other financial institutions replicate some aspects of the keiretsu system. For example, a study I performed with Tuck Business School professor Bob Hansen found that 33 percent of IBM’s stock and 50 percent of Intel’s stock were owned by institutions that held stock in both companies. Likewise, 29 percent of Apple’s stock and 20 percent of Microsoft’s stock were possessed by institutions that were shareholders of both firms.
³⁴
Additionally, some aspects of venture capital funds also resemble the keiretsu system. Typically, such funds specialize in investing in a small number of industries. Like the TIAA-CREF, the funds have an incentive to use their position as stakeholders to encourage cooperation among the companies in which they’re invested and to discourage wasteful internecine disputes.

Hansen and I found that stock diversification also helps to explain other corporate behavior, such as the prices that firms bid in mergers. While merger announcements usually increase the stock price of the firm being acquired, there is substantial evidence that the stock price of the buyer actually falls. Furthermore, the size of this drop has been increasing over time. This can be explained by stock diversification: when shareholders own both the acquired and acquiring firm, they care much more about whether the merger will increase the total value of the two firms than they do about which firm’s value increases and which decreases. If shareholders own both companies, a higher bid
simply means more money going from one of their pockets to the other. If there are diversified shareholders and multiple suitors, then shareholders will care not about the size of the bid, but rather that the total value is maximized.
³⁵

During a merger, shareholders will only be indifferent to the buyer’s stock price when they also hold shares in the target. When the target is a private, closely-held firm, you usually won’t see this disinterest. In such acquisitions, a firm will only make a bid if the merger would increase its own value. Thus, in mergers involving a publicly-held company taking over a privately-held one, the buyer’s stock price will usually rise upon the bid’s announcement.
³⁶

The overall benefits we gain from stock diversification are another example of the market acting effectively when it’s left alone. Sometimes these innovations take some time to evolve, but the inexorable direction of the market tends toward ever greater efficiency.

What kind of company comes to mind when you think of a corporate predator? The textbook example is John D. Rockefeller’s Standard Oil company, which ruthlessly gobbled up and closed down competitors in the late 1800s and early 1900s until the firm was ordered broken up by the Supreme Court.
³⁷
More recently, American Airlines was the defendant in a high-profile predation case that was eventually tossed out by the courts. Inevitably, it is large, private companies that are associated with predation in the public mind. This is quite unjust, for it is government-run companies—not private firms—that have the biggest incentives to act like predators.

As noted in Chapter One, predation—the lowering of a company’s prices below cost—usually proves too costly to be successful. After crushing a competitor, the threat of further predation has to be credible enough to keep new firms from entering the market. How is this threat
issued? A typical predator has to convince potential competitors that it values something—perhaps overall sales or market share—more than it does profits, which can suffer dramatically while a firm is engaged in predation. This is usually a difficult threat to make convincingly—after all, the overall goal of any private company is to make money.

But government-owned companies are seldom geared primarily toward making profits. Because they are frequently motivated by extraneous factors such as maximizing employment, state-owned firms can make much more credible threats of predation. What’s more, state-owned firms often don’t need to drive their competitors out of business for predation to be successful; predation can work merely by allowing state-owned firms to expand their market share or create more jobs. Public firms also frequently enjoy state financing and tax advantages that give them the financial resources needed to sustain predation-related losses much longer than private companies can. Finally, because they often don’t have freely trading stock, state-owned companies are typically immune to the stock-shorting strategy that makes it profitable for firms to enter a market dominated by a predator, as previously discussed.
³⁸

Airbus, the giant European aircraft maker, provides a telling example. Many European governments have an ownership stake in the firm, which lost billions in 2006 due to a two-year delay in the manufacture of its A380 super-jumbo. Nevertheless, the Germans worry that the French want to increase their stake in the company by up to 15 percent because “if France has the upper hand in [the company] boardroom, Germany fears it could be forced to bear the brunt of any [labor force] cut-backs.” The UK has similar concerns.
³⁹

Looking at Airbus’ production methods, we see how jobs are prioritized over profits:

Because many state-run firms likewise refuse to prioritize profits, they make ideal predators. For example, weather forecasting offers a good case study in the effectiveness of public predators. During the 1980s, private meteorology services saw a chance to make money by providing television stations with specialized forecasts that the National Weather Service hadn’t been offering. But soon after the private companies began providing this service, the National Weather Service started giving stations the same specialized forecasts for free, thus driving the private forecasting companies out of the business.
⁴¹
According to Jeffery Smith, executive director of the Association of Private Weather-Related Companies, “many commercial meteorologists have been reluctant to take an increased role in forecasting because of the constant threat of government provision of these specialized forecasting services. Private firms do not know what service the government will choose to offer next for ‘free.’”
⁴²

Other cases of public predation are evident in higher education. Public universities can charge much lower tuition than private schools because public schools enjoy more state financing. My alma mater of UCLA, for example, spends almost $40,000 per student but charges only $6,522 tuition for in-state students.
⁴³
Students generally pay a much smaller percentage of public university’s costs than students at private universities.
⁴⁴
Below-cost pricing sometimes also extends to
the smaller operations run by public universities such as bookstores, food handling, and entertainment. These businesses may receive free building space or special tax privileges that allow them to charge artificially low prices with which private vendors simply can’t compete.
⁴⁵

The comparatively low tuition for public universities undoubtedly has a big impact on a student’s choice of school. Between 1965 and 2005, when average tuition at public universities and colleges fell from 22 to 18 percent of the average private tuition, the percentage of students enrolled in public schools rose from 67 to 79 percent.
⁴⁶
This should come as no surprise—the ability to charge below-cost prices thanks to government subsidies gives public schools an enormous advantage over private universities.

In fact, state universities have acquired many formerly private universities after driving, or threatening to drive, the private schools into bankruptcy—examples include George Mason University School of Law, University of Buffalo, University of Houston, and University of Pittsburgh. In the case of the University of Buffalo, the State University of New York reportedly threatened to open up a public university across the street unless the University of Buffalo joined the state system.
⁴⁷

Private firms can’t take over their rivals so easily due to antitrust regulations. These regulations create a real difficulty for private predation—a big company may drive a competitor out of business, but the latter’s factory and other key assets are often left standing. Some new entrant can easily step in, purchase these assets at greatly discounted prices, and restart the competition. Then, the predator will face a new competitor with lower costs than its former rival had. State-owned firms, in contrast, are exempt from many antitrust rules, and this makes it easier for them to buy up a victim’s assets and forestall the entrance of new competitors.

Post offices worldwide are notorious for adopting predatory tactics against private competitors. Post offices systematically use their profits from operations where they have a government-protected monopoly
to subsidize money-losing operations in sectors where they face private competition.
⁴⁸
In 2001, the European Commission found the German post office, Deutsche Post AG, to be illegally cross-subsidizing its parcel business with funds from its first class mail monopoly.
⁴⁹
In 2005, the Danish, Spanish, and French post offices were fined for engaging in similar practices.
⁵⁰

The U.S. Postal Service engages in the same kind of chicanery. When the postal service raised first-class mail to thirty-three cents in January 1999, it simultaneously reduced the price of domestic overnight express mail from $15.00 to $13.70, even though it was already losing money at $15.00. The price, which was lowered in response to increasingly successful competition in overnight delivery from FedEx and UPS Overnight, remained below $15.00 for the next seven years.
⁵¹
Clearly the postal service was not seeking to drive its competitors out of business with this maneuver. But expanding its market share through below-cost pricing is still predation nonetheless.

There are almost endless examples of predatory practices by state-owned companies and services. One peculiar predator is the U.S. Forest Service, which requires lumber companies to bid on lumber that is profitable to cut as well as lumber that is unprofitable. Making companies bid on lumber that includes unprofitable trees reduces the amount the firms will pay and lowers the forest service’s income. Why would the forest service do that? The key, once again, is that we’re dealing with a state company that does not operate on the profit motive—the forest service’s revenue must be turned over to the Treasury Department. But requiring that unprofitable lumber and profitable lumber be bid on together increases the total amount cut. This, in turn, increases the demand for the forest service to build more roads and provide other services—activities that justify the forest service’s budget.
⁵²