When is it fair to say a small business is not one?

A recent program review by the US government’s Office of Inspector General focused on loans by the Small Business Administration made to poultry farmers. The report concluded that poultry farmers do not meet the regularly requirements of a small business and therefore are no longer eligible for small business loans. A nice article in Modern Farmer entitled “Should a poultry farm be considered a small business?” discusses this report.

In the US, most poultry growers have contracts with chicken companies, like Tyson and Pilgrim’s Pride, to raise chicks until they have grown large enough for slaughtering. These companies are known as “integrators” because so much of the poultry growing and processing operation is owned and controlled by the company (i.e., integrated into one business enterprise). The integrators own the chicks that poultry farmers raise; they determine the quality and quantity of chicks poultry farmers receive; they provide the chicken feed and dictate the operating procedures that poultry farmers must use in feeding and raising the chicks; they mandate the size and shape of the buildings poultry farmers grow the chicks in and can require growers to make changes in buildings at the grower’s expense; they can conduct surprise inspections of poultry farmer operations. Poultry farmers provide the labor in raising the chickens.

One reason why the Office of Inspector General concluded that poultry farmers were not small businesses is that they are “affiliated” with chicken companies and thus are not truly independent businesses. An entity is “affiliated” with a business operation when the business “controls or has the power to control the other” entity. According to the report, “integrators exercised comprehensive control over the growers through a series of contractual mandates and restrictions, management agreements, operating procedures, oversight, inspections, and market controls that overcame practically all of the grower’s ability to operate their businesses independent of integrator mandates.”

According to the report, 76 percent of all agricultural loans by the Small Business Administration in 2016 went to poultry farmers. The average size of loans in 2016 was $1.4 million.

If a poultry grower defaults on a small business loan, it is very difficult for the lender to recover losses through, for instance, the sale of business assets. The reason is that the value of grower facilities is strongly tied to the production contracts that growers make with integrators. If the integrator cancels a particular grower’s contract, the grower usually has no option but to exit the business. In most rural areas where poultry farming occurs, there is only one integrator with whom a grower can contract. The program review report notes “substantial loss in the value of a grower’s facility without the integrator contract.” Economists would say the salvage value of poultry barns is very low. I guess an interesting question to consider is why a lender would make a loan to a poultry grower if the risk of default is closely tied to integrator behavior and the salvage value of assets backing the loan is low. Loans guaranteed by the US government is a reasonable answer.

My colleague, Mary Hendrickson, and I have written about the unfairness of the poultry contracting and growing system. In a paper published in 2016 (here), we show how the relative dependency of poultry growers combined with a lack of contractual and other safeguards create an unfair system for them.

Is it fair to poultry growers that the Small Business Administration will not recognize them as small businesses? As stated in the Modern Farmer article, “There is an argument to be made that by not helping poultry farmers get loans, the SBA would be hurting poultry farmers.” Thus, I can see how poultry growers might assert that the change in designation–if upheld after further government review–is unfair to them. If growers can no longer expect to obtain small business loans, then a claim of unfairness might make sense. Dr. Hendrickson and I, along with two doctoral students, have a new paper, where we not only assess the validity of unfairness claims by poultry growers, but also provide a framework explaining why a violation of expectations is important when assessing claims of unfairness.

In the long-run, however, the change in designation of poultry growers might be a good thing. One could argue, as noted in Modern Farmer, that the ability of growers to obtain small business loans “is currently propping up a wildly damaging system.” If it becomes more difficult or even impossible for growers to obtain such loans, then maybe that will push the system to change more in favor of poultry growers.

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Economic principles and healthcare reform

On Thursday, May 4, 2017, the US House of Representatives passed a bill repealing major aspects of President Obama’s healthcare law (Obamacare), as reported (here) in the Wall Street Journal and other news outlets. The bill goes to the Senate for a vote. The bill ends mandates for people to carry health insurance and for companies to offer specific types of health coverage, among other things. Another Wall Street Journal article (here) states that backers of the bill “are betting that these changes will engender competition, draw healthier people into the insurance pool and cut premium prices overall.” Interesting, this is the same justification that backers of Obamacare gave when it was passed in 2010.

I know a thing or two about economics. There is nothing in economic theory or experience to suggest that anything in the old or new laws will necessarily increase competition or lower costs. Competition exists when there are many buyers and sellers in the market, where it is relatively easy for buyers and sellers to enter or exit the market, and where “all” sellers sell products or services that are similar enough so that it is relatively easy for buyers to comparison-shop for the best product at the best price. In this system, sellers have incentives to lower costs and prices and to increase quality in order to attract customers to their products. Companies that do this well are rewarded with profits; companies that don’t do this well go bankrupt. The incentive to lower costs and prices and to increase quality diminishes when it is difficult for buyers to compare products and services — that is, when it is costly for consumers to shop around, and when companies know it is costly for consumers to shop around — and when it is difficult for potential sellers to enter markets — that is, when there are barriers to market entry. The health care system is rife with problems of comparison shopping and market barriers. That is, the health care system is not a great model of markets and competition, and it won’t be anytime soon.

The root cause of the problem with contemporary health care is the thing Americans like most about it. We pay a monthly fee for health insurance. Then when we get sick or need health care services, we might pay a nominal fee (e.g., $20) in return for health services, while most of the cost of care is paid by insurance companies whose revenue comes from the thousands of patrons paying the monthly fee. Once we have health insurance, we have no incentive to shop for the best healthcare product at the best price, but rather the best healthcare product at any price, because the primary cost of service is paid by the insurance company. The insurance company does not have a strong incentive to induce health care providers to lower costs because the company can pass costs on to patrons.

Even when individuals want to know the cost of a particular medical procedure or service, it is nearly impossible for them to get a straight answer. “How much will the physical therapy cost?” I once asked a clerk at the reception desk? “I don’t know. It depends on the contract your insurance company has with us,” was the reply. “What is your normal rate, and what discount does my insurance company offer on that rate?” I asked. “I don’t know what our main charge is. Your discount will depend on your co-pay and co-insurance.” The conversation never got any better. Only after I got the bill did I learn what the cost of the service was.

Transparency in pricing for medical care will help here. Giving individuals an incentive to price-comparison shop will help, too. Health savings accounts can do this. Recently I have been scrutinizing our health insurance bills because we have a health savings account. It’s time consuming because there are so many individual charges, most of which I do no understand. In one instance we received a bill for a doctor’s visit on a day we could prove no one in our family was at the clinic. If I was not paying out of a health savings account I would not have thought twice about questioning the bill. The insurance company would have paid it. But I did question the charge and was able to get it removed.

I understand the health care system is very complex. But economic principles are not.

Paying more for airline passengers to give up seats

In a previous blog post about the mishandling by United Airlines of a passenger that had already boarded the plane, I suggested the following thought experiment: “Suppose United offered $10,000 to each person who gave up their seat. I suspect most passengers sitting on the plane would have volunteered.”

The next day, AP News reports that “Delta OKs offers of up to $9,950 to flyers who give up seats.”

This must be just a coincidence.

A United case for free markets and clearly defined rights

A lot has been written and said about United Airlines and their mishandling of a problem of overbooking. In case anyone missed the story, a United Airlines flight was overbooked. The airline also needed to fly crew members to the plane’s destination. The airline asked for volunteers to give up seats and even offered some money as an inducement, but that wasn’t enough. So the airline randomly selected passengers to remove involuntarily. Three agreed to leave the plane but one refused. The airline called airport police, who forcibly removed the passenger. Photos and videos of the passenger being dragged out of the plane caused worldwide criticism of the incident and airline. There are numerous memes floating on the internet now inspired by the event.

I am not going to criticize the airline or defend it. Others are doing that. However, I think the story provides an ideal case for illustrating two important economic principles: the superiority of free markets and the importance of clearly defined property rights.

First, economic systems determine how scarce resources are allocated. There are different ways of doing this. One involves free markets, where the exchange of money determines how resources are reallocated. Another involves various forms of command and control, where government or other entities dictate who does what and what goes where.

The airline had (some may say created) a problem of scarcity. There were more people who needed seats than there were seats available. A free market solution to the problem is simple: offer enough money to induce people to voluntarily give up their seat. Here is a thought experiment. Suppose United offered $10,000 to each person who gave up their seat. I suspect most passengers sitting on the plane would have volunteered. The airline said it offered compensation (the WSJ article linked above states that the airline offered up to $1,000). Clearly, the airline did not offer enough. In a free market environment, if the buyer values the resource more than the holder of the resource does, then an efficient exchange can occur if the buyer offers more than the seller’s value. If it was worth more than $1,000 a seat to United to get a crew member on the plane, then the airline should have offered more. If it was not worth more than $1,000, then the airline should not have pursued the matter further. That is the simplicity of the free market.

When there is command and control, such as when the government decides who flies and who doesn’t, then the government uses the power of the state to enforce its preferences, which we saw clearly here when the airline utilized police to drag an unwilling passenger off the plane. If the airline had utilized market principles, then there would have been no incident worth reporting. Stated differently, when markets function well (and when they are allowed to function well), then there is almost never a story to report. I find that interesting.

Second, when there is confusion about property rights, then there will be conflicts. People who buy plane tickets, either with a seat assignment or who are sitting in a seat, believe they have rights to the seat on the plane. In contrast, airlines not only can overbook but also can involuntarily deny boarding of passengers and even tell passengers they have to get off the plane, suggesting the airline believes it has rights to the seat on the plane. (Anyone interested can read United’s Contract of Carriage document here, especially rule 25, which describes what the airline’s obligations and rights are with respect to “denied boarding compensation”).

Regardless of whether passengers or airlines actually own rights, it is the beliefs they hold that matter most here. If passengers believe they have rights to the seat and if airlines believe they control those rights, then there will be a conflict when there is a problem of overbooking (that is, economic scarcity). Markets won’t work well here because there is no basis for determining who should pay and how much, since there is uncertainty about who initially owns the right to be transferred. If the airline believes it has the right, then it doesn’t need to offer any compensation. It can just drag unwilling passengers off the plane and place other passengers in the vacated seats.

The Nobel winning economist Ronald Coase described this problem and pointed to a solution: make clear who has rights to the seat. According to the Coase Theorem, bargaining is efficient when property rights are clearly defined and when bargaining is reasonably feasible. Airlines have demonstrated that bargaining for overbooked seats can work if they just offer enough compensation, suggesting they effectively acknowledge the beliefs of passengers that passengers hold rights to seats they have paid for, regardless of what their overbooking rules say.

The lesson here is therefore simple. If airlines are going to overbook their flights, then they should be prepared to pay passengers enough to induce volunteers to vacate their seats on the plane.

Economic models, high-priced consultants and ethical analysis

A colleague sent me a ProPublica article that explains how some “professors make more than a thousand bucks an hour peddling mega-mergers.” That’s a lot of money, even by consulting standards. MBA business consultants can charge between $200 and $600 an hour. Top partners in consulting firms might charge between $800 and $1200. A Wall Street Journal article in 2011 reported that top lawyers charged as much as $1000 an hour. But some economists are pulling in $1300 an hour as consultants.

To be fair, in a free market buyers and sellers should be able to negotiate for exchange prices. If someone is demanding $1300 an hour for their services and another is willing to pay it, then there is nothing objectionably wrong about the arrangement.

In this case the economic consultants are hired by firms that want to merge with or acquire other companies. The consultants are tasked with building a strong case, based on solid and objective economic principles and evidence, that the merger is in the interest of the industry, business, consumers and everyone else. What makes the article interesting is not that there are high priced economic consultants. It is that these consultants often get the antitrust analysis wrong. They build the arguments on speculation. They ignore or trivialize inconsistent or contradictory evidence. They use “junk science,” in the words of a Justice Department official quoted in the article.

A cynic might say that companies are paying the economists whatever price they will accept to argue whatever the company wants them to say, regardless of economics. Apologies to my lawyer friends, but isn’t this what lawyers do? So economists are on the same level as lawyers now?

Economics is a science. And economic models, when used appropriately, can provide a degree of objective assessment. The subjectivity comes in determining which economic models to use and what evidence to incorporate into the analysis. The ethical problem arises when the prospect of financial gain (in this case, a $1300 an hour contract) influences which models and what evidence to utilize. As noted by the authors, “The government’s reliance on economic models rests on the notion that they’re more scientific than human judgment. Yet merger economics has little objectivity. Like many areas of social science, it is dependent on assumptions, some explicit and some unseen and unexamined. That leaves room for economists to follow their preconceptions, and their wallets.”

The implication is that government regulators might be convinced a proposal is best for stakeholders (notice I didn’t use the word stockholders) when it is really only in the interest of the company seeking the merger–and comes at the expense of other stakeholders. In the case of a proposed merger between cell phone companies AT&T and T-Mobile, the economic consultant wanted to make this argument: “That even though prices would have risen for customers, the companies would have achieved large cost savings. The gain for AT&T shareholders … would have justified the merger, even if cell phone customers lost out.”

Let’s hear it for the economists.

When is an increase in price fair?

In my previous post I wrote about the fairness of drug companies that dramatically increase the price of their products. I suggested, and public reaction confirmed, that these price increases are considered unfair.

When is a price increase fair? When is it unfair?

The economic principle of profit maximization tells us that firms ought to increase prices when there is an increase in demand or a decrease in supply, regardless of whether the change is short-term or permanent. So if a hurricane is closing in on the East coast of the U.S., then suppliers of lumber, bottled water, gasoline and other supplies that people will need should and will increase the prices of these things … a lot. But is that fair?

Daniel Kahneman, Jack L. Knetsch and Richard Thaler published a paper on this topic 30 years ago in the American Economic Review. They argued that people’s perceptions of fairness will (or ought to) constrain impulses to take advantage of short-run increases in demand or other reasons to increase prices, under certain conditions.

Their discussion entails two elements. One has to do with reference points and the other has to do with reasons for gaining at the expense of others.

First, a reference point is the basis upon which people create expectations about the fairness of a transaction or a change in prices. If transactions or price changes are consistent with the reference point, then people will judge the transactions or price changes as fair. In other words, reference transactions and reference profits are considered fair. If there is a deviation from the reference point, then assessments of fairness will be made based on whether good reasons exist for the deviations.

The authors define the reference points as follows:

Market prices, posted prices, and the history of previous transactions between a firm and a transactor can serve as reference transactions. When there is a history of similar transaction between firm and transactor, the most recent price, wage, or rent will be adopted for reference unless the terms of the previous transaction were explicitly temporary. For new transactions, prevailing competitive prices or wages provide the natural reference.

For example, if a gas station has been selling gas for $1.99 a gallon for several weeks, then the reference price is $1.99 a gallon, and people will expect that to be the price the next time they get gas. If the price of gasoline increases, say to $2.09 a gallon, then people will likely consider the price increase unfair unless they understand there to be a good reason for the change. Good reasons have reference points, too. For example, raising prices at the expected rate of inflation is not considered unfair, since inflation-based price increases can be a reference point. We have historical experience with that, so there is no basis for claiming unfairness. The same about price changes in gasoline. If the reference point for price changes is 5 cents a gallon, then people won’t be bothered by finding the price of gasoline is higher by 5 cents the next time they buy gas. But if prices increase by more than 5 cents, then they might believe or expect something unfair is happening at their expense.

Understanding reference points for transactions, pricing and profits can help us understand why unfairness might be claimed when businesses increase prices. For example, if employees had previous experiences of getting pay increases when competitors raised their employees’ wages, then a reference point is created for employees. But if the employer has not historically increased wages when their competitors have, then the reference point for the employer will differ from that of the employees, resulting in disagreements about fairness.

Second, an important principle of fairness is that one should not gain by imposing a cost or harm on others.

Raising the price of lumber, bottled water, gasoline and other supplies that people will need when a hurricane is imminent can be considered imposing a harm on others to acquire a short-term gain. It doesn’t matter that economics dictates that price increases are needed to resolve shortages that will arise when there is a sudden increase in demand. There is usually no viable reference point for such behavior.

Raising prices because a business experiences an increase in costs is different. Such behavior is not considered as imposing a harm on others merely to benefit at their expense. Businesses are not gaining substantially, if at all, when they increase prices to cover their rising costs.

The implication is that people are willing to accept as fair an increase in price to cover rising costs. They also consider it fair for businesses to maintain prices when costs decline. But people consider raising prices when demand increases or without explanation or justification to be unfair.

Most people have no reference point for drug prices rising 5000 percent or even 500 percent. Such behavior is very unfair.