The new issue of the Journal of Law & Economics is available online. This is an exciting development for me because the issue includes my paper with Ben Klein on The Economics of Slotting Contracts (SSRN version available here), and because it has been a very long wait to see the paper in final form (note the new release is of the August 2007 issue of JLE). The primary contribution of the paper is to explain the incidence of shelf space contracts as a consequence of the normal competitive process and examine the conditions under which those contracts will take the form of a lump sum per-unit time payment rather than a wholesale price or volume discount. We also have provide some empirical evidence that is consistent with the time series and cross-sectional incidence of slotting across product categories (see also here).

Readers with an interest in antitrust might want to also check out the Duso, Neven & Roller event study analysis of EU merger decisions and Taylor’s analysis of NIRA cartel performance. And to be filed under the category of “law of unintended consequences,” Jonathan Klick and Thomas Strattman also have a very interesting empirical piece demonstrating that state mandates requiring coverage of diabetes treatments have resulted in offsetting behavioral changes and higher Body Mass Index after the mandates.

The Klein and Wright abstract is below the fold:

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Tyler Cowen invokes Klein and Leffler (1981) to explain the the apparently high price of paid by Client #9 for sex, arguing that high price in combination with the repeat purchase mechanism were part of a self-enforcement mechanism designed to assure performance (in this case, presumably, sex and secrecy). That the $4,300 represents a substantial premium over the competitive price in order to assure such performance is plausible, but there is another possible story. Self-enforcement requires a premium stream sufficient to facilitate performance, not more. The premium must be greater than the possible gains from non-performance. What are those gains from providing sex but not secrecy in this case? One could tell a story that the shirking gains are not incredibly high, and therefore the required premium stream would be low since any expected gains from shirking must be offset by the expected costs associated with the prostitute incriminating herself. Plus, how large could the private benefits be for disclosing this information?  Further, wouldn’t there necessarily be some private sanction from the employer for disclosure?  We are talking about the world of illegal economic activity and non-legal sanctions.   In other words, one might expect that an efficient self-enforcement mechanism might involve the employer’s commitment to supplement additional enforcement capital.

If this story were correct, there would not be a huge premium stream required to assure performance and we would be left with the inference that $4,300 is the competitive market price for the services of an upscale prostitute. I find that argument plausible as well.  But this interpretation tends to overlook or discount the gains from potential extortion or media attention for the prostitute and overestimates the expected costs of the criminal penalties. Under this second interpretation, where extortion is a significant component of the gains to shirking and those gains are large (for example, some fraction of the customer’s wealth), one might reasonably argue that the premium stream embodied by the $4,300 is far too low to assure performance!  However, I do agree with Cowen that it doesn’t make sense to design a self-enforcement mechanism and then incriminate oneself as appears to have occurred here.

A story in today’s WSJ highlights Dell’s rather slow move into retail distribution of its PCs.  The delay has been, at least in part, calculated to control the image of Dell’s products with its customer base.  For example, Dell’s new arrangement with Best Buy is designed to restrict Best Buy’s product line on some margins as part ofan effort to Dell sales from cannibalizing its Web customers.  Like with most distribution restraints, the manufacturer and retailer attempt to align incentives and facilitate performance.  In thise case, Dell was apparently concerned with Best Buy’s incentive to alter its product line up in a way that would harm Dell’s image and so included contractual restraints to reduce this incentive:

Dell’s biggest concern was that its products be positioned among the higher-end PCs in Best Buy stores, say executives from both companies — a must for Dell since Best Buy hosts more affluent electronics shoppers. The discussions became so detailed that executives from both sides even homed in on the colors of the notebooks that should be sold at Best Buy.

I wonder if Dell’s contracts include shelf space provisions.

A few days ago, I posted a comment about Starbucks’ recent disclosure that its average per store traffic has gone down slightly even though overall profits have gone up. I suggested a number of explanations for these phenomena consistent with a story that consumer taste for the Starbucks product has not diminished. One of these explanations was that Starbucks makes its product available to non-Starbucks retailers and that consumers may be turning increasingly to these other retailers. That is, consumers could be shifting away from Starbucks stores rather than away from the Starbucks product. In passing, I observed that Starbucks’ distribution of its product to non-Starbucks stores is proconsumer and belies the accusations of some opportunistic competitors who claim that Starbucks’ business model is anticompetitive.

Yesterday, Stephen Bainbridge helpfully pointed out that Starbucks owns its stores and does not franchise them (correcting my reference to Starbucks “franchisees”). At the same time, Stephen also notes that Starbucks does license holders of otherwise inaccessible real estate to sell Starbucks products, an arrangement that is economically indistinguishable from franchising. I appreciate this clarification from Stephen. But I also should say that the analysis and conclusions in my original post do not turn on the distinction between Starbucks owning or franchising its stores. The important point is that the Starbucks product is available at other places besides Starbucks stores, such as at Barnes & Noble. Whether these alternatives are created by franchise or license is immaterial. Stephen does not dispute my conclusion that the antitrust allegations against Starbucks are without merit. And though he presents the point as “a problem with [my] analysis,” Stephen’s correction is, as Josh explains, really factual rather than analytical.

Leaving aside the issue of why traffic is down at Starbucks stores, Stephen raises (or rather recycles from a superb earlier posting he wrote back in 2003) the important question of why some firms like Starbucks choose to own their own stores (i.e., to vertically integrate) while other firms such as Subway choose to franchise. Many great minds have weighed in on this question over the years, beginning (at least implicitly) with Ronald Coase’s great 1937 essay “The Nature of the Firm” (which uses variation in transaction costs to explain a firm’s choice between internal and external contracting) and continuing most recently with Josh’s and Larry Ribstein’s excellent postings in response to Stephen.

I wish to add here only one point to the analysis. Whatever its economic benefits, vertical integration has the added virtue that it can reduce a firm’s exposure to certain types of antitrust claims. While a franchisor and franchisee can be sued under Section 1 of the Sherman Act for anticompetitive vertical restraints (such as vertical price fixing or other forms of restricted distribution such as territorial restraints), a single firm or a parent and its wholly owned subsidiaries are immune from such suits under the Supreme Court’s Copperweld decision, which held that a firm cannot conspire with itself for purposes of satisfying the conspiracy element of Section 1. At the same time, even while reducing exposure under Section 1, vertical integration by a firm with an already high market share can increase the firm’s exposure to a monopolization (or attempted monopolization) claim under Section 2.

The antitrust factor may well be one explanatory variable in Starbucks’ decision to own its stores rather than franchise them and Subway’s decision to franchise rather than own. Starbucks has a high and growing market share in the market for retail coffee, particularly if one defines the product market narrowly to include only “high end” coffee. It is plausible that a court could find it to have some degree of “market power” (though not “monopoly power”) in this market, which makes it vulnerable to Section 1 claims with respect to its arms’ length, vertical arrangements. Owning its own stores reduces that exposure, and since the stores have been owned from the start rather than acquired later there isn’t an apparent act of monopolization that would increase the firm’s exposure under Section 2. Subway, by contrast, seems much less dominant in its product space and indeed may not even have “market power” at all. If that is right, then Subway would benefit from vertical integration much less than Starbucks does–at least from an antitrust perspective.

Needless to say, other factors may well be at work besides the antitrust factor, as Josh, Larry, and Stephen ably suggest. My point here is only to add antitrust as another variable that may well explain firm franchising behavior in some range of cases.

Professor Bainbridge offers a correction to Keith’s Starbucks analysis by pointing out that Starbucks does not have franchisees. I don’t think the franchise/ franchisee distinction has much to do with Keith’s conclusion that whatever is going on is not an antitrust problem. But the Professor is on to a really cool question about franchising and vertical integration. Professor Bainbridge presents the contrasting franchising decisions by Starbucks and Subway as a transactions cost puzzle and links to a fuller analysis of this problem here:

What bugs me about the Subway v. Starbucks problem is that I can’t see any reason to believe that Subway’s transaction cost schedule is going to differ from that of Starbucks.

Bainbridge continues with the conventional account of the economics of franchising, focusing primarily on monitoring costs:

Franchising gives a residual claimant-like status to the local franchisee, while the franchise contract gives the franchisee incentives to ensure that the local employees comply with brand requirements. Franchising thus can be understood as an adaptive response to the problem of monitoring numerous employees in countless locations.

If this analysis is correct, one would expect to see corporate ownership in settings where monitoring via a vertically integrated management structure can be effected at low cost (relative to situations in which franchising dominates). But does Starbucks really face lower monitoring costs than Subway? If not, did Starbucks make an economic error by not going the franchise route?

The comments to Professor Bainbridge’s prior analysis from the folks at Marginal Revolution (and others) following the post hint at cross-store cannibalization as the key to the economic explanation. This is basically right, or at least, on the right track. But I think all this talk about “monitoring” and “transactions costs” is covering up some really interesting economics that shed some light on vertical contracting more generally. Don’t get me wrong, the critical variable that should influence the vertical integration decision here is indeed (as Professor Bainbridge says) the monitoring costs of franchisor owned outlets relative to franchised oulets. But I think these rather vague labels are blurring some important underlying economics.

So what’s going on with Starbucks’ decision to vertically integrate its outlets? I offer some analysis below the fold.

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U of Chicago Law Professors Douglas Baird and M. Todd Henderson (my very smart, very tall law school classmate) recently posted a provocative paper on SSRN. The paper, Other People’s Money, contends that “the oft-repeated maxim that directors of a corporation owe a fiduciary duty to the shareholders” is an “almost-right principle that has distorted much of the thinking about corporate law in recent decades.” Baird and Henderson argue that we should scrap this “almost-right” but mischief-causing principle in favor of a principle that would ground duties to all investors in contract.

Given innovations in corporate finance, the lines among shareholders, debtholders, and creditors have become quite blurred. Accordingly, Baird and Henderson argue, “[i]dentifying only shareholders as investors, as opposed to all providers of capital, is misleading.” Moreover, giving common stockholders the most privileged spot in the pecking order, as the notion of fiduciary duties owed to shareholders seems to do, may be inappropriate. How, for example, could the directors of a distressed corporation ever file for bankruptcy, thereby harming shareholders at the expense of creditors? Baird and Henderson argue that theorists committed to “the sacred cow that the duty of the directors is owed solely to the shareholders” have “paint[ed] themselves into embarrassing corners” trying to address the filing of a bankruptcy petition and other situations where shareholder interests seem appropriately subordinate to those of other capital providers.

If we are to jettison the notion that fiduciary duties are owed to shareholders, what principle should replace it? The most obvious candidate, Baird and Henderson observe, would be a rule that “directors must adopt the course that, in their judgment, maximizes the value of the firm as a whole.” (And a strong business judgment rule would apply to directors’ decisions.) Under this approach, which resembles the approach Judge Easterbrook took in In re Central Ice Cream Co., 836 F.2d 1068 (7th Cir. 1987), “claims by one class of investor against another alleging breach of fiduciary duty would fail so long as the directors acted reasonably to enhance firm value.”

But Baird and Henderson maintain that this “maximize the value of the enterprise” approach is also deficient. In particular, it fails to account for common situations in which senior investors, such as venture capitalists who own preferred stock with voting rights, bargain for the right to “pull the plug” on a venture — even though doing so would leave common stockholders with nothing and wouldn’t maximize the value of the firm ex post. Such arrangements, Baird and Henderson argue, may be value-maximizing ex ante because they give managers (generally junior claimants) an incentive to manage well. But, of course, the provisions can’t have this value-enhancing effect if they can’t be enforced due to a fiduciary duty running to common stockholders. Baird and Henderson thus argue that courts shouldn’t “stand in the way” of this “contracting regularity.” Instead, courts should honor contracts among directors and capital providers — even those that would disadvantage common stockholders.

In all, a terrific paper. It’s consistent with my view (explained in detail here) that the contracts between corporate constituents should be freely tailorable by the parties, and with my argument (set forth in the last part of this paper) that fiduciary duties should not preclude corporations from authorizing certain forms of insider trading.

My only quibble with the paper is that it seems to suggest in a couple of places that we should junk altogether the notion of fiduciary duties owed to shareholders. (See, e.g., page 8: “Hence, it may make sense to eliminate the concept of fiduciary duty from corporate law altogether.”) I wouldn’t go that far. Fiduciary duties running to shareholders exist because the cost of drafting contracts that would expressly state the constraints on managers’ conduct is simply too great. Because managers and shareholders can’t envision all the various contingencies that will arise, decide up front how those issues should be resolved, and memorialize those decisions in an express contract, the law polices manager conduct by positing amorphous duties of diligence and loyalty — duties whose precise content is fleshed out ex post. As Easterbrook and Fischel put it, “The only promise that makes sense in such an open-ended relation [as that between managers and shareholders] is to work hard and honestly.” The fact is, we need fiduciary duties running to shareholders to act as contractual gap fillers; we shouldn’t jettison them altogether.

That said, we should recognize that fiduciary duties owed to shareholders are nothing more than contractual gap-fillers. That is, they are contract terms that exist absent some provision to the contrary. Thus, to quote Easterbrook and Fischel again, “Because the fiduciary principle is a rule for completing incomplete bargains in a contractual structure, it makes little sense to say that ‘fiduciary duties’ trump actual contracts.”

If fiduciary duties are so construed, the concern that animates Baird and Hnderson becomes easy to remedy. Suppose a corporate charter were to include some provision stating that fiduciary duties to shareholders shall not be violated by executing or performing contracts with other capital providers as long as those contracts were in the best interests of the firm, measured from the perspective of the ex ante bargain among investors. The fiduciary duties owed shareholders — important contractual terms in the bargain between shareholders and managers — would still exist but wouldn’t be violated by actions authorized by contracts with other capital providers. This, I think, is a better outcome than scrapping altogether the notion of fiduciary duties running to shareholders.

Despite some language that might suggest otherwise, I believe this is the outcome Baird and Henderson are ultimately advocating. The penultimate paragraph of the paper suggests as much:

Board decisions should follow control rights, wherever and in whatever form they are manifest, and courts should largely get out of the way. This means courts should refuse to give creditors fiduciary duties (say in the zone of insolvency), refuse to allow shareholders to use fiduciary duties as a mechanism for upsetting director decisions that increase firm value or are conceivably part of the investors’ ex ante bargain, and refuse to perpetuate the inefficient link between disclosure and fidicuary duties. Directors should take from court decisions the simple maxim that they should do what is in the best interest of the firm, measured from the perspective of the ex ante bargain among investors. This will mean maximizing the firm value in nearly every case, but…sometimes acting in ways that seem selfish but are really just efficient and, when viewed ex ante, value-maximizing.

The Searle Center at Northwestern University School of Law will be holding a conference on this subject starting a week from today on Thursday, November 15th.   I’m very much looking forward to participating.  I will be a discussant on a panel focusing on the contracts at issue in the Microsoft case, and responding (along with Michael Whinston and Scott Stern) to papers on this topic from Bill Page and John Lopatka.   I’m not quite sure yet whether I will have slides for my discussion but will post them here if I do.  The conference line up, agenda, and papers are all available at the website.

From the NY Times:

Federal regulators on Wednesday approved a rule that would ban exclusive agreements that cable television operators have with apartment buildings, opening up competition for other video providers that could eventually lead to lower prices.

The Federal Communications Commission unanimously approved the change, which Chairman Kevin Martin said would help lower cable rates for millions of subscribers who live in apartment buildings and other multi-unit dwellings, or about 25 million households. He said the move would particularly help minorities who disproportionately live in multi-unit dwellings.

What is at issue here is the exclusive contracts between cable operators and the owners of “multiple dwelling units” (MDUs). From what I understand, the FCC order appears to prohibit the enforcement of both existing and new exclusive arrangements with MDUs as anticompetitive contracts. It is well known in the economics literature that exclusive contracts, and competition for access to consumers through the use of exclusives, can generate significant pro-competitive benefits.

According to FCC Commissioner McDowell’s Concurring Statement, the FCC’s record after studying this issue in 2003 and allowing these contracts recognized this fact as well as the potential for anticompetitive behavior in certain cases. It is unclear why the FCC reversed ground. A few statements from Commissioners cite to evidence that cable rates have increased over the last decade or so. But it is unclear whether there was any analysis that supports the view that any increase in prices is related to these contracts.

Apartment owners are not so excited about the move. From the LA Times:

“You prevent the apartment owner from playing one provider off against another to get the best possible price and the best possible service,” said Jim Arbury, senior vice president of the National Multi Housing Council, a trade group representing large-building owners, managers and builders. “The people aren’t going to get the choice the FCC thinks they’re going to get.”

The cable industry is also obviously against the Order, which would void existing contracts with MDUs which spurred the providers to invest millions of dollars to wire apartment buildings and provide upgrades.  The parties that appear to be complaining the loudest about the contracts are phone companies who are trying to compete with the cable providers by selling TV services over their lines.

In any event, the FCC Order produces a nice natural experiment. According to the LA Times story, about 30 states currently allow exclusive contracts with MDUs while other state legislation already banned the contracts. The FCC Order, if upheld after an anticipated showdown in court, will only impact those states that currently allow it. Any guesses as to what the impact of the FCC order will be on prices?

I am pleased to announce that that Thom’s excellent and provocative paper on Weyerhaeuser and the Search for Antitrust’s Holy Grail has made the Top 10 list (at #10) for Antitrust & Regulated Industries and Antitrust Law and Policy (#7). Congrats Thom! On top of that, I am doubly pleased that my own Behavioral Law and Economics, Paternalism, and Consumers Contracts: An Empirical Perspective has made a few SSRN Top 10 lists (#5 for Consumer Law, #7 in the Journal of Contract and Commercial Law, and #10 in the Management Research Network).  Sorry in advance if I missed others!

After receiving the page proofs last week, I’m posting “Behavioral Law and Economics, Paternalism, and Consumer Contracts: An Empirical Perspective” to SSRN. I wrote this paper for last year’s NYU Journal of Law & Liberty Symposium on Behavioral Economics’ Challenge to the Classical Liberal Program. The basic idea of the paper is an evaluation of the empirical evidence concerning behavioral and neoclassical theoretical predictions in a few settings where behavioral anomalies are frequently argued to justify paternalistic measures: credit cards, standard form contracts, and shelf space contracts. Here’s the abstract:

Modern legal scholars frequently and increasingly base their analyses on the assumption, grounded largely in the extensive experimental literature, that individuals are subject to a number of systematic behavioral biases. Within the legal literature, behavioral economic analysis has been relied upon to generate a significant number of proposals for paternalistic regulation. These proposals are frequently accompanied by claims that neoclassical economics is insufficiently flexible to deal with these empirical observations, and that behavioral law and economics is as a superior guide for policy analysis. These claims must ultimately be resolved empirically and turn on whether incorporating insights from behavioral economics improves our ability to explain the law, understand the behavior of economic agents, or predict the consequences of legal change. This paper focuses on the shared interest of both neoclassical and behavioral economists in empiricism and explanatory power. It asks whether behavioral economic analysis of law has increased our knowledge in an area of “consumer contracts.” Specifically, the paper surveys the available empirical evidence to assess claims from the behavioral law and economics literature involving exploitation of consumer biases with credit cards, standard form contracts, and shelf space contracts. I find that the empirical studies of firm and consumer behavior in these examples do not support the claims that behavioral law and economics generates greater predictive power than conventional price theory.

is here, over at eCCP, and differs somewhat from Thom’s.

The takeway excerpt is:

Credit Suisse has important implications for antitrust practice. The decision’s effect is to narrow the scope of antitrust law and to invite efforts by regulated industries to narrow it still further. The court’s “clearly incompatible” standard is new and (though it purports not to) seems to water down considerably the old “plain repugnancy” test of Gordon v. New York Stock Exchange, Inc. 422 U.S. 659, 682 (1975). Under the new incompatibility standard, there no longer has to be an actual conflict between antitrust and other federal law for antitrust implicitly not to apply. Even a mere regulatory overlap may now be sufficient to trigger antitrust immunity. (Recall that in Credit Suisse the Court assumed that both antitrust and the SEC disapproved of the tying and other practices in question, and yet the Court still considered the two bodies of law incompatible on account of the regulatory overlap.) ….

Going forward, the Court will need to tighten the rule in Credit Suisse if it wants antitrust to continue to operate as Congress intended it to in conjunction with the compartmentalized maze of federal regulatory law. No one thinks that securities firms should be exempt from the legal obligations that generally flow from non-securities law (antitrust aside). If we expect to hold securities and other regulated firms accountable for torts and breaches of contract, or for crimes and discrimination, then why not also hold them accountable for antitrust violations? If Congress says otherwise, that is one thing. But if Congress is silent on the question, a federal agency should not have have any more power than a state to confer antitrust immunity upon those that it regulates. Of states we require a clearly articulated policy that presents an actual conflict, not merely the possibility of future potential incompatibility. From federal agencies we should not expect any less.

Just yesterday, in its historic decision in Leegin, the Court strongly reaffirmed its confidence in the Rule of Reason’s workability by overturning Dr. Miles and extending the rule’s reach to vertical RPM. That workability should make us equally confident that antitrust can peacefully coexist with the reguatory state.

Marginal Revolution’s Alex Tabarrok has a good post responding to recent attacks on the extension of credit to poor borrowers (and in particular, this rant from Nouriel Roubini).  Here is a taste:

Roubini and others generating hysteria about defaults in the mortgage market are credit snobs - they think credit is something that only the rich can handle.  Just look at the language that Roubini uses to analogize borrowers - they are “reckless patients” who “spent the last few years on a diet of booze, drugs and artery clogging junk food.”  Similarly, the Washington Post tells us that it’s the end of the “borrowing binge.”

Yeah, we get it.  Credit is ok for us, the “sober” borrowers but poor people can’t handle credit.  Too much credit among the poor generates decay and social pathology.  Credit must be regulated.  We can’t, for example, have credit stores in poor neighborhoods.  Don’t you know that credit is bad for people without self-discipline?   Let the poor buy on installment credit?  That’s unconscionable.  Today’s furor over sub-prime mortgages is the same old story.

Basic economics says that people should borrow so that they can consume based upon their permanent income.  Modern day financial markets are finally making this possibility a reality.  Combine financial innovation, strong US economic performance and a global savings glut and it makes sense that credit should become easier to obtain.  We see the benefits of financial innovation in bringing credit to the poor not just in the United States but around the world.  Will Roubini next be calling for the retraction of Muhammad Yunus’s Nobel Prize?

Check out the comment thread too.  It’s pretty good.

Peter Klein’s post over at the always excellent Organizations and Markets reminded me that I have been wanting to blog about the most recent exchange between Ben Klein and Ronald Coase over the asset specificity, vertical integration, and the famous Fisher Body - General Motors example which has become a classic example of hold up in the literature. While this example from the original Klein, Crawford, and Alchian (1978) piece is almost 30 years old, and has been the subject of literally thousands of pages of debate and an entire JLE issue (April 2000), there is still some disagreement over the facts and what they tell us about the relationship between asset specificity and vertical integration.

In some ways, this newest part of the exchange is much ado about nothing in so far as it will not add much to our fundamental understanding of the theory of the firm. The holdup theory and the relationship between asset specificity and vertical integration is perhaps the most empirically tested economic propositions of modern industrial organization. On the other hand, there is probably something to learn from the most recent (and most heated in terms of tone) exchange in terms of both (1) what actually happened with the Fisher Body-General Motors relationship, and (2) the process of academic discourse in economics.

Recently, however, the debate (which had been dormant for awhile) got a tad bit uglier. Apparently, Klein had obtained a copy of the original 1919 Fisher Body-General Motors contract which had been previously unavailable and sent the contract and an early version draft of his new paper to Coase who responded with the publication of “The Conduct of Economics: The Example of Fisher Body and General Motors,” which is essentially an attack on Klein’s account and April 2000 JLE response. Coase essentially alleges that Klein made up the Fisher Body story to fit the theory but that a hold up “never happened” because Fisher Body did not actually mislocate plants or adopt an inefficient low-capital production technology which were the two mechanisms for holdup Klein had previously discussed (more on what actually did happen later). Coase goes on to criticize economists more generally for a failure to check facts and propensity to rely on theory alone.

Klein has now responded with “The Economic Lessons of Fisher Body-General Motors“, which has been posted on SSRN and is forthcoming in International Journal of Law and Business. Here is the abstract:

The costs of using rigid, inherently imperfect, long-term contracts to solve potential holdup problems, and the corresponding flexibility advantages of vertical integration, are illustrated by the Fisher Body-General Motors case. The holdup of General Motors by Fisher Body is shown to have involved Fisher renegotiating its body supply contract with G.M. so that, contrary to the original understanding, G.M. made half of the required investments in new body plants. Under the unchanged cost-plus contract terms designed to provide Fisher with a return on its equity capital investments, the decline in Fisher Body’s capital to sales ratio led to a substantial wealth transfer from G.M. to Fisher. G.M. was forced to accept this unfavorable contract adjustment because it desired co located body plants and was operating under a long-term exclusive dealing arrangement designed to protect Fisher Body’s original G.M.-specific capacity investments. The contract adjustment demonstrates the importance of distinguishing between inefficient threatened holdup behavior and the efficient way it is in both transactors’ interests to actually accomplish a holdup. Contrary to Ronald Coase’s recent criticism, this analysis reconciles all the available evidence.

Klein’s new analysis incorporates the previously unavailable 1919 contract to the existing Dupont case record which showed clear evidence (never disputed to my knowledge) of Fisher Body’s expressed refusal to locate plants adjacent to G.M. facilities and evidence of a dramatic increase in Fisher Body’s measured capital to sales ratio after 1922 and demonstrates that Fisher Body leveraged its bargaining position created by GM’s exclusive purchasing commitment to renegotiate a favorable contract adjustment in 1922 prior to agreeing to co-locate plants.

Klein’s analysis adds new evidence (the contract and 1922 contract adjustment) to the factual record and corrects the details of his previous account: it was not mis-locating plants but a threat to mis-locate plants combined with a reduction in capital to sales which resulted in a substantial increase in Fisher Body profits from 1922-26. As Klein writes:

Focusing on the 1922 contract adjustment as the way Fisher Body held up General Motors reconciles all the available evidence. Specifically, the fact that no plants were mislocated and that the contract required Fisher Body to use efficient production technology is fully consistent with Fisher Body’s initial refusal to locate body plants adjacent to GM assembly facilities, the reduction in Fisher Body’s actual measured capital to sales ratio and GM’s complaints about the extra costs it was bearing due to Fisher Body’s reduced capital intensity. Moreover, the contractual adjustment is consistent with the economic theory of holdup behavior, where transactors will attempt to hold up their transacting partner in the most efficient manner.

I will leave to readers to work through both the Coase and Klein articles on their own, but I thought I might share a few reflections on this exchange below the fold.

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Steve Levitt thinks that tenure is overrated. But relative to what? Levitt proposes doing away with tenure because it distorts the incentives of scholars to front load their productivity and then ride off into the sunset after tenure is granted. Surely he is right about this incentive effect. Levitt also makes quick work of the frequently raised defense that tenure is necessary to protect those doing politically unpopular work and adds that:

If the U of C told me that they were going to revoke my tenure, but add $15,000 to my salary, I would be happy to take that trade. I’m sure many others would as well. By dumping one unproductive, previously tenured faculty member, the University could compensate ten others with the savings.

It must not be that simple because few schools have tried, and my sense is that those that took a stab at it capitulated quickly and reinstated tenure. What am I missing?

Levitt’s post provoked a response from Greg Mankiw suggesting that the piece Levitt is missing is faith in markets:

My guess is that a more typical faculty member would place a larger monetary value on having tenure. If so, universities may well be better off by paying lower salaries to tenured faculty, despite the adverse incentive effects, than paying higher salaries to professors without tenure. In other words, Steve thinks the competitive market for professors is resulting in inefficient contracts, while I believe that, absent any reason for market failure, the labor contracts we observe are likely to be efficient. (We Harvard profs always have to remind those Chicago guys that competitive markets work pretty well.)

The last paranthetical line is pretty funny. But it is true that there is some tension in Levitt’s claim that we should believe in competitive labor markets to protect those fired for political reasons but not to produce efficient labor contracts in the first instance. Perhaps he has something in mind to reconcile these claims, but color me skeptical for the moment. While I don’t pretend to know the precise form of the optimal labor market contract in higher education, markets have a remarkable history of producing efficient contractual forms and institutions that economize on these complex and dynamic costs. The persistence of these contractual forms is probably a fairly good sign that it is efficient.

However, the enormous complexity of the tradeoffs involved in altering the dynamic incentives of scholars within a department would appear to cut both ways. And probably across institutions as well. For example, a second tier school whose hiring strategy involves a greater reliance on “gambling” on young scholars and weeding out those that underperform at the tenure stage might face vastly different incentives than a top 10 law school facing very different constraints. One can also imagine other dimensions on which the tenure considerations and optimal “lifecycle” productivity incentives for scholars might vary across departments and universities. With all this variation between and within universities why the near universal adoption of tenure despite the obvious incentive costs that Levitt identifies?

Perhaps the attacks on the tenure are a good example of the nirvana fallacy. The tenure system is not perfect. But while it distorts incentives, perhaps these effects are dominated by the costs of the alternative governance institutions and contractual forms? But are these alternative forms really that bad?

The most likely alternative candidates are delegation of more power to the Dean or other senior faculty members. Mankiw describes some of the problems with the former and Dan Solove over at Coop explores some issues with the “firing by faculty” model. But the inefficiences cannot just be a few bad decisions made for political reasons. As Levitt suggests, the market will protect those productive professors who are fired for political reasons. There are examples abound that suggest he is right. But maybe something larger is at stake. Perhaps the increased divisiveness and resources devoted to these sorts of decisions by the faculty at reduces productivity. But are those effects so large as to swamp the beneficial incentive effects of doing away with the tenure system? It is hard for me to believe this. Mostly because GMU is a place that is very conducive to and rewarding of productivity. It is tough for me to imagine a set of political issues that would actually reduce my own productivity (lots of other things: blogging, March Madness, poker … but not faculty politics). But I’ve also only been a faculty member for a few years and perhaps I am too green to understand how ugly things can get in other places.

All of this leads me to more questions than answers. Does the tenure model really reduce faculty divisiveness relative to alternatives? Does this argument imply that faculty collegiality (or at least, lack of divisiveness) really has productivity effects? Should untenured faculty members blog about tenure and effects on productivity instead of writing? Is my Dean reading this? Gotta go.