Thursday, July 5, 2018

Review of The Collected Works of Armen A. Alchian: Volume 2 by Armen A. Alchian

Since reading about Armen Alchian and writing about his Vertical Integration and Appropriable Rents paper, I have been wanting to read more of his work. To give you a sense of his style, his college textbook begins:

"Ever since the fiasco in the Garden of Eden, most of what we get is by sweat, strain, and anxiety. Two villains – nature and other people – prevent us from getting what we want. Nature is niggardly: it provides fewer resources than we could use, and much of what is available is made useful only by hard work. As for other people, the problem stems not from malevolence: their wants and ours simply exceed what is available."
I have had his textbook on my list to read, but when I was in a used bookstore I saw a collection of his work on property rights and economic behavior. It has a libertarian bent - one of his initial claims is that the "freedom to acquire and dispose of property rights plays a fundamental role in ensuring that assets reach and remain in their highest valued uses." Another funny question he asks is, "How do we make a voter bear the cost of bad judgment in his votes?" If only we could.

The most interesting paper is still Vertical Integration and Appropriable Rents. Much economics literature, including Alchian's work, is about why firms exist - beginning with Coase's transaction cost theory of the firm. (The "why firms exist" question is really asking why any particular firm is one firm and not two or N firms.)

Why does a newspaper company typically own an editorial content production business AND a printing business, when it could be two firms - the content firm outsourcing the printing of the newspaper to the printing firm? The usual transaction cost explanation does not work very well here. Also, book publishers and magazine publishers tend not to do their own printing. And that is the clue that leads to the Alchian "appropriable rents" explanation. The newspaper printing press is more specialized to the printing of the newspaper than other presses are to books and magazines, because newspapers are far more time sensitive than those other types of publishers. Also, the newspaper is more vulnerable to "opportunistic" behavior by the owner of the press than a book publisher would be. Even if the terms of the printing arrangement are contractually very well specified, an independent press owner would more easily be able to hijack the newspaper's profits through threats of production delays or by alleging higher production or maintenance costs

Thus, Alchian's theory is that if a substantial portion of the value of an asset is dependent on some other particular asset, both assets will tend to be owned by one party, forming a vertically integrated "firm". If you read Phil Greenspun's explanation of why airlines lease aircraft, it is a clear appropriable rent explanation, except in reverse:
A competent pilot union negotiator will present the airline with a plan to transfer essentially all expected future profits into the paychecks of pilots. It does not make sense to accept less because the pilots always have the power to strike and shut the airline down. The only real point of discussion would concern the best estimate of what the airline's profits are likely to be during the term of the contract.

During periods of economic growth, the negotiators peering in the future will tend to see a picture of increasing profits and therefore the airline will agree to substantial pay and benefits increases for the pilots. Should the economy turn down during the contract period, the pilots, having expected to collect 95 percent of the airline's profits, will in fact be entitled to 115 percent of the airline's profits. As the airlines tend to operate with fairly small reserves, paying out 115 percent of profits results in the airline seeking Chapter 11 bankruptcy protection and a federal judge adjusts the pilot union contract so that the pilots are back to collecting 95 percent of the new estimated profit figure.

This cycle of union contract negotiation and Chapter 11 bankruptcy is one reason that the airlines lease rather than own airplanes. By having the main assets in the hands of third parties, it turns out to be a reasonably efficient way of allocating airline profits. The stakeholders who suffer the most are public equity shareholders (the "widows and orphans"), who get wiped out with every bankruptcy filing. The leasing companies get paid, the airline executives get paid, the unionized workers get paid as much as possible, lawyers and Wall Street banks get fees from every bankruptcy, and the public shareholders get 5 cents back for each dollar that they invested.
Most entrepreneurs can sense when a specialized investment would be appropriable, and therefore unwise, but investors do make this mistake and then get held up now and again. An example that occurred to me was GT Advanced Technologies, which supplied sapphire screen material to Apple. Enticed by Apple's order sizes, they made very specialized investments in expanding furnace capacity but ended up going bankrupt after Apple kept squeezing them.

The Appropriable Rents paper is Alchian's second-most cited (by 8k papers). The most cited, which is in this compilation, was "Production, information costs, and economic organization" with Harold Demsetz. However, in a later talk called "Reminiscences of Errors" (in this compilation too), he explains why he thinks that 1972 paper is "partially obsolete".

So Alchian is known for the Appropriable Rents paper and it is the most interesting one (at least in this collection) for investors to think about. Unless you are interested in the history of the libertarianish law and economics movement or very interested in the theory of the firm, I would stick to that one paper.


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