Wednesday, June 10, 2009

Labor Unions and Management Incentives

Several commenters on Dr. George Reisman’s recent post at the Mises Blog about the collapse of G.M. have been criticizing him for placing too much of the blame on the Unions and not enough on the company’s management. While I agree that management can’t be let off the hook, I think it is important to realize what an important role the Union’s played in the bad management of the companies they parasitized. As economically informed persons, the readers of the Mises blog ought not to need to be reminded of the importance of incentives. So let us look at the incentives that compulsory labor unionism gave the management of G.M. and the many other companies that they have sucked dry.

In a free market a company’s labor costs (in terms of money) are going to be set by the least efficient producer who is a purchaser of that particular type of labor. In the instance of a car company like G.M. it would compete with other car producers and the producers of motorcycles, trucks etc. for auto assembly line workers. (this is obviously a huge oversimplification of the types of labor, but it works for this discussion) In such a free market, the management of such a company has a huge incentive to increase the long term productivity of its workers. Since it only has to pay the wage set by the least productive company, all improvements in productivity (in money terms) goes to the shareholders, who are likely to award management for this increase in profits. (It should be noted that leading producers may well pay a premium to get the best workers, but that is only if it will lead to increased profits. It should also be noted that the workers will benefit from the increase in productivity due to the fall in the price of the products that they produce, the fall in prices being a result of the increased productivity.) In contrast under compulsory labor unionism, any long term increase in profits will be extorted by the union. (Remember S. Gompers famous dictum about the social responsibility of business being to raise profits. This had the obvious corollary of allowing the union to extort higher money wages.) Thus as long as it is not about to be driven out of business, a unionized business has little incentive to increase the long term productivity of its workers, because the benefit (in money terms) will go to the workers. This is also true of other long term strategies to increase profitability. If the increase in profitability lasts to the next contract negotiation, then the union will claim that the increased profitability justifies higher wages.

In a free market, business practices that increase profits in the short run but are damaging to the business in the long run tend to be weeded out because the difference between such short term thinking and long term thinking is made manifest in the profits and losses of the company. The long term thinking is rewarded and short term thinking is punished. By contrast under compulsory unionization, short term thinking is to a certain extent encouraged. Profits that are made by decisions that are profitable in the short term but destructive in the long term can be kept by the managers and shareholders because they are transitory and already gone by the time the next union negotiations come around. The union can’t get their hands on them. Even worse it becomes difficult to distinguish between long term and short term thinking. From the point of view of an investor looking at two unionized companies or an upper level manager looking at two divisional managers of a unionized company, there is little to distinguish the between the two. If one manager increases productivity, profits rise in the short term and then fall in the long term as they are extorted from the company by the union. If another manager makes a decision to cut corners and use substandard materials, his profits will rise in the short term and fall in the long term as he losses clients. From the prospective of the investor or upper management the results look to be the same, short term profits and long term losses. From one perspective this is a distortion of information in the hayekian sense that leads to bad decision making, but from another perspective one could argue that unionization destroys the difference between good and bad decisions. From that perspective one could argue that there is no good decision for the management of a unionized company to make.

In a free market, losses or even worse the prospect of bankruptcy are to be avoided like the plague. To the extent that senior managers are paid on performance or are even share holders of the company the incentive to avoid losses or bankruptcy are obvious. Further either will make capital more expensive or harder to come by in the future. However under compulsory unionization the incentives are different. The only thing that can make the union willing to moderate its demands or in extreme cases actually offer concessions is the prospect of the company going out of business. (As Eastern airlines shows this is not always true, some unions would rather the company go under than make concessions.) If the union is willing to dicker, then the management gains new a perverse incentive, the incentive to be mediocre. As long as the company is near the edge of bankruptcy management may hope for concessions. As long as the company underperforms, moderate demands can be hoped for. If the company starts to flourish however, the only thing to be expected is more extreme demands from the union. (This is why unions that refuse to budge even in the face of disaster as at eastern airline are acting in a certain sense rationally. Only if an entire industry is threatened does it make sense for the union to make concessions, otherwise they are underwriting the bad management of a particular company and encouraging other companies to get in trouble. This more than anything ought to show the perversity of compulsory labor unionism.) So for a unionized company mediocrity becomes the path of safety for management.

It is quite right to say that truly competent management would not succumb to these incentives, but do the right thing regardless. So, now I want to turn to the effects of these incentives on management and the types of people who are willing to work as managers and who will flourish as managers under the above incentives.

Let us take three managers Manager Able, Manager Bad and Manager Cares-less. Manager Able is the type of person who is conscientious and always thinks things though logically and makes the right choice. Manager Bad is the type we all know if we have ever worked in a large company that is not well managed. He is the type who joins a project just as it is about to succeed and takes the credit. He is an expert at making short term decisions and taking the credit for the short run returns but bails from the project before the long run arrives. In short he is a prick who’s only talents are sucking up and self promotion. Manager Cares-less is also a type we all know, the kind that goes along to get along. If the company he works for is well managed and the incentives are right he will perform adequately possibly even very well, but if not, then not. How will these three managers fare under the above incentives?

Manager Able will ignore the incentives to short term thinking and against long term thinking. He will understand that the long term always comes and that only long term thinking really works. So his decisions will always be to make the right choice. But think what this looks like to higher management, Manager A is always investing the company’s money in projects that make money at first but that start to fail as the union increases its demands.

Manager Bad on the other hand looks wonderful. His projects almost never need increased funding, long term increases in productivity are not for him. He is always cutting expenses that are important in the long run but have no short term impact. Manager B may be wreaking havoc on the company but it is not apparent to his managers, they see the same short term profitability that Manager A achieved but without the initial costs.

Manager Cares-less will at first be somewhat random in whether he adopts long term or short term profitability as his goal, but as the incentives work on him he will start to act in a way indistinguishable from Manager B. This because unlike A who will stand up to criticism from higher management and do the right thing anyway, C will go along with what his manager wants.
From the perspective of higher management A is underperforming, C has trouble at first but improves, and B is a star. Consider who will get promotions, who will leave the company and who will stay.

This only considers the first two incentives. Once the incentive to mediocrity hits Manger A is in even more trouble. He is the one who is always threatening the company with superior performance, that is, with higher labor costs.

Obviously this process will take time. At first a well managed firm will have almost all As and Cs (at this point in a well run firm they will not be easily distinguished.) in management Bs will be weeded out early. But over time the perverse incentives will make Cs act badly and make Bs look good. At first higher management will be overwhelmingly made up of As with a few good acting Cs but as it gets harder to distinguish good performance from bad more Cs good and bad acting, and eventually Bs will end up at higher levels in management. In this context it is significant that G.M. and Chrysler have been unionized for a little more than 70 years, one life time (i.e. three score and ten) or two long generations (i.e. 35 instead of 25 years). This is more than enough time for the rot to become pervasive.

This brings me back to a part of the Dr. Reisman’s post “The philosophical tapeworm lay within the minds of those running the company. For decades, it led them never to take a stand on principle and forcefully resist the UAW. Always the present cost of a major strike was allowed to outweigh the prospect of the ultimate destruction of the company, which was never considered fully real because it lay in the future.” Part of this mentality is the result of the type of person who will work at a unionized firm in face of the aforementioned incentives. At first with long term oriented management there will be attempts to resist unionization or at least unreasonable demands by the union. But as the perverse incentives work their way with the type of people in management the will to resist will be lost. The long term will be unreal to the type of manager who will flourish in such a company.

In sum, it is true that G.M. has had bad management that in part led the company to ruin. But true economists do not look only at surface causes as Dr. Reisman’s critics do. As the late Henry Hazlitt wrote, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” It is above all the policy of compulsory unionization that has led G.M. and many other great American companies to disaster and in many cases total destruction. Dr. Reisman is enough of an economist to understand this and brave enough to say it.