Are Good Management Practices Bad?

NBER Paper of the Week #1

The clear NBER paper of the week is “Inefficient Labor Market Sorting”, by Carsten Eckel and Stephen Yeaple. It considers whether better management practices might actually reduce social welfare. This is surprising, given what the first order effect are. Management has an enormous impact on productivity; I am writing a blog post at the moment on it, but the solidest evidence is that of Bloom, Eifert, Mahajan, McKenzie, and Roberts (2013). In a randomized controlled trial, where some firms were randomly selected to receive management training, and some were not, implementing better management practices led to massive improvements in productivity. The profits of treated firms increased by 17%, the equivalent of an additional $300,000 a year in profits. Other literature ties poor management practices to protection from competition. Schmitz 2005 shows how, after the introduction of cheap Brazilian ore imports to the Great Lakes, Minnesotan and Canadian mining companies were able to greatly increase their productivity, in ways which were available to them the whole time but never acted upon while they didn’t face much competition. There are a lot more papers along this line, in the lineage of Harvey Leibenstein’s “X-inefficiency” but these few will suffice. Management matters, a lot, and exposure to competition should tend to induce changes to better management practices, and reallocate workers to the firms which do this.

What works for the individual firm, however, may not scale up to the whole economy. Imagine that there are two types of firms – those with good and bad management practices. Good management practices entail some fixed cost, but allow firms to accurately tell how much each employee is adding to productivity, and pay them exactly that. Firms with bad management practices can only pay the average productivity to each employee. We assume that employees know how productive they are. If so, there is an incentive for above average employees at the firms with bad management practices to leave for firms which pay them their own marginal product, even if they would actually be less productive. In equilibrium, *too much* labor would flow to the most productive firms, and subsidizing less productive firms would actually increase social welfare. The market failure here is due to incomplete information, which is far more insidious than one would think. (Joe Stiglitz wrote a summary in 2000 of the contributions of information economics, which I highly recommend reading).

To illustrate with numbers, imagine that there are two types of firms, productive and unproductive (that is, those with and without good management practices). Productive firms produce an average product of 2 per employee, and all of their employes produce between 1 and 3. The unproductive firms produce an average of 1 per employee, with employee production between 0 and 2. In the former firm, each employee is paid precisely what they produce; in the latter, all workers are paid 1. An employee who produced 2 at the less productive firm would find it worthwhile to switch to a less productive job at the second type of firm, even if they produced less — the best employees leave for jobs where they are paid more, but are less productive. The Bloom et al paper may be picking up a partial equilibrium effect, which would not replicate if extended to all firms in a market. 

Notice that I said may. These are some pretty bizarre conclusions, even from a sensible-on-the-face-of-it model. I don’t really believe it’s the only thing going on in the world, obviously. A subsidy for less productive firms founders upon a lack of a truthful revelation mechanism; it is quite easy to make your firm less productive! More importantly, this distortion is only large if there are a substantial numbers of small firms which do not adopt better management practices. In a world where most firms have adopted the good practices, the distortion from people leaving the less productive firms is reduced. 

In the real world, the zero-profit condition may also be unrealistic. Governments often subsidize small businesses out of pure sentimentalism for small businesses. Many unproductive companies also exist through regulatory arbitrage, and their small size and non-adoption of better management practices is not due to avoiding fixed costs which need always exist. An increase in competition may change more than simply level of competition — it may also change the regulatory environment. Also, firms could be not adopting better management practices because the cost of doing so is dependent upon what everyone else is doing. If so, then subsidizing better management practices increases welfare. We don’t know which world we live in without empirical testing, and alas, this paper does not do that — it only provides suggestions for how one might go about it.

This paper is intriguing in a way few others are. It will likely set off a small literature testing the idea. I hope to write something doing this myself.