The Mythical "Seven-Percent Rule" for Downsizing

James Surowiecki takes a look at whether downsizing has proven to be a successful strategy for revitalizing struggling businesses:

It’s the Workforce, Stupid!, by James Surowiecki, The New Yorker: In the nineteen-nineties, with U.S. corporations in the midst of what the Times called “the downsizing of America,” a new term appeared: the “seven-per-cent rule.” It was a simple formula: when a company announces major layoffs, its stock price jumps seven per cent. ... So when, recently, two companies with lagging stock prices—Circuit City and Citigroup—announced major job cuts, one might have expected their stock to soar. Instead, Circuit City saw its stock price tumble four per cent the day after it announced it was getting rid of thirty-four hundred of its most experienced sales associates, and Citigroup’s stock barely budged when it said it would be cutting seventeen thousand jobs.

This may have surprised the executives who had planned the cutbacks, but it shouldn’t have. Over the past decade, many academics have looked at how layoffs affect stock prices, and they’ve found that the seven-per-cent rule is bunk. Instead of rising sharply, the stock of companies that trim their workforces is likely to fall. A recent meta-study ... concluded that, on average, markets had “a significantly negative” reaction to job cuts. ...

Downsizing may make companies temporarily more productive, but the gains quickly erode, in part because of the predictably negative effect on morale. And numerous studies suggest that, despite the lower payroll costs, layoffs do not make firms more profitable...

If the track record of layoffs in improving corporate performance ... is so mediocre, why do executives still find them tempting? One reason is ... the vividness heuristic: the tendency to give undue weight to particularly vivid or newsworthy examples. In discussions of downsizing, you don’t often hear about all the companies that cut payrolls and then continued to struggle. Instead, it’s the stories of companies that have reaped dramatic benefits from downsizing ... that become templates for how the process works. Executive overconfidence exacerbates this problem: a C.E.O. is far more likely to see himself as capable of pulling off what Jack Welch did at G.E. than to recognize the probability that layoffs will make only a trivial difference.

The increasingly short-term nature of C.E.O.s’ jobs, along with the pressure ... to deliver results quickly, doesn’t help matters. The average C.E.O.’s tenure today is just six years, long enough to see the benefits of downsizing (like a lower payroll) but not long enough to suffer costs that may appear in the long term. ...

The word “downsizing” wasn’t even invented until the mid-seventies. The waves of layoffs that began at the end of that decade and peaked after the recession of 1990-91 were largely a response ...[from] manufacturing companies swamped by foreign competitors and stuck with excess capacity. More recently, however, downsizing has become less a response to disaster than a default business strategy, part of an inexorable drive to cut costs. That’s why Circuit City can proclaim, “Our associates are our greatest assets,” and then lay off veteran salespeople because they earn fifty-one cents an hour too much.

There’s nothing wrong with cost-cutting, and in any dynamic economy layoffs will be necessary. The problem is that too many companies [evaluate] workers solely in terms of how much they cost, rather than how much value they create. This is understandable: after downsizing, it’s easier to measure a lower wage bill than it is to see the business the company isn’t getting because it has too few salesmen, or the new products it isn’t inventing because its R. & D. staff is too small. These lost opportunities may be hard to measure, but over time they can have a huge impact on corporate performance. Judging from its reaction to layoff announcements, the stock market understands this. It’s time executives did, too.

I'll add, in very general terms, that there are three types of downsizing that can occur. The first is the result of a change in demand, e.g. foreign competitors produce the goods cheaper or consumers change their preferences and no longer purchase as many of the goods. For example, another pizza store opens down the road (or in China) increasing the competition and you need one less delivery driver, so you downsize, that sort of thing. But there's no fundamental change in technology within the firm.

The second is to eliminate waste and inefficiency due to bad decisions in the past. Here you don't eliminate the pizza driver because demand has changed, demand is the same, the problem is that you hired too many drivers last month and, realizing that, you reduce the number. Rescaling in response to changes in demand, or eliminating efficiencies at the given scale of operation seem to be the type of downsizing described above.

The third type of downsizing is driven by technological change, i.e. from changes on the supply side. Automating a production line to reduce costs per unit would, for example, downsize the labor force in a firm. A new factory could put a large part of a town dependent upon the factory out of work. Unlike the downsizing described above, which may or may not increase profit depending on factors such as whether it is cutting waste or changing the scale of operation, a technologically driven downsizing should, in general, increase profit. (And, as noted in the article, another way to reduce profit is to eliminate workers you mistakenly think you don't need in a cost-cutting frenzy, but really do need, or from layoffs caused by mismatches between the short-term incentives of the executive and the long-run incentives of the firm.)

One last thought. A "vividness heuristic" may be at work here too. Large-scale layoffs attributable to foreign competition make the news and grab lots of attention (hi Lou), more so than layoffs from technological change, though these get attention too at times. But it does seem, for example, that globalization gets more blame than the internet when jobs are electronically outsourced even though technology is driving the change.

Update: Circuit City's Job Cuts Backfiring, Analysts Say

Comments

[kharris]

You have ignored one category of layoff, one that helps explain why the stock of firms announcing layoffs don't necessarily rise in response to the announcement.

Some firms manage expenses to hit short-term targets. If sales are lagging projections, then the manager can still come close to the revenue or margin target by reducing costs. It is pretty obvious that not all cost cutting is created equal. If a firm has a certain minimum staffing needed to maintain quality or meet longer-term plans, cutting to meet short-term targets diminishes the firm's longer-term prospects.

If "vividness" is what is wanted by the manager making the cuts, then there is a strong reason to suspect the manager is more worried about appearances in the near term than performance in the longer term.

[knzn]

Statistics (most clearly, the Business Employment Dynamics data, but other data confirm the conclusion) show a much lower rate of job destruction today than 10 years ago, and by most statistical indications, the rate 10 years ago was lower than 20 years ago or 30 years ago. I definitely get the impression that, over this time that job destruction has been declining, people have come to feel less secure in their jobs, which is something of a puzzle. Perhaps the problem is that it has become increasingly hard to find a new job once you lose your old one. (That’s almost a direct implication of the reduced rate of job destruction: if the job destruction rate falls, the job creation rate also has to fall; otherwise employment will grow too rapidly and soon use up the entire labor force.)

[Bruce Wilder]

rents, rents, rents

imports of manufactured goods, deregulation (particularly in transporation), Wal-Mart, etc. all meant the elimination of jobs, where people were earning significant rents -- that is, they were paid significantly more than they would be, in their next best job.

What makes losing a job costly is the loss of rent -- the reduction in income that can not be duplicated. If you lose a job and immediately get another that pays the same, the job loss is merely annoying, the costs limited to the transition cost.

Use of a large, bureaucratic organization by a for-profit business enterprise implies that there exists some economic value in telling people what to do, that is in supervising and coordinating their activities, in a way that achieves compliance to command. For such hierarchies to work, the organization has to be able to use its labor well enough to earn and pay a rent directly related to being employed by that particular organization, so that losing the job is costly to the employee.

If being able to tell the employee, in detail, what to do and how to do it, did not produce enough economic value to pay a rent, then the company would simply buy the equivalent service at the market rate, and not enter into an employment relationship.

Obviously, in the real world, not all employment relationships are created equal -- some are close equivalents to buying a labor service at market. The classic corporate job, complete with health benefits and pension, however, did earn the employee a rent and the corporation loyalty and obediance.

My analytical point is that the existence of large, bureaucratic enterprises implies that they are paying labor rents, and are technically efficient enough to augment labor productivity by the amount of the rent.

In interpreting the real world, there are a number of caveats to be applied. Obviously, in the real world, not all employment relationships are created equal -- some are close equivalents to buying a labor service at market. The classic corporate job, complete with health benefits and pension, however, did earn the employee a rent and the corporation loyalty and obediance.

In the real world, being able to pay a rent, and therefore to build a great organization, is not going to be exclusively a matter of bootstrapping off of the technical efficiency of the organization, itself. Most companies are built on some "equity" resources, which earn large rents, and insure the company's results and continued existence -- a technology, franchise, reputation, etc., which allow the corporation to attenuate risks. These can and do involve various barriers to competition, which give the phrase, rent-seeking its pejorative content.

The existence of/potential for rents in business and employment was an important factor in creating the need and opportunity for unions.

To me, the key phrase in the post is:
"The problem is that too many companies [evaluate] workers solely in terms of how much they cost, rather than how much value they create."

Great organizations are capable of achieving a high degree of technical efficiency from figuring out what people should do and getting them to do it in a regimented fashion.

Layoffs, Surowiecki seems to be trying to say, can represent giving up on that capability, that potential, and with it the ability of a lot of people to earn a decent living.

The issue here should not be reduced to how frequently layoffs happen.

The issue ought to be whether large organizations are well-enough managed to produce the technical efficiency and labor rents we should expect.

[cm]

knzn: Bingo. What you are describing happened "back then" (in the "good old days"?) was perhaps largely "creative destruction", where jobs disappeared largely because of aggregate structural turnover into different jobs. Today if there is a "creative" part, it may be happening elsewhere and not here. Also it is perhaps not just a matter of the sheer number of jobs. When looking at job boards, there seem to be a lot of open positions, but it looks like, along the lines of Bruce Wilder's words, the have the "rents" stripped from them.

[cm]

And then don't forget the useful aspect of the intimidation mileage you get out of the expectation of the annual 5% "bottom" trimming. The phrase "make sure you are not in the bottom 5%" has surely not been heard from just a few management figures. (It's 5% where I work -- of course not "officially officially" acknowledged but very well made known, perhaps it's different numbers elsewhere.)

This may as well already be priced in as a "cost of business" -- just "manage" your workforce size so that you always have a few percent buffer and can easily let a few people go, or conversely hire a few bodies now and then when the squealing of your overworked people filters through the management chains. Shouldn't be a problem in large companies with heavily diluted expense structures.

[Bruce Wilder]

The dynamic implications of significant progress in improving a hierarchical organization's efficiency and productivity are not always going to be reward for virtue.

It is a messy, unvirtuous world out there, not at all as Dr. Pangloss would imagine it free from constraints on the possible.

If efficiency/productivity improves 10% and sales increase 5%, something has to give.

People often make the point that aggregate productivity tracks wages. But, that doesn't work at all in the disaggregate. Improving productivity is likely to benefit those improving their productivity not at all.

[Tom Geraghty]

Maybe this has something to do with it:

Downsizing in America: Reality, Causes, And Consequences:

From the Publisher -- Baumol, Blinder, and Wolff also reveal what they call the dirty little secret of downsizing: it is profitable in part because it holds down wages. . . . reducing employee rolls increased profits, since downsizing firms spent less money on wages relative to output but it did not increase productivity. . . . downsizing transferred income from labor to capital - from workers to owners.

[robertdfeinman]

If we take as a given that the rise of computerization led to a boom in productivity then there are two countervailing forces at work now.

First, the gains from going from manual to computerized have mostly been realized, so the one-time jump in efficiency is over. If you buy a nail gun to replace a hammer then upgrading to a new model isn't going to get you the same benefits.

Second, computers have started to become a serious overhead issue of their own. Instead of just replacing adding machines and filing cabinets they are now being used for communications and transaction processing. These new areas have exposed firms to all sorts of technical problems and risks. We are all familiar with stories of computer viruses, but if you follow the trade press you will see that there are dozens of products being offered to help deal with problems. These include things like optimizing network traffic, to supporting wireless devices, to managing the power and air conditioning in distant computer centers remotely.

So, perhaps, a lot of the layoffs starting in the 1970's were, at least indirectly, related to computerization and getting rid of people did save money. Now firing people may be just an indication that the firm is no longer growing and needs to retrench. No wonder the news isn't met with enthusiasm.

[James Killus]

Bruce Wilder,

I know the term has a long history, but I don not think it either fair or accurate to apply the term "rent" to everyone who is "paid significantly more than they would be, in their next best job."

Someone who has a marketable high skill, say a construction ironworker, may be laid off for all sorts of market reasons having to do with a decline in ironwork construction in his area (spike in interest rates, new zoning regs, some completely new technology). The difference between his ironworking wages and fry cook is not a "rent" by any standard I can discern; it is a market decline for his investment in his skill set.

I think it might be useful to consider reasons for layoffs that do not involve "rational" decisions. The fact is that many managers hate workers, and other managers like to be seen as "tough." Add to that the fact that it is upper management that makes the decisions to have layoffs, while it is front line management that must actually decide who is laid off and/or tell the workers that they are being laid off, and there you are.

By the way, folks, layoffs often fail reduce costs short term, due to severance costs. You do get the "one time charge against earnings" phenomenon, but the stock market may have caught on to that scam.

[anne]

http://www.nytimes.com/2007/05/01/business/01labor.html?ex=1335672000&en=5968d6894addb84f&ei=5090&partner=rssuserland&emc=rss

May 1, 2007

Wal-Mart Accused of Labor Violations
By STEVEN GREENHOUSE

In its first study of how an American company treats its workers, Human Rights Watch asserted yesterday that Wal-Mart's aggressive efforts to keep out labor unions often violated federal law and infringed on its workers' rights.

Human Rights Watch, which typically focuses on rights violations in Burundi, North Korea or other foreign countries, found that when Wal-Mart stores faced unionization drives, the company often broke the law, by, for example, eavesdropping on workers, training surveillance cameras on them and firing those who were pro-union.

"While many American companies use weak U.S. laws to stop workers from organizing, the retail giant stands out for the sheer magnitude and aggressiveness of its anti-union apparatus," the human rights group wrote.

Wal-Mart Stores has more than 1.3 million workers at its nearly 4,000 stores in the United States, and none of those workers is unionized.

Wal-Mart, in response, vigorously defended its labor practices. David Tovar, a Wal-Mart spokesman, said that Wal-Mart provided an environment for open communications and gave its employees "every opportunity to express their ideas, comments and concerns."

"It is because of our efforts to foster such an environment that our associates have repeatedly rejected unionization attempts," he said....

[Bruce Wilder]

To address JK's concerns:

I think your example of the iron-worker, who becomes a fry cook, is, indeed, an example of someone losing their investment in human capital skills.

Analytically, the human capital skills of an iron worker are a sunk cost investment, and the returns on those investments are, properly, termed a quasi-rent. Returns on a sunk cost investment are termed quasi-rents precisely because they resemble rents in certain respects.

I was trying to draw attention to the fact that employment in large organizations is associated with an expectation of a higher wage, and that is part of what make large-scale layoffs costly for people. Large, bureaucratic organizations pay those premiums, those labor-rents, to induce obediance, and large organizations can pay those labor-rents, because, they can increase the productivity of the people they hire by improving technical efficiency through management (telling people what to do and when to do it, in accord with a rational plan).

To my mind, an extreme example of organizational efficiency would be an automobile assembly plant, where thousands of people work together in one place, assembling out of hundreds or thousands of parts, an automobile worth tens of thousands of dollars. Assembly-line workers do not have "skills" in the sense of the craft skills of an ironworker. But, they can make very good money, from their willingness to show up on time and do what they are told to do, (no matter how mind-numbing it may be). In an auto assembly plant, the task of an individual worker is usually reduced to something that takes under a minute (the base task cycle time of auto assembly plants is usually set under 1 minute, equivalent to an output of 60 autos/hour).

I would not discount the importance of having a lot of people in an auto plant, who can understand how the system works, and how to make every minute aspect of the system adapt and improve. Dynamically, the ability of workers to, say, apply methods of statistical quality control matter.

But, my point is that the organization and its technical efficiency can and do create productivity and labor-rents quite apart from what we might conceive of as a marketable craft skill.

In relation to trade policy, it ought to be noted that high productivity, high wage organization falls into the category of "increasing returns" formation.

[TJM]

kharris:If sales are lagging projections, then the manager can still come close to the revenue or margin target by reducing costs.
As I'm sure you know, revenue is not increased by reducing costs. But I think what you meant, about margin targets, depends on the time frme involved. Financial statements lag, sometimes by as much as 30-45 days in public companies.
Being involved with restructurings for the last 25 years, I can tell you that it is virtually impossible to save (cut costs) your way to prosperity.
Downsizing has unintended consequences as well, in that the most mobile employees (those not just skilled but capable) often prove how mobile they are to the manager who looks solely at costs.

[Bruce Wilder]

I think the labor-rents from organizational efficiency figure in the skyrocketing compensation of CEOs. I think CEOs are, in effect, skimming labor-rents from lower level employees, as opposed to cheating stockholders (although, of course, cheating stockholders also goes on).

Paying labor-rent is related to the way the organization functions, though -- its economic function is to induce loyalty and obediance to satisfy the requirements of organizing of technical efficiency. So, skim enough labor-rent, and the organization gradually weakens in its ability to produce technical efficiency, because the workforce becomes more difficult to select and discipline (selection and discipline, like adverse selection and moral hazard, being two aspects of the same thing), or more stressed out and frustrated and dissatisfied, less loyal, etc.

(If someone wants a test of my labor-rent skimming hypothesis, I'll suggest that CEO compensation is better predicted by the number of employees than by the company's profitability or growth.)

[Barry]

Knzn: " I definitely get the impression that, over this time that job destruction has been declining, people have come to feel less secure in their jobs, which is something of a puzzle. Perhaps the problem is that it has become increasingly hard to find a new job once you lose your old one. (That’s almost a direct implication of the reduced rate of job destruction: if the job destruction rate falls, the job creation rate also has to fall; otherwise employment will grow too rapidly and soon use up the entire labor force.)"

As you've pointed out, it can be very, very hard to find a well-paying job once laid off (IIRC, there've been numerous studies which show that the wage reduction effects are either permanent, or very long-term).

An additional reason for increased insecurity is that people have realized that continual 'downsizing' is a way of life, now. It's not just during recessions, or if your employer is being slammed; it's for all seasons.

[James Killus]

I think that by the time a term as grotesque as "labor-rent" appears, it is time to cook up a term that better describes the situation.

There are no skills that exist without relationship to the general circumstances. But one might obtain some better measure of insight if one looks at such characteristics as fungibility, training, "sweat equity in the sunk cost," etc.

Perhaps this has to do with me being prissy, but "labor-rent" does feel a little like disrespect for those who are the target of the term.

[Bruce Wilder]

A rose might be a rose by another name, but economics cannot function without an awkward and ugly jargon -- so have the gods decreed it.

If I were going to discard a term, it would be "skills".

Economic commentary is always in severe danger of deteriorating into mindless moral hortatories favoring thrift, hard work, sound money, balanced budgets, trade surpluses, more education, etc. "Skills" is a term of little use in real economic analysis, but all too easily exploited by those certain that the right economic policy is in accord with their moral ideals.

[Bruce Wilder]

Just to clarify, I did not intend to denigrate anything James Killus wrote. Just not wild about "skills" as a term.

[cm]

James Killus: You may perceive the term "labor-rent" to be offensive; I don't. I can report that several others in my vicinity who I consider to be reasonably well-paid who have looked for other jobs have found that keeps them from leaving as often those "rents" are not matched. Being in a general environment with a rather high specialization of skills, that's admittedly difficult to tell apart from skill/experience premiums. (But then arguably those are precisely rents.)

There is a related phenomenon of e.g. vacation entitlements increasing with "tenure", like 1 day per year of employment. Leave, and you have to start over. That's a kind of "rent" too.

[ninjaplease]

Re: Anne,

Wal*Mart is the means through which Joe-6Pack can actively participate in the global economy, if Wal*Mart treats its workers so badly, then why do they work there? Let THE MARKET decide how they're treated!

Those workers should be thankful they even have those jobs, if rural Chinese could be imported en masse, they could do those jobs at subminimum wage by declaring them all "Managers."

Globalization is truly the way to lower healthcare costs by lowering health-care worker wages.

[reason]

I actually wonder how much of the "downsizing" actually happens. Attention spans are short, announce and then - well forget about it.

One thing that hasn't been discussed here, is the problem with the loss of knowledge during downsizing. The management class rarely knows how to run the business (as against knowing how to "manage" the business), and sometimes they don't know who does.

[cm]

reason: But then if you manage to hold your turnover rate low enough, things quite likely will somehow work out, as at least in an established, low-growth business surprisingly many things can apparently run on "autopilot", or to rephrase that, if you don't depend on a lot of innovation, it is always far easier to tweak an existing system (no less by people you have been there for a while) than breaking new ground. And then it's not like you cannot replace key positions -- being an established industry, there are enough takers who had had it at your respective competitors. If that should fail, you can always "focus on your core competencies".

[James Killus]

Let me put it like this. It appears to me that the term "rents" has come to mean "any payment that exceeds what would be predicted by a perfect competition commodity model." If I am wrong about that, I am hoping to be enlightened. If that is the correct observation, however, then "rent" has become both hostage to a (not very realistic) model, and also so broad as to become essentially meaningless.

I understand Bruce Wilder's objection to the word "skill," though I might have couched it more in terms of antipathy to its obverse, the word "unskilled," which usually constitutes a bundle of capabilities that are supposedly possessed by everyone whose labor is of value. That then slides the least-common-denomenator-weasel-word to "worker." Someone who lacks the basic commodity skills cannot be a "worker," thus becoming of less value than certain sorts of dogs, horses, and chimpanzees.

Which reminds me: Cheetah is 75, having lived an astonishingly long time for a chimpanzee, as well as far surpassing most actors in Hollywood in fame, and, perhaps, acting skill. Hurray for Hollywood.

[cm]

James Killus: Why don't you put forward your definition of rent, and how you would describe the phenomenon that Bruce Wilder and myself were referring to. I mean this seriously. I think your characterization of how I interpreted the term (I'm not going to speak for Bruce on this count) is largely correct.

[cm]

And when speaking of weasel-words, what are you referring to and why are you putting a negative connotation on it?

[James Killus]

Reasonable questions, cm. Let me note that my complaints have to do with distinctions. For example, certain economic outcomes are very much a matter of chance. I would not consider someone who wins the lottery as having collected a "rent," for example, despite his/her having an outcome that is very much above the commodity level (expected value of a lottery ticket). I would call that a "jackpot," as it is a more descriptive term.

Similarly, if someone is better at poker than others, I would not call that person's desire to play poker, rather than, say craps, to be a matter of "rent seeking behavior." It looks more to me like specialization and competative advantage. If the person isn't the best poker player, but still does better at poker than at craps, then it would be a comparative advantage. So I'm still not wanting to use the word "rent," despite the likelihood that the individual is doing better than a pure commodity market would indicate.

Marketable labor capabilities (which I'll attempt to use in place of "skills") are not transferable to any real extent, so they are almost totally illiquid. I may observe that one of the criticisms of the comparative advantage model is that it makes an assumption about capital being relatively immobile, which may not be the current situation. Investments in labor skills (nope, just can't seem to get away from the word), on the other hand, only move with the labor force itself, the international flows in labor are much less than flows of manufactured goods. In any case, "human capital" (an even worse phrase than "skilled workforce") looks to be more illiquid than even land, but less mobile (currently) than what is usually called "capital" (which is to say, money). Each should be modeled differently, so I feel that merging the terminologies invites misinterpretation, and probably fuzzy thinking.

As for "weasel words," I was trying to get across the point that every "unskilled worker" I've ever known actually has many skills. A friend of mine once complained about IT managers wanting "60 watt programmers," the notion being that programmers are not, in fact, interchangeable. I have the same view of workers generally, and I think that there is a managerial tendency to believe that the reverse is true.

Bottom line: some people, for various reasons, are better at some tasks than others. To call an attempt to match the tasks with the people who do them the best "rent seeking behavior" seems weird and opaque to me. The same is true about the desire to perform tasks that pay the most. This may perhaps reflect my writerly desire to have terminology that is clear and unambiguous.

I'll also note that an awful lot of what is often called "rent seeking behavior" looks more to me like "tax farming," a phrase that has a more interesting origin.

[cm]

James Killus: Interesting points, but I don't see my question answered. It is understood that a "trained up" worker (on the specific product, work environment, and the local human/social factors) represents a higher value than a likewise credentialed worker across the street. And if that justifies a premium beyond the expected cost of getting that other guy up to speed, you can call that a risk premium, but can you not also look at it as Joe collecting a rent just for being himself, in his capacity of making a known contribution and being a known risk, warts and all? Like your staying with a good mechanic/dentist/hairdresser once you found one with whom you are satisfied, even if cheaper competition is around and there are one or two minor things that could be better. I'm quite sure that's what Bruce Wilder was referring to too.

What regards fungibility of programming skills, I'm sure you are familiar with the concept of Taylorism and the mildly but far from impressively successful attempts at applying it to higher-complexity jobs where the complexity cannot (so far?) be captured in a practical rulebook. What makes "unskilled" or "low skilled" jobs that is precisely the amenability to standardization on lowest-common-denominator skill requirements (and nominal ones at that, some requirements are always hidden as they defy formalization, or are in cases illegal). Many confuse that with the actual skill level of the people filling those positions.

[cm]

I'm referring to the particular aspect of Taylorism of limiting job requirements to such an extent as to maximize the fungibility of the job, precisely to remove the potential for an "exceptional" worker to capture rent.

[James Killus]

cm,

My point here is that if you use the phrase "collecting a rent just for being himself," despite the fact that every single word in the phrase is used in ordinary parlance, no one except a trained economist is going to have the slightest idea of what you are talking about. I'll also note that I think it's a dreadful description of the situation, which is to say, no I do not look at the fellow in that way, and think it intellectually dubious to do so. Staying with the "tried and true" can more easily (and correctly) be viewed as the purchase of comfort, or the avoidance of the cost of switching, neither of which even deviate from a commodity model, if you include all the variables in the model.

Now "risk premium" does have some meat on its bones, but it's still limiting to call every statistical or random occurrance "risk." The fact that some people are better at some things than others may well be random, but it isn't "risk" as such.

As for answering your question of what I call "rent," I call it "a payment for the temporary use of some material good." For the range of financial transfers, I usually use words like wages, interest, fees, transfer payments, tolls, taxes, tax farming, privilege, winnings, extortion, and fraud.

I find that people often understand what I mean when I use these words, and when they do not, a little explanation will at least clarify our differences, rather than requiring a few semesters' worth of the glossary of economics.

[cm]

James Killus: In my conceptual framework, "risk" is synonymous with the uncertainty of whether a hypothetical choice absent full information will turn out to be a "good" choice, i.e. serve its purpose and not incur adverse effects (regardless of whether full information is even a well-defined concept under the circumstances). And it is as such applicable to singular events.

[cm]

James Killus: I was just using phraseology I learnt at this very blog and a few others (as somebody for whom English is a second language on top of it).

Please suggest an appropriate term for the phenomenon that a monopolistic or oligopolistic entity charges excessive fees for a product/service you are compelled to purchase e.g. by law or custom, and for which you have to go through them, either by mandate or because they are otherwise the only providers you can use. That's different from extortion, and it's not fraudulent either unless some kind of misrepresentation is involved. Neither is it "just" a fee.

[James Killus]

cm,

When the entity's privilege is due to legal compulsion, I consider it to be a legally mandated transfer payment, the equivalent of taxation. However, governments call some sorts of taxes "fees," thereby playing some word games themselves. But then, that is what governments do.

In some cases, I like the word "toll." I have heard the liscensing fees paid to Microsoft for their OS called both a "tax" and a "toll," the latter because one must pay it to get to what one really wants: the applications that run on the PC.

The notions of "custom" and "habit" generally need further analysis. There is a quaint phrase that used to be in vogue: "good will." In its best usage, it represented an expectation of a certain level of service and insurance against being disappointed or mislead. Misleading someone about the quality of the goods or services that you are selling them carries a whiff of fraud, and trademark piracy (e.g. fake Rolexes) is fraudulent.

Certain sorts of providers of information and entertainment, let's use authors as examples, have become name brands. If I buy a novel by Stephen King or a Harry Potter book by Rowling, there is a certain expectation that it will be a certain kind of work and meet certain expectations. That is "good will" and "reputation" and it can be lost by either of them repeatedly disappointing their readers. This sort of branding brings in greater than commodity income, yet I would never call it "rent."

In conversation with a friend about this, I realized another serious problem with the term "rent" as often applied. I know how much rent I pay on houseing, or an office; I can look at the cancelled checks. But this other "rent" is not directly observable. A worker earns a wage and some fraction of it is "rent." What fraction? Well, out come the models, and the calculations, then there are arguments. Perhaps there is agreement at the end, perhaps not.

So the usage has a history in economics and economists use the term freely, too freely in my opinion. I prefer a more nuanced and descriptive analysis. I especially prefer to not use the same phraseology for observable phenomena as phenomena that cannot be directly observed. I believe this preference is more than just a matter of taste.

[cm]

James Killus: Thanks for keeping up responding. Even though we are getting into hair-splitting territory, here a few more remarks.

Generally, that you cannot quantify something, that doesn't mean it's not there. You can characterize it qualitatively or "abstractly quantify" it, but then we are getting back to "weasel words". Nonetheless quantifying something abstractly in a good-faith conversation is valuable, it may convey a perspective about the thing being discussed on a party that hadn't previously considered that.

The terms "toll" sounds interesting and appropriate, but is nevertheless overly metaphorical.

Concrete examples for my abstractly stated case could be automotive liability insurance (minimum legal mandate, diluted by the "asset coverage" principle), or the expense of a decent funeral (custom). Both of these are, rightly or wrongly, considered to have a "rip-off" component that is substantial right in the range of coverage/service level that is considered to be unavoidable. Compare also pricing of essential vs. discretionary goods/services. Aspects making this difficult to judge involve fixed costs of business and the fact that costs are often heavily diluted, and it's not easy to determine who's actually doing the ripping-off. For example, office rents go by zoning, "location", and the type of business (i.e. the expectation of how much the business can charge the end consumer). I suppose medical practitioners face higher rent per square foot than nail studios, but who knows? Similarly for equipment; I'm not sure whether doctors making out better than the makers/dealers of the equipment doctors need to use by contemporary standards.

[James Killus]

cm,

I agree that calculated, as opposed to directly observed, quantities can be real enough; my concern is to always make the underlying assumptions of the calculation explicit, in order to know when one has exceeded the range of a given model.

I just did a quick review of the Ricardian theory and I note, interestingly enough, that Ricardo considered all land rent (more specifically, all rents on agricultural land) to be what he was labeling; he considered the "natural" rent, which is to say the implied value, of farmland to be zero. This is certainly true in the sense that, given few enough people, the value of everything is zero. So Ricardo was definitely beginning from first principles.

I've more-or-less decided that a subject as broad (and important) as the differential nomenclature in economics, what sorts of things I'd like to see called fees, tolls, subsidies, private taxes (the legal right to demand money from those to whom no service has been provided by the tax collector), etc., should probably be given more attention and length than I can provide here. So I'll probably spend some time on the matter over the next few days or so and post the result to either my web page newsgroup or my blog. I'll try to let you know when (and if) I manage to accomplish that.

[cm]

Thanks, that's much appreciated.

[James Killus]

Just an update. I've started some posting on the rents/tolls thing etc.:

http://unintentional-irony.blogspot.com/2007/05/playing-rent-i.html

Just in case anyone is interested.